Consumption, Savings, and the Distribution of Permanent Income

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Abstract:

Rising inequality in the permanent component of labor income, henceforth permanent income, has been a major force behind the secular increase in US labor income inequality. This paper explores the macroeconomic consequences of this rise. First, I show that in many common macroeconomic models—including models with precautionary savings motives—consumption is a linear function of permanent income. This implies that macroeconomic aggregates are neutral with respect to shifts in the distribution of permanent income. Motivated by this neutrality result, I develop novel approaches to test for linearity in US household panel data, which consistently estimate the elasticity of consumption to permanent income in common precautionary savings models. The estimates suggest an elasticity of 0.7, soundly rejecting linearity. To quantify the effects of this deviation from neutrality, I extend a canonical precautionary savings model to include non-homothetic preferences across periods, capturing the idea that permanent-income rich households save disproportionately more than their poor counterparts. The model suggests that the US economy is far from neutral. In the model, the rise in US permanent labor income inequality since the 1970s caused: (a) a decline in real interest rates of around 1%; (b) an increase in the wealth-to-GDP ratio of around 30%; (c) wealth inequality to rise almost as rapidly as it did in the data.

Notes:

Revise and resubmit at Econometrica
Last updated on 01/17/2020