In March 2000, Congress voted to abolish the Social Security earnings limit for workers over the age of 65. As a result, persons over the age of 65 will receive full Social Security benefits regardless of how much they earn in wages or salaries. The change was made retroactive to January 2000. An earnings limit still applies, however, to people between ages 62 and 64 who collect Social Security and earn wages or salaries over a specified exempt amount.
Policy debates about the Social Security earnings limit must weigh several different concerns. This paper explores whether eliminating the earnings limit for workers aged 62-64 might cause some people to claim Social Security earlier in their lives. The issue of when to claim Social Security benefits can be separated analytically from the question of whether the earnings limit has an impact on the number of hours worked. The earnings limit only affects people who already receive Social Security; therefore, those who are considering whether to reduce their work hours, or retire completely, must already have made an affirmative decision to receive Social Security.
There is some evidence to support the proposition that, if the earnings limit were lifted for ages 62-64, more workers might apply for Social Security below the "normal retirement age." This is the Social Security Administration's term for the age of eligibility for full Social Security benefits. The normal retirement age is currently set at 65 and two months, but it is scheduled to rise to 67 by 2022. Benefits received before the normal retirement age are reduced to reflect the actuarial consequences of receiving benefits over a longer period. Under current law, the benefit reduction can range up to a maximum reduction of 20.8 percent of benefits. Therefore, lifting the earnings limit might reduce the standard of living for early claimants as well as for their widows.
Description of the Earnings Limit
The earnings limit reduces Social Security benefits when a beneficiary's labor income exceeds a certain threshold called the "exempt amount." The earnings limit applies only to wage and salary income above the exempt amount; it does not apply to pension, dividend, or interest income that may exceed the exempt amount, because the FICA tax is paid only on wages and salaries. The exempt amount changes annually based on wage growth. In recent years, the exempt amounts were as follows:
Until the law was changed in 2000, the earnings limit reduced the Social Security benefit by one of two calculations, depending on the age of the beneficiary.
- For ages 62-64, the Social Security Administration withheld $1 in benefits for every $2 in wages earned above the exempt amount.
- For ages 65-69, $1 was withheld for every $3 in wages above the exempt amount.
The 50-cents-on-the-dollar benefit reduction for ages 62-64 is still in place, while the earnings limit has been lifted for age 65 and over starting in 2000.
While the earnings limit is perceived as a tax, individuals will eventually recapture all of their earnings limit benefit reductions once they reach normal retirement age, and if they live long enough. Benefit recapture is accomplished by recomputing the monthly benefit when the beneficiary reaches normal retirement age. The period required for full recapture of benefits is computed actuarially.
Because benefits are recaptured, it has been argued that the earnings limit functions like a program of enforced savings, although whether this forced saving is efficient has been debated. It may be inequitable to certain racial or income groups that tend to have shorter lifespans. (Gruber and Orszag, 1999)
The Earnings Limit Can Be a Significant Disincentive to Claiming Benefits Before the Normal Retirement Age, for People Who Perceive it as a Tax
Workers aged 62-64 currently face a combination of two disincentives for claiming Social Security benefits: (1) the earnings limit, which is perceived as a tax despite the subsequent recapture of benefits; and (2) the actuarial reduction to the benefits of people who apply for Social Security before the normal retirement age (currently 65 and two months). The earnings limit affects only individuals age 62-64 who are still in the workforce and have earnings above the exempt amount. The actuarial reduction, however, affects all individuals who apply for Social Security benefits before the normal retirement age.
The actuarial reduction for claiming benefits before the normal retirement age is 5/9 percent of the primary insurance amount (PIA) for every month that benefits are received before the normal retirement age. Because the normal retirement age is currently 65 and two months, someone who claims benefits immediately upon turning 62 would experience the highest possible actuarial reduction in benefits, which currently is 20.8 percent. By 2022, when the normal retirement age will have risen to 67, the highest possible reduction will reach 30 percent (resulting in a benefit of 70 percent of PIA), for someone who claims benefits immediately upon turning 62. Under current law, however, survivor benefits will always remain at least 82.5 percent of the worker's PIA for surviving spouses above the full benefit age. Unlike the earnings limit, benefits that are reduced under the actuarial reduction are not returned when the beneficiary retires from the workforce.
If the earnings limit were lifted for workers aged 62-65, this would remove some, but not all, of the disincentive to claiming Social Security before the normal retirement age. That is, there would be no earnings limit on top of the actuarial reduction, which would still continue in force.
