Earnings dynamics and top-earnings inequality

Karl Harmenberg and Raysa Lizarraga ()

No 01/2025, Working Papers from Centre for Household Finance and Macroeconomic Research (HOFIMAR), BI Norwegian Business School

Abstract: We introduce a simple generalization of the canonical permanent-transitory earnings process, a square-root process. The square-root process generates a Pareto tail in earnings and is able to match the dynamics of top-earnings inequality over the life cycle while retaining a good match to the covariance structure of earnings. By contrast, the canonical model fails to match the dynamics of top-earnings inequality over the life cycle. Since our square-root process is simple, with only one state variable, it can easily be used in structural macroeconomic models.

Pages: 30 pages
Date: 2025
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