Governance Matters and Entrepreneurial Activities

Introduction

More countries are paying attention to new economic models, and one such approach that is getting more consideration and offering much potential is entrepreneurship (National Commission on Entrepreneurship, 2002). A study of European Union countries showed that 83% of the annual change in gross national product (GNP) is related to the growth in sales revenue of smaller firms surpassing the growth of larger firms (Thurik, 1994). In India, entrepreneurship aids in reducing poverty and helps to grow the number of middle-class people within the country (Gupte, 2004). Moreover, the US Small Business Administration calculates that 53.7% of all employment and 55% of all innovations in the United States stem from new or small businesses (Heriot & Campbell, 2006).

Given the important role of entrepreneurship in the growth of emerging nations, particularly with regard to providing employment and driving economic development (Kula & Tatoglu, 2003), many scholars and policymakers have attempted to understand the factors influencing the entrepreneurial activities. One of the categories of determinants of entrepreneurial activities is governance components, as opposed to business factors. While it is observed that the business determinants of entrepreneurial activities have been analyzed to a considerable degree, the governance components have received limited attention. It has been due mainly to the lack of reliable and internationally comparable governance indicators and entrepreneurial activities measurement. But in recent years, the annually published data on entrepreneurial activity by the World Bank Entrepreneurship Survey and Global Entrepreneurship Monitor (GEM)1 and governance indicators by the World Bank Development Research Group (Kaufmann, Kraay, & Mastruzzi, 2008a, 2008b, 2009) make such a study possible. Consequently, a number of empirical studies have recently examined the importance of governance for entrepreneurial activities (e.g., Klapper, Amit, Guillén, & Quesada, 2007; Klapper et al., 2009). However, these studies have focused only on the average of governance indicators (voice and accountability, political stability and lack of violence/terrorism, government effectiveness, regulatory quality, rule of law, and control of corruption) and have not examined the effect of the individual dimension of governance on entrepreneurial activities. In addition, most of the previous studies have concentrated on very specific indicators such as institutional uncertainty, political freedom, protection of property rights, country external conflicts, and control of corruption (e.g., Anokhin & Schulze, 2009; Brunetti & Weder, 1998; Desai, Gompers, & Lerner, 2003; Gholipour, Tajul, Nikbin, & Ekhtiari, 2010).

The present study is the first attempt to cover all governance indicators and examine their individual effects on the entrepreneurial activities. Moreover, most of the previous research on the influence of political variables on entrepreneurship consisted of cross-country studies (see, e.g., Brunetti & Weder, 1998; Gholipour et al., 2010). Despite attempts to distinguish other influences, the results of these cross-country studies may well reflect other nonmeasured influences that vary across countries but not over time. For this reason, the results of such studies may not apply to relevant changes in policy-related variables over time (Busse & Hefeker, 2007). In principle, since the bias in the estimates of such effects could be in either direction in a time series, it is important to supplement the cross-section studies with time-series estimates (Busse & Hefeker, 2007).

The present study is the first such attempt to regress governance indicators based on a number of dimensions and some control variables on the entrepreneurial activities (which is provided by GEM). From the point of view of the policymaker, it would be interesting to know which governance components matter most for entrepreneurship. In other words, policymakers need to know what governance and institutional factors promote entrepreneurial activities. Therefore, this study can give some insights to policymakers. Additionally, the results of this study suggest some implications for transnational corporations since they may influence host countries' governance matters by their magnificent financial resources, political power, human capability, or even diplomatic strength (Ordeix-Rigo & Duarte, 2009).

In short, the purpose of this article is to examine governance indicators and to identify the relative importance of these indicators for entrepreneurial activities after controlling for other relevant determinants of observed changes in entrepreneurial activities. We examine the influences of voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law, and control of corruption. For this purpose, we have selected a set of 40 countries for seven years.

The rest of the article is organized as follows. In the second section, there is an overview of the importance of governance for entrepreneurial activities. The third section reviews previous studies. In the fourth section, the Global Entrepreneurship Monitor (GEM) conceptual model is explained, followed by a section that describes the data and the variables used in the regression and a section that presents methodology. Section seven explains the estimation model and reports the results. Section eight concludes.

