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The Unobserved Returns to Entrepreneurship

Abstract

This paper seeks to understand the returns to self-employment. The analysis is motivated by the empirical puzzle that most entrepreneurs enter and persist in self-employment, despite lower initial earnings and earnings growth (Hamilton, 2000). I propose a new hypothesis to make sense of this observation. In particular, reported income is unlikely to be a good measure of the return to self-employment given the underreporting incentive, and opportunities available to business owners. Moreover, business owners also have access to multiple avenues for compensating themselves and their employees. As such, any survey of business owners will face great difficulties in capturing the many ways in which business income can be received. As evidence for the potential importance of such understating, Slemrod (2007) reports that the evasion rate amongst non-farm proprietorships varies between 18 and 57 percent depending on industry. In this paper, I make use of the PSID to test my hypothesis. The estimation strategy relies on the presumption that reported consumption by the self-employed will not be systematically misreported, even though income can easily be. The results indicate that individuals report earning 27 percent less but appear to consume 5 percent more in self-employment. This implies a 32 percent differential between reported wage and consumption for the selfemployed, indicating that the former measure is not a good barometer of the financial returns to self-employment. Furthermore, this increased consumption does not seem to be offset by higher uncertainty as evidenced by my finding, that the variance in consumption while selfemployed is not significantly different than that in wage employment. Other results include that the self-employed work longer hours and that consumption is the same as that prior to self-employment for those who return to wage employment.

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