The Consumption and Wealth Effects of an Unanticipated Change in

Lifetime Resources

Tullio JappelliUniversità di Napoli Federico II

Mario PadulaUniversità della Svizzera Italiana

The Bank of Italy’s Analysis of Household Finance, December 3-4, 2015

1

The old days

Do people respond to unanticipated changes in resources?

1. Nature of change Fiscal vs. monetary shocks Temporary (tax rebate, bonus) vs. permanent

tax reform Current vs. lifetime resources

2. Nature of response: Consumption, wealth, labor supply, portfolio choice

3. Heterogeneity of responseDue to horizon, liquidity constraints, precuationary saving, behavioral theories

4

Outline

- The reform of severance pay of Italian public employees

- Simulated effect on wealth and consumption.

- Difference-in-difference estimates using SHIW data.

- €1 reduction in severance pay increases wealth-income ratio by 0.32 and reduces consumption-income ratio by 0.03.

5

Permanentshock

Transitoryshock

Anticipatedincrease

Anticipateddecline

Anticipated income changes

Unanticipated income changes

Positive Negative

Large Small

Size

Check in the mail

PayrollCoupons

Context

RecessionAsset liquidity

DebtAge

6

Many MPCs…

Consumption response

Measuring MPC from unanticipated income shocks

To estimate response of consumption to income shocks

1. Write income process (say transitory/permanent decomposition). Then estimate MPCs using restrictions that theory imposes on the var-cov matrix of consumption and income growth residuals.

Hall and Mishkin (1982), Blundell, Pistaferri & Preston (2008)

2. Subjective expectations: how will you spend hypothetical income increase / decrease? Saving, Consumption, Debt.- Don’t need data on consumption or worry about income process.- Can easily look at MPC heterogeneityShapiro & Slemrod (various years), Jappelli & Pistaferri (2014)

3. Natural experimentsGruber (1997), Browning & Crossley (2001), Paxson (1993), Fuchs-Schundeln (2005), Di Maggio et al. (2014), Surico &Trezzi (2015). 7

A permanent income change: reform of severance pay of Italian public

employees Intertemporal model: effect on wealth and

consumption.

Difference-in-difference using SHIW data from 1989-2010.

€1 reduction in severance pay reduces consumption relative to income by 0.03. The wealth-income ratio increases by 0.32. The offset ratio is 0.4.

Young vs old employees, more than 1 public employee

Robustness

Why is the reform interesting?

Vast literature on the effect of transitory shocks on consumption, much less on the effect of permanent shocks.

Some papers look at change in disability (Browning and Crossley, 2001).

Others look at consumption and wealth effects of social security reforms (Attanasio and Brugiavini, 2003; Attanasio and Rohwedder 2003; Bottazzi, Jappelli and Padula, 2006).

We study effect on both wealth and consumption looking at sizable and unanticipated changes in future income.

The severance pay reform In 2000 Italy replaced its traditional system

of severance pay for public employees with a new system.

Old regime: severance pay was proportional to the final wage before retirement.

New regime: proportional to lifetime earnings.

The reform entails substantial losses for future generations of public employees, in the range of €20,000-30,000, depending on seniority.

Contracts

Severance payment

Private employees

All Years of contributions ×0.0691× yearly salary. Contributions are capitalized with accrual rate equal to 0.015+0.75

Public employees Pre-reform

All Years of contributions × 0.80 × (final yearly salary / 12)

Public employees Post-reform

Before 2000 Pro-rata regime, with two components, until and after 2010, with weights given by years of service.

After 2000 Same as private employees

The size of the shock Before the

reform

After the reform

(1)

Contracts signed before

December 2000 (2)

Contracts signed after

December 2000 (3)

g=1.53%, y0=15,800

76,195 69,303 58,065

g=2.23%, y0=18,000

116,517 100,976 77,996

g=2.62%, y0=20,000

146,234 124,342 92,980

Assumptions: 40 years of work; in column (2) contract is signed in 1995; g and y are historical averages for all emplyees

Simulations

In the pre-reform regime, severance pay is:

In the post-reform regime:

Results differ depending on when the reform occurs in the course of the life-cycle.

