This paper sheds light on the nature of labor income risk by exploiting the information contained in the joint dynamics of households’ labor earnings and consumption-choice decisions. In particular, this paper attempts to discriminate between two leading views on the nature of labor income risk: the “restricted income profiles” (RIP) model — in which individuals are subjected to large and persistent income shocks but face similar life-cycle income profiles — and the “heterogeneous income profiles” (HIP) model — in which individuals are subjected to income shocks with modest persistence but face individual-specific income profiles. Although these two diferent income processes have vastly di¤erent implications for economic behavior, earlier studies have found that labor income data alone is insufficient to distinguish between them. This paper, therefore, brings to bear the information embedded in consumption data. Specifically, we apply the powerful new tools of indirect inference to rich panel data on consumption and labor earnings to estimate a rich structural consumption-savings model. The method we develop is very flexible and allows the estimation of income processes from economic decisions in the presence of nonseparabilities between consumption and leisure, partial insurance of income shocks, frequently

In this paper we revisit two well-known facts regarding lifecycle expenditures. The first is the familiar “hump ” shaped lifecycle profile of nondurable expenditures. The second is that cross-household consumption inequality increases steadily throughout the life cycle. We document that the behavior of total nondurables masks surprising heterogeneity in the lifecycle profile of individual consumption sub-components. We find that three categories (food, nondurable transportation, and clothing) account for both the entire decline in mean expenditure post-middle age and a substantial amount of the increase in cross sectional dispersion over the life cycle. All other nondurable categories we study show no decline in mean expenditure over the life cycle nor do they show an increase in cross sectional dispersion over the life cycle. We provide evidence that the categories driving life cycle consumption are either inputs into market work (clothing and transportation) or are amenable to home production (food). Changes in the opportunity cost of time will cause movements in expenditures on such goods even if there is no change to lifetime resources. We then discuss how the patterns documented in the paper

In this paper we ask whether public intervention can improve the allocation of risk in an economy in which private financial markets do not provide full insurance. The answer depends crucially on the fundamental friction that limits private risk sharing in the first place. If risk sharing is limited because some insurance markets are missing for model-exogenous reasons (as in Ayiagari, 1994) publicly provided risk sharing (via a progressive tax system, say) always improves on the allocation of risk. If instead insurance markets exist but their use is limited by the absence of complete enforcement (as in Kehoe and Levine, 1993) then the provision of public insurance via a progressive income tax system can crowd out the provision of private insurance to such an extent that total consumption insurance is reduced. The idea is that with progressive taxation the government increases the value of being excluded from insurance markets and hence weakens the enforcement mechanism of private contracts. In order to quantify these effects we fully characterize equilibria in an economy with limited enforcement and a continuum of agents so that our baseline income and consumption distribution can match the respective distributions in US data. We find that for plausible parameter the crowding-out effect of public insurance on private insurance can be substantial.

We consider a dynamic Mirrlees economy in a life cycle context and study the optimal insurance arrangement. Individual productivity evolves as a Markov process and is private information. We use a first order approach in discrete and continuous time and obtain novel theoretical and numerical results. Our main contribution is a formula describing the dynamics for the labor-income tax rate. When productivity is an AR(1) our formula resembles an AR(1) with a trend where: (i) the auto-regressive coefficient equals that of productivity; (ii) the trend term equals the covariance productivity with consumption growth divided by the Frisch elasticity of labor; and (iii) the innovations in the tax rate are the negative of consumption growth. The last property implies a form of short-run regressivity. Our simulations illustrate these results and deliver some novel insights. The average labor tax rises from 0 % to 40 % over 40 years, while the average tax on savings falls from 20 % to 0 % at retirement. We compare the second best solution to simple history independent tax systems, calibrated to mimic these average tax rates. We find that age dependent taxes capture a sizable fraction of the welfare gains. In this way, our theoretical results provide insights into simple tax systems.

