FROM EARNINGS INEQUALITY TO CONSUMPTION INEQUALITY * Orazio Attanasio, Gabriella Berloffa, Richard Blundell and Ian Preston This paper studies the paths from inequality in earnings to inequality in household con- sumption. We show that careful study of the evolution of the variances and covariances of earnings and consumption within cohorts across time can identify permanent and transitory shocks. We present an application to the evolution of inequality in the United Kingdom. We extend previous results to recognise separate earnings of partners in couples. The path from inequality in hourly wages to inequality in household consumption and ultimately welfare is mediated by numerous household decisions. Consump- tion changes are in¯uenced by labour supply choices and by the availability of saving and transfers to buffer temporary and unexpected shocks and by the ex- istence of formal or informal insurance arrangements. This paper argues that the simultaneous analysis of earnings and consumption data can add key insights to our understanding of the evolution of inequality. In particular, the simultaneous analysis of consumption and earning inequality can be helpful in: (i) decomposing shocks to earnings and wages into transitory and permanent components; (ii) determining which shocks individual households are able to smooth out and which they are not; (iii) differentiating responses to various components of earnings ± in particular, the effect of shocks to primary earners and spouse. The large increase in wage inequality during the 1980s and early 1990s (docu- mented, for instance, by Katz and Murphy, 1992; Levy and Murnane, 1992; Karoly, 1993; Katz and Autor, 1999) spurred more recent research that has attempted to decompose shocks into transitory and permanent components. Gottschalk and Mof®tt (1994), Mof®tt and Gottschalk (1995), Buchinsky and Hunt (1996), Git- tleman and Joyce (1996), for instance, studied longitudinal data to document a strong increase in the variance of permanent shocks in the 1980s and a progres- sively more important role for transitory shocks. Several studies, such as Cutler and Katz (1991, 1992) and Slesnick (1993), have looked at the evolution of consumption inequality and documented an increase during the same period, albeit not as large. Other studies including Mace (1991) and Attanasio and Davis (1996) have used consumption and wages simultaneously * Thanks are due to seminar participants at the RES and the NBER for useful comments on earlier versions of this paper. This study is part of the research programme of the ESRC Centre for the Microeconomic Analysis of Fiscal Policy at IFS. We are also grateful to the Leverhulme Trust for funding under the project on ÔThe changing distribution of consumption, economic resources and the welfare of households'. Material from the FES made available by the CSO through the ESRC data archive has been used by permission of the controller of HMSO. Neither the CSO nor the ESRC Data Archive bear any responsibility for the analysis or interpretation of the data reported here. The usual disclaimer applies. The Economic Journal, 112 (March), C52±C59. Ó Royal Economic Society 2002. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA. [ C52 ]