10.8 NS N Y 1

00.0691 (1 )

N N tt

tS Y

Income process

1 1

0 0

T Nt tt t N

t t

C Y SR R R

1

00

max ( )T

tt

tE U C

1 1 1

1 1

t t t

t t t

Y P VP GPZ

Wealth-income ratio before and after the severance pay reform

Change in the wealth-income ratio

c/y before and after the severance pay reform

Change in c/y

An unanticipated negative income shock to lifetime resourcesreduces consumption and increases wealth relative to income.

Both effects depend on the size of the shock, and are stronger for younger workers.

Data

Pooled 1989-2010 sample from SHIW

Age 20-55, 39% public, 61% private

Exclude self-employed and workers near to retirement.

Wealth-income ratio, by occupation

23

45

6W

ealth

-inco

me

ratio

1990 1995 2000 2005 2010

Public employees Private employees

Consumption-income ratio, by occupation

.7.7

5.8

.85

.9C

onsu

mpt

ion-

inco

me

ratio

1990 1995 2000 2005 2010

Public employees Private employees

Difference-in-difference estimates

y = wealth or consumption-income ratiod>0 in the regression for the wealth-income

ratiod<0 in the regression for the consumption-

income ratio.

Assumptions the reform is exogenous with respect to

consumer decisions; the reform is exogenous with respect to

changes in sample composition (no labor supply response).

it i t i t it ity M POST M POST x d

Baseline estimates Wealth-income ratio Consumption-income

ratio Public employee 0.015 0.002 (0.065) (0.010) Post-reform period 0.772 0.059 (0.063)*** (0.009)*** Public employee post-reform 0.321 -0.030 (0.101)*** (0.015)** Age 0.088 -0.004 (0.003)*** (0.000)*** Male 0.093 -0.009 (0.063) (0.009) Family size 0.051 -0.009 (0.021)** (0.003)*** College degree 1.814 -0.137 (0.079)*** (0.012)*** High school diploma 1.290 -0.082 (0.052)*** (0.008)*** Resident in the Centre 0.507 0.037 (0.063)*** (0.009)*** Resident in the South -0.040 0.092 (0.057) (0.008)***

Regressions by number of public employees

Wealth-income ratio

Consumption-income ratio

One public employee -0.001 -0.016 (0.068) (0.010)* More than one public employee -0.204 -0.090 (0.101)** (0.015)*** Post-reform period 0.745 0.058 (0.068)*** (0.010)*** One public employee post-reform 0.281 -0.026 (0.105)*** (0.015)* More than one public employee 0.363 -0.030 post-reform (0.161)** (0.024)

Strongest impact for households with more than 1 public employee

Young vs. old workers Wealth-income ratio

Consumption-income ratio

30 years of contributions

>30 years of contributions

30 years of contributions

>30 years of contributions

Public employee -0.078 0.392 0.006 -0.022 (0.063) (0.150)*** (0.007) (0.010)** Post-reform 0.672 1.194 0.067 0.018 (0.071)*** (0.152)*** (0.016)*** (0.010)* Public employee 0.406 -0.081 -0.034 -0.011 post-reform (0.119)*** (0.253) (0.014)** (0.016)

Strongest impact for young public employees.

Robustness tests

Group-specific pre-treatment trends. Restrict sample to years before the reform and

redefine the post-reform dummy as 1 after 1995. Add to baseline specification post-1995 dummy

and interaction with public employee dummy.

Define treatment group as households whose all members are public employees and control group as households whose all members are private employees.

Regional dummies, sector dummies.

Stronger effects among household with higher education.

Summary

Consumption and wealth effects of 2000 severance pay reform: unanticipated negative shock to lifetime resources.

Baseline: on average, reduction in severance pay equal to one year’s income increases wealth by 4 months income. The offset ratio is 0.4.

The reform reduces consumption by 3pp relative to income.

Heterogeneity: wealth and consumption response stronger among households with more than one public employee and young workers, who expect the strongest decline in severance pay.

Summary

There is no single MPC.

Identify nature of income shock. Several strategies: structural models, natural experiments, direct survey questions.

Effect of shocks depends on whether it is perceived as permanent or transitory

Importance of heterogeneity of response.