Financial Stress Thresholds and Household Equivalence Scales

Abstract

This paper relates indicators of household financial stress to household income and expenditure with the objective of identifying household stress thresholds and comparable equivalence scales. A model is proposed whereby households try to absorb income shocks or shifts by shrinking consumption or engaging in consumption substitution, and is applied to data from the Household, Income and Labour Dynamics in Australia Survey. Households have different capacities to absorb a shock or shift, with those unable to absorb a shock or shift being financially stressed. The distribution of household financial stress thresholds is estimated, and is found to be dependent on heterogeneity in both welfare sensitivity and discretionary consumption stickiness. We also examine the equivalence scales implied by the model and derive the distortion associated with the assumption of homogeneity. We find that this assumption has a distortionary impact and results in significant over- or underestimation of equivalence scales depending on household type and size.