Learning Your Earning: Are Labor Income Shocks Really Very Persistent?

The current literature offers two views on the nature of the labor income process. According to the first view, individuals are subject to very persistent income shocks while facing similar life-cycle income profiles (the RIP process, Thomas MaCurdy 1982). According to the alternative, individuals are subject to shocks with modest persistence while facing individual-specific profiles (the HIP process, Lee A. Lillard and Yoram A. Weiss 1979). In this paper we study the restrictions imposed by these two processes on consumption data—in the context of a life-cycle model—to distinguish between the two views. We find that the life-cycle model with a HIP process, which has not been studied in the previous literature, is consistent with several features of consumption data, whereas the model with a RIP process is consistent with some, but not with others. We conclude that the HIP model could be a credible contender to—and along some dimensions, a more coherent alternative than—the RIP model. (JEL D83, D91, E21, J31)