Specification tests for random-effects transition models: an application to a model of the British youth training scheme.

Abstract

We develop diagnostic tests for random-effects multi-spell multi-state models focusing on: independence between the unobserved heterogeneity and observed covariates; mutual independence of heterogeneity terms; and distributional form. They are applied to a transition model of the British youth labor market, revealing significant mis-specifications in our initial model, and allowing us to develop a considerably better-fitting specification that would have been difficult to reach by other means. The improved specification implies reduced estimates of the effectiveness of the youth training scheme (YTS), but we nevertheless retain the conclusion of significant positive effects of YTS on employment prospects.