(¶ Click here to see Chart 1: Comparison of Benefit Reductions Under Earnings Limit to Actuarial Benefit Reduction For a Worker Retiring at Age 62 and Entitled to Maximum Benefit Year 2000.)
In fact, the earnings limit may be a more significant disincentive than is the actuarial reduction for claiming benefits before the normal retirement age, at least from the perspective of people aged 62-64 who are still in the workforce.A simple, back-of-the-envelope comparison shows that for workers aged 62-64 who earned more than $17,236 in 2000, the earnings limit reduction was larger than the actuarial reduction for early benefits. This is shown in Chart 1. The horizontal line with small squares shows the largest possible dollar reduction in benefits that a person could experience for taking benefits before the normal retirement age: in 2000, this was $3,578. This actuarial benefit reduction is a function of the age at which one first claims benefits, and the dollar amount of the benefit. It is assumed here that the individual experienced the largest possible actuarial reduction, currently 20.8% of the benefit amount, because he claimed Social Security immediately upon reaching age 62, and that the individual's wage history entitled him to the maximum benefit of $17,200 in 2000 (20.8% * $17,200 = $3,578).
The line with dots represents the benefit reduction under the earnings limit. The earnings limit reduction is zero up to the exempt amount, after which the reduction increases with wages along the horizontal axis. The earnings limit reduces benefits by one dollar for every two dollars in wage or salary income over the exempt amount, for ages 62-64 (this produces a 45 degree angle above the exempt amount).
For the benefit loss from the earnings limit to equal (or exceed) the largest possible actuarial reduction, the individual would have to earn $7,156 (or more) over the earnings limit exempt amount (in 2000, this implies total wages of $10,080+ $7,156 = $17,236). For this person, the loss in benefits from the earnings limit would amount to $3,578 (one half of $7,156). This is exactly equal to the largest possible actuarial reduction for early benefits. At higher wages, the size of the earnings limit reduction grows larger, while the actuarial reduction remains constant.
The illustration above employs the largest possible dollar amount for the actuarial reduction in benefits. Many workers would face a smaller actuarial reduction, either because they took benefits some time after their 62nd birthday but before the normal retirement age, or because they were not entitled to the maximum benefit under the law before the reductions. The earnings limit reduction does not change, however, for a given wage in the year 2000. Thus, some workers would find that the earnings test benefit reduction would begin to surpass the actuarial reduction at wages that are lower than $17,236.
The Well-being of Retirees, Particularly Widows, Could Fall if More People Claimed Social Security Before the Normal Retirement Age
Would more people claim early Social Security benefits if the earnings limit were removed? Jonathan Gruber and Peter Orzag estimated a large and significant effect on benefits claims if the earnings limit were removed. Specifically, their recent work suggests that a $1,000 increase in the earnings limit could increase the share of the elderly men receiving SS by up to 1.59 percent, and that complete removal could increase that share by up to 13.5 percent. Other specifications of the model suggest smaller impacts for men, however. The results were even larger for women: a $1,000 increase in the earnings limit could increase the share of elderly women receiving Social Security by up to 3.34 percentage points, and complete removal could increase recipiency by up to 20 percentage points, although again, other specifications of the model suggest smaller impacts (Gruber and Orszag, 2000).
If additional workers claimed Social Security before the normal retirement age, this could reduce the future welfare of retirees and their spouses. Widows in particular could face reduced well-being if their spouses claimed benefits before the normal retirement age. Gruber and Orszag found that widows whose deceased spouses claimed early benefits had a mean annual benefit that was $7,753 in 1998, or $65 below the 1998 poverty line of $7,818. By contrast, widows whose deceased spouses waited until normal retirement age to claim benefits had a mean benefit of $9,661, or $1,843 above the 1998 poverty line. About one third of the difference between the groups can be attributed to the choice to take early retirement, with the remaining two-thirds of the difference resulting from the fact that those whose spouses chose early retirement tended to have lower PIAs. It should be noted that these estimates consider Social Security benefits only, and do not include other possible sources of income such as pensions or assets.
According to the Social Security Administration's estimates, if the earnings limit had never existed in law, and if most workers had applied for Social Security benefits immediately upon turning 62, then by 1994 an additional 700,000 people age 62 and over would have been in poverty. Workers who claimed Social Security right at age 62 would have had a higher total income as long as they continued to work, but by 1994 many of them had fully retired from the workforce and were relying on a reduced Social Security benefit. The poverty rate of this age group would have increased from 12.0 percent to 13.9 percent. About 70 percent of those moving into poverty would have been women (Social Security Administration, 2000.)
