In October of last year, the U.S. unemployment rate hit 4.1 percent—its lowest since January 1970. This low unemployment rate just continued a trend of declining rates that has been one of the identifying characteristics of the ongoing economic expansion. All the while, lots of firms and industries continue to clamor for qualified workers to fill vacant jobs. But with the national economy experiencing such a tight labor market, this has not been an easy task, especially as the U.S. economy approaches its tenth year of expansion.

The length and strength of this expansion has pushed labor markets to new extremes and drawn in large numbers of workers who previously had not been in the labor force. As Poole and Wall describe in the lead article of this issue, the face of the labor force has changed dramatically over the past few decades—but especially in the 1990s. Many more women over 20 are not only in the labor force, but employed. And the share of black men employed has nearly recovered from the blows suffered in the 1970s and early 1980s. The teen-age population has made similar strides, as Poole and Wall also note. But even with all of these new workers, vacant positions abound.

There is a population, however, that contains a sizable pool of workers that remains somewhat untapped: those near or at retirement age. In 1998, an estimated 19.5 million people—or more than 11 percent of the population 25 years and older—in the country were between the ages of 60 and 69.1 Of these people, 35 percent (about 6.8 million) were labor force participants; that is, they were either employed or actively looking for work. Of these, about 6.6 million were employed, implying an unemployment rate of just 2.9 percent. Clearly, people in this age bracket who choose to enter the labor force are very likely to be working. The big question, then, is why do so few choose to be in the labor force in the first place?

When Earning Too Much at Work Hurts

The obvious answer, of course, is that most are retired. Even though mandatory retirement was eliminated in the mid-1980s, workers still tend to retire when they reach 65 years of age. In fact, if the labor force number just given is divided into two groups—those between 60 and 64 years old and those between 65 and 69—nearly 70 percent are in the younger age bracket. Indeed, the number of people in the older group who participated in the labor market in 1998 was less than half that of the younger group. Despite appearances, however, there is nothing magical about the age of 65. Rather, this is the age that has been institutionalized because it is when a person is able to begin collecting full Social Security benefits (reduced benefits are available at age 62).2 By itself, receiving full benefits might seem like enough of an incentive to encourage someone to withdraw from the labor force. But the Social Security system provides another powerful, but less obvious, retirement incentive: the retirement earnings test.

The earnings test is basically a tax on earnings for those who are between 62 and 70 years old and receive Social Security benefits.3 Its intent is to move people out of the labor force and into retirement. In 1998, the test worked as follows (see accompanying table):

• Those under 65 years of age could earn up to $9,120 a year without any reduction in Social Security benefits. For each $2 earned above $9,120, benefits would be reduced by $1, until all benefits were gone. This amounts to a 50 percent tax on earnings above $9,120 for those in this age group. (The benefits are not forfeited, however, because future benefits will be raised to compensate for the loss today.)
• Those between 65 and 69 years of age could earn up to $14,500 a year without any reduction in Social Security benefits. For earnings above this threshold, benefits would be reduced $1 for every $3 in earnings until all benefits were gone. This group effectively faces a 33 percent tax on earnings above $14,500.
• Those 70 and older face no benefit reduction, regardless of earnings.

These are extremely large penalties for continuing to work while collecting Social Security benefits—particularly for the younger age group. And these benefit reductions occur at low income levels—levels that under normal circumstances would, at most, be subject to a 15 percent income tax. Thus, it's easy to see how the earnings test could work to push someone out of the labor force. If one chose to stay in, however, the number of hours worked would likely be limited to avoid the penalty. Until just recently, though, the evidence in the literature did not support these assertions.

On the One Hand...

Virtually all earlier studies that examined the effect of the earnings test on the labor supply of older workers concluded that the effect is small.4 The studies found that eliminating the earnings test would have, at most, a minor effect on the work activity of older Americans, especially those 65 and over, because many factors play a role in the retirement decision. In fact, according to the studies, some of these factors—such as private pensions and health status—have much more influence on retirement decisions than the earnings test. Furthermore, the studies also found that over time the earnings test has been relaxed—that is, exempt income thresholds have been raised and penalty rates have been lowered—without much effect on the labor supply decisions of older Americans.

...But on the Other Hand

In a June 1999 study, however, economist Leora Friedberg contradicts the findings of the previous literature. Friedberg asserts that the earnings test's predicted effects are apparent in the data, particularly the expected adjustment of work hours to keep earnings just below the exempt income thresholds. In her study, Friedberg shows that not only have workers adjusted their hours to avoid the earnings test penalty, but they have actually shifted their hours as the thresholds have increased. This type of clustering just below the exempt income threshold amounts, Friedberg argues, is evidence that the earnings test has indeed led many workers to limit their labor supply.

All told, Friedberg predicts that eliminating the earnings test would bolster the labor supply of those at or above the current exempt amount, raising their working hours by 5.3 percent, and it would do this at a small cost to the government. That said, Friedberg also projects that in 2002, when the exempt amount for those 65 and older rises to $30,000, the labor supply of those with earnings in this neighborhood will actually fall as they adjust to the penalty. On top of this, more people over time will be facing the more restrictive 50 percent tax penalty (currently affecting those between ages 62 and 64), as the retirement age gradually increases to 67.

Retiring the Earnings Test

The earnings test, introduced in 1939, was meant to induce retirement. Since the 1950s, the test has been gradually relaxed, as the focus has shifted toward encouraging work and saving. Given today's strong market conditions, a continually declining median retirement age, and an increasing life expectancy, the earnings test seems an anachronism. Eliminating the earnings test would likely increase the available pool of qualified workers, enabling firms to fill vacancies. Friedberg's findings could, therefore, be just the catalyst needed to launch the serious discussion this issue truly deserves.

Paige M. Skiba provided research assistance.

Endnotes

1. This and other population figures stated do not include those in the armed services or those who are institutionalized (in prisons, nursing homes, mental institutions and the like). [back to text]
2. The "official" retirement age will gradually rise from 65 to 67 between 2003 and 2027. [back to text]
3. The earnings test affects only earned income, such as wages and salaries. It does not affect unearned income, such as dividends and pensions. This tax on earnings is separate from income taxes owed to the government. The term "tax" is used because the benefit reduction is basically an amount of money a person must pay the government. [back to text]
4. See, for example, Leonesio (1990) and Packard (1990). [back to text]

References

Friedberg, Leora. "The Labor Supply Effects of the Social Security Earnings Test," NBER Working Paper 7200 (June 1999).

Leonesio, Michael V. "The Effects of the Social Security Earnings Test on the Labor-Market Activity of Older Americans: A Review of the Evidence," Social Security Bulletin (May 1990), pp. 2-21.

Packard, Michael D. "The Earnings Test and the Short-Run Work Response to its Elimination," Social Security Bulletin (September 1990), pp. 2-16.

Poole, William, and Howard J. Wall. "Price Stability and the Rising Tide," The Regional Economist, Federal Reserve Bank of St. Louis (January 2000), pp. 5-9.

Social Security Administration. "Social Security Facts and Figures," publication No. 05-10011 (April 1998).