People do not adapt. New analyses of the dynamic effects of own and reference income on life satisfaction

Abstract

Do people adapt to changes in income? In contradiction to much of the previous literature, I find no evidence of adaptation to income in GSOEP (1984-2015) and UKHLS (1996-2017) data. Furthermore, I find that people also do not adapt to changes in reference income. Instead, reference income effects may be subject to reinforcement over time. Following the empirical approach of Vendrik (2013), I obtain these findings by estimating life satisfaction equations in which contemporaneous and lagged terms for a respondent’s own household income and their estimated reference income are simultaneously entered. Additionally, I instrument for own income and include lags of a large set of controls. What was found to be adaptation to raw household income in previous studies turns out tohave been driven by reinforcement of an initially small negative effect of household size that grows large over time. Implications of this result for the estimation of equivalence scales with subjective data are discussed.