Uncertainty in Human Capital Investment and Earnings Dynamics

There is a literature that examines the statistical properties of earnings dynamics by testing heterogeneous growth against random walk. This test is of great consequence because rejection of heterogeneous growth has often been interpreted as rejection of a key role for heterogeneity in human capital investment over the life-cycle. This paper shows that optimal life-cycle investment behavior implies the presence of a permanent component in earnings levels as well as the individual heterogeneity in earnings slopes. Permanent shocks are induced by the response of individuals to human capital investments due to transitory shocks to the rental rate of human capital. We incorporate uncertainty about future rental rates for human capital into an optimal life-cycle human capital investment model and obtain an earnings equation implied by the solution to the worker’s optimal investment decision. Using the National Longitudinal Survey of Youth 1979 (NLSY79), we con…rm that heterogeneity in earnings slopes, permanent errors, and transitory shocks all play a signi…cant role in earnings dynamics. We also learn that a worker’s earnings are more a¤ected by shifts in human capital accumulation path than by individual di¤erence in the ability to produce human capital. Keywords: Earnings Equation, Human Capital Theory, Random Growth, Random Walk, Rental Rate of Human Capital JEL Classi…cation Number: J22, J24, J31 1 I am especially grateful to Joseph Altonji and Fabian Lange for invaluable discussions and feedback. I have also bene…ted from helpful comments and suggestions made by Manuel Arellano, Hanming Fang, Yuichi Kitamura, Costas Meghir, Paul Schultz, and seminar participants at University of Washington and Yale University.