Discussion paper

DP14538 Higher-Order Income Risk over the Business Cycle

We extend the canonical income process with persistent and transitory risk to
shock distributions with left-skewness and excess kurtosis, to which we refer as higher-
order risk. We estimate our extended income process by GMM for household data
from the United States. We find countercyclical variance and procyclical skewness of
persistent shocks. All shock distributions are highly leptokurtic. The existing tax and
transfer system reduces dispersion and left-skewness of shocks. We then show that
in a standard incomplete-markets life-cycle model, first, higher-order risk has sizable
welfare implications, which depend crucially on risk attitudes of households; second,
higher-order risk matters quantitatively for the welfare costs of cyclical idiosyncratic
risk; third, higher-order risk has non-trivial implications for the degree of self-insurance
against both transitory and persistent shocks.

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Citation

Busch, C and A Ludwig (eds) (2020), “DP14538 Higher-Order Income Risk over the Business Cycle”, CEPR Press Discussion Paper No. 14538. https://cepr.org/publications/dp14538