Testing Parental Altruism:Implications of a Dynamic Model Kathleen McGarry 1 Department of Economics University of California,Los Angeles and NBER original version,February 1998 this version,April 2006 1I am grateful to Michael Hurd,Janet Currie,Wei-Yin Hu,and Jean-Laurent Rosenthal for helpful comments.Financial support was received from the National Institute on Aging through grant number T32-AG00186 and from the Brookdale Foundation
Testing Parental Altruism: Implications of a Dynamic Model Kathleen McGarry 1 Department of Economics University of California, Los Angeles and NBER original version, February 1998 this version, April 2006 1I am grateful to Michael Hurd, Janet Currie, Wei-Yin Hu, and Jean-Laurent Rosenthal for helpful comments. Financial support was received from the National Institute on Aging through grant number T32-AG00186 and from the Brookdale Foundation
Abstract Each year parents transfer a great deal of money to their adult children.While intuition might suggest that these transfers are altruistic and made out of concern for the well-being of the children, the fundamental prediction of the altruistic model has been decisively rejected in empirical tests. Specifically,the required derivative restriction-that an increase of one dollar in the income of the recipient,accompanied by a decrease of one dollar in the income of the donor,leads to a one dollar reduction in transfers-fails to hold.I show in this paper that in fact,this prediction will not hold if parents use observations on the current incomes of children to update their expectations about future incomes.This result implies that many past studies have relied on too restrictive a test,and furthermore,that our ability to distinguish empirically between altruistic and exchange behavior is severely limited.The paper also analyzes the variation in transfer behavior over time and finds substantial change across periods in recipiency status as well as a strong correlation between inter vivos transfers and the transitory income of the recipient.This evidence suggests that dynamic models can provide insights into transfer behavior that are impossible to obtain in a static context
Abstract Each year parents transfer a great deal of money to their adult children. While intuition might suggest that these transfers are altruistic and made out of concern for the well-being of the children, the fundamental prediction of the altruistic model has been decisively rejected in empirical tests. Specifically, the required derivative restriction–that an increase of one dollar in the income of the recipient, accompanied by a decrease of one dollar in the income of the donor, leads to a one dollar reduction in transfers–fails to hold. I show in this paper that in fact, this prediction will not hold if parents use observations on the current incomes of children to update their expectations about future incomes. This result implies that many past studies have relied on too restrictive a test, and furthermore, that our ability to distinguish empirically between altruistic and exchange behavior is severely limited. The paper also analyzes the variation in transfer behavior over time and finds substantial change across periods in recipiency status as well as a strong correlation between inter vivos transfers and the transitory income of the recipient. This evidence suggests that dynamic models can provide insights into transfer behavior that are impossible to obtain in a static context
1 Introduction Intergenerational transfers between family members are an important economic phenomenon,par- ticularly those transfers from parents to children.Gale and Scholz (1994)estimate yearly flows between parents and their non-coresident children of $50 billion in 1999 dollars.Because of the magnitude of the funds involved such transfers are likely to have a substantial impact on other economic behaviors.Certainly they will affect the well-being of both donors and recipients and will have consequences for the distribution of wealth.In addition,however,familial transfers may interact with public transfers,and in doing so could alter the effectiveness of government assistance programs. The importance of the effects in any of these dimensions depends crucially on the motivation behind the private transfers.While the relationship between motive and impact has been long recognized,only recently have data of sufficient quality to test alternative hypotheses become available.Unfortunately,despite several efforts,a consensus has not yet been reached on the most appropriate model of behavior as none of the hypothesized models appears to be consistent with observed patterns giving. The two most prominant models of familial behavior,altruism and exchange,make very dif- ferent predictions about the redistributional aspects of private transfers,and about the interaction between public and private assistance,so distinguishing between the two is of both theoretical and practical interest.In the literature,attention has centered on testing the predictions of the altruism model.This model,wherein parents care about the welfare of their children,makes strong predic- tions about the signs and relative magnitudes of the effects of the donors'and recipients'incomes on transfer amounts,so testing is apparently straightforward.However,while the standard altruism model is written in a static context with the effects of interest being changes in lifetime transfers in response to changes in permanent incomes,the actual data used to test the model come from a dynamic world:Researchers observe current rather than permanent income,and single period rather than lifetime transfers.As I show in this paper this difference in measurement is likely to lead to incorrect conclusions in tests of the model's validity. Recent work testing the predictions of the altruism model in a dynamic context (Altonji, Hayashi,and Kotlikoff,1997)has concluded that the model is inconsistent with observed data
