9 The Economics of Social Safety Nets: Here to Catch Us When We Fall?

What are Social Safety Nets?

What happens if you get sick? Will you have enough money to retire one day? How do governments support our health and old age? This chapter answers these important questions about the social safety net, the supports that people can rely on should they get sick, become disabled, or lose their job. The social safety net goes by different names. Sometimes it is referred to as social protection or social insurance. There are a variety of different programs that are part of the social safety net in different countries, often with confusing names. For example, in the United States we have Medicare, which provides health insurance to seniors, and Medicaid, which provides health insurance to low-income families. All the policies we discussed in the poverty chapter are part of the social safety net as well.

In this chapter we will focus on the insurance aspects of the social safety net. Private insurance programs are when you make a regular payment, called a premium, to a private company. In return, you receive a benefit if some (usually bad) event occurs in the future. For example, you may pay renter’s insurance. If the pipes leak on to your computer in your apartment, renter’s insurance will pay out a benefit to repair or replace your computer. Most private insurance is voluntary—you can choose whether or not to get it—although there are exceptions. You are required by the government to have car insurance in the United States. Banks will only lend for a home mortgage if you have homeowner’s insurance. Although these forms of insurance may be mandatory, they are still private insurance because you are paying a private firm the premium.

Social insurance programs require paying a premium to the government rather than a private company. The premium is often a contribution from your paycheck if you are working. For example, in the United States, 6.2% of each paycheck goes towards Social Security, the program that supports seniors in their old age.^[1] Employers pay an equivalent amount as well. In Egypt, workers contribute 14% of their base pay towards social insurance for old age,^[2] similar to social security in the United States.

Social insurance programs may overlap with private insurance programs. For example, there are both private ways to save for retirement, through retirement savings accounts, and social insurance programs such as Social Security. There are also social safety net programs that pay out based on need rather than contribution. For example, while Medicare is funded by contributions of workers before they reach old age, Medicaid helps low-income families based on their income, and is funded primarily by tax dollars from society overall.

Countries also vary in how extensive the social safety net is. Some countries have broad and generous social safety net programs while others rely primarily on the private sector or individuals to take care of old age, insurance, or health care. An important purpose of this chapter is understanding why there may be government involvement in these sectors—why is the safety net a social undertaking? The chapter specifically examines two major social insurance topics. First, we examine the case of Social Security and saving for old age in the United States. Then we study the issue of health insurance, which is a mix of public and private programs in the United States. Lastly, we examine funding for the social safety net in the context of government spending and debt.

Saving for old age

Private market options

How can people make sure they have enough income for their old age? Individuals may want to retire. For health reasons, it may not even be possible to keep working at a certain point. However, retiring requires having sufficient income to meet your needs in old age. Individuals can save for retirement, for example putting money into a savings account or investing in property. Retirement savings are often in stocks, shares in a company, that pay dividends (regular payouts from the company’s profits). People can also buy bonds, essentially IOUs (for example, a bond to fund Amazon’s takeover of Whole Foods^[3]) that generate interest (pay a percentage out every year). Savings accounts may also generate interest, as banks will pay you to keep your money there (so they can loan it out to others and receive even more interest). Another option is an annuity, a fixed sum of money paid every year, bought in either in a lump sum or over time. These options have varying degrees of risk. Different types of bonds may be more or less risky, while stock prices, dividends, and savings interest are highly variable. Annuities are a safer investment, since payouts are fixed, but they may lead to less total income than riskier investments. There are tradeoffs between the degree of risk and the rate of return (how much you receive).

Another way individuals may save for old age is through their workplace. People can often invest in stocks, bonds, and annuities through private firms at their workplace in a way that has special tax status, deferring taxes until funds they are withdrawn. These accounts, often referred to as 401(k)s, have this special tax status and are available from many employers. Alternatively, some firms may provide pensions. Pensions are like annuities—fixed annual payments—that are funded by the firm. Firms build up savings in a pension fund to pay out to retired workers.

Why is the government involved in savings?

