Idiosyncratic Income Risk Research Articles

Credit Shocks and Equilibrium Dynamics in Consumer Durable Goods Markets

This paper studies equilibrium dynamics in consumer durable goods markets after aggregate credit shocks. We introduce two novel features into a general-equilibrium model of durable consumption with heterogeneous households facing idiosyncratic income risk and borrowing constraints: (i) indivisible durable goods are vertically differentiated in their quality and (ii) trade on secondary markets at market-clearing prices, with households endogenously choosing when to trade or scrap their durables. The model highlights a new transmission mechanism for macroeconomic shocks and successfully matches several empirical patterns that we document using data on U.S. car markets around the Great Recession. After a tightening of the borrowing limit, debt-constrained households postpone the decision to scrap and upgrade their low-quality cars, which depresses mid-quality car prices. In turn, this effect reduces wealthy households' incentives to replace their mid-quality cars with high-quality ones, thereby decreasing new-car sales. We further use our framework to evaluate targeted fiscal stimulus policies such as the Car Allowance Rebate System in 2009 (``Cash for Clunkers'').

Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk

English Abstract: We characterize the optimal linear tax on capital in an Overlapping Generations model with two period lived households facing uninsurable idiosyncratic labor income risk. The Ramsey government internalizes the general equilibrium feedback of private precautionary saving. For logarithmic utility our full analytical solution of the Ramsey problem shows that the optimal aggregate saving rate is independent of income risk. The optimal time-invariant tax on capital is increasing in income risk. Its sign depends on the extent of risk and on the Pareto weight of future generations. If the Ramsey tax rate that maximizes steady state utility is positive, then implementing this tax rate permanently generates a Pareto-improving transition even if the initial equilibrium is dynamically efficient. We generalize our results to Epstein-Zin-Weil utility and show that the optimal steady state saving rate is increasing in income risk if and only if the intertemporal elasticity of substitution is smaller than 1. German Abstract: Sollten Kapitaleinkommen besteuert werden? Diese Frage hat in der Theorie der optimalen Besteuerung und in ihrer quantitativen Anwendung schon eine lange Reihe okonomischer Literatur beschaftigt. Fruhere Antworten zu dieser Frage, unter Verwendung relativ stilisierter okonomischer Rahmenbedingungen, waren negativ. Das bedeutet, die Literatur kam zu dem Schluss, dass optimale Kapitaleinkommenssteuern null seien. Dies steht im Gegensatz zu den hohen Steuern auf Kapitaleinkommen, die in allen Industriestaaten zu beobachten sind. Eine aktuellere, grostenteils quantitative Literatur fand hingegen heraus, dass optimale Kapitaleinkommenssteuern positiv sein sollten. Grunde fur diese Feststellung sind, dass zum einen Kapitaleinkommenssteuern ein effektiver Ersatz fur fehlende altersabhangige Einkommenssteuern sein konnen, zum anderen dass sie ein effektives umverteilendes Steuerinstrument sind (von einkommensstarken zu einkommensschwachen Haushalten), und zum dritten, dass die Besteuerung von Kapitaleinkommen eine Absicherung gegen Einkommens- oder Renditeschocks aus der ex-ante Perspektive darstellen. Unser theoretisches Paper gibt neue analytische Einsichten fur Grunde fur optimale Steuern auf Kapitaleinkommen, die Aufschluss daruber geben, welche Mechanismen die Resultate in der uberwiegend quantitativen Literatur treiben. Wir legen den Fokus auf einen Effekt, der bisher in der Literatur keine explizite Aufmerksamkeit erfahren hat, der jedoch implizit in zahlreichen quantitativen Studien uber optimale Kapitaleinkommenssteuern prasent ist. In Gegenwart von Einkommensrisiken und unvollstandiger Absicherung gegen diese, sichern sich Haushalte gegen niedrige Einkommensrealisierung durch privates Sparen ab. Wir zeigen, dass ein solches vorsorgendes Sparverhalten negative Effizienzwirkungen in der aggregierten Volkswirtschaft haben kann, insbesondere fur die Renditen aus Kapitalanlagen. Der Staat internalisiert dieses negative Feedback. Wenn diese negativen Feedback-Effekte stark genug sind, dann sollten optimale Kapitaleinkommenssteuern positiv sein. Um diese Einsichten in all ihrer theoretischen Klarheit abzuleiten, halten wir das okonomische Umfeld, das wir betrachten, sehr stilisiert. Wahrend wir dadurch sehr klare und trennscharfe Charakterisierungen der treibenden Krafte der optimalen Kapitaleinkommenssteuern liefern konnen, ist es trotzdem wichtig zu betonen, dass unser theoretischer Beitrag nicht beabsichtigt, ein realistisches okonomisches Modell fur eine quantitative Exploration zu stellen. Folglich ist der Hauptzweck unserer Analyse, hilfreiche Einsichten fur eine verbesserte Interpretation der Erkenntnisse in der existierenden quantitativen Literatur uber optimale Kapitaleinkommenssteuern zu bieten.

Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk

Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk

Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk

We characterize the optimal linear tax on capital in an Overlapping Generations model with two period lived households facing uninsurable idiosyncratic labor income risk. The Ramsey government internalizes the general equilibrium feedback of private precautionary saving. For logarithmic utility our full analytical solution of the Ramsey problem shows that the optimal aggregate saving rate is independent of income risk. The optimal time-invariant tax on capital is increasing in income risk. Its sign depends on the extent of risk and on the Pareto weight of future generations. If the Ramsey tax rate that maximizes steady state utility is positive, then implementing this tax rate permanently generates a Pareto-improving transition even if the initial equilibrium is dynamically efficient. We generalize our results to Epstein-Zin-Weil utility and show that the optimal steady state saving rate is increasing in income risk if and only if the intertemporal elasticity of substitution is smaller than 1.

Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk

We characterize the optimal linear tax on capital in an Overlapping Generations model with two period lived households facing uninsurable idiosyncratic labor income risk. The Ramsey government internalizes the general equilibrium feedback of private precautionary saving. For logarithmic utility our full analytical solution of the Ramsey problem shows that the optimal aggregate saving rate is independent of income risk. The optimal time-invariant tax on capital is increasing in income risk. Its sign depends on the extent of risk and on the Pareto weight of future generations. If the Ramsey tax rate that maximizes steady state utility is positive, then implementing this tax rate permanently generates a Pareto-improving transition even if the initial equilibrium is dynamically efficient. We generalize our results to Epstein-Zin-Weil utility and show that the optimal steady state saving rate is increasing in income risk if and only if the intertemporal elasticity of substitution is smaller than 1.

Life-cycle consumption, precautionary saving, and risk sharing: an integrated analysis using household panel data

AbstractThis paper presents an integrated model of household consumption behavior and examines its testable implications for various theories of consumption, using panel data on Korean households. The model is framed with an extended Euler equation by incorporating aggregate/idiosyncratic and anticipated/unanticipated income changes with aggregate and idiosyncratic income risk measures. The model can test seven restricted but competing hypotheses such as life-cycle and precautionary saving with and without liquidity constraints, complete risk sharing, and incomplete risk sharing with and without precautionary saving. Each alternative hypothesis is rejected in favor of the integrated model to explain households’ consumption behavior in the panel.

Redistribution and insurance with simple tax instruments

We analyze optimal taxation of labor and capital income in a life cycle framework with idiosyncratic income risk and ex-ante heterogeneity. Tax instruments are simple in that they can only condition on current income. We provide a decomposition of labor income tax formulas into a redistribution and an insurance component. The latter is independent of the social welfare function and determined by the degree of income risk and risk aversion. The optimal linear capital tax is non-zero and trades off redistribution and insurance against savings distortions. Our quantitative results reveal that the insurance component contributes significantly to optimal labor income tax rates and provides a lower bound on optimal taxes. Optimal capital taxes are significant.

Adjustable- or Fixed-Rate Mortgage? Optimal Mortgage Choice with Idiosyncratic Income Risk

This paper identifies the optimal mortgage choice of homeowners, who are subject to counter-cyclical income volatility and idiosyncratic income risk. Interest rates are found in the market equilibrium of investors with similar income risk exposures, leading to pro-cyclical equilibrium interest rates. As adjustable-rate mortgages provide a hedge against systematic income risk for homeowners, the key determinant of the optimal mortgage choice is the correlation of income with the business cycle: Homeowners with highly (low) correlated income choose an ARM (FRM). The cutoff-level for the correlation of income is decreasing in the homeowner's risk aversion. That is, the more risk-averse homeowners are more likely to choose an adjustable-rate mortgage compared to less risk-averse homeowners. The mortgage choices of homeowners have an impact on the financial market equilibrium. Equilibrium interest rates become less volatile and the market price of income volatility risk increases for larger shares of adjustable-rate mortgages. In the financial market and mortgage choice equilibrium, all markets clear and no homeowner finds it optimal to switch mortgage type.

Redistribution and Insurance with Simple Tax Instruments

We analyze optimal taxation of labor and capital income in a life-cycle framework with idiosyncratic income risk. We provide a novel decomposition of labor income tax formulas into a redistribution and an insurance component. The latter is independent of the social welfare function and determined by the degree of income risk and risk aversion. The optimal linear capital tax is non-zero and trades off redistribution and insurance against savings distortions. Our quantitative results reveal that the insurance component contributes significantly to optimal labor tax rates and provides an informative lower bound on optimal taxes: even for welfare functions that do not value redistribution, marginal tax rates are positive for all income levels. Optimal capital taxes are significant and yield sizable welfare gains; in particular if labor income taxes are suboptimal.

