Labor Income Risk Research Articles

Monetary non-neutrality in a multisector economy: The role of risk-sharing

We show that the degree of risk-sharing among heterogeneous workers is a key determinant of monetary non-neutrality in a multisector sticky-price model. In this framework, workers are employed across different sectors, earning distinct wages. The limited ability of workers to fully insure against labor income risks results in strategic complementarity in firms' price-setting decisions with respect to aggregate shocks and strategic substitutability with respect to idiosyncratic shocks. These pricing interactions lead to sluggish adjustments of the price level in response to monetary and other aggregate shocks, causing significant fluctuations in the output gap while maintaining large responses of individual prices to idiosyncratic shocks. We illustrate these results across three stylized asset market scenarios: complete markets, non-contingent bond-only markets, and financial autarky.

TRADE SHOCKS AND HIGHER‐ORDER EARNINGS RISK IN LOCAL LABOR MARKETS

AbstractThis article investigates the relationship between international trade and asymmetrical labor income risk. Using the case study of Brazil, we inspect how an increase in import penetration following the China shock impacted the distribution of idiosyncratic earnings changes across the country's local labor markets. We find that an increase in import penetration leads to a more dispersed and negatively skewed distribution. These effects can be explained by an increase in the volatility of hours worked following job and industry transitions, particularly from involuntary job separations.

A Theory of the Term Structure of Interest Rates under Limited Household Risk Sharing

Abstract We present a theory in which the interaction between limited sharing of idiosyncratic labor income risk and labor adjustment costs (that endogenously arise through search frictions) determines interest rate dynamics. In the general equilibrium, the interaction of these two ingredients relates bond risk premiums, cross-sectional skewness of income growth, and labor market tightness. Our model rationalizes an upward-sloping average yield curve and predicts a negative relation between labor market tightness and bond risk premiums. We provide evidence for our theory’s mechanism and predictions.

Spouses in The Same Boat: Labor Income Risk and Intra-Household Risk Sharing

Spouses in The Same Boat: Labor Income Risk and Intra-Household Risk Sharing

Diversifying Labor Income Risk: Evidence from Income Pooling

Diversifying Labor Income Risk: Evidence from Income Pooling

Target benefit versus defined contribution scheme: a multi-period framework

AbstractA target benefit plan (TBP) is a collective defined contribution (DC) plan that is growing in popularity in Canada. Similar to DC plans, TBPs have fixed contribution rates, but they also implement pooling of longevity and investment risk. In this paper, we formulate a multi-period model that incorporates two sources of risk – asset risk and labor income risk for active members. We present an optimal investment and retirement benefits schedule for TBP members with a fixed contribution rate. Using Australian data from 1965 to 2018, we evaluate the performance of the optimal TBP scheme and compare it to the optimal DC scheme. By adopting the benefit–investment strategy derived in this paper, we demonstrate the stability of benefit distribution over time for a TBP scheme in this stochastic formulation. To outperform the DC scheme’s benefit payment, careful consideration shall be given to the benefit target in the TBP scheme. A high target may not be achievable, while a low target can impede the accumulation momentum of the fund’s wealth in its early stages. Moreover, a TBP fund’s investment strategy is primarily influenced by the wealth target, with more aggressive investments in risky assets as the wealth target increases. This analysis may shed light on the possible improvements to retirement planning in Australia. Although the results are sensitive to the choice of model parameters, overall, the proposed TBP promotes system stability in various scenarios.

Labor Income Risk and the Cross-Section of Expected Returns

Labor Income Risk and the Cross-Section of Expected Returns

The Effects of Labor Income Risk Heterogeneity on the Marginal Propensity to Consume

The Effects of Labor Income Risk Heterogeneity on the Marginal Propensity to Consume

Does idiosyncratic risk matter for climate policy?

AbstractThis paper studies the implications of distortions in intertemporal margins for the conduct of climate policy. We do so by introducing a framework that combines a standard two-period overlapping generations (OLG) model with a tractable model of household heterogeneity, in which over-accumulation of capital arises from uninsurable idiosyncratic labor income risk. We illustrate that market-based climate policies must be adjusted when the government cannot provide full insurance to households by taxing only capital and is constrained to transfer resources across generations for risk-sharing. In a numerical exercise, we find that idiosyncratic risk leads to an optimal capital income tax rate of 35 per cent and a carbon price 7.5 per cent lower than its first best.

