The economics of self employment and entrepreneurship cambridge

The Economics of Self-Employment
and Entrepreneurship

As self-employment and entrepreneurship become increasingly important in our modern economies, Simon C. Parker provides a timely,
definitive and comprehensive overview of the field. In this book he brings
together and assesses the large and disparate literature on these subjects and provides an up-to-date overview of new research findings. Key
issues addressed include: the impact of ability, risk, personal characteristics and the macroeconomy on entrepreneurship; issues involved in raising finance for entrepreneurial ventures, with an emphasis on the market
failures that can arise as a consequence of asymmetric information; the
job creation performance of the self-employed; the growth, innovation
and exit behaviour of new ventures and small firms; and the appropriate role for governments interested in promoting self-employment and
entrepreneurship. This book will serve as an essential reference guide
to researchers, students and teachers of entrepreneurship in economics,
business and management and other related disciplines.
S I M O N C . P A R K E R is Professor and Head of Economics at the University of Durham. He is also Director of the Centre for Entrepreneurship
at Durham Business School. Professor Parker has published widely
in economics journals on a variety of issues on self-employment and
entrepreneurship.



The Economics of
Self-Employment and
Entrepreneurship
Simon C. Parker


  
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Cambridge University Press
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Published in the United States of America by Cambridge University Press, New York
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© Simon C. Parker, 2004
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For Lisa

Contents

List of Figures
List of Tables
Preface
Glossary of commonly used symbols

page xi
xii
xiii
xv

1 Introduction
1.1
1.2
1.3
1.4

Aims, motivation and scope of the book
Structure of the book
Definition and measurement issues
International evidence on self-employment rates
and trends
1.4.1 The OECD countries
1.4.2 The transition economies of eastern Europe
1.4.3 Developing countries
1.5 Self-employment incomes and income inequality
1.5.1 Incomes and relative incomes
1.5.2 Income inequality

1.5.3 Earnings functions
1.6 Some useful econometric models
1.6.1 Occupational choice and probit/logit models
1.6.2 The structural probit model
1.6.3 Extensions to cross-section models of occupational choice
1.6.4 Issues arising from the use of time-series and panel data
Notes

1
2
3
5
8
9
12
12
14
14
18
20
24
24
26
27
29
31

I Entrepreneurship: theories, characteristics
and evidence

37

2 Theories of entrepreneurship

39

2.1 ‘Early’ views about entrepreneurship
2.2 ‘Modern’ economic theories
2.2.1 Introduction and some definitions
2.2.2 Homogeneous individuals
2.2.3 Heterogeneous entrepreneurial ability
2.2.4 Heterogeneous risk aversion
2.3 Conclusion
Notes

39
43
43
46
54
61
64
65

vii


viii

Contents

3 Characteristics of entrepreneurs and the environment
for entrepreneurship
3.1 Relative earnings, human and social capital
3.1.1 Earnings differentials
3.1.2 Human capital
3.1.3 Social capital
3.2 Personal characteristics and family circumstances
3.2.1 Marital status
3.2.2 Ill-health and disability
3.2.3 Psychological factors
3.2.4 Risk attitudes and risk
3.2.5 Family background
3.3 Entrepreneurship and macroeconomic factors
3.3.1 Economic development and changing industrial structure
3.3.2 Unemployment
3.3.3 Regional factors
3.3.4 Government policy variables
3.4 Conclusion
Notes

68
68
68
70
74
74
74
75
76

83
84
86
86
94
99
102
106
107

4 Ethnic minority and female entrepreneurship

113

4.1 Ethnic minority entrepreneurship
4.1.1 Discrimination
4.1.2 Positive factors
4.1.3 Conclusion
4.2 Female entrepreneurship
4.2.1 Explaining female self-employment rates
4.2.2 Female self-employed earnings
4.2.3 Conclusion
4.3 Immigration and entrepreneurship
Notes