Importance of Governance for Entrepreneurial Activities

Good governance and political stability are the prior condition to establishing a favorable business environment (Klapper et al., 2009). In an uncertain environment characterized by unclear property rights, constant policy surprises and policy reversals, uncertain contract enforcement, and high corruption, entrepreneurs are reluctant to commit resources. This reaction of the private sector would translate into lower aggregate investment and distorts the allocation of resources and reduces economic growth (Brunetti, Kisunko, & Weder 1998). Busse and Hefeker (2007)) state that changes in government policy and/or political institutions can affect entrepreneurial behavior, as the risk premium incorporated in any investment project is influenced by political risk. Fogel, Hawk, Morck, & Yeung (2006)) argue that rules, regulations, and property rights and their enforcement facilitate entrepreneurship because they affect transactional trust among business parties. In other words, weak property rights protection, corruption, and an inefficient judicial system can impede information flow, raise information costs, and erode the gains from information and as a result hinder entrepreneurial activity.

According to the World Trade Organization (WTO, 2004), high-quality institutions lead to reducing information asymmetries and channel information about market conditions, goods, and participants efficiently, which in turn can encourage people to start a business in the country. However, institutional deficiencies lead to less competitive, diversified, and developed markets, which can discourage entrepreneurial activity (Fogel et al., 2006). Dickinson (2004)) indicated that if property rights are clear and legally enforceable, then more extensive entrepreneurship and economic growth will become sustainable within the Russian federation. Tyson, Petrin, and Halsey (1994)) state that the foundation stone on which entrepreneurial promotion must rest is a stable system of property rights. Khavand (2009)) argues that favorable political and legal conditions as well as a pleasant business environment are important in all economic activities. He emphasizes that government stability, creditability of the justice system, and the confidence level of economic players in the government's institutions/rules, as well as the quality of a country's international relationships to create adequate security at the regional and international levels for the country, are very vital for investment decisions and business start-ups.

In summary, political stability, low internal and external conflicts, well-defined rules and regulations, well-protected property rights, and an efficient judicial system all promote entrepreneurship. To illustrate, Figure 1 clearly depicts the importance of better governance (measured by the average of six aggregate governance indicators: voice and accountability, government effectiveness, regulatory quality, political stability, rule of law, and control of corruption) for greater entrepreneurship (measured by entry rate) (Klapper et al., 2007).

Literature Review

There are several studies in the literature regarding the relationship between political factors and entrepreneurial activities. This section of the article surveys some of the most relevant studies. Pastor and Hilt (1993)), by focusing on seven Latin American countries from 1973 to 1986, found that democracy is positively and significantly associated with private investment. In other words, they argued that since democracy receives broad domestic support, avoids irregular political changes, and institutionalizes income redistribution, democratic developing countries have fewer property rights violations and more private investment.

In their article, Brunetti et al. (1998)) proposed an indicator of the “credibility of rules” based on a private-sector survey conducted in 58 countries. They tested this indicator and its components (local entrepreneurs' views of the predictability of changes in laws and policies, of the reliability of law enforcement, of the impact of discretionary and corrupt bureaucracies, and of the danger of policy reversals due to changes in governments) in standard cross-country growth and investment regressions and found that low credibility of rules is associated with lower rates of investment and growth. Brunetti and Weder (1998)) found that there is a negative link between institutional uncertainty and private investment.

Mbaku (2000)) argued that in order to prepare for sustainable development and reduce poverty in Africa, African countries must engage in state reconstruction to provide themselves with governance structures that minimize political opportunism (such as bureaucratic corruption and rent seeking) and resource allocation systems that enhance indigenous entrepreneurship and promote wealth creation. Feng (2001)) examined the effects of politics on aggregate private investment in developing countries for the period 1978 to 1988. Feng found that political freedom, political instability, and policy uncertainty all affect the individual's decision to invest.

By focusing on central and eastern Europe, Rose-Ackerman (2001) suggested that the control of corruption and development of institutionalized trust plays an important role in making an institutional framework in which innovation and entrepreneurship can grow. In the statistical work using firm-level data over 1998 to 2000, Batra, Kaufmann, & Stone (2003) found that a high frequency of corruption, lack of policy predictability, financing difficulties, and high taxes each had significant negative impacts on firms' investment growth. Desai et al. (2003)), by focusing on European Union members and central and eastern European countries, reported more entrepreneurship in less corrupt countries and in countries that better protect private property rights. Högfeldt (2005)) and Fogel, Morck, and Yeung (2005)) argued that government favoritism toward large established corporations (because politicians find dealing with the controlling owners of a few large corporate groups is simpler and more predictable than dealing with the managers of many smaller independent firms) adversely affects entrepreneurship.