High Marginal Tax Rates on the Top 1%? Lessons from a Life Cycle Model with Idiosyncratic Income Risk

In this paper we argue that very high marginal labor income tax rates are an effective tool for social insurance even when households have preferences with high labor supply elasticity, make dynamic savings decisions, and policies have general equilibrium effects. To make this point we construct a large scale Overlapping Generations Model with uninsurable labor productivity risk, show that it has a wealth distribution that matches the data well, and then use it to characterize fiscal policies that achieve a desired degree of redistribution in society. We find that marginal tax rates on the top 1% of the earnings distribution of close to 90% are optimal. We document that this result is robust to plausible variation in the labor supply elasticity and holds regardless of whether social welfare is measured at the steady state only or includes transitional generations.

Cleaning the gears: Counter-cyclical asset trading with financial transactions taxes

Abstract This paper analyzes the effect of financial transactions taxes (FTT) and idiosyncratic income risk on counter-cyclical asset trading. The model is in the class of DSGE models with incomplete markets. The paper is able demonstrate the potential welfare loss from the imposition of FTT on agents through two factors: higher coefficient of variation of consumption and higher incidence of constrained credit. The paper is also able to demonstrate the effect of FTTs on the market through three factors: significantly lower trading volume, higher variance in unencumbered markets, higher volume in unencumbered markets.

Tracing Tails – Large Idiosyncratic Income Shocks in a Heterogeneous Agent Asset Pricing Model

I present evidence that large individual income changes can help explaining the size and value premium in a cross-section of portfolio returns. I develop a tail risk measure, the Idiosyncratic Income Risk Factor and estimate it on US income data. The results show that the extreme income shocks vary with the state of the economy. In an augmented Consumption-Based Asset Pricing Model, the Idiosyncratic Income Risk Factor emerges as a priced factor when explaining a cross-section of returns of 25 portfolios sorted by size and book-to-market ratio. The findings support Krebs’ (2004) critique of the Constantinides and Duffie (1996) idiosyncratic risk asset pricing model: central moments of the cross-sectional distribution of income cannot be used to test the implications of the Constantinides and Duffie (1996) model. I present evidence that supports the notion of a fat-tail-generating personal disaster process affecting asset prices.

Social Security and the Interactions between Aggregate and Idiosyncratic Risk

We ask whether a PAYG-financed social security system is welfare improving in an economy with idiosyncratic and aggregate risk. We argue that interactions between the two risks are important for this question. One is a direct interaction in the form of a countercyclical variance of idiosyncratic income risk. The other indirectly emerges over a household's life-cycle because retirement savings contain the history of idiosyncratic and aggregate shocks. We show that this leads to risk interactions, even when risks are statistically independent. In our quantitative analysis, we find that introducing social security with a contribution rate of two percent leads to welfare gains of 2.2% of lifetime consumption in expectation, despite substantial crowding out of capital. This welfare gain stands in contrast to the welfare losses documented in the previous literature, which studies one risk in isolation. We show that jointly modeling both risks is crucial: 60% of the welfare benefits from insurance result from the interactions of risks.

Implications of Heterogeneity in Preferences, Beliefs and Asset Trading Technologies for the Macroeconomy

This paper extends the methodology developed in Chien, Cole and Lustig (2011 & 2012) (hereafter CCL2011 and CCL2012, respectively) to analyze and compute the equilibria of economies with heterogeneous agents who have different asset trading technologies and are subject to both aggregate and idiosyncratic income risk. The different asset trading technologies, which are designed to replicate the portfolio behavior seen in the data, fall into two classes. Active traders manage the composition of their portfolios among a given set of assets in addition to choosing how much to save. Passive traders take their portfolio composition as given and choose only how much to save. There can be a wide variety of different cases within each classes. For active traders, the trading technology varies depending on the set of assets that they can use, while for passive traders it varies with the specific portfolio composition rule. In CCL2011 and CCL2012, all of our agents had to have the same CRRA flow utility functions, discount rates, and beliefs. In this extension, this restriction is relaxed greatly extending the set of economies to which our method applies. This richer degree of heterogeneity allows the model to match a number of key features of the data.

