“Inferring Labor Income Risk From Economic Choices: An Indirect Inference Approach” by Tony SMITH
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 different income processes have vastly different 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 non-separabilities between consumption and leisure, partial insurance of income shocks, frequently binding borrowing constraints, missing observations, among others. In this estimation, we use an auxiliary model — which forms the bridge between the data and the consumption-savings model — that provides a sharp distinction between the RIP and HIP models. Finally, we conduct formal statistical tests to assess the extent to which the RIP and HIP models find support in the data.