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This paper investigates the existence of liquidity constraints facing entrepreneurs in the United Kingdom. Using a household-level panel data set, entry to self-employment is shown to be a function of household net worth. We use inheritances and unanticipated movements in house prices as instruments for shocks to liquidity. Results indicate that inheritances are a poor instrument for liquidity constraints because both past and future inheritances predict entry to self-employment. House prices shocks are a more plausible instrument because self-employed households disproportionately re-mortgage, but our results again indicate little evidence of house price shocks unbinding liquidity constraints facing the would-be self-employed.

This paper examines the impact of movements in household wealth on entrepreneurial activity undertaken by households in the United Kingdom (UK), using a UK household panel data set. This is not a wholly new field and, in common with several other studies, we find evidence that household financial wealth is positively related to subsequent entry to self-employment. Several papers have argued that this finding provides evidence for the hypothesis that some households face liquidity constraints when seeking to undertake entrepreneurial activities. However, caution must be exercised in interpreting this relationship: various selection mechanisms, for example household human capital attributes or unobserved abilities (such as financial acumen), may generate an underlying association between financial wealth and a propensity to self-employment without liquidity constraints playing a part. A standard response to this problem of interpretation utilises positive ‘shocks’ to household financial wealth as a potential instrument for the unravelling of liquidity constraints facing would-be self-employed households. Depending on the particular study, different indicators of ‘shocks’ have been used: inheritances, redundancy payments, lottery wins and changes in self-reported housing wealth are all examples. An obvious problem with some of these indicators is that they measure events that are not truly exogenous to the decision to become self-employed: for example, receipt of redundancy payments may arise from a conscious decision to leave paid employment in order to enter self-employment. Other indicators can be reasonably treated as having some degree of exogeneity (e.g. the exact timing of receipt of an inheritance, or local house price changes) and this provides a test, exploited by Hurst and Lusardi (2004), of whether the timing of such events is associated with subsequent self-employment decisions. Timing matters, as those authors argue, because of the likely association of such events with the household’s level of wealth in general. In any event, the role of both levels of wealth and (instrumented) shocks to wealth should be tested in an explanatory model. In our paper, we test or retest several of these ideas in the UK context. The panel data set that we use has been exploited before (Taylor, 2001) but we now have more waves of data with the appropriate variables, so allowing us to test a much richer set of hypotheses. We find that levels of household wealth and business start- ups are indeed positively correlated, but as explained previously, this finding does not necessarily indicate the presence of liquidity constraints. We therefore augment the model with the standard instruments for wealth ‘windfalls’, including receipt of inheritances and ‘shocks’ to local house prices – the latter calculated at a more disaggregated level than the usual regional measure adopted by several other studies. Several studies have examined the role of inheritances in the UK context and shown significant positive effects on business start-ups but, in common with Hurst and Lusardi (2004) for the US, we cast doubt on the interpretation of this result as evidence of liquidity constraints by examining the timing of the inheritance relative to business start-up. However, in contrast to those authors, perhaps because of the finer disaggregation of our instrument and its different construction, we do find some evidence that shocks to local (i.e. county-level) house prices are a predictor of a spell of self-employment. From this last finding, we should find a relationship between re-mortgaging behaviour, business start-ups and house price shocks. So we then examine the relationship between re-mortgaging activity and self-employment, and also between house price ‘shocks’ and re-mortgaging. We find evidence that self-employed start-ups disproportionately use re-mortgaging as a financing strategy, but that the probability of remortgaging in response to house price shocks is not significantly different between self-employed starters and other households, conditioned on the determinants of becoming self-employed. Our results therefore suggest that local house price shocks, suitably measured, may be the best predictor of small business start-ups from among the several indicators of household financial wealth, but no clear evidence that house price shocks unbind liquidity constraints that deter business start-ups.

This paper has examined the impact of household wealth on transition to self-employment in a UK panel data set using values of recently received inheritances and house price movements as instruments for financial wealth. The existing literature indicates that household self-employment entry is predicted by household wealth and also by receipt of ‘windfall’ payments such as inheritances, lottery winnings and bonus payments. This relationship pointed towards the existence of liquidity constraints preventing low wealth households form entering self-employment. By exploiting the panel dimension of the data set used in this paper, entry to self-employment is shown to be weakly dependent on household net worth. Controlling for household characteristics, incomes, educational background and recent labour market experience an increase in net worth of £100,000 is associated with a 27% increase in the probability of entering self-employment. This relationship is also shown to be non-linear: the association between wealth and transition appears to be wholly driven by households at the higher end of the wealth distribution. However, the findings from instrumental variable regressions call into question the existence of financial constraints to self-employment. Using values of inheritances received in the period leading up to and soon after household embark upon self-employment, both past and future inheritances are shown to predict self-employment entry. This result, in line with findings by Hurst and Lusardi (2004), indicates that the value of inheritances is most likely not measuring shocks to liquidity but rather the increment of household wealth over the life-cycle, and/or the underlying propensity to become self-employed. Housing wealth is potentially an alternative instrument for financial liquidity. Although house price movements do not provide financial windfalls to households as the value of housing equity is tied-up in the home, they do endow households with additional collateral against which potential entrepreneurs can secure finance through mortgage markets. Given that housing is a dominant asset in household portfolios, house price changes explain much of the variation in household net worth, especially in the later period considered, and is therefore associated with self-employment start-ups. However, when we estimate the unanticipated component of house price movements as the residuals from an AR2 process, and use this alternative instrument, the evidence for shocks to household liquidity impacting transition into self-employment is weakened. We then considered whether households entering self-employment systematically have higher probabilities of refinance when they obtain positive house price shocks. Controlling for other important determinant of remortgaging activity (notably, moving house), and control for the self-selection into self-employment, we find no evidence of differential refinancing rates in response to house price ‘windfalls’. This does not rule out that some households are liquidity-constrained; merely that households that are setting up businesses behave no differently from other households when they receive windfall gains. What are the policy implications of the study? The findings suggest that, since households with greater wealth are more likely to start-up businesses, start-up costs may not be trivial. In particular, the role of housing equity as collateral seems important, as in Black et al. (1996). Forward-looking households should therefore accumulate capital to engage in start-ups, but it is a strong step from that to argue that start-ups are thereby limited by financial constraints. Indeed, when we use instruments to measure (the unravelling of) financial constraints, the results are weak, in contrast to some other studies of the UK. Specifically, the paper calls into question the validity of so-called financial ‘windfalls’ as strong instruments for household liquidity. This study does not claim that households can engage in perfect credit markets, nor that all of the existing evidence for financial constraints is implausible. Rather, it calls for better tests of the financial constraints hypothesis.