114
115
120
123
124

124
126
129
129
132

II Financing entrepreneurial ventures
5 Debt finance for entrepreneurial ventures
5.1 Models of credit rationing and under-investment
5.1.1 Type I credit rationing
5.1.2 Type II credit rationing and under-investment
5.1.3 Arguments against the credit rationing hypothesis
5.1.4 Conclusion: evaluating the theoretical case for credit
rationing
5.2 Over-investment
5.3 Multiple sources of inefficiency in the credit market
5.4 Conclusion
Notes

6 Other sources of finance
6.1 Informal sources of finance
6.1.1 Family finance
6.1.2 Micro-finance schemes

135
137
139
140
142
150

154
156
158
159
160

165
165
165
167


Contents
6.1.3 Credit co-operatives, mutual guarantee schemes
and trade credit
6.2 Equity finance
6.2.1 Introduction
6.2.2 The scale of the equity finance market for
entrepreneurs
6.2.3 Factors affecting the availability of equity finance for
entrepreneurs
6.2.4 Equity rationing, funding gaps and under-investment
6.2.5 Policy recommendations
6.3 Conclusion
Notes

7 Evidence of credit rationing
7.1 Tests of Type I rationing
7.1.1 The Evans and Jovanovic (1989) model
7.1.2 Effects of assets on becoming or being self-employed

7.1.3 Effects of assets on firm survival
7.1.4 Effects of assets on investment decisions
7.2 Critique
7.3 Tests of Type II credit rationing
Notes

III Running and terminating an enterprise
8 Labour demand and supply
8.1 Entrepreneurs as employers
8.1.1 Evidence about self-employed ‘job creators’
8.1.2 Evidence about job creation by small firms
8.2 Entrepreneurs as suppliers of labour
8.2.1 Hours of work
8.2.2 Retirement
Notes

9 Growth, innovation and exit
9.1 Jovanovic’s (1982) dynamic selection model
9.2 Growth and innovation
9.2.1 Gibrat’s Law and extensions
9.2.2 Evidence on growth rates
9.2.3 Innovation
9.3 Exit
9.3.1 Survival rates and their distribution
9.3.2 Two useful econometric models of firm survival
9.3.3 Determinants of entrepreneurial survival and exit
9.4 Conclusion
Notes

ix

169
171
171
171
173
174
176
177
178

179
180
180
181
182
183
183
186
189

191
193
193
193
194
197
197
204
206

208
208
213
213
215
216
218
218
220
222
227
229

IV Government policy

233

10 Government policy: issues and evidence

235

10.1 Credit market interventions

236


x

Contents

10.2
10.3
10.4

10.5

10.6
Notes

10.1.1 Loan Guarantee Schemes
10.1.2 Other interventions
Taxation, subsidies and entrepreneurship: theory
Tax evasion and avoidance: theory
Taxation, tax evasion and entrepreneurship: evidence
10.4.1 Income under-reporting by the self-employed
10.4.2 Tax, tax evasion and occupational choice:
econometric evidence
Direct government assistance and regulation
10.5.1 Entrepreneurship schemes targeted at the
unemployed
10.5.2 Information-based support for start-ups
10.5.3 Regulation and other interventions
Conclusion

11 Conclusions
11.1 Summary
11.2 Implications for policy-makers
Note

References
Author index
Subject index

236
241
242
246
249
249
251
253
253
255
257
260
262

266
266
268
271

272
308
308


Figures

2.1 Occupational choice with two occupations,
entrepreneurship (S ) and paid-employment (E )
5.1 The supply of and demand for loans
5.2 Stiglitz and Weiss’ (1981) credit rationing model
5.3 Redlining
5.4 The use of two-term contracts to separate hidden types
9.1 Selection and Survival in the Jovanovic (1982) model

page 59
140
146
148
151
211

xi


Tables

1.1 Aggregate self-employment rates in some selected
OECD countries, 1960–2000
1.2 Aggregate self-employment rates in some selected
transition economies, 1980–1998/1999
1.3 Aggregate self-employment rates in developing
countries, 1960s–1990s
3.1 Reasons given for becoming self-employed in the UK
3.2 Self-employment rates in the British regions, 1970 and
2000
3.3 Summary of determinants of entrepreneurship

