The Timing of Parental Income and Child Outcomes: The Role of Permanent and Transitory Shocks. CEE DP 120
Author: Tominey, Emma
Date: 2010-10-00
Type: Reports - Research
Subjects: Foreign Countries,Family Income,Change,Children,Adolescents,Human Capital,College Attendance,Intelligence Quotient,Health,Dropouts,Robustness (Statistics),Siblings

How do shocks to parental income drive adolescent human capital, such as university attendance, IQ and health? Unexpected changes to family income may have a predictable effect on child adolescent outcomes, by shifting the money parents spend on human capital investments in their children. The extent to which consumers insure themselves against changes in income has been well documented in the economics literature, however little is known about how the evolution of household income drives the human capital of their children. This paper fills the gap and makes two important innovations by firstly estimating the effect of shocks across the life cycle of childhood, from age 1-16 and secondly distinguishing between income shocks that are permanent and transitory. The author explores heterogeneity in the time profile of the effect of transitory income shocks upon outcomes, by focusing on liquidity constrained households. With imperfect access to credit markets, liquidity constrained agents are unable to borrow or save in order to smooth transitory income shocks sufficiently. Consequently the author would expect to find a larger effect of transitory income shock in liquidity constrained households. The data in this paper takes the population of around 600,000 Norwegian children, born in the 1970s and tracked through to 2006, which provides in depth information on annual household income plus a range of adolescent outcomes, including years of schooling, high school dropout, university attendance and IQ and health test scores from a set of army tests for males. The data indicate a strong and significant correlation between the initial condition and child outcomes. A rise in initial income levels by 1 standard deviation raises child human capital by up to 0.4 standard deviations (equivalent, for example, to nearly a year of schooling). This shows that family background matters--there is significant dispersion in outcomes for the sample of Norwegian children, determined at the start of their lifetime. For all outcomes except health, the effect of a household permanent income shock is significant and declines across child age, as predicted by the Permanent Income Hypothesis (PIH). However there is volatility in this relationship, which may be picking up changes in maternal labour supply. Mothers have less attachment to the labour market and their labour supply is more sensitive, for example to children starting school. By focusing just on paternal income, noise in the decline is smoothed out for all outcomes. The difference in the health outcome is likely due to crude measurement in the data. In general, permanent shocks to paternal income have a large effect early in the lifetime of the child and this effect falls across child age, to zero at age 16. For all outcomes, transitory income shocks have a small and constant effect across child age. This suggests that parents are optimising, by smoothing parental investment against transitory shocks in a similar manner to consumption smoothing. However interestingly, for a sample of liquidity constrained parents, child human capital behaves differently to consumption upon receipt of an income shock. It was anticipated that human capital responses to income shocks would be larger for the liquidity constrained sample, as without full access to the credit markets, parents are unable to smooth the effect of the shock. Instead, transitory income shocks have a &quot;smaller&quot; effect on child human capital for a group of households with permanent income in the second decile or below, compared to the total sample. The author argues that for this group of parents, investment goods such as books, high quality nursery care or private tuition are not necessities given that children receive free state education. Rather, liquidity constrained parents raise consumption on goods like household utilities, child clothing and food when they receive an income shock. Estimation by DWMD is appended. (Contains 27 figures, 7 tables and 32 footnotes.)