Earnings dynamics and top-earnings inequality

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.