Private Income Transfers and Market Incentives

The paper introduces labor supply considerations and labor earnings uncertainty into a parent-child framework in the presence of Becker's (1991) "merit goods." I investigate the implications of various parental bequest rules on the effort decisions of the offspring, where the parent cannot perfectly observe her child's market activities. The asymmetry in information and preferences gives rise to a moral hazard problem, and as a result, the parent may not fully insure her child because the source of risk is not entirely exogenous. In this case, optimal parental transfers are shown to be state-contingent. Moreover, the child's effort is higher in the case with a merit good and parental transfers than in the case without a merit good. On the other hand, certain empirically observed bequest rules provide disincentives for high effort, even in the presence of a merit good. As a result, proper incentives together with a merit good are needed. Finally, the model raises interesting issues regarding wealth mobility and public policy