Tuesday, October 03, 2006

My Public Economics class

Today's subject: social insurance.

xtIt's odd how leading economists, including very good ones such as Jonathan Gruber, the author of the textbook I am using, acquiesce to categories that have no economic substance. They could say that they're deferring to common usage, but don't always do so and may not always realize it.

Case in point: Gruber defines social insurance - following prevailing conventional wisdom - in terms of private insurance, which he says is characterized by (1) premiums, (2) event conditioning (i.e., it's paid when and if X happens), and (3) lack of income conditioning. This supposedly explains why Social Security is "social insurance" but the income tax and welfare system aren't.

In fact, insurance is a kind of bet one places to hedge other bets one is forced by circumstances to make with the aim of directing dollars to states of the world where they are expected to have greater marginal value in utility terms. One doesn't insure against horrific events, such as the death of a child, that don't make the marginal dollar more valuable. One does sometimes insure against good things, such as living longer & thus needing more money, or having an untreatable medical condition that becomes treatable.

Let's look at Social Security and the 3 supposed key features. It doesn't meaningfully have premiums absent arm's length exchange. What it has is the arbitrary designation of certain compelled tax revenues as ostensibly earmarked to pay over the long term for the program. Earmarking is an interesting issue, having to do with the effort to create political binding pre-commitment, but has nothing to do with premiums as such. If they ended the earmarking and folded the Social Security premiums into general revenues, absolutely nothing would change beyond bookkeeping unless (as is plausible) actual political decisions changed.

Event conditioning: OK, the Social Security life annuity addresses life expectancy risk and provides insurance against living "too long." Probably not a mode of insurance that the government has to provide on adverse selection grounds, the usual lead argument for government involvement. Rather, the argument is paternalism if people under-save and under-annuitize with a dollop of externalities if they would get public support in the absence of other resources.

But insofar as you expect to live to retirement age, a retirement benefit is not event-conditioned in the usual insurance sense - it relates to an event that just happens at a certain point, rather than one that is risky.

OK, lack of income conditioning. Well, it is pure formalism to say that Social Security isn't income-conditioned. Even leaving aside the payroll tax financing to focus exclusively on the benefit side, we could make it income-conditioned with no change in substance whatsoever if we simply reshuffled existing fiscal rules so that the effect of partial income taxation of Social Security benefits was formally made part of Social Security.

Also, why would anyone say insurance isn't income-conditioned? All insurance other than automobile insurance isn't automobile accident-conditioned. Likewise, insurance that isn't income insurance isn't income-conditioned. By definition, income insurance is income-conditioned and other insurance isn't.

We don't observe much income insurance outside of the fiscal system due to the adverse selection problem. (People expecting low income would disproportionately sign up.) This is why the government provides it through income taxation and welfare, among other fiscal instruments. As recognized in the Mirrlees tradition in optimal income taxation, income insurance via taxes and welfare is the government insurance example sine qua non.

Only, it doesn't have anything that we arbitrarily label as a premium, so the economic substance doesn't count.


Buce said...

Most interesting and instructive post, but I'd love to hear you on an issue that has long bothered me--why /isn't/ there a viable private annuity market in this country? Yes, they are available, but the prices make no sense at all, and nobody seems to market them. A friend who knows this stuff better than I blames "adverse selection"--apptly you do not, and I am tempted to agree with you.

But then why, exactly?

BTW there is a tantalizing, tho incomplete, discussion of this topic in Brink Lindsey's "Against the Dead Hand"--re privatization in
Chile--seems to suggest there /is/ a functioning annuity market there, but the treatment is too thin to be really helpful

Daniel Shaviro said...

Possibly I overstated in this post the case against the adverse selection problem being crucial here. I am dubious about it because we have a flourishing market for life insurance, which is the same bet as a life annuity, only with the sides reversed. Policyholder bets on dying soon rather than longer life.

Plus, feeding into the paternalism theme that I think underlies Social Security, if there is really serious adverse selection then it has to be because not as many people are seeking to annuitize as would with more farsighted planning. The thin demand makes adverse selection comparatively more important.

Bill Gentry said...

Nice post on another language problem in public finance. While it seems like the government-provided pension system (i.e., Social Security) should fall under the umbrella defintion of social insurance, it doesn't seem to meet the criteria posed for social insurance.

I would add that while receiving Social Security is not tied to income (though if someone lived his or her entire life without a job -- living off a trust fund, perhaps -- then he or she would not qualify for SS), the amount of the payment depends on earnings.

I think the work by Olivia Mitchell, Jim Poterba, Mark Warshawsky, and Jeff Brown is fairly convincing that adverse selection is a serious issue for private annuity markets: the life expectancy of the annuitant pool is quite different than the population as a whole. Of course, some of this difference might just reflect the positive correlation between wealth and life expectancy.

Life insurance and annuities are like taking different sides of the same bet, however there are a couple of differences. Insurance companies invest considerably more in screening for life insurance than for annuities. The reason is clear: buying life insurance while on one's death bed is a good deal. Why don't they screen for annuities? The road to a favorable annuity rate is to look sick. One might be able to manipulate measures of health -- e.g., a short burst of tobacco consumption just prior to the screening. Also, I think that it is possible that short term consumption patterns can cause spikes in cholesterol -- but it is hard to get these levels to go down very fast. If it is easier to fake having a short life expectancy than a long life expectancy, then screening in the annuity market will be less effective than in the life insurance market. If screening is uneffective, then the adverse selection problem will affect all annuitants' prices.

A second difference is the role of long-term mortality risk. What types of shifts in long-term mortality risk would affect the products? For insurers to take a bath on life insurance, people must suddenly die sooner than expected. This problem is bounded by the fact that the person must be alive to buy the policy. In contrast, for annuities, the insurer takes a big bath when people live a long time. This risk could have what is known as a long tail for writing annuity contracts so that the exposure is worse for annuities than life insurance. This sort of risk is somewhat difficult for insurers to hedge.

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