Consumption Partial Insurance in the Presence of Tail Income Risk

TL;DR

This paper introduces a framework to measure how consumption responds to income shocks, especially extreme tail risks, revealing asymmetric effects and variation across demographics using recent data.

Contribution

It develops a nonlinear consumption model incorporating higher-order income moments and estimates asymmetric pass-through rates of income shocks to consumption.

Findings

17% pass-through for negative shocks versus 9% for positive shocks

Pass-through rates increase with the severity of shocks

Tail income risk significantly influences consumption behavior

Abstract

We propose a simple framework to measure consumption insurance against income shocks that accounts for higher-order moments of the income distribution. We derive a nonlinear consumption function in which the extent of insurance varies with both the sign and magnitude of shocks. Using recent PSID data, we estimate an asymmetric pass-through of bad versus good permanent shocks - 17% of a 3 sigma negative shock transmits to consumption versus 9% of an equal-sized positive shock - with greater pass-through as shocks worsen. These consumption transmission rates further vary by age, wealth, and along the income distribution. Our results align with survey responses to hypothetical events and suggest that tail risk matters substantially for consumption.