J Bus Ethics (2015) 127:251264

DOI 10.1007/s10551-013-2030-6

Competing Against the Unknown: The Impact of Enabling

and Constraining Institutions on the Informal Economy
B. D. Mathias Sean Lux T. Russell Crook
Chad Autry Russell Zaretzki

Received: 7 September 2012 / Accepted: 19 December 2013 / Published online: 4 January 2014
Springer Science+Business Media Dordrecht 2014

Abstract In addition to facing the known competitors in

the formal economy, entrepreneurs must also be concerned
with rivalry emanating from the informal economy. The
informal economy is characterized by actions outside the
normal scope of commerce, such as unsanctioned payments
and gift-giving, as means of influencing competition.
Scholars and policy makers alike have an interest in mitigating the impacts of such informal activity in that it might
present an obstacle for legitimate commerce. Received
theory suggests that country institutions can enable and
constrain productive activity, and, in doing so, influence

competitive obstacles in a country. Leveraging 13,670

responses from entrepreneurs distributed across 59 countries, we provide evidence that two particular types of
enabling institutions, countries property rights regulations
and cooperative actions, are useful for lowering the
obstacles presented by informal activity. We also find
evidence that two constraining institutions, economic and
financial regulations lead to more obstacles presented by
informal activity. We describe implications for entrepreneurs, policy makers, and future researchers stemming
from these findings.
Keywords

Institutional theory
Informal activity

T. Russell Crook: Revision submitted for publication consideration at

the Journal of Business Ethics.
B. D. Mathias
T. Russell Crook (&)
Department of Management, College of Business
Administration, The University of Tennessee, Knoxville,
TN 37996, USA
e-mail: trc@utk.edu
B. D. Mathias
e-mail: bmathias@utk.edu
S. Lux
Center for Entrepreneurship, University of South Florida, 4202
East Fowler Avenue, BSN 3403, Tampa, FL 33620, USA
e-mail: slux@usf.edu
C. Autry
Department of Marketing and Supply Chain Management,
College of Business Administration, The University of
Tennessee, Knoxville, TN 37996, USA
e-mail: autry@utk.edu
R. Zaretzki
Department of Statistics and Operations Management, College
of Business Administration, The University of Tennessee,
Knoxville, TN 37996, USA
e-mail: rzaretzk@utk.edu

The informal economy is huge, in terms of both its

practical impact on economic activity and the intellectual disciplines that touch on this form of production and exchange.
Paul Godfrey.
A substantialif not hugeportion of the worlds
commerce occurs informally through unregulated economic activities (Godfrey 2011; Webb et al. 2009). Webb
et al. (2009, p. 492) described informal activity as, the set
of illegal yet legitimate (to some large groups) activities
through which actors recognize and exploit opportunities.
Examples include employment without secure contracts,
making social protection payments, clandestine sales, and
the use of informal payments and gift-giving as performance inducements.
Informal activities are thought to comprise more than
half of economic output in developing economies (La Porta
and Shleifer 2008) and a significant percentage of total

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commerce in many developed countries as well (Bruton

et al. 2012). In fact, Godfrey (2011) points to studies (e.g.,
Sassen-Koob 1989; Vogel 2006) that suggest that informality may comprise as much as 90 % of activity in certain
trades in the economy, such as construction, and 15 % of
employment in certain areas, such as Los Angeles.
Accordingly, the informal economy has drawn much
attention from researchers. Scholars have investigated a
variety of related topics and outcomes of informal activity,
including the potential for poverty alleviation/exacerbation
(e.g., London 2008; Pimpa and Fry 2012; Prahalad and
Hart 2002) and market development (Mair et al. 2012), the
ethical implications of informal activities (e.g., Apressyan
1997; Hudson and Wehrell 2005; Nwabuzor 2005), and the
role of personal ties in conducting informal activities (e.g.,
Gaughan and Ferman 1987).
Throughout the world economic landscape, different
levels of informal and formal activity persist. Received
theory suggests that institutions within a given country
effectively shape the level of informal activity (North
1990). Institutions are those informal traditions and formal
establishments that regulate exchange (North 1990).
Informal traditions refer to traditions characterized by
social and behavioral norms (Biggart and Delbridge 2004;
Blau 1964; Ouchi 1980), whereas formal institutions refer
to the constitutions, laws, and treaties that regulate economic exchange within a country (North 1981, 1990). For
economic institutional scholars, entrepreneurs localized
pursuit of informal economic activities suggests that local
formal institutions are ineffective (Eggertson 1990; North
1990). In such cases, the rules of the game perversely
reward informal activities instead of socially beneficial
formal activities. Specifically, certain informal institutions
may serve to tilt the competitive balance, making it
increasingly difficult for entrepreneurs engaged in the
formal economy to establish a competitive advantage.
Thus, at some level, informal activities become an obstacle
to entrepreneurial success.
The objective of this research is to extend the current
understanding of the institutions that shape formal versus
informal exchange across globally diverse settings. Primarily, we assert that the presence of informal activities
in an economy is attributable not only to institutional
ineffectiveness, but also to the types of institutions that
incentivize or disincentivize formal versus informal activities. According to institutional theory, two basic mechanisms exist for aligning societies and entrepreneurs
interests: (1) societies can incentivize, or enable, entrepreneurs to engage in socially beneficial economic activities, or (2) societies can disincentivize, or constrain,
entrepreneurs from engaging in undesirable economic
activities (as per North 1990). Metaphorically speaking,
institutions can be characterized as the proverbial carrot or

