Income at risk

Nearly 40 percent of households would struggle to finance an unexpected $400 expense, according to a Fed survey conducted in late 2018. It’s an indication of how dependent many American families are on every paycheck. What if that paycheck shrinks? Or disappears altogether?

Income risk—expected or unexpected changes, or “shocks,” to individual and household income—is a reality of life for all and a matter of subsistence for many. A recent working paper from the Opportunity & Inclusive Growth Institute at the Minneapolis Fed investigates income risk in depth and provides a detailed picture of how different U.S. households experience variations in earnings when the economy does well, and when it doesn’t.

The research focuses on several issues. The central question: How does income risk vary over the business cycle—does it diminish or rise during economic expansions, or recessions? Also, who faces higher income risk? For instance, are older households more or less income-secure than younger households? The study examines sources of income risk as well and explores measures that might reduce it. From a policy standpoint, this research is rich ground for those who seek to address income insecurity by designing potential remedies to help families “smooth consumption”— in the parlance of economics—when shocks hit.

When do earnings vary most?

In “Cyclical Labor Income Risk,” Makoto Nakajima, an Institute scholar, and Vladimir Smirnyagin analyze U.S. data between 1978 and 2014 to understand how household incomes vary over economic cycles, who this income risk affects most strongly, and what factors protect households against business cycle volatility.

Their key conclusion, around which the rest of the analysis unfolds, is that labor income risk of household heads is countercyclical. That is to say, during economic contractions, labor income for primary breadwinners exhibits greater variance and skews more negatively. By greater variance, the economists mean a wider range of labor income shocks between positive and negative. So during downturns, both good and bad news is more dramatic. But the negative skewness indicates that during recessions, large income changes are more likely to be negative. When the nation enjoys an expansion, the opposite is true. The range of shocks narrows, and large negative income surprises happen less often. This seems to confirm a common intuition about the impact of downturns and recoveries.

A closer look

The economists then dive deeper into this cyclicality, uncovering other dimensions of risk: by income components (hours worked versus pay per hour), by household age, and by availability of income insurance through sources other than household head.

Source of income risk

Economists have long wondered whether income volatility during business cycles is due to fewer hours worked (including job loss) or reduction in pay per hour. In their analysis, Nakajima and Smirnyagin find less cyclicality in wages than in income, “hinting at an important quantitative role of hours (most likely, employment and unemployment).” This is consistent with what many economists find: Wages tend to be inflexible. Rather than changing pay per hour, employers are prone to hire or fire, suggest the economists and, to a lesser degree, to modify working hours.

Age of household heads

Are young households more or less economically vulnerable during recessions than older households? Who benefits most from expansions? The economists divide their data between households whose primary income earner is aged 22-39 years and those aged 40-60. They find that wages and income of older households exhibit twice as much overall income volatility as those of younger households, but that business cycle fluctuation in income risk is experienced more by the young. In other words, while young households generally face smaller shocks than older households, they are more exposed to negative outcome in recessions.

Insurance from other income sources

Nakajima and Smirnyagin gather data on income from second earners in households and on government taxes and transfers (unemployment compensation, disability benefits, and the like). These could help households stabilize income when breadwinners’ income is exposed to ups and downs. They find that second-earner income lowers skewness of income risk but not cyclicality—meaning that household income still varies with business cycles when spouses bring home a second paycheck, but large negative shocks aren’t as common, thanks to the contribution by the second earner.

Government taxes and transfers, on the other hand, smooth both channels of volatility, diminishing the range between highs and lows, and also its variation between expansions and contractions.

To estimate the protection against income “disaster” provided by these two insurance channels, the economists study “tail event” probabilities by carrying out a 1,000-period simulation of 100,000 individual income histories. The analysis shows that having a second earner decreases the probability of a 50 percent decline in household income by 40 percent, and government taxes and transfers further lower that probability by another 30 percent.

Conclusion

At heart, the importance of this research lies in the fact that income risk is central to household financial well-being. Income uncertainty is so prevalent among U.S. households that understanding its true dimensions and causes is essential for policymakers who seek policies to mitigate it and to economists hoping to better understand the true cost of business cycles.