PUBLIC FINANCE AND

TAXATION
Eco 301
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Part Two:

ANALYSIS OF PUBLIC EXPENDITURE

1) Selection of Public Projects

2) Government Provision of Public Goods

3) Government Programs for the Poor

4) Social Insurance Program

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4) Social Insurance Programs

Introduction

Social insurance refers to government-sponsored programs which are designed

to provide financial support to people during the time of need. The main social
insurance programs that currently exist in the United States include: a) Social
Security (officially known as Old Age, Survivor and Disability Insurance OASDI),
which provides families with protection against the loss of income due to death
of a family bread winner, disability, and old age; b) Medicare, which provides
affordable health coverage to both the disabled and those who have reached
the age of 65; and c) Unemployment Insurance, which provides partial and
temporary wage replacement to individuals who have lost their jobs. All of
these programs were originated from the Social Security Act of 1935 and its
many subsequent amendments.
I. Characteristics of Social Insurance Programs
Social insurance programs share certain common characteristics mainly:

1) Benefits, eligibility and other aspects of the program are defined by law.

2) Benefit payments begin with some identifiable occurrence such a retirement,

illness, disability, or unemployment.

3) They are funded by taxes or premiums paid by (or on behalf of) of participants .

4) Each program serves a defined population, and participation is either compulsory

or the program is heavily subsidized that most eligible individuals choose to
participate.

5) Programs are not means-tested, which means a participant receives the benefits
whether or not he/she is in need for financial assistance.
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II. Social Security Program

2.1 Program Development

The Social Security program is the government’s largest social insurance programs. It
was established in 1935 to elevate some of the sufferings created by the Great
Depression. The official name of the program is Old Age, Survivors, Disability, and
Health Insurance, which reflects its various functions.

The program intended to have many of the characteristics of a private

retirement plan in which participants would make contributions while still working in
exchange for benefits after they are retired.

The program has gone through several modifications and its benefits have
expanded a great deal since it was initiated. The program was modified in the late
thirties to provide retirement benefits to participants who reach the retirement age
and also to provide benefits to surviving dependents of those covered. The program
was expanded again in 1956 to provide disability insurance, to those in the program
and expanded in 1965 to give medical benefits to those over sixty-five under the
Medicare program.
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2.2 Program Eligibility

To be eligible for program benefits, an individual must have

worked for at least 10 years in a covered job. Although
benefits are tied to the individual’s contribution level, the
benefits paid do not reflect the present value of past
contributions, as it would be under a private retirement
system. Under certain circumstances, benefits might exceed
payments, while in other situations it might be less.
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2.3 Program Funding

A) Fully Funded Scheme

Initially, the program was based on a fully funded scheme, which means that
received benefits are totally withdrawn from the accumulated contributions
and interest of the worker’s established fund.

B) Pay-As-You-Go System

The occurrence of the Great Depression in the 1930s had wiped out workers’
savings in their social security funds. In 1939, the system of the social
security program was switched from fully funded to a pay-as-you-go basis.
This change was made because of two main reasons: 1) using social security
funds for other purposes, and 2) the fear of some politicians from government
inefficient management of this fund. The Pay-as-You-Go system implies that
benefits paid to current beneficiaries come from payments made by current
workers, not from those beneficiaries’ accumulated funds.
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2.4 Program Finance
Social security benefits are financed by a special payroll tax which is
a flat percentage of an employee’s annual gross wage/salary up to a
certain amount. Half the tax is paid by the employee and the other
half is paid by the employer.
Table 7.1: Social Security Tax Rates
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Year Combined Max. Taxable S.S. as % of
Tax Rate Income Total [Link] .
1950 3.00 3,000 2.5
1960 6.00 4,800 12.7
1970 8.40 7,800 20.7
1980 10.16 29,700 24,8
1990 12.40 51,300 35.4
2000 12.40 76,200 36.2
2003 12.40 87,000 36.4

2013* 12.40 117,000 37.0 .