1 Introduction Intergenerational transfers between family members are an important economic phenomenon, particularly those transfers from parents to children. Gale and Scholz (1994) estimate yearly flows between parents and their non-coresident children of $50 billion in 1999 dollars. Because of the magnitude of the funds involved such transfers are likely to have a substantial impact on other economic behaviors. Certainly they will affect the well-being of both donors and recipients and will have consequences for the distribution of wealth. In addition, however, familial transfers may interact with public transfers, and in doing so could alter the effectiveness of government assistance programs. The importance of the effects in any of these dimensions depends crucially on the motivation behind the private transfers. While the relationship between motive and impact has been long recognized, only recently have data of sufficient quality to test alternative hypotheses become available. Unfortunately, despite several efforts, a consensus has not yet been reached on the most appropriate model of behavior as none of the hypothesized models appears to be consistent with observed patterns giving. The two most prominant models of familial behavior, altruism and exchange, make very different predictions about the redistributional aspects of private transfers, and about the interaction between public and private assistance, so distinguishing between the two is of both theoretical and practical interest. In the literature, attention has centered on testing the predictions of the altruism model. This model, wherein parents care about the welfare of their children, makes strong predictions about the signs and relative magnitudes of the effects of the donors’ and recipients’ incomes on transfer amounts, so testing is apparently straightforward. However, while the standard altruism model is written in a static context with the effects of interest being changes in lifetime transfers in response to changes in permanent incomes, the actual data used to test the model come from a dynamic world: Researchers observe current rather than permanent income, and single period rather than lifetime transfers. As I show in this paper this difference in measurement is likely to lead to incorrect conclusions in tests of the model’s validity. Recent work testing the predictions of the altruism model in a dynamic context (Altonji, Hayashi, and Kotlikoff, 1997) has concluded that the model is inconsistent with observed data. 1
Specifically,a fundamental prediction of the altruism model-that conditional on transfers being made,an increase of one dollar in the income of the recipient,accompanied by a decrease of one dollar in the income of the donor,will lead to a one dollar reduction in transfers-was decisively rejected.(I will term this relationship the "derivative restriction."1)However,under reasonable assumptions about the formation of expectations of future income,the derivative restriction will not hold.Thus,caution should be used when drawing conclusions from studies that have used the restriction as a test of altruism.Furthermore,because this derivative restriction has been the sole means of differentiating between altruism and exchange regimes,my result suggests that our ability to distinguish between the two explanations of behavior may be severely limited.2 The model developed here assumes that the future income of a child is not known,rather the parent knows only its distribution.Observations on the child's current income in each period provide new information that is used to update the distribution of future income.Changes in this distribution affect expected future transfers,and in a dynamic model feed back to affect current transfers.Through this mechanism,the responsiveness of current transfers to changes in current income is reduced,causing the derivative restriction to fail. Intuitively,consider an example wherein the arrival of a new observation on the child's income causes the parent to reduce her estimate of the child's future income and consumption.Not only will the parent wish to increase transfers in the current period,but she will also expect to increase future transfers as well.In this case the derivative of interest-the change in current transfers for a change in current income-differs from its value in the absence of updating,and the derivative restriction predicted by the static altruism model no longer holds. Using data from the Health and Retirement Survey (HRS),the paper provides an empirical test of this dynamic framework.Specifically,I examine the relationship between current transfers and both current and lagged income of the potential recipient and find that both variables have significant explanatory power.I interpret these results as evidence that a parent's assessment of her child's future income depends on past realizations of income.This result is consistent with Altonji et al.use the term "transfer income derivatives restriction." 2An alternative test of the two models relies on the sign of the effect of the recipient's income on the amount of the transfer.An altruism model predicts a negative relationship while either a positive or negative relationship is consistent with exchange.An estimated positive effect can therefore be used to discount the altruism model. However,recent empirical work has consistently found a negative relationship,and thus this test has provided no distinguishing power. 2
Specifically, a fundamental prediction of the altruism model—that conditional on transfers being made, an increase of one dollar in the income of the recipient, accompanied by a decrease of one dollar in the income of the donor, will lead to a one dollar reduction in transfers—was decisively rejected. (I will term this relationship the “derivative restriction.”1) However, under reasonable assumptions about the formation of expectations of future income, the derivative restriction will not hold. Thus, caution should be used when drawing conclusions from studies that have used the restriction as a test of altruism. Furthermore, because this derivative restriction has been the sole means of differentiating between altruism and exchange regimes, my result suggests that our ability to distinguish between the two explanations of behavior may be severely limited.2 The model developed here assumes that the future income of a child is not known, rather the parent knows only its distribution. Observations on the child’s current income in each period provide new information that is used to update the distribution of future income. Changes in this distribution affect expected future transfers, and in a dynamic model feed back to affect current transfers. Through this mechanism, the responsiveness of current transfers to changes in current income is reduced, causing the derivative restriction to fail. Intuitively, consider an example wherein the arrival of a new observation on the child’s income causes the parent to reduce her estimate of the child’s future income and consumption. Not only will the parent wish to increase transfers in the current period, but she will also expect to increase future transfers as well. In this case the derivative of interest–the change in current transfers for a change in current income–differs from its value in the absence of updating, and the derivative restriction predicted by the static altruism model no longer holds. Using data from the Health and Retirement Survey (HRS), the paper provides an empirical test of this dynamic framework. Specifically, I examine the relationship between current transfers and both current and lagged income of the potential recipient and find that both variables have significant explanatory power. I interpret these results as evidence that a parent’s assessment of her child’s future income depends on past realizations of income. This result is consistent with 1Altonji et al. use the term “transfer income derivatives restriction.” 