Human capital risk and economic growth

This paper develops a tractable incomplete-markets model of economic growth in which households invest in risk-free physical capital and risky human capital. The paper shows that a reduction in uninsurable idiosyncratic labor income risk decreases physical capital investment, but increases human capital investment, growth, and welfare. A quantitative analysis based on a calibrated version of the model reveals that these effects are substantial and of the same order of magnitude as the effects of distortionary income taxation. The analysis further suggests that government-sponsored severance payments to displaced workers increase growth and welfare even if these payments have to be financed through distortionary income taxation.