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On the Persistence of Income Shocks over the Life Cycle: Evidence, Theory, and Implications

Author

Listed:
  • Fatih Karahan

    (Federal Reserve Bank of New York)

  • Serdar Ozkan

    (Federal Reserve Board)

Abstract

How does the persistence of earnings change over the life cycle? Do workers at different ages face the same variance of idiosyncratic earnings shocks? This paper proposes a novel specification for residual earnings that allows for an age profile in the persistence and variance of labor income shocks. We show that the statistical model is identified, and we estimate it using Panel Study of Income Dynamics data. We find that shocks to earnings are only moderately persistent (around 0.75) for young workers. Persistence rises with age, up to unity, until midway through life. The variance of persistent shocks exhibits a U-shaped profile over the life cycle (with a minimum of 0.01 and a maximum of 0.05). These results suggest that the standard specification in the literature (with age-invariant persistence and variance) cannot capture the earnings dynamics of young workers. We also argue that a calibrated job turnover model can account for these nonflat profiles. The key idea is that workers sort into better jobs and settle down as they age; in turn, magnitudes of wage growth rates decline, thereby decreasing the variance of shocks. Furthermore, the decline in job mobility results in higher persistence. Finally, we investigate the implications of age profiles for consumption–savings behavior. The welfare cost of idiosyncratic risk implied by the age-dependent income process is up to 1.6 percent of lifetime consumption lower compared with its age-invariant counterpart. This difference is mostly due to a higher degree of consumption insurance for young workers, for whom persistence is moderate. These results suggest that age profiles of persistence and variances should be taken into account when calibrating life-cycle models. (Copyright: Elsevier)

Suggested Citation

  • Fatih Karahan & Serdar Ozkan, 2013. "On the Persistence of Income Shocks over the Life Cycle: Evidence, Theory, and Implications," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 16(3), pages 452-476, July.
  • Handle: RePEc:red:issued:10-74
    DOI: 10.1010/j.red.2012.08.001
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    Cited by:

    1. Findeisen, Sebastian & Sachs, Dominik, 2017. "Redistribution and insurance with simple tax instruments," Journal of Public Economics, Elsevier, vol. 146(C), pages 58-78.
    2. Arifur Rahman, 2017. "Heterogeneous labor earning shock process in finite horizon," LIS Working papers 721, LIS Cross-National Data Center in Luxembourg.
    3. Giesecke, Matthias & Bönke, Timm & Lüthen, Holger, 2011. "The Dynamics of Earnings in Germany: Evidence from Social Security Records," Annual Conference 2011 (Frankfurt, Main): The Order of the World Economy - Lessons from the Crisis 48692, Verein für Socialpolitik / German Economic Association.
    4. Findeisen, Sebastian & Sachs, Dominik, 2014. "Efficient Labor and Capital Income Taxation over the Life Cycle," Working Papers 14-17, University of Mannheim, Department of Economics.
    5. Arifur Rahman, 2018. "Equitable Redistribution without Taxation: A lesson from East Asian Miracle countries," LIS Working papers 726, LIS Cross-National Data Center in Luxembourg.
    6. Fatih Guvenen & Fatih Karahan & Serdar Ozkan & Jae Song, 2015. "What Do Data on Millions of U.S. Workers Reveal about Life-Cycle Earnings Risk?," NBER Working Papers 20913, National Bureau of Economic Research, Inc.
    7. repec:bla:intfin:v:20:y:2017:i:2:p:174-188 is not listed on IDEAS
    8. Mariacristina De Nardi & Giulio Fella & Gonzalo Paz-Pardo, 2018. "Nonlinear household earnings dynamics, self-insurance, and welfare," Discussion Papers 1817, Centre for Macroeconomics (CFM).
    9. William Blankenau & Xiaoyan Youderian, 2015. "Early childhood education expenditures and the intergenerational persistence of income," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(2), pages 334-349, April.
    10. repec:eee:jimfin:v:85:y:2018:i:c:p:168-186 is not listed on IDEAS
    11. Krueger, Dirk & Ludwig, Alexander, 2016. "On the optimal provision of social insurance: Progressive taxation versus education subsidies in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 77(C), pages 72-98.
    12. Valentina Bosetti & Marco Maffezzoli, 2013. "Taxing Carbon under Market Incompleteness," Working Papers 2013.72, Fondazione Eni Enrico Mattei.
    13. Sanchez, Manuel & Wellschmied, Felix, 2017. "Modeling Life-Cycle Earnings Risk with Positive and Negative Shocks," IZA Discussion Papers 10925, Institute for the Study of Labor (IZA).
    14. Furceri, Davide & Loungani, Prakash & Zdzienicka, Aleksandra, 2018. "The effects of monetary policy shocks on inequality," Journal of International Money and Finance, Elsevier, vol. 85(C), pages 168-186.
    15. Blundell, Richard & Graber, Michael & Mogstad, Magne, 2015. "Labor income dynamics and the insurance from taxes, transfers, and the family," Journal of Public Economics, Elsevier, vol. 127(C), pages 58-73.
    16. Claudio Campanale & Marcello Sartarelli, 2018. "Life-cycle Wealth Accumulation and Consumption Insurance," Working papers 055, Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino.
    17. Corina Boar, 2017. "Dynastic Precautionary Savings," 2017 Meeting Papers 343, Society for Economic Dynamics.
    18. Taghizadeh-Hesary, Farhad & Yoshino, Naoyuki & Shimizu, Sayoko, 2018. "The Impact of Monetary and Tax Policy on Income Inequality in Japan," ADBI Working Papers 837, Asian Development Bank Institute.
    19. Taghizadeh-Hesary, Farhad & Yoshino, Naoyuki & Shimizu, Sayoko, 2018. "The Impact of Monetary and Tax Policy on Income Inequality in Japan," ADBI Working Papers 837, Asian Development Bank Institute.
    20. Heidrich, Stefanie, 2016. "Essays on Intergenerational Income Mobility, Geographical Mobility, and Education," Umeå Economic Studies 932, Umeå University, Department of Economics.
    21. Staley, Mark, 2018. "The Knowledge-Diffusion Bottleneck in Economic Growth and Development," MPRA Paper 87255, University Library of Munich, Germany.
    22. Amaral, Pedro S., 2017. "Monetary Policy and Inequality," Economic Commentary, Federal Reserve Bank of Cleveland, issue January.

    More about this item

    Keywords

    Idiosyncratic earnings risk; Incomplete markets models; Earnings persistence; Consumption insurance;

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials

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