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2.5 Program Benefits

An individual’s social security benefit depends on his/her earnings history,

age, and other personal circumstances. The following steps are used to
calculate social security benefits:

Average Indexed Monthly Earnings (AIME )= average wage during working life

Primary insurance amount =

90% (of the first $600 of AIME) + 32% (of AIME $600 to $3,653)

+ 15% (of AIME above $3,653)

Monthly benefit has an identified maximum ceiling which can not be exceeded
no matter how much is the AIME of the beneficiary.
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Example1:
Calculate the retirement benefits of two program participants whose AIME are
$7,800, and $3,500 respectively, in case the maximum ceiling is $1800. Calculate the
percentage of monthly retirement benefit and interpret the results.
Solution
Retirement Benefit of Participant A =
90% x $600 + 32% x ($3,653 - $600) + 15% ($7,800 - $3,653)=
$540 + $977 + $622 = $2,139
This participant will receive only the maximum monthly benefit of $1,800.
Percent of Monthly Benefit = Monthly Benefit X100
AIME
= $1,800 X100 = 23%
$7,800
Retirement Benefit of Participant B =
90% x $600 + 32% x ($3,500 - $600) =$540 + $928 = $1,468
Percent of Monthly Benefit = $1,468 X100 = 42%
$3,500
The program has a redistributive function which favor those with less income.
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2.6 Program Distributional Function

As indicated earlier, social security is not just an insurance, it is also an income

redistribution device. This means, on average, the benefits received would equal the
premiums paid. Actually, some types of people receive more than what they paid. This
means that the social security payments (i.e. social security wealth) of some people are
less than the value of their benefits.

By comparing both social security wealth and payments for different workers
categories, it was found that those who have lower income levels receive higher levels
of benefits and vise versa. The redistributive nature of the program becomes evident
also in its treatment of various types of beneficiaries such as married individuals. A
married couple is eligible to receive 150 percent of the Social Security benefit paid to a
single individual.

For most workers, Social Security is compulsory. This is so because some workers
come out better than others under the system, there would be a tendency for those
workers who benefit best to willingly participate in the program, while those who do not
expect to get a good deal would be likely to bypass the system. In insurance terms, this
is known as the problem of adverse selection.
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2.7 Long-term Stress on Social Security
Currently, social security payroll taxes exceed the benefits that are
being paid out. However, this situation is expected to change in the
future. One of the main reasons for that is the sudden increase of the
number of retirees in the 2030s (baby boom generation of the
1970s). To deal with this situation the government might have to take
one or both of the following actions: 1) reduce the level of provided
benefits, and 2) increase the level of collected taxes.

Example 2:

The current number of workers of country A is 36 million, the number

of retirees is 12 million, average monthly wage is $1,240, and social
security payroll tax rate is 12%. It is expected that by 2030, the
number of workers will increase by 15%, the number of retirees will
increase by 25%, and the average monthly wage will be the same.
A) Explain how this phenomenon will affect the social security system
in this country, and
B) How the government can deal with this situation.
 Solution:
A) This situation will increase the dependency ratio
Dependency ratio = number of retirees / number of workers
B) There are two approaches to deal with this situation:

1- Reduce benefits:
Since Nb X B = t XNw X w
* t (tax rate), Nw (number of workers), and w (average wage/worker); then
B2019 = (t X Nw X w)/ Nb
Current average benefit
B2019 = (12% X 36 X $1,240) / 12 = $446.4
If this level of taxes remains, the government has to reduce the average benefit
Expected average benefit in 2030
B2030 = (12% X 41.4 X 1,240)/ 15 = $410.7
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2- Increase tax rate:

Since Nb X B = t XNw X w
Then t2030 = (Nb2030 X B2019) / (Nw2030 X W2030)
Expected tax rate in 2030
t2030 = (15X446.4)/(41.4 X1,240)= 6,696/49,845 =13%

These results indicate that in order to deal with this

situation, the government may have to lower the level
of average benefit from $446.4 to $410.7, increase the
level of tax from %12 to %13, or mix between these to
methods.
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Thank you 