The textbook version of the life-cycle permanent income hypothesis with no liquidity constraints predicts that consumption should react very little to transitory shocks to income and very strongly to permanent shocks. This prediction has important policy implications, i.e., to understand the response of consumers to tax rebates or increases that are made for stabilization purposes. In recent years there has been a resurgence of interest in estimating these important parameters, either using quasi-experimental data (such as randomization of the timing when tax rebate checks are received by households, see Christian Broda and

We compare the empirical performance of a standard incomplete markets asset pricing model with that of a novel model with constrained Pareto‐optimal allocations. We represent the models’ stochastic discount factors in terms of the cross‐sectional distribution of consumption and use these representations to evaluate the models’ empirical implications. The first model is inconsistent with the equity premium in the United States, United Kingdom, and Italy. The second model is consistent with the equity premium and the risk‐free rate in all three countries if the coefficient of relative risk aversion is roughly 5 and the quarterly discount factor is less than 0.5.