On the other hand, to the extent that the earnings limit caused people to reduce their work hours, so as to hold their wages under the exempt amount, abolishing the earnings limit could cause people to increase their work hours. This could lead to more consumption and even to more savings. A few empirical studies of labor supply have found a small increase in work hours as a result of removing the earnings limit, although others have found the effect on labor to be negligible. (See the Data Digest entitled, "The Social Security Earnings Limit and Work and Retirement Incentives," for a more detailed discussion of the labor supply response to the earnings limit.)
It has also been argued that the earnings limit induces people to retire completely from the workforce: to the extent that this might be true, lifting the earnings limit might cause more husbands to remain in the workforce, to the possible benefit of future widows. It is very difficult to quantify how retirement behavior would change in the absence of the earnings limit. The earnings limit is only a small piece in the complex retirement decision, which addresses health, attitudes towards one's job, and the prospect of receiving Social Security as a replacement income. One study which addressed the effect of the earnings limit on employment found little evidence that more men would participate in the workforce if the earnings limit were raised or abolished, although the evidence is somewhat stronger for women. (Gruber and Orszag, 2000.)
It is also possible that people who file for benefits below the normal retirement age might save part of their additional income for later in their lives. Economic research suggests, however, that people at very low incomes are not likely to save out of additional income.
Benefits to Delaying the Receipt of Social Security
There are clear benefits to delaying the receipt of Social Security benefits, stemming from the fact that delay allows the worker or retiree to minimize or entirely avoid the actuarial reduction for benefits received before the normal retirement age. Additionally, when benefits are first claimed after age 65, they are increased actuarially through the delayed retirement credit.
Coile, Diamond, Gruber and Jousten suggest that delaying benefit receipt would be particularly valuable to workers who expect to live longer than average, married men in general, and married men with younger spouses in particular. For the base case, a couple with one earner, the gains from delaying benefits receipt for three years until age 65 amounted to 650 percent of the primary insurance amount (PIA). Additionally, delay may bring additional gains to risk-averse individuals. This is because Social Security provides a real annuity that is not available in the private market, and individuals are able to purchase more of this annuity by delaying benefits receipt. (Coile, Diamond, Gruber and Jousten, 2000)
There is some evidence to support the theory that eliminating the earnings limit for a given age group would increase the number of Social Security benefit claims among this age group. This can be attributed to the common, but incorrect, perception that the earnings limit is a tax on labor income.
In particular, if the earnings limit were eliminated for ages 62-64, one would expect to see an increase in claimants among this group, even though they would still face an actuarial disincentive to claiming benefits. Because of the benefits to delaying the receipt of Social Security, however, it is unlikely that 100% of these individuals would begin to receive Social Security.
Claiming benefits below the normal retirement age can have potentially negative consequences for the well-being of workers below the normal retirement age, and even more so for the widows that outlive them. This is because of the actuarial reduction that is made to benefits that are received before the normal retirement
Coile, Courtney, Peter Diamond, Jonathan Gruber and Alain Jousten, "Delays in Claiming Social Security Benefits," National Bureau of Economic Research, Working Paper No. 7318, August 1999.
Gruber, Jonathan and Peter Orszag, "What to do About the Social Security Earnings Test?" Center for Retirement Research, Boston College, July, 1999.
Gruber, Jonathan and Peter Orszag, "Does the Social Security Earnings Test Affect Labor Supply and Benefits Receipt?" September, 2000.
Social Security Administration, Office of Policy, February, 2000. Available at: www.ssa.gov/policy/pubs/policypapers/RET_repeal.html.
- This will be true, at least, for workers who regard the earnings limit as a tax and do not realize that benefit reductions are potentially re-captured in full after retirement, over the course of a reasonably long life.
- For workers who waited until 63 or 64 to claim Social Security, the percentage amount of the actuarial reduction to benefits would be smaller than 20.8%. As a result, the dollar amount of the actuarial reduction would be smaller. The other circumstance involves workers who do claim benefits immediately upon turning 62, but who are entitled to a lower original (before reductions) benefit based on their work history. These workers would still face the maximum percentage reduction of 20.8 percent, but the percentage actuarial reduction would be applied to a smaller base. Again, the dollar amount of the benefit reduction would be smaller. Graphically, in both cases the horizontal line representing the actuarial reduction to benefits would shift downward in a parallel fashion, and would cross the earnings test line at a lower wage.
Written by Alison Shelton, AARP Public Policy Institute
May be copied only for noncommercial purposes and with attribution; permission required for all other purposes.
Public Policy Institute, Public Affairs, AARP, 601 E Street, NW, Washington, DC 20049