Health risk and the welfare effects of Social Security

AbstractWe quantify the importance of idiosyncratic health risk in a calibrated general equilibrium model of Social Security. We construct an overlapping generations model with rational-expectations households, idiosyncratic labor income and health risk, profit-maximizing firms, incomplete insurance markets, and a government that provides pensions and health insurance. We calibrate this model to the US economy and perform two computational experiments: $\left (i\right)$ cutting Social Security’s payroll tax, and $\left (ii\right)$ modifying Social Security’s benefit-earnings rule. Our findings suggest that health risk amplifies the welfare implications of both experiments: downsizing Social Security always leads to higher overall welfare, but the welfare gain is larger when we account for health risk, and increasing the progressivity of Social Security’s benefit-earnings rule has a larger positive effect on welfare in the presence of health risk. We also find that allowing households additional tools to self-insure against health risk weakens the precautionary motive, so our experiments have similar welfare implications both with and without health risk.

Skewed Idiosyncratic Income Risk over the Business Cycle: Sources and Insurance

We provide new evidence on business cycle fluctuations in skewed labor income risk in the United States, Germany, Sweden, and France. We document four results. First, in all countries, the skewness of individual income growth is strongly procyclical, whereas its variance is flat and acyclical. Second, this result also holds for continuously employed, full-time workers, indicating that the hours margin is not the main driver; additional analyses of hours and wages confirm that both margins are important. Third, within-household smoothing does not seem effective at mitigating skewness fluctuations. Fourth, tax-and-transfer policies blunt some of the largest declines in incomes, reducing procyclical fluctuations in skewness. (JEL E23, E24, E32, H24, I38, J22, J31)

Political Uncertainty and Household Stock Market Participation

AbstractUsing microlevel panel data and a difference-in-differences identification strategy, we study the effect of political uncertainty on household stock market participation. We find that households significantly reduce their participation and reallocate funds to safer assets during periods of increased political uncertainty prior to gubernatorial elections. The decline in participation is related to households’ response to elevated asset risk and their incentive to hedge increased labor income risk. In situations where uncertainty remains high after elections, pre-election reduction in participation is only partially reversed.

Mixed models for optimal saving with labor income risk and interest-rate risk.

In this paper, optimal saving models with two risk components are studied: the labor income risk and the interest rate risk. These risks can be modeled probabilistically by random variables or possibilistically by fuzzy numbers. In mixed models, one of the components is probabilistic and the other one is possibilistic. After the construction of two mixed models of optimal saving, several notions of precautionary saving are defined. These measure the variation in optimal saving level when moving from one model to another (usually by adding a risk component). The main results of the paper establish necessary and sufficient conditions on the positivity of different precautionary savings. (This means that the presence of new risks generates extra-saving.)

Countercyclical Labor Income Risk and Portfolio Choices over the Life Cycle

Abstract I estimate a life cycle model of portfolio choices that incorporates the relationship between market returns and the skewness of idiosyncratic income shocks. The cyclicality of skewness can explain (a) low stock market participation among young households, (b) why the equity share of participants slightly increases until retirement, and (c) why renters invest less in stocks than do homeowners. With a relative risk aversion of 6 and yearly participation cost of $250, the model matches the evolution of wealth, participation, and conditional equity shares over the life cycle. Nevertheless, cyclical skewness increases the equity premium by at most 0.5 percentage points. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Labor market policies, informality and misallocation

PurposeThe purpose of this paper is to understand labor market regulations and their consequences for the allocation of resources.Design/methodology/approachThis paper constructs a theoretical model to study labor market regulations in developing countries and how it affects the allocation of resources between the less productive informal activities and more productive formal activities. It also provides empirical support for some theoretical results using cross-country data.FindingsWhen workers are risk-averse and the market for insurance against labor income risk is missing, regulations that provide insurance to workers (such as severance payments) reduce misallocation. However, regulations that simply create barriers to the dismissal of workers increase misallocation and end up reducing the welfare of workers. This study also provides some empirical evidence broadly consistent with the theoretical results using cross-country data. While dismissal regulations increase the share of informal employment, severance payments to workers do not.Research limitations/implicationsThe empirical exercise is constrained by the lack of availability of good data on the informal sector.Originality/valueThe analysis of the alternative labor market regulations analyzed in this paper in the presence of risk-averse workers is an original contribution to the literature.

