Can Families Smooth Variable Earnings?

THE LABOR MARKET in the United States is marked by considerable year-to-year variation in individual earnings.' In theory, variation in the earnings of family heads need not be a source of welfare loss to families. Families can rely on their own savings, the labor supply of other family members, and government tax and transfer programs to smooth this variation, so that family consumption remains unchanged. In practice, however, these sources of consumption smoothing may be far from adequate. This issue takes on particular salience in the United States today, because of a substantial increase in the instability of earnings over the past twenty years. As Peter Gottschalk and Robert Moffitt have shown, and as we confirm below, earnings variation has trended upward since the early 1970s. We estimate that over the period 1970-91, earnings variation has grown by a striking 76 percent. The purpose of this paper is to assess the completeness and the sources of smoothing of idiosyncratic earnings variation. We use two survey data sets with information on income and consumption to estimate the relationship between variation in the earnings of household heads and variation in their families' consumption. In our analysis, we employ an instrumental variables (IV) strategy designed to deal with