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

Author

Listed:
  • Fatih Karahan

    () (Department of Economics, University of Pennsylvania)

  • Serdar Ozkan

    () (Department of Economics, University of Pennsylvania)

Abstract

How does the persistence of earnings change over the life cycle? Do workers at different ages face the same variance of idiosyncratic shocks? This paper proposes a novel specification for residual earnings that allows for a lifetime profile in the persistence and variance of labor income shocks. We show that the statistical model is identified and estimate it using PSID data. We strongly reject the hypothesis of a at life-cycle profile for persistence and variance of persistent shocks, but not for the variance of transitory shocks. Shocks to earnings are only moderately persistent (around 0.75) for young individuals. Persistence rises with age up to unity until midway in life. On the other hand, the variance of persistent shocks exhibits a Ushaped profile over the life cycle (with a minimum of 0.01 and a maximum of 0.045). Our estimate of persistence, for most of the working life, is substantially lower than typical estimates in the literature. We investigate the implications of these profiles for consumption-savings behavior with a standard life-cycle model. The welfare cost of idiosyncratic risk implied by the age-dependent income process is 32% lower compared to an AR(1) process without age profiles. This is mostly due to a higher degree of consumption insurance for young workers, for whom persistence is moderate. We conclude that the welfare cost of idiosyncratic risk will be overstated if one does not account for the age profiles in the persistence and variance of shocks.

Suggested Citation

  • Fatih Karahan & Serdar Ozkan, 2009. "On the Persistence of Income Shocks over the Life Cycle: Evidence and Implications, Second Version," PIER Working Paper Archive 10-012, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania, revised 05 Apr 2010.
  • Handle: RePEc:pen:papers:10-012
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    File URL: http://economics.sas.upenn.edu/system/files/working-papers/10-012.pdf
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    Cited by:

    1. Arslan, Yavuz & Taskin, Temel, 2011. "Price search, consumption inequality, and expenditure inequality over the life cycle," MPRA Paper 34874, University Library of Munich, Germany.
    2. David Weiss & Cezar Santos, 2011. "Why Not Settle Down Already? A Quantitative Question," 2011 Meeting Papers 921, Society for Economic Dynamics.

    More about this item

    Keywords

    : Idiosyncratic income 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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