9.1 Firm birth and death interactions
10.1 Features of LGSs in the UK, the USA, France,
Germany and Canada

xii

page 9
10
10
80
99
104
226
237


Preface

Entrepreneurship is a subject that is commonly taught and researched in
business schools, but seldom if at all in economics departments. Consequently, most books on entrepreneurship tend to be written from a
business and management perspective. Such books often downplay, or
ignore altogether, the contribution of modern economics to our understanding of the subject. Indeed, it is common to find them referring to
‘the contribution of economics’ mainly in terms of the treatises of Frank
Knight and Josef Schumpeter – works that were published more than half
a century ago! Of modern economics, there is little mention, apart from
the occasional disparaging remark that competitive general equilibrium
theory leaves little or no room for the entrepreneur, so modern economics
has little to offer the study of the subject.
The present book hopes to convince the reader that the foregoing is
an unduly negative assessment, by reviewing the many contributions that

modern economics has brought, and continues to bring, to our understanding of self-employment and entrepreneurship. These contributions
include rigorous analyses of occupational choice (‘what economic factors help explain who becomes an entrepreneur?’); the efficiency and
economic impact of entrepreneurial ventures (‘what is the economic importance and value of entrepreneurship?’); and the appropriate role of
governments with respect to entrepreneurship (‘what is the rationale for
intervening in the market economy to encourage entrepreneurship?’). It
is hoped that, by drawing together these contributions in this book, readers who have been trained to ignore or dismiss economics’ contributions
to the subject will be motivated to think again, and may learn from the
many insights that it has generated.
Of course, the book also addresses a target audience of economists,
with an agenda of raising the profile of entrepreneurship in that subject.
It is unclear why entrepreneurship plays such a marginal role in most
economics departments. It is possible that economists are suspicious of a
subject with an avowedly mongrel provenance, which reflects a multiplicity of different, and often non-quantitative, perspectives. From a personal
xiii


xiv

Preface

standpoint, the multidisciplinary nature of entrepreneurship posed one
of the greatest challenges in writing this book. It also offered some of the
greatest rewards.
My own view is that the multidisciplinary nature of entrepreneurship
is a potential strength, rather than a weakness. But this potential will
be achieved only if students and researchers take the trouble to break
the boundaries of narrow scholarship, an ideal to which this book is
dedicated. Indeed, the book does not confine itself exclusively to one
paradigm, despite its predominantly economics-based perspective. The
book does attempt to reach out beyond economics in many places, and

includes several references to contributions from other disciplines.
The book might never have seen the light of day without the support of
Chris Harrison, the Publishing Director of Humanities & Social Sciences
at Cambridge University Press. I am also grateful to Alison Powell at
Cambridge for the production of this book.


Glossary of commonly used symbols

VARIABLES

a
A
α, β, γ , ϑ, ω
b
B
BAD
c, c(·)
C
D
dz
δ
e
E
E
φ(·)
(·)
f (·), F(·)
g(·), G(·)
g

= (·, . . .)
hE
h S, h
H
I
IIN
k

age or years of experience
production function shift variable
(vectors of ) parameters
a ‘bad’ (risky) entrepreneurial type or venture
real current or lifetime wealth of an individual
a contract term yielding disutility to borrowers
cost, cost function
collateral
debt repayment an entrepreneur owes a bank
increment of a Wiener process
subjective intertemporal discount rate
effort
paid-employment
the expectations operator
the density function of the standard normal distribution
the distribution function of the standard normal
the density and distribution functions of a random
variable
the density and distribution functions of another
random variable
a ‘good’ (safe) entrepreneurial type or venture
a lending contract whose arguments are the contract

terms
employee work-hours
self-employed work-hours
total employee labour input
non-labour income
identically and independently normally distributed
physical capital input

xv


xvi

Glossary of commonly used symbols

λ
L
L
M, NM
n
nj

p
P
π
πB
q
q (·, . . .)
Q
r

rA
rR
R
Rf
Rs
ρ

s
s ch
S
σ2
σj
t
T
Ti j , Ti j (·)
τ
ς
θ
u, v,
U(·)
V(·)

