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Means Testing Social Security: Modeling and Policy Analysis

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Abstract

The aging demographic has brought retirement income reform to the center of the policymaking arena. This project has deployed cutting edge modeling techniques to examine the economic impacts of means-testing in the Australian and U.S. contexts. Since 1909, the mainstay of Australia’s retirement policy has been a flat-rate, means-tested age pension. Since the 1990s, this has been supplemented by a mandatory prefunded Defined Contribution type pension plan. Contrary to conventional wisdom, our analysis has found that means testing delivers fewer overall distortions and increased welfare compared to a universal pension offering the same maximum benefit level. It also shows that all means-tested programs generate higher welfare benefits than Pay-As-You-Go (PAYG) pension programs. The channels through which these outcomes are delivered are complex, but most importantly, for a given individual pension payment, means testing reduces the revenue requirement, thus lowering tax rates on workers. Compared to an OECD average of 9.5% of GDP allocated to retirement payouts, Australia’s annual payouts sit at 2.9% of GDP. Hence, the comparison with many OECD countries reveals that Australian pension arrangements are cheaper both at present and based on future projections. Means-testing can also increase incentives for self-provision. Reduced or zero public benefits payable to the richest groups of retirees improve labor-force participation. Modeling shows that aggregate labor supply can be 1.4% higher with means testing than with a universal pension. The standard means test in Australia applies to both labor earnings and capital income. But eliminating the means test on earnings further enhances mature labor force participation. Mature (65+) labor force participation improves by 24.6% when labor earnings are fully exempted, from a low base. Overall, the study suggests that means testing is an important potential policy reform that has been undersold in past literature.

Key Findings

  • Contrary to conventional wisdom, our analysis has found that means testing delivers fewer overall distortions and increased welfare compared to a universal pension offering the same maximum benefit level.
  • Compared to an OECD average of 9.5% of GDP allocated to pension spending, Australia’s annual spend is 2.9% of GDP. Hence, the comparison with many OECD countries reveals that Australian pension arrangements are cheaper both at present and based on future projections. The lower cost is largely due to the flat rate benefit and means testing.
  • Means testing also increases incentives for self-provision. Reduced or zero public benefits payable to the richest groups of retirees can improve labour force participation for that group. Lower public spending on pensions can lead to higher aggregate labour supply – modelled to be 1.4% higher with means testing than with a universal pension.

Citation

Chomik, Rafal, John Piggott, Alan D. Woodland, George Kudrna, and Cagri Kumru. 2016. "Means Testing Social Security: Modeling and Policy Analysis." Ann Arbor, MI. University of Michigan Retirement Research Center (MRRC) Working Paper, WP 2016-337. https://mrdrc.isr.umich.edu/publications/papers/pdf/wp337.pdf

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Project

Paper ID

WP 2016-337

Publication Type

Working Paper

Publication Year

2016