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Many public policies are designed to encourage self-employment. However, because self-employment experiences are typically brief, it becomes important to understand the long-term consequences of entering and then leaving self-employment. Using the Panel Study of Income Dynamics (PSID), we examine the effects of brief self-employment experience on subsequent labor market outcomes. We find that, relative to continued wage employment, brief spells in self-employment do not increase—and probably actually reduce—average hourly earnings upon return to wage employment. We also find that those who experience self-employment have difficulty returning to the wage sector. However, these consequences are small compared to similar experiences in unemployment.

Should public policy be designed to explicitly favor small businesses and self-employed workers? Citing the many potential benefits of entrepreneurship, a large number of countries and an increasing number of US states are actively encouraging individuals to become self-employed. For example, US tax policies have traditionally favored sole proprietors relative to wage earners and larger businesses. The US Small Business Administration also invests billions of dollars annually to help new firms get started. More recently, self-employment programs have targeted individuals who are receiving unemployment insurance or other public assistance benefits.1 The hope is that not only would these workers eventually leave the public program rolls as a result, but also that they might create new jobs for other unemployed individuals. Perhaps as a result of this menu of public policies, a growing number of American workers are leaving the wage-and-salary ranks to start their own businesses. Indeed, nearly 1 in 10 American workers is self-employed and a growing number of women are becoming self-employed each year. At the same time, it is widely known that many spells in self-employment end within the first few years of business. Thus, in evaluating the potential costs and benefits of public support for entrepreneurial activities, it becomes important to understand the labor market consequences associated with entering and then leaving self-employment. In a sense, self-employment can be viewed as a human-capital-enhancement or job-training program. It has the potential to increase general human capital, thereby enhancing earnings and employment options in the wage sector after exiting self-employment. Alternatively, it might stagnate any job-specific skills that had previously been gained in wage employment or serve as a signal of labor market instability, leading to reduced earnings or employment prospects after exiting.2 Therefore, uncovering the consequences of spells in self-employment is left to empirical analysis. With the exception of Evans and Leighton (1989), Ferber and Waldfogel (1998), and Williams (2000), little attention in terms of empirical research has been given to the longer-term consequences faced by those leaving self-employment for a wage job. These studies, which focus on the effects of self-employment experience on earnings outcomes, while instructive have a number of shortcomings which we attempt to overcome. We improve on previous estimates of the relative wage returns of self-employment experience to wage sector experience by utilizing panel data that are more representative of the population (the Panel Study of Income Dynamics (PSID)) and by controlling for the implied job change associated with a transition into self-employment. In addition to wage outcomes, we also examine the consequences of self-employment experience for other labor market outcomes, including the probability of unemployment and part-time employment.3 Our main findings are as follows. Within 5-year windows between 1979 and 1990, a significant proportion of wage workers experienced a short spell (lasting four years or less) of self-employment. These short spells of self-employment tended to be very brief—two-thirds to three-quarters of them lasted 1 year or less. Unlike previous research, we find evidence that short spells of self-employment are associated with lower wages upon return to the wage and salary sector for men. However, when we control for job turnover, these negative wage effects dissipate. For American women, while spells of self-employment are also associated with a reduction in wages, the results are generally not statistically significant. Full-time working men and women who subsequently experience a self-employment spell appear to have some difficulty returning to full-time employment. These small negative consequences associated with short spells of self-employment contrast with the more severe negative consequences associated with similar spells of unemployment. We begin in Section 2 with some background and a review of the earlier literature. We focus on the wage consequences of self-employment experience in 3, 4, 5 and 6. Section 3 provides a discussion of the data and a descriptive analysis of our sample. Section 4 describes our multivariate econometric approach, and Section 5 presents results and discussion. Section 6 contains a number of robustness checks. In Section 7, we examine the effect of self-employment on the probability of subsequent part-time employment and unemployment. A discussion of conclusions and policy implications closes the paper in Section 8.