Bitzenis and Nito (2005)) evaluated the various obstacles that Albanian entrepreneurs encounter in their local business environment. Using interview and questionnaire techniques, their results showed that the most important obstacles that entrepreneurs encountered in Albania included unfair competition, changes in taxation procedures, lack of financial resources, and problems related to public order. Klapper (2006)), by using a cross-country time-series data set, showed a strong correlation between entrepreneurship and the quality of the legal and regulatory environment, ease of access to finance, and prevalence of informality. Similarly, Klapper et al. (2007)), by using cross-country, time-series entrepreneurial activity data provided by the World Bank Group Entrepreneurship Survey and the average of the six governance indicators provided by the World Bank Worldwide Governance Indicators, found that there are significant relationships between entrepreneurial activity and indicators of economic and financial development, the quality of the legal and regulatory environment, and governance. They showed especially that there is a strong and significant relationship between higher business entry rates and better governance. Klapper et al. (2009)) found that, in a sample of 100 countries over an eight-year period (2000–2007), greater ease in starting a business and better governance are associated with increased entrepreneurial activity. More specifically, they also showed that there is a negative relationship between political risk and business creation, with countries with lower political risk having significantly higher business entry rates.

Mitchell and Campbell (2009)) showed that business venturing within the United States is caused in part by corruption. They concluded that venturing in the United States is an adaptation to overall bad economic conditions—poverty and public corruption. However, since their result was unusual and inconsistent with international literature, they suggested that the relationship obtained from the states may not generalize to other nations. Using longitudinal data from 64 nations, Anokhin and Schulze (2009)) provided strong and positive support for the relationship between control of corruption and entrepreneurship/innovation. They argued that in corrupt environments, agency and transactions costs and other nonproductive consequences of corruption constrain the scale and scope of economic activity and subsequently reduce the magnitude of the incentive facing the prospective entrepreneur or innovator. Gholipour et al. (2010)) focused on the country's external conflicts and its effect on entrepreneurial motivation. Using a questionnaire technique, they showed that besides the business environment, the country's external conflicts are very important for potential entrepreneurs to start up a business in Iran.

GEM Conceptual Model

The GEM conceptual model is relevant here, as it addresses the relationship between national-level business activity and institutional environments (Acs, Desai, & Hessels, 2008). The general idea of the GEM model is that the various entrepreneurial framework conditions affect entrepreneurial activity by enhancing opportunity recognition and skills perception. In other words, the conceptual model employed by GEM indicates that opportunity recognition and entrepreneurial potential are influenced by factors of entrepreneurial environments (Mai & Gan, 2007). These factors are: availability of finance, government policies, government programs, education and training, research and development transfer, commercial and legal infrastructure, internal market openness, and access to physical infrastructure (Reynolds, Hay, & Camp, 1999).

Mai and Gan (2007) argue that the GEM model reveals that in social, cultural, and political conditions, entrepreneurial environments affect entrepreneurial opportunities and capacities, which both support each other to produce entrepreneurial activities. According to Levie and Autio (2008)), the GEM model serves as a vehicle to interpret both the data collection process and provide a framework for theory and policy. Levie and Autio (2008)) applied the GEM model and shows that there is a sound theoretical backing for the GEM conceptual model and entrepreneurial framework conditions. Therefore, in this study, similar to previously mentioned studies, the GEM model will be employed for estimation since the government policies and programs, institution quality, and political conditions are important factors influencing entrepreneurial activities.

Data and Variables

The analysis comprises the period 2002 to 2008 for a sample of 40 countries (see Appendix). The relatively small size of our sample is due to the limited availability of the entrepreneurial activities series. The relationship between governance indicators and entrepreneurial activities is our main concern. Data relating to the entrepreneurial activities (measured by early-stage entrepreneurship or TEA rate) is obtained from Global Entrepreneurial Monitor (GEM)2 annual executive report. The TEA rate is defined as a percentage of 18–64 (years of age) population who are either a nascent entrepreneur3 or owner-manager of a new business.4 The GEM research program was initiated in 1999 to collect cross-national harmonized data sets on entrepreneurship on an annual basis. One of the major strengths of the GEM project is the application of uniform definitions and data collection across countries for international comparisons (Acs et al., 2008).

