Abstract

The trade-off between risk and return plays a central role in empirical work on investment in physical capital. In contrast, this trade-off has received little attention in the empirical literature on investment in human capital. To date, there is little causal evidence on how education affects life-cycle earnings profiles, earnings uncertainty, and unemployment risk. Yet theory suggests these factors could be important both to accurately measure the returns to education, to explain the decision to invest or not in education, and to understand the observed earnings dynamics and inequality over the life-cycle.

The primary contribution of our paper is to incorporate earnings uncertainty and employment risk in the empirical measurement of the returns to education. To do so, we first characterize the causal relationship between schooling and earnings over the life-cycle, following the same individuals across their working lifespan. This relationship allows us to draw conclusions about how additional schooling affects the level and dispersion of earnings over the life cycle. To try to disentangle uncertainty from heterogeneity, we next model the underlying earnings process, targeting the estimated causal relationship between schooling and earnings over the life-cycle. We then fit a life-cycle model with precautionary saving motive to the estimated earnings process and observed consumption profiles. The estimated model allows us to quantify how earnings uncertainty and employment risk affect the incentives to invest in education, and to examine the extent to which the progressive tax-transfer system distorts these incentives.