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Inferring labor income risk from economic choices: an indirect inference approach

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  • Fatih Guvenen
  • Anthony Smith

Abstract

This paper uses the information contained in the joint dynamics of households’ labor earnings and consumption-choice decisions to quantify the nature and amount of income risk that households face. We accomplish this task by estimating a structural consumption-savings model using data from the Panel Study of Income Dynamics and the Consumer Expenditure Survey. Specifically, we estimate the persistence of labor income shocks, the extent of systematic differences in income growth rates, the fraction of these systematic differences that households know when they begin their working lives, and the amount of measurement error in the data. Although data on labor earnings alone can shed light on some of these dimensions, to assess what households know about their income processes requires using the information contained in their economic choices (here, consumption-savings decisions). To estimate the consumption-savings model, we use indirect inference, a simulation method that puts virtually no restrictions on the structural model and allows the estimation of income processes from economic decisions with general specifications of utility, frequently binding borrowing constraints, and missing observations. The main substantive findings are that income shocks are not very persistent, systematic differences in income growth rates are large, and individuals have substantial amounts of information about their future income prospects. Consequently, the amount of uninsurable lifetime income risk that households perceive is substantially smaller than what is typically assumed in calibrated macroeconomic models with incomplete markets.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 450.

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Date of creation: 2010
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Handle: RePEc:fip:fedmsr:450

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  1. John M. Abowd & David Card, 1986. "On the Covariance Structure of Earnings and Hours Changes," NBER Working Papers 1832, National Bureau of Economic Research, Inc.
  2. Fatih Guvenen, 2007. "Learning Your Earning: Are Labor Income Shocks Really Very Persistent?," American Economic Review, American Economic Association, vol. 97(3), pages 687-712, June.
  3. Flavio Cunha & James Heckman & Salvador Navarro, 2005. "Separating uncertainty from heterogeneity in life cycle earnings," Oxford Economic Papers, Oxford University Press, vol. 57(2), pages 191-261, April.
  4. Baker, Michael, 1997. "Growth-Rate Heterogeneity and the Covariance Structure of Life-Cycle Earnings," Journal of Labor Economics, University of Chicago Press, vol. 15(2), pages 338-75, April.
  5. Jonathan Heathcote & Fabrizio Perri & Giovanni L. Violante, 2009. "Unequal we stand: an empirical analysis of economic inequality in the United States, 1967-2006," Staff Report 436, Federal Reserve Bank of Minneapolis.
  6. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2004. "Cyclical Dynamics in Idiosyncratic Labor Market Risk," Journal of Political Economy, University of Chicago Press, vol. 112(3), pages 695-717, June.
  7. Phelan, J.C., 1990. "Incentives, Insurance And The Variability Of Con Somption And Leisure," Working papers 90-26, Wisconsin Madison - Social Systems.
  8. Meghir, Costas & Pistaferri, Luigi, 2002. "Income Variance Dynamics and Heterogeneity," CEPR Discussion Papers 3632, C.E.P.R. Discussion Papers.
  9. Haider, S.J., 2000. "Earnings Instability and Earnings Inequality of Males in the United States: 1967-1991," Papers 00-15, RAND - Labor and Population Program.
  10. Pierre-Olivier Gourinchas & Jonathan A. Parker, 2002. "Consumption Over the Life Cycle," Econometrica, Econometric Society, vol. 70(1), pages 47-89, January.
  11. Mark Huggett & Gustavo Ventura & Amir Yaron, 2007. "Sources of Lifetime Inequality," Working Papers gueconwpa~07-07-04, Georgetown University, Department of Economics.
  12. Pedro Carneiro & Karsten T. Hansen & James J. Heckman, 2003. "Estimating Distributions of Treatment Effects with an Application to the Returns to Schooling and Measurement of the Effects of Uncertainty on College," NBER Working Papers 9546, National Bureau of Economic Research, Inc.
  13. Richard Blundell & Ian Preston, 1997. "Consumption, inequality and income uncertainty," IFS Working Papers W97/15, Institute for Fiscal Studies.
  14. Richard Blundell & Luigi Pistaferri & Ian Preston, 2004. "Imputing consumption in the PSID using food demand estimates from the CEX," IFS Working Papers W04/27, Institute for Fiscal Studies.
  15. MaCurdy, Thomas E., 1982. "The use of time series processes to model the error structure of earnings in a longitudinal data analysis," Journal of Econometrics, Elsevier, vol. 18(1), pages 83-114, January.
  16. Vasia Panousi & Ivan Vidangos & Giovanni Violante & Bradley Heim & Fatih Guvenen, 2010. "Idiosyncratic Income Risk Estimated From IRS Administrative Wage Data," 2010 Meeting Papers 108, Society for Economic Dynamics.
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