From Wages to Welfare: Decomposing Gains and Losses From Rising - PowerPoint PPT Presentation

From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality Jonathan Heathcote Federal Reserve Bank of Minneapolis and CEPR Kjetil Storesletten Federal Reserve Bank of Minneapolis and CEPR Gianluca Violante New York University, CEPR, and NBER Cornell, November 18 2010 Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 1/32

Rising wage inequality Major transformation in the structure of relative wages in the U.S. 1. Increase in the education wage premium 2. Increase in wage dispersion within education groups ◮ Both permanent and transitory components ↑ Among sources of this trend: skill-biased demand shift (technology, trade/offshoring), deunionization, shift in contractual arrangements ⊛ Katz-Murphy (1992), Krusell et al. (2000), Acemoglu (2002), Acemoglu-Autor (2010), Feenstra-Hanson (1996), Burstein-Vogel (2010), DiNardo-Fortin-Lemieux (1996), Acemoglu-Aghion-Violante (2001), Lemieux-Mcleod-Parent (2009) Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 2/32

Trend in wage inequality from CPS College Wage Premium Variance of Log Wages 0.5 1.75 1.7 0.45 1.65 1.6 0.4 1.55 1.5 0.35 1.45 1.4 0.3 Total Variance 1.35 Residual Variance 0.25 1.3 1970 1975 1980 1985 1990 1995 2000 2005 1970 1975 1980 1985 1990 1995 2000 2005 Year Year Male workers aged 25-60. Hourly wage = annual earnings/annual hours Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 3/32

The question W HAT ARE THE WELFARE IMPLICATIONS OF THIS SHIFT IN THE WAGE STRUCTURE ? Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 4/32

Contrasting views of rising inequality • Implies lower expected welfare for U.S. households (i) Higher permanent wage risk and imperfect risk sharing • Presents new opportunities to U.S. households (ii) Higher returns to education and investment in human capital (iii) Higher transitory wage volatility and flexible labor supply Challenge: quantifying the relative importance of these three channels Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 5/32

Two alternative methodologies Welfare is a function of consumption and leisure, not of wages 1. Empirical approach • Looks directly at shifts in the empirical distribution of consumption and leisure through a social welfare function • In comparing distributions, data are demeaned 2. Structural approach • Uses a model to draw mapping from shift in wage distribution to shift in the distribution of consumption and leisure • Allows for relative wage movements to affect mean consumption and mean leisure (“level effects") Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 6/32

T HE E MPIRICAL A PPROACH Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 7/32

Trend in consumption inequality from CEX Variance of Log 0.5 Wages 0.45 Consumption 0.4 0.35 0.3 0.25 1970 1975 1980 1985 1990 1995 2000 2005 Year Equivalized consumption expenditures = nondurables, services, small durables and estimated flow from vehicles and housing ⊛ Cutler-Katz (1991, 1992), Slesnick (1994, 2001), Krueger-Perri (2003, 2006) Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 8/32

Trend in consumption inequality from CEX Variance of Log 0.5 Wages Consumption IS 0.45 Consumption IS/DS 0.4 0.35 0.3 0.25 1970 1975 1980 1985 1990 1995 2000 2005 Year Combining CEX Interview Survey (IS) and Diary Survey (DS), one finds larger increase in consumption inequality ⊛ Attanasio-Battistin-Ichimura (2007), Attanasio-Battistin-Padula (2010), Aguiar-Bils (2010) Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 9/32

Trend in leisure/hours inequality from CPS If leisure is valued, then the distribution of hours worked affects welfare Variance of Log Market Hours Variance of Log Market Hours 0.3 0.3 0.25 0.25 0.2 0.2 0.15 0.15 0.1 0.1 Men Women 0.05 0.05 1970 1980 1990 2000 1970 1980 1990 2000 Year Year Leisure = 1 − h market − h home , but h home is poorly measured ⊛ Aguiar-Hurst (2006), Ramey (2006), Knowles (2009) Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 10/32

