Earnings Risk and Heterogeneous Expected Earnings Profiles

We add to the debate about whether empirical models of earnings dynamics should allow for unobservable heterogeneity in expected earnings growth rates by considering the consequences for estimating the variance of earnings shocks. Several tests are proposed, some that extend and augment earlier evidence, and some entirely new. In every case, empirical evidence from the Panel Study on Income Dynamics favors models lacking such heterogeneity. Such models invariably indicate workers face greater risk of permanent earnings shocks, implying much of the dispersion in lifetime earnings may not be predictable ex-ante.