In theory, prior self-employment experience has the potential to either improve or worsen (or have no effect on) labor market outcomes for workers who eventually return to the wage sector. Using regressions of average hourly earnings on a variety of control variables including controls for time invariant unobserved heterogeneity, we find no empirical evidence that short self-employment experiences increase wages relative to continued wage employment for men or women. If any nonzero impact can be discerned from these data, it is that (compared to wage employment) an additional year of self-employment might actually reduce post-self-employment earnings in the wage sector by anywhere from 3% to 11% for men. These results contrast to a certain extent with the results of previous research by Williams (2000) who found the returns to self-employment to be positive and equal to the returns to wage employment for men and positive but less than the returns to wage employment for women. These differences may be due, in part, to our focus on short-term self-employment as well as the differences in the age distribution of the sample used in that study which was much younger and less representative of the overall population than our sample. Unlike previous researchers, we also examine the effect of short self-employment spells on future employment prospects. In particular, we estimate the effect that self-employment experience has on the probabilities of subsequent part-time employment and unemployment. We find that, relative to wage sector experience, self-employment experience does not improve and may diminish subsequent employment outcomes. It appears that a short spell of self-employment may increase the probability of unemployment by anywhere from 3% to 10%, and part-time employment by 10–30%. These results provide useful information in terms of evaluating the potential costs and benefits of public policies that support small business formation. On the surface, efforts to increase entrepreneurial activity may result in less favorable subsequent consequences in the form of lower employment probabilities, higher part-time employment probabilities, and lower earnings upon an eventual return to the wage sector. Additionally, throughout our analysis, we compare the labor market effects of spells of self-employment to the effects of spells in unemployment, in part to shed light on the likely effectiveness of recent self-employment assistance programs focused on preventing unemployment spells. We find that the negative labor market consequences associated with unemployment spells in most of the 5-year windows examined are more severe than those associated with self-employment. Specifically, unemployment experience increases the probability of subsequent part-time employment by 14–40%, and of subsequent unemployment by 6–25%. To the extent that our analysis captures the underlying wage and employment effects of self-employment and unemployment, these results suggest that certain benefits may arise from programs that promote self-employment as an alternative to unemployment. Several caveats are in order, however. First, we have not fully addressed the issue of selection out of self-employment or unemployment. This may bias our estimates of the returns to self-employment if those who enter but do not leave self-employment within our period of analysis are those who would have had higher wages upon returning to the wage sector. Further, selection out of the self and unemployment states may differ systematically resulting in our finding of larger negative consequences to unemployment. This would be the case, for example, if individuals who are self-employed have higher reservation wages for wage sector reemployment than those who are unemployed. Second, our choice of time periods, while based on concerns of business cycles and tax changes, may be somewhat arbitrary. It could be the case that the labor market effects of self-employment and unemployment are quite different during other periods of time, especially for a window of time that spans a recession. Finally, despite accounting for wage and employment consequences, we are not able to assess nonpecuniary costs of self-employment experience such as the loss of fringe benefits. Despite all of this, we believe that our results bring to the forefront new issues for consideration in the evaluation of the likely “effect” of various self-employment assistance programs. Our results suggest that the effectiveness of such programs depends to a great extent on which sector of the labor market workers are being attracted from to become entrepreneurs. Generally, we find that workers who remain in wage sector jobs do better in terms of wage outcomes than those who experience brief spells of self-employment but that those with spells of unemployment fare even worse than those with spells of self-employment. Thus, in evaluating programs aimed at promoting self-employment among the wage employed, such as those that provide start-up grants or general tax breaks, policy makers must weigh the possible deleterious effects of spells in self-employment on wages against the possible positive aspects of such policies. On the other hand, these results suggest that an evaluation of programs that promote self-employment among the unemployed should account not only for the promise of reducing public assistance rolls and creating new jobs but also for the fact that (compared to unemployment) self-employment may provide workers with an opportunity to maintain human capital in cases where wage sector employment is not an option.