Self-Employment Dynamics and the Returns to Entrepreneurship

by Eleanor W. Dillon and Christopher T. Stanton

Overview — Why do workers turn to entrepreneurship when many entrepreneurs appear to earn less than what they could earn in paid employment? This is the first paper to characterize how the value of resolving uncertainty about entrepreneurial earnings varies over the lifecycle after adjusting for tax differences between entrepreneurs and paid workers. Findings suggest that helping people learn about their potential earnings in entrepreneurship, either by learning from other's experiences in self-employment or by experimenting themselves, can improve the efficiency of sorting workers across sectors.

Author Abstract

Small business owners and others in self-employment have the option to transition to paid work. If there is initial uncertainty about earnings in entrepreneurship, this option increases the expected lifetime value of entering self-employment relative to expected pay in a single year. This paper first documents that moves between paid work and self-employment are common and consistent with experimentation to learn about entrepreneurial earnings. This pattern motivates estimating the expected returns to entering self-employment within a dynamic lifecycle model that allows for non-random selection in and out of self-employment and gradual learning about the entrepreneurial earnings process. The model accurately fits entry patterns into self-employment by age, with returns to entrepreneurship varying over the lifecycle. The pre-tax lifetime value of self-employment is positive at the median. The option to return to paid work is large enough to reverse the result from cross-sectional studies that the median man expects to earn significantly less from self-employment. However, after accounting for progressive taxation and the additional employer portion of the payroll tax assessed on the self-employed, the median lifetime after-tax earnings gap between self-employment and paid work is approximately zero.

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