Social welfare function ∞ � W ( c , h ) = µ k U k ( c k , h k ) k = −∞ Consumption equivalent welfare change ω solves: W t ((1 + ω ) c ∗ , h ∗ ) = W t ( c ∗∗ , h ∗∗ ) Choose weights such that W reduces to average period utility in the cross-section: t u ( c, h ) = c 1 − γ 1 − γ − ϕ h 1+ σ � W t ( c , h ) = s k,t E [ u ( c k,t , h k,t )] , with 1 + σ k = t − J Enough to compare distributions of ( c, h ) before and after the shift Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 11/32

Welfare Cost ( ω ): 1980−1984 to 2001−2005 0 Percentage of Lifetime Consumption −1 σ = 1 σ = 5 −2 −3 −4 −5 −6 −7 0 1 2 3 4 5 Risk Aversion ( γ ) In the log case ( γ = 1) , ω ≈ − 2% of lifetime consumption ⊛ Attanasio-Davis (1996), Krueger-Perri (2006), Storesletten (2006) Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 12/32

A Lucas -style calculation Since shift in hours distribution has small effect, ignore it for now Assume log-normality of consumption: log c ∼ N ( − v c 2 , v c ) ⊛ Battistin-Blundell-Stoker (2010) Following the derivations in Lucas (1987): ω L ≈ − γ 2 ∆ v c γ = 1 and ∆ v c = 0 . 036 ⇒ ω L = − 1 . 8% Caveat: If the “revisionists” are correct and true rise in the variance of log consumption is twice as big ⇒ ω L = − 3 . 6% Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 13/32

T HE S TRUCTURAL A PPROACH Heathcote -Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 14/32

Demographics, preferences, and education choice • Demographics: Continuum of individuals indexed by i facing constant survival probability π from age j to j + 1 • Preferences over sequences of consumption and hours worked: � � h 1+ σ ∞ � ij ( βπ ) j U = E 0 log( c ij ) − exp ( ϕ + ϕ i ) 1 + σ j =0 • Two education levels e ∈ { L, H } denoting high -school and college ◮ Idiosyncratic utility cost χ i of attending college ◮ Fraction q of individuals with χ i < U H − U L chooses college Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 15/32

Technology and labor market • CES aggregate technology: θ � � θ − 1 θ − 1 θ − 1 Y = Z + (1 − ζ ) N ζN θ θ H L • Competitive labor markets: P e = MPL e , with e ∈ { L, H } � P H � � � � N H � − 1 ζ log ≡ p H − p L = log θ log 1 − ζ P L N L ◮ Rise in ζ 1 − ζ represents skill -biased demand shifts ⊛ Katz-Murphy (1992), Krusell et al. (2000), Acemoglu (2002), Johnson-Keane (2008) Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 16/32

Government • Runs a progressive tax/transfer scheme to redistribute and to finance (non -valued) expenditures • Balances the budget every period • Relationship between pre-tax ( y i = w i h i ) and disposable ( ˜ y i ) earnings: y i = λy 1 − τ ˜ i • τ ≥ 0 is the progressivity parameter of the system ⊛ Benabou (2002), HSV (2009, 2010) • Empirical fit of this tax/transfer system quite good on U.S. data Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 17/32

Individual wages Log individual wage is the sum of three orthogonal components log w i = p e ( i ) + α i + ε i • p e ( i ) is the log price per efficiency unit of labor of type e • ( α i , ε i ) two components determining within -group wage dispersion ◮ α follows a unit root process ◮ ε uncorrelated with α (could be forecastable) Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 18/32

Private risk -sharing • Agents can save and borrow a risk-free bond (age 0 bonds = 0) • Additional insurance against ε (financial markets, family) • Equilibrium outcome: no bond trade ⇒ α uninsurable, ε insurable Heathcote-Storesletten-Violante, ”From Wages to Welfare: Decomposing Gains and Losses From Rising Inequality” – p. 19/32