The people who opt for early retirement stop staring contribution to pension system where as they start getting the benefits of pension system. (Prieto, 1997) The traditional unfunded social security system is facing lot of problems in the United States and other developing countries with the increasing life expectancy of the people. The cost of providing any level of service is directly linked to the percentage of people who are employed against people who have already retired and enjoying pension in a pay-as-you-go system. The problem is continuing and increasing with people's move towards early retirement which is encouraged in many countries social security system. Even in the event of retirement being stabilized, the steep increase in the ratio of the aged against that of working age is contributing to the substantial raise in the cost of pay-as-you-go system. The United States estimators, who work for social security system, forecast an increase from current 12% of covered payroll taxes to 17% for cost of providing the benefits covered under the social security system. This is estimated to be 20% by 2070. (Campbell; Feldstein, 2001)

In pay-as-you-go system, taxpayers pay high cost to obtain any given benefit which demonstrates the comparative low rate of return the contributors earn on taxes paid by them in an unfunded system. Only the growth in the base tax rate is the implied rate of return on taxes payers' contribution in an unfunded system as shown in 1958 by Paul Samuelson in one of his famous papers. In U.S. system the tax is based on the cash wages which is the mode of finance and the future total growth in cash wages is the factor which determines the rate of return. The assumption that the future reduction in population growth rate will limit the implied real rate of return to less than 2% per annum is the only factor based on which the social security estimators estimate the future required tax rate increase. In spite of U.S. social security system being a pay-as-you-go module, where in the every current year, the total tax collection is used for paying benefits of retirees who are already enjoying retirement benefits; there is still an investment in government bonds in the form of a trust fund. (Campbell; Feldstein, 2001)

The overall rate of return the contributors get on the taxes they contribute and the funds available to pay the annual benefits is affected by the rate of return on the trust fund invested in government bonds. But since these interests are just a transfer within two government accounts this has no substantial economic contribution, though they can contribute to raise the return on payroll tax payment at the expense of income tax payments. Overall rate of return that participants get on their social taxes are very little influenced by the overall return on trust fund since the trust fund is very small, comprising just two years worth of benefits and not even up to 10% of current total obligations under the social security system. The actual rate of return is determined by the growth and in effect the system effectively operates on a pay-as-you-go basis. (Campbell; Feldstein, 2001)

The pay-as-you-go system costs are increasing and there are three simple ways to control these increase in costs under this system which are reduction in benefits, increase in taxes and pre-funding. These methods can be used together or individually to control the increasing costs under pay-as-you-go system. Some experts are of the opinion that by cutting the future benefits, the raise in future tax can be controlled. The changes should be to the existing structure of social security benefits with a move towards more fundamental shifts from the existing structure of social security system to a uniform benefit structure such as increase in retirement age and modification to the post retirement inflation adjustment. Some other experts are of the view to continue with the same benefit by increasing the tax rate significantly in the future. (Campbell; Feldstein, 2001)

However since both these measures of large tax rate increase or major reduction in benefits does not go well with politicians, the idea of pre-funding future benefits by keeping aside resources now and investing those set aside funds together or on individual accounts is not encouraged. The common feature of pre-funding is that of increase in national saving resulting in increase in national capital stock though the pre-funding proposals have many variations. Future retirement consumptions are financed by the increased national capital stock resulted from...

However the pre-funding concept was not accepted well by people since long because of the problem of transition generation ending up with paying twice. The transition generation has to pay the pay-as-you-go taxes to finance the benefit of those who have already retired and enjoying retirement benefits but at the same time saving for their own retirement. With the current rate of over 12% on wage income, this method will be a double burden with the transition generation ending up with paying above 24% tax on wage income. (Campbell; Feldstein, 2001)
Considering this the concept of pre-funding is not accepted since it is unfair on transitional generation and/or politically impossible to introduce. Actually the additional cost on transitional generation is smaller than that of what is highlighted by the critics since with the pay-as-you-go system; the implicit rate of interest is much lesser than the rate of interest on real saving. The actual savings required to finance any future benefits is lesser than the related pay-as-you-go tax rate. The extent of pay-as-you-go benefits can be gradually reduced because of retirees receiving some benefits from the funded part of system during the transition phase. Despite the increased aging population, without increasing the combined amounts of pay-as-you-go taxes and the compulsory savings by 2% of wage income, that is from the current 12.4% payroll taxes to a maximum of 14.4% and also without any changes in the current or future benefits a transition from pay-as-you-go system to a funded defined contribution system could be achieved as shown by Feldstein and Samwick. (Campbell; Feldstein, 2001)

The sum of OASI trust fund receipts i.e. The interest on the trust fund balance and the revenue transfer to trust fund on the basis of taxing the benefits of high income retirees and the total of OASI portion of the payroll tax is projected to cross the OASI benefits only by 2021 under the current law. Beyond 2021, public borrowings through sale of government bonds held under social security trust fund should temporarily help to continue payment of benefits. Pay-as-you-go benefits have to be cut or the tax rates have to be raised once the trust fund bonds gets exhausted in 2040. Keeping the trust fund always positive in the future without increasing the taxes, with the projected mixture of PRA annuities and the pay-as-you-go benefits for each group of retirees exceeding the pay-as-you-go benefits, that are projected in the current law is one of the main advantage of a mixed system. (Poterba, 2002)

To make this possible, the pay-as-you-go part of aggregate retirement benefits should be reduced from the extent projected in current law to the extent that can be funded but that are nevertheless high enough for combined benefits to exceed pay-as-you-go benefits projected in current law. There are many ways that a pay-as-you-go benefits can be reduced to equivalent to the extent projected in current law. Simple methods can reduce, pay-as-you-go benefits by 0.3% for each year an individual participates in a PRA system during the first five years of the program from 2003 to 2007 and 0.6% for each year in the next six years from 2008 to 2013 and 0.9% per year after 2014. (Poterba, 2002)

As far as taxes are concerned, there is no need for employees to worry much since most or all of the taxes related to their paycheck is withheld and directly paid to the IRS and state tax department by the employer. The employer does all the relevant calculations and the employee's obligation is just to file the annual tax returns with the IRS and state tax departments. But when an employees starts his own business, the tax life changes dramatically where there won't be any employer to calculate, withhold and pay taxes, instead the self-employed have to do on his own. This requires period tax calculation and filing with the IRS and state tax department which an employee may not be used to while he was an employee and not self-employed. (Fishman, 2006)

To file periodic tax calculation and filing with the IRS and state tax department, one has to maintain records of actual income and expenditure. Also the process of tax calculation and filing of tax returns gets complicated each year. When one becomes self-employed, the federal government is the one which has the biggest bite in taxes paid by a self-employed which includes income tax, self-employment tax, estimated tax and employment tax. Federal income tax and self-employment…