inverse Mills Ratio
size of a bank loan; number of bank loans
likelihood function
member of a minority (non-minority) ethnic group
the number of individuals in a sample
the number or fraction of individuals in occupation j
social welfare (function); also state-space/Kuhn–Tucker
constraint

probability of success of a new enterprise
self-employed product price
profit from entrepreneurship
banks’ expected profit on a loan
probability a self-employed individual is audited
self-employed product output
self-employed production function
aggregate demand for self-employed products
interest rate (rental price of capital)
coefficient of absolute risk aversion
coefficient of relative risk aversion
stochastic return on a risky entrepreneurial venture
actual return if a risky venture is unsuccessful
actual return if a risky venture is successful
the safe (deposit) interest rate = competitive banks’
expected return; also used as the correlation
coefficient
a random variable, a random shock
aggregate self-employment rate
years of schooling or some other measure of education
self-employment
variance of a stochastic regression disturbance term
standard deviation of income risk in occupation j
time
the number of time periods
tax liability of individual i in occupation j
income tax rate
a subsidy
an entrepreneur’s type, a member of
the set of entrepreneurial types

stochastic (regression) disturbance terms
a cardinal utility function
indirect utility, or value, function


Glossary of commonly used symbols

ν
w, w E
wS
W, X, M
ψ(·), ϕ(·)
x
x˜
xE
ξ
yj
ynj
ϒ
zi
zi∗
ζ

xvii

non-pecuniary utility advantage to self-employment
wage rate received by employees
‘wage rate’ received by the self-employed
vectors of explanatory variables
some continuous function

(uni-dimensional) entrepreneurial ability
the (ability of the) marginal entrepreneur
ability in paid-employment
proportion of working time spent in S
gross (i.e. pre-tax) income received in occupation j
net (after-tax) income received in occupation j
the state of technology
a binary observed indicator variable: equal to 1 if
individual i is self-employed, else zero
an unobserved binary latent variable: the probability
individual i chooses to be self-employed
consumption

INDEXES

i
j

(subscript) indexes an individual
(subscript) indexes an occupation, usually
self-employment (S), paid-employment (E), or
unemployment (U); but sometimes also a minority
(M) or non-minority (NM) group; or a region; or
gender
(subscript) indexes a point in time

t

OTHER SYMBOLS

y˙
ˆ

∗

(prime)
˜

time derivative of y (say)
(when used in a sample) an estimate of a parameter
optimal value (except for z∗ )
vector or matrix transpose
a marginal type

ABBREVIATIONS OF ORGANISATIONS
AND DATA-SETS

BHPS
CBO
CPS
FES
GHS

British Household Panel Survey (UK)
Characteristics of Business Owners (US)
Current Population Survey (US)
Family Expenditure Survey (UK)
General Household Survey (UK)

xviii

LFS
NCDS
NFIB
NLS
NLSY
OECD
PSID
SBA
SIPP

Glossary of commonly used symbols

Labour Force Survey (UK)
National Child Development Survey (UK)
National Federation of Independent Businesses (US)
National Longitudinal Survey (US)
National Longitudinal Survey of Youth (US)
Organisation for Economic Co-Operation and
Development
(Michigan) Panel Study of Income Dynamics (US)
Small Business Administration (US)
Survey of Incomes and Program Participation (US)


1

Introduction

The entrepreneur is at the same time one of the most intriguing and one of the
most elusive characters . . . in economic analysis. He has long been recognised as
the apex of the hierarchy that determines the behaviour of the firm and thereby
bears a heavy responsibility for the vitality of the free enterprise society. (Baumol,
1968, p. 64)
Self-employment is unquestionably the oldest way by which individuals offer and
sell their labour in a market economy. At an earlier time, it was also the primary
way. Despite this history, its principal features and the characteristics that differentiate self-employment from wage and salary employment have attracted the
attention of only a handful of students of the labour market. (Aronson, 1991, p. ix)

