Job Market Paper

"Selection and the Role of Small Business Owners in Firm Dynamics", November 18, 2011

Abstract: What makes small businesses small? Standard theories attribute size differences to efficiency, access to credit, or some combination of the two. In this paper I present new evidence on persistent earnings differentials of business owners relative to otherwise similar wage and salary workers that are difficult to explain with these two sources of heterogeneity. I develop and evaluate a Hopenhayn (1992) style model of firm heterogeneity with an occupational choice. I introduce varying preferences for business ownership consistent with the non pecuniary motives documented in Hurst and Pugsley (2011). The model nests both efficiency and credit based accounts of firm heterogeneity, and it allows me to isolate the role of each mechanism. In a calibrated version of the model I match patterns of earnings differentials between business owners relative to workers by size, age, and household wealth. By shutting down tastes, I show how ignoring preference heterogeneity leads to an overestimate of the tightness of borrowing constraints and a miscalibration of the productivity process, in particular for small businesses. Finally, I evaluate an implication of the model when extended to sectors with varying fixed costs. Low fixed cost sectors will have a greater concentration of taste-driven business owners and thus larger earnings differentials. Empirically, I find evidence for this result when I compare earnings differentials in the services and manufacturing sectors.

Supplemental Materials: Data and Programs

Published Papers

"What do Small Businesses Do?," with Erik G. Hurst, Brookings Papers on Economics Activity, Fall 2011

Abstract: In this paper, we show that most small business owners are very different from the entrepreneurs that economic models and policy makers often have in mind. Using new data that samples early stage entrepreneurs just prior to business start up, we show that few small businesses intend to bring a new idea to market. Instead, most intend to provide an existing service to an existing market. Further, we find that most small businesses have little desire to grow big or to innovate in any observable way. We show that such behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftsmen, lawyers, real estate agents, doctors, small shopkeepers, and restaurateurs. Lastly, we show non pecuniary benefits (being one’s own boss, having flexibility of hours, etc.) play a first-order role in the business formation decision. We then discuss how our findings suggest that the importance of entrepreneurial talent, entrepreneurial luck, and financial frictions in explaining the firm size distribution may be overstated. We conclude by discussing the potential policy implications of our findings.

Supplemental Materials: Data and Programs

An earlier version of this paper was titled "Understanding Small Business Heterogeneity," and was released as NBER Working Paper 17041

Press and Blog Coverage:

"The Mistake of 1937: A General Equilibrium Analysis," with Gauti Eggertsson. Monetary and Economic Studies, 24(S-1), December 2006.

Abstract: This paper studies a dynamic stochastic general equilibrium model with sticky prices and rational expectations in an environment of low interest rates and deflationary pressures. We show that small changes in the public's beliefs about the future inflation target of the government can lead to large swings in both inflation and output. This effect is much larger at low interest rates than under regular circumstances. This highlights the importance of effective communication policy at zero interest rates. We argue that confusing communications by the U.S. Federal Reserve, the President of the United States, and key administration officials about future price objectives were responsible for the sharp recession in the United States in 1937-38, one of the sharpest recessions in U.S. economic history. Poor communication policy is the mistake of 1937. Before committing the mistake of 1937, the U.S. policymakers faced economic conditions that are similar in some respects to those confronted by Japanese policymakers in the first half of 2006.

Press and Blog Coverage:

Working Papers

"Are Household Surveys Like Tax Forms: Evidence from Income Underreporting of the Self Employed," with Geng Li and Erik G. Hurst, April 2012. (Revised and resubmitted at Review of Economics and Statistics).

Abstract: There is a large literature showing that the self-employed underreport their income to tax authorities. In this paper, we quantify the extent to which the self-employed also systematically underreport their income in U.S. household surveys. To do so, we use the Engel curve describing the relationship between income and expenditures of wage and salary workers to infer the actual income, and thus the reporting gap, of the self-employed based on their reported expenditures. We find that the self-employed underreport their income by about 30 percent. This result is remarkably robust across data sources and alternative model specifications. Failing to account for such income underreporting leads to biased conclusions. We document this bias in existing measures of earnings differentials, wealth differentials, precautionary savings, lifecycle earnings profiles, and earnings variation across MSAs. Our results show that it is naive for researcher to take it for granted that individuals will provide unbiased information to household surveys given their demonstrated tendency of providing distorted reports of the same information to other administrative sources.

Supplemental Materials: Robustness Appendix, Data and Programs (Available upon Request)

"Entrepreneurship or Job Shopping: New Evidence on Small Business Formation," 2009.

Abstract: I study the population of self-employed workers surveyed in the Consumer Population Survey (CPS). Leveraging the survey instrument's longitudinal dimension, I analyze the labor force transitions of business owners, comparing them to the wage and salaried sector. Unlike previous work, new questions in the CPS allow me to study job to job and business to business transitions. I also study the cross sectional composition of both groups. In both dimensions, the populations reveal more similarities than differences creating difficulties for traditional risk-aversion, borrowing constrained, and ability-based models of entrepreneurship. The evidence supports the job-shopping models of Boyan Jovanovic (1979, 1982) and Derek Neal (1999). It also cautions against using the self-employed as a measure of "pure" entrepreneurship.

Research in Progress

"Wealth, Tastes, and Entrepreneurial Choice, August 2011. (Preliminary)

Abstract:The non pecuniary benefits of managing a small business are a first order consideration for many nascent entrepreneurs, yet the preference for business ownership is almost universally ignored in models of entrepreneurship and occupational choice. In this paper, I take seriously the possibility of non pecuniary compensation over a population of varying entrepreneurial tastes and wealth in a simple general equilibrium model of occupational choice. This yields several important results: (1) entrepreneurship can be thought of as a normal good, so the model generates wealth effects independent of any financing constraints, (2) non pecuniary entrepreneurs select into small scale firms, (3) subsidies designed to stimulate more business entry can have regressive distributional effects. Despite abstracting from other important considerations such as risk, financing constraints, and innovation, I show that non pecuniary compensation is particularly relevant in discussions of small businesses.

"The True Cost of Small Business Subsidies: Optimal Entrepreneurial Subsidies with Endogenous Entry and Private Non Pecuniary Benefits of Control,"

Abstract: Empirical work such as Jones and Williams (1998) measures significant shortfalls between the private and social returns to business investment. The workhorse endogenous growth models, such as Romer (1990) and Grossman and Helpman (1991) under a reasonable range of parametrization provide a role for government intervention to help realize an optimal level of growth. I construct a general equilibrium endogenous growth model with endogenous business formation in the presence of modest ex-ante heterogeneity in non pecuniary benefits of business ownership and entrepreneurial ability. I identify a tradeoff inherent in any small business or investment subsidy: (1) it increases investment and business formation (2) it lower aggregate productivity by enticing less productive entreprneurs out of the labor market. I find the form of the optimal subsidy. I show the welfare gains from implementing the optimal subsidy in a calibrated model of the US economy.

"Assessing the Expected Return from Lowering the Cost of Credit: Evidence from the Small Business Administration Loan Guarantee Program," with William Kerr and Ramana Nanda

"Industry and Sectoral Variation in Firm Dynamics," with Erik G. Hurst, US Census Burea Research Data Center Proposal 908, April 2011. (Approved by Census and pending IRS review)

Popular Writings

"Do Small Businesses Deserve their Reputation as Job Creators," Wall Street Journal, March 20, 2012.