On-the-job human capital investment and intertemporal substitution: New evidence on intertemporal substitution elasticity

This paper argues that estimates of intertemporal elasticity of substitution (IES) obtained from standard life-cycle models are subject to a downward bias because they neglect the life-cycle and demographic patterns of on-the-job human capital investment. Taking into account the fact that part of a worker's time at work goes to acquiring human capital in addition to his main task of producing goods, we extend the standard life-cycle model to include time spent on investing in on-the-job human capital and propose a new framework for identifying the IES. We obtain statistically significant evidence that conventional estimates of IES for total hours at work are biased downward about 20% at the intensive margin. The corresponding IES estimates for production hours are biased downward even more, which provides an explanation for why output fluctuation is greater than hours/employment fluctuation over the business cycle.