The Effect of Subjective Mortality Risk on Life Cycle Consumption and Labor Supply

Abstract:     
This paper analyzes the impact of subjective mortality risk on consumption and labor choice in a life cycle model. Using longitudinal data from the Health and Retirement Study (HRS), I estimate the intertemporal elasticity of substitution (IES) and the Frisch labor elasticity. Instead of identifying the IES using the effective interest rate as done in previous studies, I use self reported subjective probabilities of survival. Estimating the IES using the log-linearized Euler equation, I find evidence that households intertemporally substitute consumption. The estimates of the IES are statistically significant and consistent with what is predicted by theory. This result differs from other studies that find that the IES is not significantly different from zero. This paper also contributes to the literature on labor choice by analyzing the impact of survival beliefs on intertemporal labor supply. In the absence of mortality risk, individuals at the end of their working years are less responsive to expected changes in wage, with an estimated Frisch elasticity below other estimates for younger workers. After including subjective mortality risk, the effect of wage is of the same magnitude, and there exists evidence of intertemporal substitution of labor hours due to changes in subjective survival. Finally, results obtained in this paper indicate that the use of subjective survival beliefs is more appropriate than objective measures, which result in biased parameter estimates and the rejection of the life cycle model.

Keywords: consumption, labor supply, Euler Equation, subjective survival probability, intertemporal substitution

JEL Classifications: J11, J14, J22, J26

Working Paper Series