Heterogeneous Income Profi…les Model with Fixed Effects: Incorporating Health Shocks as an Application

We provide an alternative econometrics methodology to estimate a standard heterogeneous income profiles (HIP) model. Our alternative setup allows for the HIP coefficients to be fixed in the sense that they can be arbitrarily correlated with the explanatory variables of the HIP equation and can be treated as parameters to be estimated. This fixed effects approach is more general and less restrictive than the random effects approach, which assumes that the HIP coefficients are random and exogenous. As an empirical application, we analyze how much health shocks account for the persistence and variance of income shocks by including them in a standard HIP model. Our estimation results from the Panel Study of Income Dynamics (PSID) indicate that disability shock accounts for the persistence of income shocks. The decay of the impact of income shocks to one-fifth of the initial impact takes eight years for college-educated individuals from its onset, while it takes 10 years for high school-educated individuals. Health shocks contribute up to two years to the persistence of income shocks for the college educated; income shocks from which health shocks are extracted decay to one-fifth of the initial impact in six years. Health shocks have less of an impact on the persistence of income shocks for high school-educated individuals, for whom it also takes eight and a half years for the impact of income shocks from which health shocks are extracted to drop to one-fifth of the initial impact. 

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