How Important Are Idiosyncratic Shocks? Evidence from Labor Supply

The notion that individuals face idiosyncratic labor-market uncertainty is a common one. Government programs such as unemployment insurance and social security are motivated by such an idea. Economic theory, ranging from labor supply to savings behavior to asset pricing, often presupposes that such risks are important. A number of papers, however, have questioned this orthodoxy. Sumru Altug and Robert A. Miller (1990), for instance, are unable to reject a set of factor-structure restrictions implied by complete markets. John H. Cochrane (1991) and Barbara J. Mace (1991) find evidence of consumption insurance, although not against all types of risks. Robert M. Townsend (1994) documents evidence of risk-sharing in Indian villages. Michael P. Keane and Kenneth I. Wolpin (1997) argue that 90 percent of the labor-market uncertainty faced by a group of males is resolved by age 16. Other studies have suggested the opposite. Papers by Joseph G. Altonji et al. (1991), Orazio Attanasio and Steven J. Davis (1996), and Attanasio and Guglielmo Weber (1992), as well as some evidence in Cochrane (1991) and Mace (1991), suggest that risk-sharing is far from complete, in particular for low-frequency shocks. Angus Deaton and Christina Paxson (1994) show that inequality in labor earnings, total income, and consumption increases with age. They suggest that this is difficult to reconcile with standard models of complete consumption insurance. In Storesletten et al. (2000) we ask similar questions using a general-equilibrium life-cycle model. We conclude that increasing inequality with age, consumption inequality in particular, is difficult to explain in the absence of uninsured idiosyncratic shocks received throughout the working years. We argue that between 40 percent and 50 percent of an individual’s lifetime uncertainty remains unresolved prior to entering the workforce. This paper further examines the implications of increasing inequality with age. We begin by asking if a very different model, one which features full risk-sharing, can account for the data. The idea, which Deaton and Paxson (1994) attribute to Steven Davis, is that increasing income and consumption inequality can arise in a perfect insurance setting if (i) dispersion in labor productivity increases with age, and (ii) preferences are nonseparable between leisure and consumption. If this is true, an efficient allocation may feature increasing consumption dispersion, because higher-productivity workers will supply relatively more labor and be compensated with more consumption. We develop a specific model and find that, for plausible parameter values, this is exactly what happens. What also happens, however, is that such an allocation features increasing inequality in hours worked. Using data from the Panel Study on Income Dynamics (PSID), we show that inequality in hours worked is roughly constant across age. This casts doubt on the full risksharing model and strengthens the argument in favor of uninsurable idiosyncratic risk. The remainder of our paper provides a more general discussion of the evidence on inequality and age, and how this suggests an important role for idiosyncratic labor-market shocks.