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This paper analyses the effect of incarceration on labour market outcomes and identifies sources of the observed wage penalty from within firm mechanisms. The study estimates a multiple fixed effects panel model on a nationally representative linked employer-employee panel dataset for Hungary, for the period 2003-2011. It is possible to robustly identify the sources of wage penalty for ex-convicts in the data, due to the unique riches of employment history of convicts and their colleagues, and access to firm characteristics. The main model constructs an incarceration-penalty measure as the absolute difference between the post and pre-prison wage disadvantages of convicts compared to the general population. Using this penalty measure it is shown that incarceration hurts the labour market outcomes of even those ex-convicts who find jobs. The within firm analysis of employment spells suggests that the wage penalty comes from convicts working in worse jobs after prison then they did before. This result stays robust across several specifications using matched non-incarcerated control groups and other alternatives. By hiring ex-convicts for low-paid and low-skilled jobs, firms insure themselves against the risk such a hiring could entail. Convicts are willing to accept these offers as facing scarce opportunities they lower their reservation wages. This result suggests a labour market inefficiency caused by asymmetric information: ex-convicts are hired for worse jobs than they are skilled for as firms have no credible knowledge on their trustworthiness. This inefficiency calls for policy action, as low-career prospects on the legitimate labour market push ex-convicts towards crime.
