The impact of credit constraints and risk tolerance on self‐employment: Accounting for the hidden majority

Abstract Small businesses are important drivers of economic activity and job creation but face significant credit constraints. This study examines the joint impact of credit constraints and risk tolerance on a household's decision to become self‐employed using data from the 2022 Survey of Consumer Finance (SCF), and in a novel way. First, it uncovers and then accounts for the large numbers of households that are truly credit constrained yet systematically overlooked with traditional measures of credit constraints based on loan rejections. Three hidden groups are identified– underfunded borrowers, discouraged borrowers, and priced‐out borrowers– which collectively make up an actual majority of credit constrained borrowers. Second, the study isolates and estimates the independent impact of credit constraints and risk tolerance on self‐employment, avoiding a persistent common omitted variables problem in the literature. The results show that credit constraints and risk aversion significantly limit business activities. The exclusion biases are quantified.