What Do Data on Millions of U.S. Workers Reveal About Life-Cycle Earnings Risk?

We build a life-cycle model with earnings risk, liquidity constraints, and portfolio choice over tax-deferred and taxable assets to evaluate how household consumption changes in response to shocks to transitory anticipated income, such as the 2001 income tax rebate. Households optimally invest in tax-deferred assets, which are encumbered by withdrawal penalties, and exchange taxable precautionary savings for higher after-tax returns. The model predicts a higher marginal propensity to consume out of a rebate than is predicted by a standard frictionless life-cycle model. Liquidity-constrained households—with few financial assets or portfolios expensive to reallocate—consume a higher fraction of the rebates. (JEL D91, E21, G11, H24)

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Nonlinear Household Earnings Dynamics, Self-Insurance, and Welfare

Journal of the European Economic Association ◽

10.1093/jeea/jvz010 ◽

2019 ◽

Vol 18 (2) ◽

pp. 890-926 ◽

Cited By ~ 10

Author(s):

Mariacristina De Nardi ◽

Giulio Fella ◽

Gonzalo Paz-Pardo

Keyword(s):

Life Cycle ◽

Linear Process ◽

Cross Sectional ◽

Individual Level ◽

Consumption Insurance ◽

Earnings Dynamics ◽

The Individual ◽

Standard Life ◽

Earnings Risk ◽

Alternative Processes

Abstract Earnings dynamics are much richer than typically assumed in macro models with heterogeneous agents. This holds for individual-pre-tax and household-post-tax earnings and across administrative and survey data. We estimate two alternative processes for household after-tax earnings and study their implications using a standard life-cycle model. Both processes feature a persistent and a transitory component, but although the first one is the canonical linear process with stationary shocks, the second one has substantially richer earnings dynamics, allowing for age-dependence of moments, non-normality, and nonlinearity in previous earnings and age. Allowing for richer earnings dynamics implies a substantially better fit of the evolution of cross-sectional consumption inequality over the life cycle and of the individual-level degree of consumption insurance against persistent earnings shocks. The richer earnings process implies lower welfare costs of earnings risk.

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