Information on countries' governance is taken from the Worldwide Governance Indicators (WGI) research project provided by the World Bank,5 covering 212 countries and territories and measuring six dimensions of governance between 1996 and 2008.6 Kaufmann et al. (2009)) define governance as “the traditions and institutions by which authority in a country is exercised.” The six dimensions of governance are: (1) Voice and Accountability, (2) Political Stability and Lack of Violence/Terrorism, (3) Government Effectiveness, (4) Regulatory Quality, (5) Rule of Law, and (6) Control of Corruption.

Each indicator shows the country's percentile rank. Percentile ranks indicate the percentage of countries worldwide that rate below the selected country. Higher values thus indicate better governance ratings. Clearly, all six indicators are related to each other by different degrees (see Table 1), as all assess governance but from a different point of view. For example, Government Effectiveness and Control of Corruption are closely related, as the government is more effective and control of corruption is higher. As can be seen from Table 1, the partial correlation between PV and RL is 0.71. Similarly, Voice and Accountability is closely related to Rule of Law, with a partial correlation of 0.64. Moreover, most of the indicators strongly related to GDP per capita, indicating that richer countries have better governance.

Table 1. Correlation Matrix

In general, these indicators are widely recognized and used as high quality measures of political risk and institutions (Klapper et al., 2007, 2009; Outreville, 2008). Moreover, it should be noted that the logarithm for entrepreneurial activity and the governance variables (or independent variables) is used. In this study, it is anticipated that all six governance indicators have a positive relationship with entrepreneurial activities. Although we expect the positive association between the dependent variable and independent variables, we do not know the exact impact of these indicators on entrepreneurial activities.

Besides the institution and governance variables, we observe that some variables show a persistent positive influence on entrepreneurial activities. Above all, economic development is probably the most important factor in explaining entrepreneurial activities (e.g., Klapper et al., 2007; Reynolds, Bygrave, Autio, Cox, & Hay, 2002; Reynolds et al., 1999). It is argued that since the primary “opportunity” in most entrepreneurial efforts is an unmet demand for goods and services, such unsatisfied demands are likely to increase with general growth in a national economy (Reynolds et al., 2002). Klapper et al. (2007)) noted that a greater business opportunity is related to a more robust private sector. In other words, high economic growth rates may signal high investment returns and, therefore, may attract further investment (Busse & Hefeker, 2007). Hence, it is expected that higher economic developments attract further people who want to start a business. In this study, similar to the study by Klapper et al. (2007)), the log of GDP per capita will be used as a measure of economic development.

In previous studies, access to finance has been recognized as one of the main determinants of entrepreneurial activities (e.g. Bosma et al., 2008; Reynolds et al., 1999, 2002). Schumpeter (1934)) proposed that a well-developed financial system is a prerequisite for widespread entrepreneurship because most potential entrepreneurs lack extensive personal or family wealth. Klapper et al. (2007)) has found a significant positive impact of financial development on entrepreneurship. More specifically, they have shown that domestic credit to the private sector as a percentage of GDP is positively and significantly correlated with business entry rates. Perotti and Volpin (2004)) showed that there is a positive association between financial development and the entry of new, entrepreneurial firms. Thus, in this study, one would expect to see that financial development has a positive relationship with entrepreneurial activities. In this study, we also use the log of domestic credit to the private sector (as a percentage of GDP) as a measure of financial development.

Another important determinant that is likely to have an impact on entrepreneurial activities is education (e.g. Bosma et al., 2008; Reynolds et al., 1999, 2002). According to Reynolds et al. (1999)), developing new products or services and creating new businesses need for some degree of training and education. It is argued that education equips individuals with the sense of autonomy and independence, positions individuals to perceive opportunities and it also provides a pool of capable employees and technical competence needed to get a business off the ground (Reynolds et al., 1999). Therefore, it is reasonable to expect that the better educated the population the higher the level of entrepreneurial activity. In this study, the log of expenditure per student in secondary education will use as a measurement of education.

