Social Security Work Incentives are Unfair for Older Retirees

A man with average earnings who works in the year following his 69th birthday faces a net Social Security "tax" rate of more than 45 percent on his earnings that year.

Various economists have noted that the Social Security system may give the elderly an incentive to retire earlier than they otherwise would. In a recent NBER study, Social Security and Retirement in the U.S. (NBER Working Paper No. 6097), Research Associates Peter Diamond and Jonathan Gruber find that for early retirees, the system does not have much of an effect on incentives to work, but it imposes stiff penalties on work past age 65.

Diamond and Gruber note that the Social Security benefit that a worker receives is related positively, in a complicated way, to the average earnings of the worker in his or her 35 years of highest real earnings. They compute the present value--the value in the present of all future Social Security benefits minus future Social Security taxes--for workers at each age. They call this value the worker's social security wealth (SSW). They then compute the change in SSW for each additional year of work.

For median-earning married males aged 56 to 61, the researchers find, there is a net "tax" on earning. This is driven primarily by the Social Security payroll taxes that the worker pays on earnings, taxes that are not offset in present value dollars by the added benefits which the worker qualifies to receive. The most surprising conclusion in this study is that a worker who works one year after his 62nd birthday receives a net subsidy from the system for doing so, because the actuarial adjustment he receives for delaying claiming benefits more than offsets both the payroll tax and the fact that the worker is delaying receipt of benefits for one year. This is interesting, Diamond and Gruber note, because even though the system subsidizes work for 62-year-old median-earning males, the male retirement rate jumps at age 62.

The net "tax" jumps dramatically for a typical male employee who works in the year following his 65th birthday. Working during that year reduces his SSW by $2,450, which is almost 19 percent of what he would earn that year. Not surprisingly, almost 25 percent of men who worked the previous year retire in the year after they reach their 65th birthday. A man with average earnings who works in the year following his 69th birthday faces a net Social Security "tax" rate of more than 45 percent on his earnings that year.

Diamond and Gruber also perform the calculations for high-income and low-income males and for single males. They find that the age pattern and amount of disincentive varies according to income and marital status; for single workers, the implicit tax on work is much higher than for other groups.