Life-cycle portfolio choice with imperfect predictors

We study quantitatively how uncertainty in expected stock return predictability affects life-cycle portfolio choice and wealth accumulation in the presence of undiversifiable labor income risk. Households filter information about future expected returns from observed predictors and realized stock returns. Therefore, optimal portfolio choice does not only depend on financial wealth and age, as in more traditional life-cycle models. Counterfactuals demonstrate the magnitude of portfolio demand changes that depend on perceptions about underlying expected returns. On average, life-cycle asset allocation becomes more conservative than models with either i.i.d. stock returns, or with clearer signals about expected stock returns.

Equity home bias and consumption-real exchange rate puzzles: A joint solution

In a standard dynamic stochastic general equilibrium model with a complete asset market, home agents should hold a foreign equity biased portfolio to hedge the non-traded labor income risk, which contradicts home equity biased portfolios observed worldwide. As the labor income share increases, the degree of home bias should decrease because there is more incentive to hold foreign equity. In the data, there is not any evidence that the labor income share and the degree of home bias are negatively correlated. The standard model also predicts that the consumption differential-real exchange rate correlation is positive, while it is negative in the data. I show that a combination of market incompleteness, non-tradable goods, and labor supply can explain the three features above. My model can generate a large equity home bias, despite the strong positive correlation of non-traded human capital return with domestic equity return. The home bias is not sensitive to the labor income share. The consumption differential-real exchange rate unconditional correlation generated by my model simulation is zero.

Cyclical labour income risk in Great Britain

SummaryThis paper provides new evidence on the cyclical behaviour of household labour income risk in Great Britain and the role of social insurance policy in mitigating against this source of income risk. To achieve this, we decompose stochastic idiosyncratic household income into its transitory and persistent components. We focus our analysis of income risk captured by the second to fourth moments of the probability distribution of shocks to the persistent component of income. We find that household labour income risk increases during contractions via changes in third and fourth central moments of persistent shocks to labour income, whereas the variance remains acyclical. We also find that economic policy has reduced the level of risk exposure and its increase during contractions via benefits rather than tax policies.

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 effects of private precautionary saving on factor prices and taxes capital unless the weight on future generations in the social welfare function is sufficiently high. For logarithmic utility a complete analytical solution of the Ramsey problem exhibits an optimal aggregate saving rate that is independent of income risk, whereas the optimal time-invariant tax on capital implementing this saving rate is increasing in income risk. The optimal saving rate is constant along the transition and its sign depends on the magnitude 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 induces a Pareto-improving transition even if the initial equilibrium capital stock is below the golden rule.

Post-Retirement Labor and Non-Retirement Risky Asset Allocation

This article studies how post-retirement labor is related to non-retirement risky asset allocation. By using panel data from the 1992–2018 Health and Retirement Study, this article empirically finds a negative relationship over time between non-retirement risky asset allocation and post-retirement labor. Furthermore, this article explores the forced retirement risk (a type of labor income risk) for the post-retirement labor group. Descriptive findings indicate that members of the post-retirement labor group have a greater risk of being forced to retire, and the trend of forced retirement risk is inversely related to equity returns. This latter finding suggests a potential correlation between forced retirement risk and stock returns. If an individual’s human capital is at greater risk or becomes more stock-like (i.e., labor income risk correlates with stock returns), then investing in fewer risky assets would be justifiable. When both of these findings are accounted for, they corroborate the findings of this article: Post-retirement labor is negatively associated with risky asset allocation. <b>TOPICS:</b>Retirement, risk management, performance measurement, legal/regulatory/public policy <b>Key Findings</b> ▪ Post-retirement labor is negatively associated with non-retirement risky asset allocation. ▪ Forced retirement risk, a labor income risk, may be correlated with equity returns, explaining the current findings in light of previous literature and theory. ▪ Ex-retirees may rely on investment advice that is inherently founded on a view of their human capital as a bond-like asset. However, the risk characteristics of their human capital may differ fundamentally from those of other labor groups, requiring more tailored financial advice.