Income Inequality and Income Risk

Abstract

This dissertation consists of four empirical chapters with the second also making a methodological contribution. The first chapter empirically investigates the distributional consequences of the Riester scheme, the main private pension subsidization program in Germany. 38% of the aggregate subsidy accrues to the top two deciles of the income distribution, but only 7.3% to the bottom two. Nonetheless the Riester scheme is almost distributionally neutral in terms of standard inequality measures. Two effects offset each other: a progressive one stemming from the subsidy schedule and a regressive one due to voluntary participation. Participation is associated not only with high income but also with high household wealth. The second chapter solves the problem of a social planner who seeks to minimize inequality via transfers with a fixed public budget in a distribution of exogenously given incomes. The appropriate solution method depends on the objective function: If it is convex, it can be solved by an interior-point algorithm. If it is quasiconvex, the bisection method can be used. Using artificial and real-world data, an implementation the procedures shows that the optimal transfer scheme need not comply with a transfer scheme that perfectly equalizes incomes at the bottom of the distribution. The third chapter investigates the nature of earnings risk in a model of life-cycle labor supply. The recent literature on life-cycle consumption, saving and labor supply focuses on wage shocks as the central source of risk. In the paper we propose a life-cycle labor supply model that features risk in both wages and hours and disentangle their effects on earnings risk. To this end we estimate a transmission parameter that measures how permanent wage shocks impact the marginal utility of wealth. Estimating our model with the Panel Study of Income Dynamics (PSID) shows that both permanent wage and hours shocks play an important role in explaining the cross-sectional variance in earnings growth. Still, permanent wage shocks have a quantitatively larger impact on life-time earnings. Allowing for hours shocks improves the model fit considerably. The empirical strategy allows for estimating the Marshallian labor supply elasticity without the use of consumption or asset data. We find this elasticity on average to be negative, but small. Finally, we link our estimate of the transmission parameter to consumption insurance and show that the sensitivity of consumption to wage shocks implied by our estimate is in line with recent estimates in the literature. The fourth chapter is another application of a life-cycle labor supply model, but this time with a focus on progressive taxation. I quantify individuals’ exposure to permanent earnings risk and find that permanent earnings risk in the US has been on the rise since the early 2000s. Most importantly, it has taken a marked hike during the financial crisis of 2008. In contrast, the insurance effect of the progressive tax and transfer system, which mitigates this risk, has remained flat. I estimate the progressivity of the tax and transfer system using a power function approximation and evaluate its properties in representing the tax system. This progressivity parameter is sufficient to identify the insurance effect of the tax and transfer system. When progressivity is shut down, the model features 5% less insurance. Earnings risk could have been reduced to pre-crisis levels by increasing progressivity substantially, lowering the progressivity parameter from the observed level of 0.93 to 0.78.