Social Security and the Interactions between Aggregate and Idiosyncratic Risk

We ask whether a PAYG-financed social security system is welfare improving in an economy with idiosyncratic and aggregate risk. We argue that interactions between the two risks are important for this question. One is a direct interaction in the form of a countercyclical variance of idiosyncratic income risk. The other indirectly emerges over a household's life-cycle because retirement savings contain the history of idiosyncratic and aggregate shocks. We show that this leads to risk interactions, even when risks are statistically independent. In our quantitative analysis, we find that introducing social security with a contribution rate of two percent leads to welfare gains of 2.2% of lifetime consumption in expectation, despite substantial crowding out of capital. This welfare gain stands in contrast to the welfare losses documented in the previous literature, which studies one risk in isolation. We show that jointly modeling both risks is crucial: 60% of the welfare benefits from insurance result from the interactions of risks.

Should pensions be progressive?

The present paper quantitatively characterizes the consequences of rising pension progressivity in an overlapping generations model with idiosyncratic income, disability and longevity risk as well as endogenous labor supply at the intensive and extensive margin. Focusing on the German pension system which is purely earnings related, we increase the degree of progressivity and compute the optimal mix between flat and earnings-related pensions.We find that a flat-rate pension share of roughly 30% maximizes aggregate economic efficiency, since improved insurance provision dominates higher labor supply distortions. Disability risk significantly increases the optimal progressivity level, while endogenous retirement has important macroeconomic implications. Since our results are robust for a wide range of parameter specifications, they indicate that at least in Germany a move towards more redistribution within the pension system is efficient.

Optimal Progressive Taxation and Education Subsidies in a Model of Endogenous Human Capital Formation

In this paper we characterize quantitativelya the optimal mix of progressive income taxes and education subsidies in a model with endogeneous himan capital formation, borrowing constraints, income risk and incomplete financial markets. Progressive labor income taxes provide social insurance against idiosyncratic income risk and redistributes after tax income among ex-ante heterogenous households. In addition to the standard distortions of labor supply progressive taxes also impede the incentives to acquire higher education, generation a non-trivial trade-off for the benevolent utilitatian government. The latter distortion can potentially be mitigated by an education subsidy. We find that the welfare-maximizing fiscal policy is indeed characterized by a substantially progressive labor income tax code and a positive subsidy for college education. Both the degree of tax progressivity and the education subsidy are larger than in the current U.S. status quo.

A politically feasible social security reform with a two-tier structure

This paper investigates the welfare implications and political feasibility of social security reforms with a two-tier structure in Japan. We evaluate social security reforms from two points of view: (i) the ex-ante expected value of future generations, and (ii) whether current generations prefer reform to the status-quo system, which we call political feasibility. To evaluate the reforms, we use a large-scale overlapping generations model with idiosyncratic income risk and a two-tier structure. The first tier guarantees a basic pension and the second tier consists of the earnings-related part. Calibrating the parameters of the model to the Japanese economy, we compute the transition path and the two welfare criteria. We find that, given the two-tier structure in Japan, an increase in the basic pension and the abolition of the earnings-related part of the social security system improve the welfare of future generations, and ensures political feasibility when a consumption tax is the source of revenue.

Should Pensions Be Progressive? Yes, at Least in Germany!

Recent reforms that aim at reducing the upcoming burdens of population aging might seriously harm low income individuals. An increase in old-age poverty and disability will be the result. Under this prospect, the present paper quantitatively characterizes the optimal progressivity of unfunded pension systems in an overlapping generations model with idiosyncratic income, disability and longevity risk as well as endogenous labor supply at the intensive and extensive margin. Focusing on the German pension system, our model features the most recent demographic projections and distinguishes three skill classes with skill-dependent risk profiles. Starting from a baseline path that reflects a purely earnings related pension system, we increase the degree of progressivity and compute the resulting macroeconomic, welfare and efficiency effects. For our most preferred parametrization we find an optimal flat-rate pension share of 40 percent. This indicates that in Germany recent reforms that aim at raising retirement age and cutting benefit levels should be complemented by increases in pension progressivity, since improved insurance provision dominates higher labor supply distortions. In addition, we also find that reductions in the benefit level (i.e. privatization) will only reduce economic efficiency.

CONSUMPTION AND SAVING OVER THE LIFE CYCLE: HOW IMPORTANT ARE CONSUMER DURABLES?

In this paper we investigate whether a standard life-cycle model in which households purchase nondurable consumption and consumer durables and face idiosyncratic income and mortality risk as well as endogenous borrowing constraints can account for two key patterns of consumption and asset holdings over the life cycle. First, consumption expenditures on both durable and nondurable goods are hump-shaped. Second, young households keep very few liquid assets and hold most of their wealth in consumer durables. In our model durables play a dual role: they both provide consumption services and act as collateral for loans. A plausibly parameterized version of the model predicts that the interaction of consumer durables and endogenous borrowing constraints induces durables accumulation early in life and higher consumption of nondurables and accumulation of financial assets later in the life cycle, of an order of magnitude consistent with observed data.