All of the options discussed so far are based on private firms and markets providing financial products. Why would the government be involved in these markets at all? Shouldn’t people be allowed to choose how to save for old age? The main reason for government involvement is that people, when left to their own devices, are terrible at saving for old age (or saving for anything else). For example, in the United States only 47% of people report that they have savings or a rainy day fund that could cover three months of expenses.^[4] A variety of reasons could account for individuals’ difficulty saving, including information issues and uncertainty. It is hard to know how much you need for retirement or to understand complex financial products that can help with retirement.^[5] People are also bad at self-control, tend to procrastinate, and prefer money today to money tomorrow.

Social Security

Social Security is the United States social insurance program designed to act as a social safety net as people age. The program also helps address the challenges workers face in saving. The United States’ current Social Security program has its roots in the Great Depression.^[7] The Social Security Act became law in 1935 as a form of old-age insurance. It provides monthly retirement benefits to individuals 65 and older. It originally covered few workers but expanded substantially over time. Social security is credited with bringing the rate of elderly poverty from 35.2% in 1959 to 10.2% today.^[8] The reduction in elderly poverty brought about by social security illustrates some of the arguments for government involvement in saving for old age.

Benefits for social security are based on wages while working.^[9] The program was never intended to fully replace other forms of income, as it provides benefits equivalent to 42% of individuals’ previous wages. Dependents (children) and survivors (spouses) of workers who die are eligible for benefits as well. Lower-income earners receive benefits that are a greater share, around 56%, of their earnings, compared to 35% for higher-income earners.^[10]

The program uses payroll taxes (taken directly out of workers’ paychecks) to collect workers’ contributions. Workers must contribute 6.2% of their wages. The program has an equal employer share of 6.2%. Wages are taxed up to the first $128,700.^[11] Social security taxes are like automatic enrollment in retirement savings – but with no opt-out and a guaranteed benefit.

There are two important economic issues to consider with Social Security. The first is the effect of the program on labor supply. Will people work more or less as a result of having Social Security reduce their present wages but provide a future benefit? The empirical evidence shows that individuals are more likely to retire at the Social Security retirement age, reducing overall labor supply in the United States.^[12]

The second question, which we can model with a labor supply and demand diagram, is who actually pays the Social Security tax? The official rule is that employees pay 6.2% and employers pay 6.2%. However, it could be the case that employers increase wages to make up for the loss to Social Security, or that they reduce wages to cover not just the employee but also their payment. This is a question of tax incidence—who, economically, pays the tax.

Figure ‎9.1 shows a labor market where labor supply is relatively inelastic and labor demand relatively elastic. As with Social Security, each actor must pay an equal tax. Here we have simplified to make the tax a fixed $3 per hour for both the workers and employers. This tax decreases labor supply (you take home less of every dollar) and decreases labor demand (firms have to pay more for their workers). However, although each side on paper has to pay equally, the tax incidence is not equal. Moving from equilibrium 1, without the tax, to equilibrium 2, with the tax, because labor demand is more elastic, the price that firms pay with the tax has increased only a little. However, because labor supply is relatively inelastic, the wage that workers take home has dropped substantially. Relative to where they started, Peq, firms are paying a little more and workers are making a lot less. Now, if workers receive the reduction back in the form of Social Security, this is not necessarily a problem, especially if it overcomes market failures in savings. However, it does illustrate that who theoretically pays the tax is not the true tax incidence—who is affected the most by the tax.

Taking care of our health

Another key aspect of wellbeing, insurance, and the social safety net is health care. Health care is expensive. Figure ‎9.2^[13] shows health care expenditure in the United States as a percentage of GDP. It also examines the sources of spending, comparing spending from the public sector (the government) and from private sources. Health care is a growing segment of the economy. As of 2021, a total of 18% of GDP went to health care, making it one-fifth of the U.S. economy. Around 9% of our economy is private spending on health care and 9% is public spending on health care. This share has been rising substantially over time. A number of factors, including improvements in medicine and income, have contributed to this rise. In 2020, the COVID-19 pandemic contributed to the substantial rise in public health care spending particularly.

 

However, the United States is also an outlier in global health spending. We spend far more, yet have worse outcomes, in comparison to other countries. While we spent 17% of our GDP on health care as of 2019, comparable countries spent only 11% of GDP.^[14] When examining 13 developed countries, despite high spending, the United States had the highest infant mortality (deaths) and shortest life expectancy.^[15] Why is health care so expensive while outcomes are so poor?

