DP4296 The Cross-Sectional Implications of Rising Wage Inequality in the United States

Author(s): Jonathan Heathcote , Kjetil Storesletten , Giovanni L Violante

Publication Date: March 2004

Keyword(s): consumption inequality , labour supply , wage inequality , welfare

JEL(s): D11 , D31 , D58 , D91 , E21 , I32 , J22 , J31

Programme Areas: Labour Economics

Link to this Page: www.cepr.org/pubs/dps/DP4296.asp

This Paper explores the implications of the recent sharp rise in US wage inequality for welfare and the cross-sectional distributions of hours worked, consumption and earnings. From 1967 to 1996 cross-sectional dispersion of earnings increased more than wage dispersion, due to a rise in the correlation between wages and hours worked. Over the same period, inequality in hours worked remained roughly constant, and consumption inequality increased only modestly. Using data from the PSID, we decompose the observed rise in wage inequality into changes in the variance of permanent, persistent and transitory shocks. With this changing wage process as the only primitive, we show that a calibrated overlapping-generations model with incomplete markets can account for these trends in cross-sectional US data. We also investigate the welfare costs of the rise in wage in-equality: the ex-ante loss is equivalent to a 5% decline in lifetime income for the worst affected cohorts.