Labor Supply Distortions of Social Security

Abstract

Most scholars agree that there is a very tenuous connection between the taxes a person pays under the U. S. social security system and the value of the benefits later received in retirement. In several recent analyses this fact has served as a primary justification to evaluate the tax structure separately from the benefit structure. For example, Pechman, Aaron, and Taussig [10] conclude that the already loose connection between benefits and taxes should be made still looser by making the tax more progressive and the benefits even less closely related to previous taxes paid. In contrast, when Friedman [8] evaluates these elements of the system separately, he concludes that neither can be justified and proposes instead that social security be gradually phased out. Despite their disparate conclusions, these economists are in general agreement concerning the framework for their analyses: separate evaluations of the tax and benefit structures. In this paper I will defend the contrary position that the social security system cannot be adequately analyzed unless the tax and benefit structures are considered simultaneously. It will be shown that the labor supply and related welfare effects of the system depend crucially on the way in which taxes are related to benefits. The analysis of the social security payroll tax in the first section of this paper shows clearly why this is so, and the second section uses Harberger's method for estimating the welfare cost of a tax on earnings to approximate the quantitative importance of the relationship between benefits and taxes for the resulting welfare cost. I. THE LABOR SUPPLY EFFECTS OF A PAYROLL TAX