These three control variables are expected to be positively associated with entrepreneurial activities.

Methodology

This study utilized panel data using the sample of 40 countries during the period 2002 to 2008. The reason for using panel data is the fact that they usually give the researcher a large number of data points, increasing the degrees of freedom and reducing collinearity among independent variables, therefore improving econometric estimate efficiency. In addition, panel data allow researchers to test a number of important economic questions that cannot be addressed using time series or cross-sectional data sets (Chuang & Wang, 2009).

A general panel data regression model is written as Y_it = α + β X_it + e_it. Two important panel models are the fixed-effects model and the random-effects model. In order to choose the fixed- or random-effects model for the equation estimation, this study applied the Hausman (1978)) test due to the fact that this test determines the preferred model (Busse & Hefeker, 2007; Chuang & Wang, 2009). The statistics from the Hausman test suggests applying a fixed-effects instead of a random-effects model because the chi-square = 23.2 (p = 0.00), that is, the assumption that a model using random effects is preferable, is rejected. Generally, the fixed-effects estimator is used to capture unobserved country specific effects and it also produces consistent estimates (Chuang & Wang, 2009). Hence, Equation 1 is estimated by a country fixed-effects model. In other words, in this study, the panel data analysis with country fixed-effects approach allows us to distinguish more systematically between the effects of governance indicators and other variables on entrepreneurial activity over time as well as across countries.

Estimation Model and Results

We now turn to the empirical relationship between governance dimensions and entrepreneurial activities. Based on the previous discussions, the proposed model for entrepreneurial activities is as follows:

(1)

with the following expected signs:

where TEA_it stands for entrepreneurial activities for country i in period t, β0 is the country-specific fixed effect, ED_it denotes the economic development for country i in period t, FD_it denotes the financial development for country i in period t, EDU_it represents the schooling for country i in period t, GOVERNANCE_it stands for the six indictors for governance matters for country i and period t, and e_it is an error term. To avoid multicollinearity, the governance variables are added one by one to the proposed model.

As can be seen from the results of the regression, reported in column 1 of Table 2, all control variables (education, economic development, and financial development) have the expected sign and are significant at the 5% and 10% levels. The overall fit of the panel model is reasonable, taking the diversity of the country sample into account. We then add the six indicators for governance one by one to see whether they explain any variation in entrepreneurial activities in addition to the control variables (see columns two through seven in Table 2). The results show that Political Stability and Absence of Violence, Rule of Law, and Control of Corruption are positively associated with entrepreneurial activity, indicated by an estimated coefficient that is significant at least at the 10% level. The coefficient for Voice and Accountability, Government Effectiveness, and Regulatory Quality have positive signs, meaning that an improvement in these factors is positively associated with entrepreneurial activity but is not significant. Control of Corruption is significant at the 5% level, indicating a particularly close positive linkage with entrepreneurial activities.

Table 2. Panel Data Regressions, Country Fixed Effects, 2002–2008

The results for Political Stability and Absence of Violence show that entrepreneurial activities are highly sensitive to changes in government stability, internal conflicts, and external conflicts, as well as ethnic tension. In other words, the threat of incidence of civil war, trade sanctions, cross-border conflicts, or an all-out war creates higher uncertainty. Thus, entrepreneurs increase the risk premium of investment projects, which in turn reduces overall investment. As these events create higher uncertainty, they reduce entrepreneurial activities. This result is consistent with Gholipour et al. (2010)), who showed that country's external conflicts are very important for potential entrepreneurs. Moreover, this result is in accordance with Khavand (2009)), who argued that the quality of countries' international relationship to create an adequate security in regional and international level for the country is very important for investment decisions and business start-up, particularly for Iranian entrepreneurs.

