Higher-Order Income Risk and Social Insurance Policy Over the Business Cycle

This paper studies how higher-order income risk varies over the business cycle as well as the extent to which such risks can be smoothed within households or with government social insurance policies. To provide a broad perspective on these questions, we study panel data on individuals and households from the United States, Germany, and Sweden, covering more than three decades of data for each country. We find that the underlying variation in higher-order risk is remarkably similar across these countries that differ in many details of their labor markets. In particular, in all three countries, the variance of earnings shocks is almost entirely constant over the business cycle, whereas the skewness of these shocks becomes much more negative in recessions. Government provided insurance, in the form of unemployment insurance, welfare benefits, aid to low income households, and the like, plays a more important role reducing downside risk in all three countries; the effectiveness is weakest in the United States, and most pronounced in Germany. For Sweden, we find that insurance provided within households plays a similar role. We calculate that the welfare benefits of social insurance policies for stabilizing higher-order income risk over the business cycle range from 1% of annual consumption for the United States to 5% for Germany.