Entrepreneurship is increasingly in the news. Governments all over the
world extol its benefits and implement policies designed to promote
it. There are several reasons for this interest in, and enthusiasm for,
entrepreneurship. Owner-managers of small enterprises run the majority
of businesses in most countries. These enterprises are credited with
providing specialised goods and services that are ignored by the largest
firms. They also intensify competition, thereby increasing economic efficiency. Some entrepreneurs pioneer new markets for innovative products,
creating new jobs and enhancing economic growth. In a few cases, today’s
small owner-managed enterprises grow to become tomorrow’s industrial
giants. Even those that do not may create positive externalities, like the
development of supply chains that help attract inward investment, or
greater social inclusion. It is sometimes also claimed that the decentralisation of economic production into a large number of small firms is good
for society and democracy, as is the fostering of a self-reliant and hardy
‘entrepreneurial spirit’.
Entrepreneurship has only recently come to be regarded as a subject.
A complete view of it recognises its multidisciplinary academic underpinnings, drawing as it does from Economics, Finance, Business and
Management, Sociology, Psychology, Economic Geography, Economic
History, Law, Politics and Anthropology. This heterogeneous provenance
reflects the multidimensional nature of entrepreneurship, which partly
1

2

The Economics of Self-Employment and Entrepreneurship

contributes to the elusiveness of the entrepreneur alluded to by William
Baumol.
1.1

Aims, motivation and scope of the book

There is general agreement that entrepreneurship is sadly neglected in
most economics textbooks (see, e.g. Rosen, 1997; Kent and Rushing,
1999). Some commentators have attributed this neglect to an inherent
unsuitability of economics for studying entrepreneurship. These commentators allege that economics is concerned only with equilibrium outcomes in competitive markets with perfectly informed agents, whereas
entrepreneurship embodies imperfect information and unexpected innovations that disrupt equilibria (Barreto, 1989; Kirchhoff, 1991; Harper,
1996; Rosen, 1997). While it is true that economists usually take the
state of technology as given, this point should not be pushed too far.
For a start, there is much more to entrepreneurship than just innovation. This book makes the case that the tools of modern economics are
invaluable for understanding the determinants of, and constraints on,
entrepreneurship, the behaviour of entrepreneurs, the contribution of
entrepreneurs to the broader economy and the impact of government
policies on entrepreneurship. It is hoped that the book will go some way
towards correcting mistaken and prejudiced impressions about the contribution of economics to this field, and will convince the reader that it is
not an oxymoron to talk about the ‘economics of entrepreneurship’.
One aspect of entrepreneurship that economists have researched quite
thoroughly is occupational choice. Despite the limitations of employing such a narrow definition – an issue we shall discuss further below –
many applied labour economists have equated self-employment with
entrepreneurship, and have analysed behavioural choice between paidand self-employment. Unfortunately, here too the economics textbooks

have been guilty of neglect: the above quotation from Richard Aronson
about self-employment remains as true today as it did over a decade ago.
To appreciate the economic importance of self-employment, consider the
following facts:
1. Around 10 per cent of the workforces in most OECD economies
are self-employed. The figure climbs to about 20 per cent when individuals who work for the self-employed are also included (Haber,
Lamas and Lichtenstein, 1987). Two-thirds of people in the US
labour force have some linkage to self-employment, by having experienced self-employment, by coming from a background in which the
household head was self-employed, or by having a close friend who
is self-employed (Steinmetz and Wright, 1989). And by the end of


Introduction

3

their working lives, about two-fifths of the American workforce will
have had at least one spell of self-employment (Reynolds and White,
1997).
2. Between 80 and 90 per cent of businesses are operated by selfemployed individuals (Acs, Audretsch and Evans, 1994; Selden,
1999).
3. Many employees in industrialised countries claim that they would
like to be self-employed. For example, according to Blanchflower
(2000), 63 per cent of Americans, 48 per cent of Britons and
49 per cent of Germans stated a preference for self-employment over
paid-employment.1
Why have the economics textbooks so conspicuously neglected selfemployment and entrepreneurship? The answer is unclear, but might
involve a lingering mistrust of entrepreneurship among economists, and
an inability to pigeon-hole this multifaceted subject. There is certainly no
lack of research on self-employment and entrepreneurship by economists.

