Consumption and Earnings Inequality with Risky Human Capital

This paper analyzes the dispersion in consumption and earnings over the life-cycle. We first reexamine these facts by considering US data for the period (1980-2000) using alternative price deflators. We find that consumption and earnings dispersion increase with age, but that the increase in consumption dispersion is smaller than in the patterns documented by Deaton and Paxson (1994). Then, we proceed to investigate the extent to which an economic model can account jointly for these facts. A critical feature of the environment we consider is that labor earnings are endogenous. More specifically, we extend the standard human capital framework as individuals in our economy experience uninsurable, idiosyncratic shocks over the life-cycle, and face borrowing constraints. Individuals are heterogeneous at birth in terms of their initial human capital and learning ability. Idiosyncratic depreciation shocks to human capital affect current earnings as well as human capital carried over to the next period. We use this framework to answer a number of crucial questions. First, what is the role of idiosyncratic shocks vis-a-vis initial conditions in accounting for dispersion in the present value of labor earnings and other measures of earnings inequality? Second, what are the quantitative consequences on the earnings and consumption distributions of increases in human capital risk? Finally, can this model account for both the earnings and consumption dispersion facts from arbitrary distributions of initial conditions and stochastic processes for depreciation shocks? Our preliminary findings indicate that the model in our economy can go a long way in reproducing the observed earnings and consumption dispersion over the life cycle. Borrowing constraints are particularly important in generating the observed consumption dispersion profile.