Moreover, Control of Corruption is very significant for entrepreneurs, even when we control for other factors that affect entrepreneurial activities. This means that government efforts to tackle corruption (officials and the other groups) and the existence of anticorruption agency are taken into account when entrepreneurs are going to start a business. In other words, when governments control corruption, agency and transactions costs, along with other nonproductive consequences of corruption, will be limited (Anokhin & Schulze, 2009) and hence increase the incentive for the prospective entrepreneurs to start their business. Our result is in line with the findings by Desai et al. (2003)), who reported that there is more entrepreneurship in less corrupt countries and in countries that better protect private property rights. Similarly, our result is consistent with Anokhin and Schulze (2009)), who posit that better control of corruption will be associated with rising levels of entrepreneurship. In fact, control of corruption increases the possibility that potential entrepreneurs will be able to capture a larger portion of the revenues they generate, increase the reliabilities of those cash flows, and thus motivate higher levels of entrepreneurial activities (Anokhin & Schulze, 2009).

Finally, entrepreneurs seem to care about Rule of Law which means that violent crime, fairness of judicial process, enforceability of contracts, speediness of judicial processes, and private property and intellectual property rights are very vital for entrepreneurs to start any business. In fact, those countries with better conditions in terms of property rights protection provide a better investment climate and higher returns for entrepreneurs and innovators. This result is consistent with Desai et al. (2003)).

Conclusion

Entrepreneurship has been recognized as an important mechanism for economic development through employment, innovation, and welfare effects. The purpose of this study was to examine the role of governance matters as determinants of entrepreneurial activities for a panel of 40 countries from 2002 to 2008. By using fixed-effects panel analysis (and controlling for economic development, financial development, and education expenditure), empirical evidence suggests that, in particular, control of corruption and, to a lesser degree, rule of law and political stability and absence of violence are important determinants of entrepreneurial activities. Based on our results, these governance indicators matter the most when entrepreneurs confront decisions about starting a business.

The results presented in this article suggest a number of implications for policymakers and transnational corporations. Above all, since the control of corruption is the most significant governance indicator that can improve the level of entrepreneurial activities, special attention should be given to the control of corruption by policymakers in order for innovation and entrepreneurship to flourish. In fact, different anticorruption programs should be implemented by the policymakers to reduce the negative influence of corruption on entrepreneurial activities and consequently economic development of nations. Implementation of electronic government (e-government)7 has been suggested by many practitioners, researchers, and international development agencies to control corruption, particularly in developing countries and countries in transition (Bhuiyan, 2010). For example, Fan, Zhang, and Yue (2009)) concluded that e-government can reduce corruption effectively in China. Likewise, Shim and Eom (2008)) suggested that e-government has a consistently positive impact on reducing corruption.

Second, since a country's political stability and absence of violence are important for entrepreneurs to start a business, governments, for example, should create favorable political relations with other countries and try to settle internal conflicts as well as religious tension (particularly in Middle East countries) to increase opportunities and lower risks and uncertainty for prospective entrepreneurs and innovators. If governments do not regard this governance indicator seriously, they will encounter problems similar to the ones Iran has been facing in recent years. Broad economic sanctions against Iran from the United Nations Security Council, the United States, and the European Union due to their nuclear program, and violation of human rights as well as support for terrorist groups (which was claimed by the West) have hindered entrepreneurial activities in Iran.8 In fact, these external conflicts (and consequent sanctions) raised the cost of doing business, which in turn resulted in smaller return on investment for entrepreneurs in the long term.

Third, the rule of law (e.g., fairness of judicial process, enforceability of government and private contracts, private property protection, intellectual property rights protection, confidence in the police force, protection of financial assets) should be promoted if governments are to achieve higher entrepreneurial activities and subsequent meaningful economic and social development. Indeed, policymakers should attempt to prevent mafia and other outside actors from influencing and distorting the legal system. Moreover, governments must reduce threats that businesses face from common or organized crimes, which can impose costs on business. Finally, transnational corporations (seen as global institutions that have impressive financial resources, political power, human capability, or even diplomatic strength; Ordeix-Rigo & Duarte, 2009) should not only be seen as profit-making entities (particularly in developing countries) but they may also act as entities whose power and popularity can influence the governments' decision-making processes to improve governance matters, which in turn would facilitate more entrepreneurial activities. These corporations consequently may achieve better acceptance among the people within the developing countries and also create a symbiotic relationship with their key stakeholders.

Ultimately, the results of the study should be considered in light of its limitations, which also point to some issues for future research. The number of countries in our sample (40) is one of the study's limitations due to the unavailability of data from GEM for all countries. Given the data constraints, results should be viewed with caution, and hence data from more countries is needed to fully investigate these relationships and to improve our understanding.