Indeed, we hope that one of the contributions of this book is to organise and assess the current state of this branching, acquisitive and rapidly
growing literature. The book is intended to serve as a comprehensive
overview and guide to researchers and students of entrepreneurship in a
variety of disciplines, not just in Economics. The book can also be used
to support teaching in modules such as Small Business Economics and
Entrepreneurship. Readers with a working knowledge of basic undergraduate calculus, statistics and economics should cope easily with the book’s
modest technical demands. Readers without this technical background
will still be able to read the majority of the book without difficulty, and
understand the gist of the remainder by ‘reading between the Greek’.
For brevity and focus, some topics will be excluded. These include entrepreneurship in education; ‘social entrepreneurship’ and
‘intrapreneurship’;2 organisational, strategic and managerial decision
making by entrepreneurs; network and organisational ecology approaches
to entrepreneurship; ‘evolutionary economics’; and practical advice
(including ‘how to’ information) to entrepreneurs. Nor will we provide
descriptive case studies either of individual entrepreneurs, or of small
firms or the industries in which they operate. These topics are ably covered in numerous texts in the Business/Management literature, and will
not be repeated here.
1.2

Structure of the book

The remainder of this chapter is organised as follows. Section 1.3 discusses issues in the definition and measurement of entrepreneurship and


4

The Economics of Self-Employment and Entrepreneurship

self-employment. The distinction between these two concepts explains
their joint presence in the title of this book. Sections 1.4 and 1.5 introduce the reader to some stylised facts about the self-employed, including

their number, incomes and income inequality. Section 1.6 describes some
useful econometric models of occupational choice referred to extensively
in the book.
Part I deals with theories of entrepreneurship and the characteristics of entrepreneurs. Chapter 2 outlines economic theories of the
entrepreneur and entrepreneurship, both ‘early’ (Section 2.1) and
‘modern’ (Section 2.2). The former tend to paint a broad-brush picture
of entrepreneurship, whereas the latter apply the tools of microeconomics to the problem of entrepreneurship as an occupational choice.
Chapter 3 fills out some detail by considering the roles of pecuniary
factors, individual characteristics, family background and environmental variables for explaining the decision to become an entrepreneur.
Chapter 4 considers separately issues of race, gender and immigration
as they relate to entrepreneurship.
Part II treats the important problem of raising finance for entrepreneurial ventures. Chapter 5 analyses the economic issues arising
from bank finance of new start-ups, bank loans being the largest and
most frequently used source of outside funds by entrepreneurs. Although
we will touch on such ‘practical’ issues as collateral and bank–borrower
relationships, the focus of this chapter will be on the market failures that
can arise as a consequence of asymmetric information, including credit
rationing, under-investment and over-investment. These issues carry important policy implications about whether governments should encourage or discourage entrepreneurship. Chapter 6 considers other sources
of funds, including equity finance, trade credit, group lending schemes
and borrowing from family and friends. Chapter 7 summarises evidence
on whether, and to what extent, entrepreneurs face credit rationing.
Part III investigates what happens to new ventures after they are
launched. Chapter 8 discusses theory and evidence about job creation
by entrepreneurs, and their labour supply and retirement behaviour.
Chapter 9 analyses the growth, innovation and exit behaviour of new
ventures and small firms. With all of this apparatus in place, it is possible to explore systematically the scope for governments to intervene in
the market to promote entrepreneurship. This is the subject of part IV
(chapter 10). Government policies can take several forms, including
credit market interventions, taxation and direct assistance and regulation. Chapter 11 concludes, and draws together some suggestions for
future research where our understanding of particular issues is especially

incomplete.