2An alternative test of the two models relies on the sign of the effect of the recipient’s income on the amount of the transfer. An altruism model predicts a negative relationship while either a positive or negative relationship is consistent with exchange. An estimated positive effect can therefore be used to discount the altruism model. However, recent empirical work has consistently found a negative relationship, and thus this test has provided no distinguishing power. 2
the updating model introduced below.As a specification test I test the effect of future income on current transfers and find that it does not have significant explanatory power. In exploring the implications of this dynamic framework,I also examine variability of transfers over time.In the two years for which I have data I find a significant number of changes in recipiency. In each year approximately 13 percent of children are reported to be receiving transfers,yet only 5.5 percent of the sample receives transfers in both survey years.These dynamic aspects of behavior have frequently been ignored because of data limitations,3 yet from the empirical work presented here they appear to be an important phenomenon. The availability of repeated observations on each child allows me to examine transfer behavior net of permanent differences across individuals.If there exist unobserved characteristics of the parent or child that are correlated with transfer behavior and with the included measures of income, then estimated derivatives from equations that ignore these effects will be biased.In a fixed effects framework I find that the effect of current income on transfer behavior is large and significantly different from zero,but is approximately 60 percent smaller than its effect in specifications that do not control for unobservable differences across children.These results indicate a strong negative correlation between transfers and the transitory income of potential recipients and also demonstrate the necessity of adequate controls for permanent income in dynamic models of transfer behavior. The remainder of the paper is organized as follows:In section 2 I outline the standard altruism model and discuss the tests used to distinguish this model from an exchange regime.I then expand the static model to include two periods and note the conditions under which the predicted results differ.Section 3 describes the data I use in the empirical work and section 4 discusses the estimated effects of current income on transfers.A final section concludes and summarizes the results. 2 Background and Theory I divide the theoretical discussion into two subsections.The first presents the standard altruism model and the second extends this model to two periods. 3Dunn (1997),and Rosenzweig and Wolpin (1994)are exceptions.These papers both use multiple waves of the NLS surveys.However,information is not available on all siblings of the (potential)recipients,so a complete understanding of the allocation within families is not possible. 3
the updating model introduced below. As a specification test I test the effect of future income on current transfers and find that it does not have significant explanatory power. In exploring the implications of this dynamic framework, I also examine variability of transfers over time. In the two years for which I have data I find a significant number of changes in recipiency. In each year approximately 13 percent of children are reported to be receiving transfers, yet only 5.5 percent of the sample receives transfers in both survey years. These dynamic aspects of behavior have frequently been ignored because of data limitations,3 yet from the empirical work presented here they appear to be an important phenomenon. The availability of repeated observations on each child allows me to examine transfer behavior net of permanent differences across individuals. If there exist unobserved characteristics of the parent or child that are correlated with transfer behavior and with the included measures of income, then estimated derivatives from equations that ignore these effects will be biased. In a fixed effects framework I find that the effect of current income on transfer behavior is large and significantly different from zero, but is approximately 60 percent smaller than its effect in specifications that do not control for unobservable differences across children. These results indicate a strong negative correlation between transfers and the transitory income of potential recipients and also demonstrate the necessity of adequate controls for permanent income in dynamic models of transfer behavior. The remainder of the paper is organized as follows: In section 2 I outline the standard altruism model and discuss the tests used to distinguish this model from an exchange regime. I then expand the static model to include two periods and note the conditions under which the predicted results differ. Section 3 describes the data I use in the empirical work and section 4 discusses the estimated effects of current income on transfers. A final section concludes and summarizes the results. 2 Background and Theory I divide the theoretical discussion into two subsections. The first presents the standard altruism model and the second extends this model to two periods. 3Dunn (1997), and Rosenzweig and Wolpin (1994) are exceptions. These papers both use multiple waves of the NLS surveys. However, information is not available on all siblings of the (potential) recipients, so a complete understanding of the allocation within families is not possible. 3