Using the Survey of Income and Program Participation (SIPP), we document a significant and positive association between earnings risk (both permanent and transitory) and the level of earnings across 21 industries. We propose an equilibrium framework to analyze the interplay between earnings volatility and the distribution of skills across workers in determining a relationship between earnings and risk. We use the model to decompose how much of the empirical correlation represents compensation for risk and how much represents selection. The positive association between permanent risk and earnings is compensation for risk, but selection is responsible for the observed relationship between temporary risk and the level of earnings.
JEL classification: E21, E24, J24, J31
Key words: selection, compensating differential, precautionary savings, earnings inequality
The authors thank Gustavo Canavire for his excellent research assistance and Yongsung Chang, Mark Bils, Fernando Borraz, Christopher Carroll, Juan Dubra, Juan Carlos Hatchondo, Georgui Kambourov, David Lagakos, Martin Lopez-Daneri, B. Ravikumar, Victor Rios-Rull, Cesare Robotti, Richard Rogerson, Yongseok Shin, Gustavo Ventura, and Ron Warren for their comments and suggestions and seminar participants at dECON FCE-UDELAR, the Central Bank of Uruguay, Atlanta Fed, NBER Summer Institute EFACR, St. Louis Fed, University of Iowa, and the University of Georgia. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
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