This installment looks at how Social Security elegantly balances competing visions of what it means for this type of system to be “fair.”
Why do you earn what you earn?
Think about why you have the income you have, compared to someone else’s.
Maybe you get paid $40,000 a year. Or (less likely), it’s $200,000 a year.
Why do you have one and not the other?
With some pretty strong simplification, and maybe a bit of arbitrary line drawing, we can put the causes into two buckets.
The first is merit: your hard work, your intelligent decision-making, your creative problem-solving.
The second is fortune: good luck lifting some people up, bad luck dragging others down.
Remember that Social Security runs off of a “flat” tax, where everyone pays the same 12.4% of their payroll income, up to $168,000 of income (so maxing out their Social Security taxes at $20,832).
Given that people are mostly putting in the same portion of their income, how much should each person get back?
That “should” depends on your sense of the mix of merit and fortune.
By merit alone
Imagine a world where the only thing that’s operating is merit: if I have more income than you, it’s some combination of me working harder, making smarter decisions, solving problems more creatively.
In that situation, with the flat tax on the front end funding the program, a “fair” retirement system would be one where everybody’s pension was proportional to their income. My $200,000 income leads to an $80,000 pension, while your $40,000 income leads to a pension of $16,000.
Over the whole range of incomes, this would lead to a situation like in the figure below. The orange line is your pension benefit, as a percentage of your income, and everyone has the same. The blue line is your pension benefit, and it rises as a straight line: doubling your income means doubling your pension.
That outcome wouldn’t necessarily be compassionate, and it would mean pretty severe old-age poverty for many people, but if differences in income really are from merit, then it would be fair.
A role of the dice
At the other end of the scale, imagine that all income differences are from luck. In that case, there’s no moral reason for my pension to be larger than yours. Regardless of what our income was during our working life, our pension should be, say, $30,000.
This is illustrated in the following image. The blue line is flat, because everyone gets $30,000. The orange line falls over time, approaching 0%, because that payout of $30,000 is a smaller and smaller share of your income as you look at larger incomes.
The complications of reality
Here in the real world, most people who give it a moment’s thought will conclude that income differences come from a tangle of both merit and luck, with different elements in different cases. A person high up the income scale is emotionally predisposed to put more weight on merit, while someone further down may see fate playing a larger role, but most people will acknowledge the presence of both types of factors to some degree.
The structure of Social Security taxes and benefits reflects that reality. It’s certainly not the only way one could do so, but it is a reasonably effective one, shown in the image below.
As your income rises, your benefit rises as well. That means that higher merit is recognized (to some degree) with more dollars. It also means that you can’t “game” the system—you can’t get a larger pension by working less. If you put fewer dollars in, you will get fewer dollars out. To the extent that higher rewards incentivize more diligent work, the Social Security system recognizes that.
In this image, the blue line rises more slowly as as working-life income goes up, but it does rise.
At the same time, people with lower incomes in their working life get a higher replacement ratio in retirement. That can be seen as some approximate recognition of the role that luck has played in why each person has the income they have.
The orange line illustrates this with a higher replacement ratio at the left end of the chart, falling off as we mov to the right.
Takeaway
A couple of posts from now, I’ll get into an important implication of this structure, which is that individual accounts within Social Security—something George W. Bush was aiming for in 2005—would obliviate this balance.
For now, the thing to remember is that the balance exists.
By merit alone
Imagine a world where the only thing that’s operating is merit: if I have more income than you, it’s some combination of me working harder, making smarter decisions, solving problems more creatively.
In that situation, with the flat tax on the front end funding the program, a “fair” retirement system would be one where everybody’s pension was proportional to their income. My $200,000 income leads to an $80,000 pension, while your $40,000 income leads to a pension of $16,000.
Over the whole range of incomes, this would lead to a situation like in the figure below. The orange line is your pension benefit, as a percentage of your income, and everyone has the same. The blue line is your pension benefit, and it rises as a straight line: doubling your income means doubling your pension.
 |
A role of the dice
At the other end of the scale, imagine that all income differences are from luck. In that case, there’s no moral reason for my pension to be larger than yours. Regardless of what our income was during our working life, our pension should be, say, $30,000.
This is illustrated in the following image. The blue line is flat, because everyone gets $30,000. The orange line falls over time, approaching 0%, because that payout of $30,000 is a smaller and smaller share of your income as you look at larger incomes.
