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This paper sheds light on the nature of labor income risk by exploiting the informa- tion contained in the joint dynamics of households'labor earnings and consumption- choice decisions. In particular, this paper attempts to discriminate between two lead- ing views on the nature of labor income risk: the "restricted income pro…les"(RIP) model— in which individuals are subjected to large and persistent income shocks but face similar life-cycle income pro…les— and the "heterogeneous income pro…les"(HIP) model— in which individuals are subjected to income shocks with modest persistence but face individual-speci…c income pro…les. Although these two dierent income processes have vastly dierent implications for economic behavior, earlier studies have found that labor income data alone is insu¢ cient to distinguish between them. This paper, there- fore, brings to bear the information embedded in consumption data. Speci…cally, we use the powerful new tools of indirect inference to estimate, using rich panel data on consumption and labor earnings, a structural consumption-savings model with bor- rowing constraints and risk-averse households. The method we develop is in fact more general than this particular application and allows the estimation of income processes from economic decisions in the presence of non-separability between consumption and leisure, partial insurance of income shocks, missing observations, among others. In this estimation, we use an auxiliary model— which forms the bridge between the data and the consumption-savings model— that provides a sharp distinction between the RIP and HIP models. Finally, we conduct formal statistical tests to assess the extent to which the RIP and HIP models …nd support in the data.

Inferring Labor Income Risk from Economic Choices: An Indirect Inference Approach