Introduction

1.3

5

Definition and measurement issues

The problem of defining the word ‘entrepreneur’ and establishing the boundaries
of the field of entrepreneurship still has not been solved. (Bruyat and Julien, 2001,
p. 166)

Our first and most pressing task is to define entrepreneurs and
entrepreneurship. Unfortunately, this happens to be one of the most
difficult and intractable tasks faced by researchers working in the field.
There is a proliferation of theories, definitions and taxonomies of entrepreneurship which often conflict and overlap, resulting in confusion
and disagreement among researchers and practitioners about precisely
what entrepreneurship is (see Parker, 2002a). For example, consider the
following illustrative and abbreviated set of viewpoints. In applied work,
labour economists often equate entrepreneurs with the self-employed, on
the grounds that the self-employed fulfil the entrepreneurial function of
being risk-bearing residual claimants. However, others think this definition is too broad, claiming that only business owners who co-ordinate
factors of production (in particular, those who employ workers) are really entrepreneurs. Still others think that the economist’s definition is too
narrow, because it excludes entrepreneurship in the corporate and social
spheres. Then there are those steeped in the Schumpeterian tradition who
argue that entrepreneurship is identified primarily with the introduction
of new paradigm-shifting innovations. Others again have emphasised psychological traits and attitudes supposedly peculiar to entrepreneurship.

And so the list goes on.
It is easier to define the terms ‘self-employed’ and ‘self-employment’,
though even here there are measurement problems and disagreements,
which we discuss below. Given the widespread availability of data on the
self-employed in government and private surveys world wide, it is also
an easier entity to operationalise in empirical research (Katz, 1990). To
cut through a paralysing and ultimately fruitless debate, and to achieve
consistency, we will adopt the following convention in this book. At the
conceptual level, the terms ‘entrepreneur’ and ‘entrepreneurship’ will be
used; at the practical level, where issues of measurement, estimation and
policy are involved, we will use the closest approximation to the manifestation of entrepreneurship that appears to be suitable. That will usually
be ‘self-employment’, though occasionally the term ‘small firm’ will be
more relevant. Note that the problems of defining ‘small’ firms are also
non-trivial. Firm-size definitions are arbitrary and industry-specific, and
are not obviously congruent with entrepreneurship. Not all entrepreneurs
run small firms, and not every small firm is run by an entrepreneur (Brock
and Evans, 1986; Holtz-Eakin, 2000).


6

The Economics of Self-Employment and Entrepreneurship

The self-employed are often taken to be individuals who earn no wage
or salary but who derive their income by exercising their profession or
business on their own account and at their own risk. Likewise, partners
of an unincorporated business are usually classified as self-employed. It
is sometimes helpful to partition the self-employed into employers and
own-account workers (the latter of which work alone), or into owners of
incorporated or unincorporated businesses. In most countries, incorporation of a business renders it susceptible to company law, which requires

the owner to publicise stipulated data about the business. In the UK and
USA, for example, these include audited accounts if business turnover
exceeds a specified level. Despite the costs and inconvenience involved,
there are several advantages to incorporation. They include: protection from creditors via limited liability; favourable pension contribution
rules; greater credibility with customers (Storey, 1994b); and payment
of corporation tax on company profits, which at high owner incomes
may be substantially lower than personal income tax rates (Fuest, Huber
and Nielsen, 2002). Incorporated business owners can either receive an
employee salary as a director of their company, or they can pay themselves
dividends – so escaping payroll taxes in some jurisdictions, including
the UK. Most self-employed people in most countries own unincorporated businesses,3 which renders their incomes liable to personal income
tax.
The first definitional problem is that in many countries (including the
UK and USA), owners of incorporated businesses are defined as employees rather than self-employed. This is despite them resembling in all
other respects (e.g. residual claimant status) the ‘self-employed’. This is
sometimes an important distinction in applied self-employment research.
Second, for some individuals, the legal and tax-based definitions of selfemployment are at variance with each other. In law, the issue comes down
to whether there is a contract of service or a contract for services. The first
indicates paid-employment, the second self-employment.4 In contrast,
different criteria are often used for determining who is self-employed for
the purposes of income taxation and social security eligibility. There is no
shortage of examples where the legal and tax definitions fail to coincide
(Harvey, 1995; Dennis, 1996).
Third, in many government surveys used in empirical research, selfemployment status is self-assessed by the survey respondents. This can
lead to further differences in the classification of workers, compared with
legal and tax-based definitions (Casey and Creigh, 1988; Boden and
Nucci, 1997). Partly for this reason, some surveys (e.g. the UK Labour
Force Survey (LFS) and the US Characteristics of Business Owners
(CBO)) use tax-based definitions of self-employment.