The complications of reality
Here in the real world, most people who give it a moment’s thought will conclude that income differences come from a tangle of both merit and luck, with different elements in different cases. A person high up the income scale is emotionally predisposed to put more weight on merit, while someone further down may see fate playing a larger role, but most people will acknowledge the presence of both types of factors to some degree.
The structure of Social Security taxes and benefits reflects that reality. It’s certainly not the only way one could do so, but it is a reasonably effective one, shown in the image below.
As your income rises, your benefit rises as well. That means that higher merit is recognized (to some degree) with more dollars. It also means that you can’t “game” the system—you can’t get a larger pension by working less. If you put fewer dollars in, you will get fewer dollars out. To the extent that higher rewards incentivize more diligent work, the Social Security system recognizes that.
 |
| Figures retrieved on April 17, 2025, from https://www.ssa.gov/oact/quickcalc/index.html Birthdate Jun 15, 1960; retirement date June, 2027 |
In this image, the blue line rises more slowly as as working-life income goes up, but it does rise.
At the same time, people with lower incomes in their working life get a higher replacement ratio in retirement. That can be seen as some approximate recognition of the role that luck has played in why each person has the income they have.
The orange line illustrates this with a higher replacement ratio at the left end of the chart, falling off as we mov to the right.
Takeaway
A couple of posts from now, I’ll get into an important implication of this structure, which is that individual accounts within Social Security—something George W. Bush was aiming for in 2005—would obliviate this balance.
For now, the thing to remember is that the balance exists.
People who earn more (and thus pay more Social Security taxes) get back more dollars in their monthly benefit checks. A reward for your merit in having a higher salary.
People who earn less get a monthly benefit check that is a higher percentage of what they put in. A recognition of the element of luck in why your salary isn't so high.
Next time: Why the trust fund isn't a shell game, but an intergenerational promise between income levels, and how the people on the hook for that promise are looking to get out of it.
Addendum (April 22): The life-expectancy penalty for poverty
The body of the post shows how people lower down the income scale get a larger replacement ratio - in a sense, a better return on their Social Security taxes - than people higher up the income scale.
But it turns out that there's a correlation between income and wealth, with higher incomes being correlated with longer life expectancy (imagine, if you will, me looking shocked).
Chetty et al. (2016), "The Association Between Income and Life Expectancy in the United States, 2001–2014" use 1.4 billion tax records from a 16-year window to calculate the effect, illustrated most clearly for my purposes in the figure below.
 |
| Fig 4A from Chetty et al. (2016) |
Ballpark adjusting for changes since the publication of that paper, we might take $40,000 as the 5th ventile, and $120,000 as the 15th ventile.
It looks like someone at the 15th ventile lives to about 83. The 5th ventile is harder to say, because it matters a lot which city you're in (a poor person pays much bigger life-expectancy penalty in Detroit than in New York). But 77 wouldn't be unrepresentative.
The median (at the 10th ventile) is about 81.
If our $40,000 earner and our $120,000 earner both retire at 67 and live to the median life expectancy of 81, the first will collect $239,064 over their 14 years of retirement, or 5.98 times their annual income, while the other will collect $487,872 over that same time, or 4.01 times their annual income.
But if we have each person live until their income-specific life expectancy, the poorer person collects $170,760 over their 10 years of retirement (4.27 times their annual income), while the richer one collect $557,568 over their 16 years of retirement (4.65 times their annual income).
In this particular example, the life-expectancy penalty of poverty outweighs the redistributive structure of Social Security.
An economist might argue that each person's benefits should be subject to a time-preference discount rate, reflecting the fact that some of the richer person's benefit is coming farther in the future.
If we subject both people's benefits to a 3% annual discount rate, the present value of the poor person's benefits comes to $145,662, or 3.64 times the annual income, while the richer person's discounted present value of benefits is $437,729, or 3,65 times the annual income. In this case, Social Security's redistributive effect isn't reversed, but it is wiped out.
One way to compensate for that would be to skew the replacement ratio even more in favor of people at the lower end of the income scale.
I don't see the political constellation to make that possible.
Another approach would be to reduce the life-expectancy penalty of poverty, through things like truly universal health insurance, and better availability of medical care in poorer neighborhoods and rural areas.
I don't the the political constellation for that, either.
No comments:
Post a Comment