RIP to HIP: The Data Reject Heterogeneous Labor Income Profiles

Idiosyncratic labor incomes are typically modeled either by stochastic processes featuring heterogeneous income profiles (HIP) or restricted income profiles (RIP). The HIP assumes

that individual labor income grows deterministically at an unobserved rate and contains a persistent but stationary component, while the RIP assumes that income contains a random walk, a stationary component, and no unobserved deterministic growth-rate component. I show that if idiosyncratic labor income contains a persistent component, a deterministic household-specific trend, and a random walk component, then all of the components can be identified. Using data on idiosyncratic labor income growth from the Panel Study of Income Dynamics, I find that the estimated variance of deterministic income growth is zero, i.e.,

the HIP model can be rejected. The RIP model with a permanent component cannot be rejected. This result is important for an appropriate choice of modeling the heterogeneity in individual incomes and calibrating/estimating macro models with incomplete insurance markets and heterogeneous agents.

For more information, contact Dirk Krueger.