Income Dynamics, Income Risk, and Inequality
Economic Policy, Applied Economics
Final Report Abstract
Income inequality in industrialized countries is large and is still growing. The research project studies how much of observed inequality results from risk in contrast to individual choices. While income risk is usually detrimental to welfare, job mobility choices of workers that also lead to income inequality increase welfare. The current research project examines the link between productivity risk and income risk to shed light on the question how much income inequality can be attributed to risk. Most existing studies on income risk assume frictionless, competitive markets where income equals productivity. To address the question of the transmission of productivity risk into income risk, I look at the data through the lens of a state of the art labor market model augmented by important features of observed employment relationships, namely, long-term contracts and limited contract enforceability. Technically, this results in a model with onesided limited commitment. The research project aims at structurally estimating the model using data of actual employment histories from Germany. Two problems make this challenging: First, the model must be capable to explain income and mobility dynamics of observed employment histories. Second, an estimation approach has to be developed and implemented that can identify the unobserved model parameters using available data. Structural estimation of labor market models with rich heterogeneity is currently the research frontier in the macro labor literature. No commonly used methods or approaches exist so that the implementation requires experimentation, adaptation, and refinement of existing estimation approaches. Results of this research project are threefold: First, I provide a descriptive analysis of income and mobility dynamics for Germany. Second, a heterogeneous agent model with limited commitment together with a life-cycle extension of the model have been developed. Third, an indirect inference approach for the structural estimation has been developed, and identification of the unobserved model parameters has been tested. The work program has been complemented by the acquisition of detailed knowledge of methods for structural estimation, in particular, indirect inference. Once the model has been estimated, the model can be used to deliver new insights for the welfare costs of labor market risk or the design of optimal labor market and tax policies. The fact that the model is mircofounded will allow to study the links between labor market policy, income risk, and inequality. The research project will therefore deepen our understanding of the interaction of income dynamics, income risk, and inequality.
