Nº 37 (June, 2006). Walter Sosa-Escudero, Mariana Marchionni & Omar Arias. 

This paper uses a unique panel dataset (1995-2001) of rural El Salvador to investigate the main sources of the persistence and variability of incomes. First we propose an econometric framework where a general dynamic panel model is validly reduced to a simple linear structure with a dynamic covariance structure, which augments considerably the number of  degrees  of  freedom  usually  lost  in  the  construction  of  instruments  to  estimate  standard dynamic panel models. Then we investigate the extent to which families are continuously poor due  to  endowments  (observed  and  unobserved)  that  yield  low  income  potential  or  due  to systematic income shocks that they are unable to smooth. We find that life-cycle incomes are largely explained by the relatively time-invariant productive characteristics of families and their members  such  as  education,  public  goods  and  other  assets.  Observed  income  determinants account for about half of income persistence. Controlling for unobserved heterogeneity leaves little room for pure state dependence. Although of second order, high volatility and the inability to  insure  from  shocks  is  a  more  important  source  of variation in incomes than in developed countries. Low-income potential is the more likely source of poverty traps in Rural El Salvador. Many of the family endowments are manipulable by policy interventions, although many not in the short term.