The role of health insurance

Often, researchers point to health insurance as contributing to high costs.^[16] With health insurance (whether provided by the government or a private insurer), individuals have a complex set of potential costs. Typically, plans have a deductible, a fixed amount that insurance does not cover before paying benefits. For example, you might have to pay the first $1,000 of your health expenses. Insurance often requires cost-sharing as well. People with health insurance who seek medical care may have co-insurance payments, where they have to pay a percentage of costs. For example, individuals may have a co-insurance rate of 20%, where they pay 20% of costs and the insurer pays 80%. Alternatively, individuals may have a co-payment (co-pay) for their visit, a fixed amount, like $20 for an office visit or $250 for an emergency room visit.

Although individuals have to pay for insurance and also have various forms of potential cost-sharing, effectively insurance decreases the price of health care to individuals. It does not, however, decrease the price of health care for insurance companies or society. This disconnect leads to the situation modeled in Figure ‎9.3, for the case of a co-pay for doctors’ visits. If there were only a private market for doctors’ visits, then supply and demand would determine an equilibrium of five million visits with a price of $100 per visit. However, once there is insurance, the price to the patient drops. The patient now pays only $50 per visit as the co-pay. Now people would choose to have more visits, 6 million total when the price is $50. The additional visits cost insurance and society. Additionally, the visits become more expensive to society (or the insurance company), at $120 each. Ultimately, patients pay for higher costs through their premiums (if they have private insurance) or through their taxes (if there is government funded insurance).

When individuals use more health care because they have insurance, this is a form of moral hazard. Moral hazard occurs when individuals change their behaviors as a result of having health insurance. This may mean that they go to the doctor more.^[17] It may also mean that they have less healthy or more risky behaviors because they know if they get sick or injured, they have insurance. Research shows that having insurance reduces healthy behaviors, for example, it increases smoking and drinking and reduces exercise. ^[18]

If health insurance has all these problematic effects, why do people buy health insurance? Primarily, they want to insure themselves against risk of illness or injury. They also want financial predictability. In the United States, 46% of bankruptcies included medical problems as a factor.^[19] That same motivation for insurance, to insure against risk, remains. However, insurance also creates all sorts of distortions in markets. Another substantial issue in insurance markets is referred to as adverse selection. Adverse selection occurs in insurance markets when riskier individuals buy insurance, but less risky individuals do not. For example, someone with an underlying medical condition may buy insurance but someone who is healthy will choose not to buy insurance. If only sick(er) people buy insurance, it becomes extremely expensive.

Health policy in the United States

Health care and health insurance are critical issues in the United States. There are a number of reasons we have identified that these markets may not work well on their own. Market failures tend to lead to government intervention. The United States has a substantial government role in health care, a regulatory role as well as one in financing and providing healthcare. First, for individuals 65 and older, we have Medicare, a health insurance program for seniors. Medicare, like Social Security, is funded by payroll taxes. Individuals pay in while working and receive benefits at 65. For low-income families, we have Medicaid, health insurance funded by government tax dollars.

Other people may receive their health insurance from private or non-profit insurers. However, there are a number of regulations and government supports for health care. Specifically, in 2010, the U.S. Congress passed the Patient Protection and Affordable Care Act (ACA), often referred to as Obamacare.^[20] The ACA mandated that every individual buy insurance (or face a penalty). Frequently people could buy insurance through their employer or received insurance as an employment benefit. However, individuals without employer-provided insurance could, under the new law, shop in newly created state marketplaces for for-profit or non-profit insurance plans. Individuals also received subsidies, if they qualified due to their income, to make insurance more affordable. The law includes a number of other provisions about essential health benefits that must be included in insurance, and addressed other issues as well, such as the share of insurance that may go towards profits versus medical care. Why is health insurance mandated under the ACA? Recall our earlier discussion of adverse selection. Typically, it is sicker people who buy insurance. Requiring everyone to buy insurance helps make sure that there are (currently) healthy individuals with insurance to help spread out the costs of insurance.

