Learning your Earning: Are Labor Income Shocks Really That Persistent?

In this paper we examine the risk situation facing individuals in the labor market. The current consensus in the literature is that the labor income process has a large random walk component. We argue two points. First, the direct estimates of this parameter (from labor income data) appear to be upward biased due to the omission of heterogeneity in income profiles across the population that would be implied, for example, by a human capital model with heterogeneity. When we allow for differences in profiles, the estimated persistence falls from 0.99 to about 0.8. Moreover, the main evidence against profile heterogeneity in the existing literature---that the autocorrelations of income changes are small and typically negative---is in fact also replicated by the profile heterogeneity model we estimate, casting doubt on the previous interpretation of this evidence. Second, we embed this process in a life-cycle model to examine how it alters the consumption-saving decision of individuals. We assume that---as seems plausible---individuals do not know their profiles exactly at the beginning of life, but learn in a Bayesian way with successive income observations. We find that learning is very slow and affects consumption choice throughout the life-cycle. The model generates substantial rise in consumption inequality over the life-cycle, which matches empirical observations (Deaton and Paxson 1994). Moreover, the shape of the age-inequality profile is non-concave as in the data, but unlike in a model with very persistent shocks. Finally, the consumption profiles of college graduates are steeper than high-school graduates in the model consistent with the data because they face a wider dispersion of, and hence uncertainty about, income growth rates. Overall this evidence indicates that income shocks may be significantly less persistent than what is currently assumed.