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We revisit to what extent the increase in income inequality over the last 30 years has been mirrored by consumption inequality. We do so by constructing two alternative measures of consumption expenditure, using data from the Consumer Expenditure Survey (CE). We first use reports of active savings and after tax income to construct the measure of consumption implied by the budget constraint. We find that the consumption inequality implied by savings behavior tracks income inequality closely between 1980 and 2007. Second, we use a demand system to correct for systematic measurement error in the CE’s expenditure data. Specifically, we consider trends in the relative expenditure of high income and low income households for different goods with different income elasticities. Our estimation exploits the difference in the growth rate of luxury consumption inequality versus necessity consumption inequality. This “double-differencing, ” which we implement in a a regression framework, corrects for mis-measurement that can systematically vary over time by good and income group. This second exercise also indicates that consumption inequality has closely tracked income inequality over the period 1980-2007. Both of our measures show a significantly greater increase in consumption inequality than what is obtained from the CE’s total household expenditure data directly.

Abstract: We document that there has been a large increase in the cyclicality of the incomes of high-income households that coincides with the rise in their share of total income. In the U.S., since the early 1980s, the incomes of those in the top 1 % of the income distribution, which are on average 11 times the average income, have been 2.4 times as cyclical as average income resulting in the top 1 % bearing 28 % of aggregate income fluctuations. Prior to the early 1980s, the income of the top 1 % was slightly less cyclical than that of the average household. The change in top 1 % income cyclicality is to a large extent due to an increase in the share and cyclicality of wages and salaries. This high cyclicality among top incomes is also found i) for households without stock options, ii) for changes in income for the same set of households over time, iii) for post-tax, post-transfer income, and iv) for consumption in the available data. We contrast the cyclicality of the top 1 % with the cyclicalities of groups further down the income distribution, and reconcile our findings with the earlier literature. We document a link between the increased income share and increased income cyclicality of the top 1%, finding that the cyclicality of the top 1 % increases decade by decade as the top 1 % income share increases, and across countries increases in income cyclicality of the top 1 % are highly correlated with increases in top 1 % income shares. This close relationship suggests a common cause, which we conjecture is technological change that increase the optimal production scale of the most talented. * For helpful comments, we thank the editors Justin Wolfers, David Romer, our discussants Rebecca Blank and Erik

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The paper studies how high leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of the rich, a large increase in leverage for the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where these features arise endogenously as a result of a shift in bargaining powers over incomes. A financial crisis can reduce leverage if it is very large and not accompanied by a real contraction. But

We use a new, large, and con dential panel of tax returns to shed light on the permanent versus transitory nature of rising inequality in individual male labor earnings and in total household income, both before and after taxes, in the United States over the period 1987-2006. Due to the quality and the signi cant size of our dataset, we are able to conduct our analysis using rich and precisely estimated error-components models of income dynamics. Our main speci cation nds evidence for a quadratic heterogeneous income pro les component and a random walk component in permanent earnings, and for an ARMA component with moderate persistence in transitory earnings. We nd that the increase in inequality over our sample period was entirely permanent for male earnings, and predominantly permanent for household income. We also show that the tax system, though reducing inequality, nonetheless did not materially a ect its increasing trend. Furthermore, we compare our model-based ndings against those of simpler, non-model-based inequality decomposition methods. We show that the results for the trends in the evolution of the permanent and transitory variances are remarkably

Abstract We evaluate the effectiveness of a more progressive tax scheme in raising government revenues. We develop a life-cycle economy with heterogeneity and endogenous labor supply. Households face a progressive income tax schedule, mimicking the Federal Income tax, and flat-rate taxes that capture payroll, state and local taxes and the corporate income tax. We parameterize this model to reproduce aggregate and crosssectional observations for the U.S. economy, including the shares of labor income for top earners. We find that a tilt of the Federal income tax schedule towards high earners leads to small increases in revenues which are maximized at an effective marginal tax rate of about 36.9% for the richest 5% of households -in contrast to a 21.7% marginal rate in the benchmark economy. Maximized revenue from Federal income taxes is only 8.4% higher than it is in the benchmark economy, while revenues from all sources increase only by about 1.6%. The room for higher revenues from more progressive taxes is even lower when average taxes are higher to start with. We conclude that these policy recommendations are misguided if the aim is to exclusively raise government revenue. JEL Classifications: E6, H2.