Consumption and Savings Under Non-Gaussian Income Risk

Recently, Guvenen et al. (2017) document three broad empirical findings on idiosyncratic earnings risk over the life cycle. First, the distribution of earnings changes displays substantial deviations from lognormality—the standard assumption in the incomplete markets literature. In particular, earnings changes display strong negative skewness and extremely high kurtosis. Second, these non-Gaussian features vary significantly both over the life cycle and with the earnings level of individuals. Third, shocks have asymmetric mean reversion: For high income individuals positive earnings shocks are quite transitory, whereas negative shocks are very long-lasting, and vice versa for low income workers. In this paper, we study consumption-savings implications of these features of the data. For this purpose we solve and simulate a life-cycle consumption-savings model that allows for non-Gaussian income risk. The idiosyncratic income fluctuations we document generate large welfare costs, and the implications for wealth inequality and partial insurance differ from those of a Gaussian process in important ways.