Although the United States has substantially increased regulations in health care, costs remain high. Empirically, the United States actually has fewer doctors and hospital visits than other countries, suggesting that higher prices may be a driving factor in our high health care spending, not higher use of health care.^[21] How we pay doctors may be a central issue to high costs. Commonly, doctors in the United States are paid on a fee-for-service basis. Doctors receive fees for each service they perform. This creates an incentive to do more services—perhaps an extra test or scan. Patients lack the information or expertise to know that these additional services may be unnecessary, leading to unnecessary medical spending. Alternative models than fee-for-spending are also challenging to design but may be more effective.^[22] If doctors are paid per patient rather than procedure, they may pick healthier patients. Therefore, building in additional payments for working with patients with chronic health conditions is necessary. This is just one example of the complexities of addressing incentives within the medical system.

Government Spending

Social safety nets and health care have an enormous role in government spending in the United States. Figure ‎9.4^[23] shows the United States federal government budget for the year 2022. States may also collect taxes and have substantial budgets, as do counties and cities. However, when we are thinking about social safety nets and especially social insurance, the federal government is the main player. The figure distinguishes between revenues (money coming in) and spending (money going out). Some of the money being spent is mandatory—it has to be spent based on law. Mandatory spending is also often referred to as an entitlement. Social insurance programs are common entitlements, where an individual pays in during their working years and then is entitled to a benefit.

Where does most of our federal money come from? First, 2.6 trillion dollars comes from individual income taxes. Then 1.5 trillion are from payroll taxes, which are designed to fund social insurance. Corporate income taxes provide 425 billion in revenues, and the remaining 356 billion in revenues is from other sources.

 

On the spending side, Social Security is the single biggest government expenditure, at 1.2 trillion dollars. Medicare is 747 billion, followed by Medicaid at 592 billion. The remaining mandatory programs, such as unemployment insurance, veterans’ benefits, the earned income tax credit, Supplemental Nutrition Assistance Program (SNAP or food stamps), and many others, together total 1,583 billion.^[24] These are the mandatory government expenses. Mandatory spending totals 4.1 trillion dollars compared to 1.7 trillion of discretionary spending. Discretionary spending is what lawmakers control through specific bills and acts. Almost half of discretionary spending is defense (751 billion). Another important expense is interest on our national debt (475 billion).

Why do we have to pay interest on our debt? Each year when the budget is set, there may be a budget surplus (revenue > spending) or a budget deficit (revenue < spending). The deficit in 2022 was projected at 1.4 trillion.^[25] When there is a deficit, the government will pay for the extra spending by borrowing money from the public through bonds or securities. As deficits and surpluses add up over time, if we end up owing money, this is our debt. As of 2022, public debt^[26] was equal to 97% of our GDP—24.3 trillion dollars. In one sense, this is alarming—it is a huge amount of money. However, from another angle, we have less debt than what our economy produces in a single year.

The real issue is the long-term outlook of our debt, which is poor under current law. Increases in the cost of social insurance programs—especially Medicare and Social Security—are a major problem. If current spending and revenue patterns continue and projected Medicare and Social Security trends play out, debt would reach 144% of GDP by 2049.^[27] That could be more problematic than the current situation, as the public holding government debt might start to worry about being paid back, leading to higher interest rates (another expense for the government).

Linked to our debt challenges are challenges paying for Social Security and Medicare. These programs rely on the payments of current workers—which pile up in trust funds—to help fund current benefits. Such a system is referred to as pay-as-you-go. In contrast, a system where individuals’ benefits are funded by their initial contributions would be fully funded. Demographic factors play an important role in pay-as-you-go systems. When populations are young, there are a lot of workers paying in and few people receiving benefits. As populations age—as the baby boomers are doing in the United States—there are many more people with benefits, yet relatively fewer workers paying in. Currently, the structure of Social Security is unsustainable. The shortfall in the long run (through 2093) amounts to 4.6% of taxable payroll.^[28] Although concerning, this is a solvable problem. Benefits can be reduced, the age of receiving benefits adjusted, or payroll taxes changed.

Summary and Conclusions

Safety nets are critical to ensuring that citizens are secure in their health or retirement. Although individuals can save for old age or buy health insurance on the private market, a number of challenges and market failures make the performance of the private market on its own problematic. Therefore, governments build social safety net programs. Social insurance programs, where individuals contribute from payroll taxes, were the particular focus of this chapter. Social Security (for old age income) and Medicare (for old age health care) are the largest social insurance programs in the United States. They are also our largest budget expenditures. Since these programs are not fully funded, reforms are needed to ensure their long-term sustainability. Think about how you would like to see these programs reformed—and tell your government representatives!

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