On the Persistence of Income Shocks Over the Life Cycle: Evidence and Implications

45 Pages Posted: 14 Dec 2009 Last revised: 24 Dec 2009

See all articles by Fatih Karahan

Fatih Karahan

Federal Reserve Bank of New York

Serdar Ozkan

University of Toronto

Date Written: December 9, 2009

Abstract

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 theoretically that the statistical model is identified and estimate it using data from the PSID. We strongly reject the hypothesis of a flat 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 and decreases to around 0.95 toward the end of the life cycle. On the other hand, the variance of persistent shocks exhibits a U-shaped profile over the life cycle (with a minimum of 0.01 and a maximum of 0.045). 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. Under natural borrowing limits, 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. The results hold qualitatively for an economy with no borrowing, although the difference between specifications is smaller (23%). We conclude that the welfare cost of idiosyncratic risk is overstated.

Keywords: Idiosyncratic income risk, Incomplete markets models, Earnings persistence, Consumption insurance

JEL Classification: C33, D31, D91, E21, J31

Suggested Citation

Karahan, Fatih and Ozkan, Serdar, On the Persistence of Income Shocks Over the Life Cycle: Evidence and Implications (December 9, 2009). PIER Working Paper No. 09-045. Available at SSRN: https://ssrn.com/abstract=1522184 or http://dx.doi.org/10.2139/ssrn.1522184

Fatih Karahan

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Serdar Ozkan (Contact Author)

University of Toronto ( email )

Toronto, Ontario M5S 3G8
Canada

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