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stick, with enabling institutions representing the former

and constraining institutions representing the latter.
Specifically, we theorize that enabling institutions are
useful in that they encourage formal activities, whereas
constraining institutions discourage informal activities.
Given that informal activity is a potential obstacle for
entrepreneurs worldwide, and that little is known about
whether and to what extent these different types of institutions enable or constrain such activity, our purpose is to
investigate enabling and constraining institutions and their
impact on informal economic activity. In executing the
research, we contribute to the rapidly developing knowledge stream on informal activity.
We begin by reviewing the institutional economics and
the informal activity literatures that develop the concepts of
enabling and constraining institutions. We then justify
research hypotheses asserting that enabling institutions are
negatively related to entrepreneurial perceptions that
informal activity is an obstacle of formal activity, and
constraining institutions are positively related to entrepreneurial perceptions that informal activity is an obstacle of
formal activity. We test our hypotheses using data from the
World Bank Enterprise Surveys, which contain responses
from entrepreneurs across 59 countries. Our results are
consistent with our hypotheses, and we discuss their
implications for entrepreneurs, policy makers, and the
scholarly community in our conclusion.

Literature Review and Hypotheses Development

Several definitions of institutions exist in organizational
science. Neoinstitutional theory scholars describe institutions as the informal and formal sources of pressures on
economic activity existing within countries (Battilana
2006; DiMaggio and Powell 1983). Institutions thus
include governments, laws, courts, professions, interest
groups, and public opinion (Scott 2008). Institutions have
also been conceptualized in broader terms as the nonmarket
aspects of society that impact exchange (Baron 1995),
which are described in terms of social, political, and legal
institutions (Baron 1995; Boddewyn 2003). In both conceptualizations, institutions are depicted as being consisted
of both informal (e.g. public opinion and special interest
groups) and formal (e.g. governments, laws, and courts)
factors.
Norths seminal (1990) work proposes that institutions
regulate the rules of economic exchanges within countries.
He asserts that formal institutions can be described as
either political or economic, and that political rules (i.e.
constitutions and common law) typically lead to economic
rules (i.e. trade laws and regulations), although the causality runs both ways (North 1990, p. 48). Informal

Informal Activity

institutions are noted to evolve over time through repeated

interaction and exchange (Blau 1964), whereas formal
institutions are typically created by political organizations.
Likewise, informal institutions exist either in the absence
of formal institutions, such as social norms and standards
of conduct, or as extensions, elaborations, and modifications of formal rules (North 1990, p. 40).
The purpose of the institutions of each type is to
encourage socially desirable activities and discourage
socially undesirable activities by economic actors (Baumol
1990; Eggertson 1990; North 1990). Entrepreneurship,
innovation, and technological development are perhaps the
most desired economic activities (Baumol 1990; Teece
2010), as these developments lead to new, more efficient,
and more effective forms of economic activity, such as
reductions in relative prices over time as well as making
higher quality goods and services available at increasingly
lower prices (North 1990). Baumol (1990) described such
activities as productive entrepreneurship.
Alternatively, because nations have finite human and
natural resources, great interest exists in discouraging
socially undesirable economic activities (Mehlum et al.
2006). A key implication from both North (1990) and
Baumol (1990) is that formal economic activities are
generally productive, but informal activities are generally
unproductive because they undermine productive entrepreneurship and do not enhance innovation or technological developments. Yet, in spite of their drawbacks,
undesirable activities abound. Informal activities undermine formal activities by supporting or inhibiting some
entrepreneurs and not others (e.g., through bribery,
obtaining favorable government contracts) and thereby
upsetting regular market mechanisms. They also discourage productive entrepreneurship by channeling talent and
resources away from legitimate, formal endeavors, and in
doing so, present significant challenges and obstacles for
entrepreneurs operating in the formal sector (Minniti
2008).
Institutions and Informal Activity
While institutional economics scholars have a relatively
long-established tradition in understanding and maximizing
socially beneficial economic activities, interest in informal
activity has only recently gained traction within strategic
management research (e.g., Webb et al. 2009). To apply
and integrate these two perspectives, a merger of nomological terms and definitions across these two academic
conversations is required. From a strategic management
perspective, informal economic activity is described as
illegal, unproductive, entrepreneurial activity in most
mature institutional environments. Webb et al. (2009) view
these activities as ways that entrepreneurs can recognize

253

and exploit opportunities. However, defined using institutional economics terminology, informal activity simply
violates formal institutions while largely adhering to most
informal institutions. In the latter case, though similar to
destructive entrepreneurship in terms of illegality, informal
activity diverges from destructiveness in that it often
enjoys broad social support.
Herein, we adopt a synthesized view of the informal
institutional phenomena. Specifically, although informal
activity may provide entrepreneurs economic returns and
customers desired products and services, it also often
serves to undermine and potentially crowd-out regular,
productive entrepreneurship (Estrin et al. 2012). In line
with prior studies (e.g., Minniti 2008), we suggest that
formal activities are for the most part equivalent to productive entrepreneurship, and that governments have an
interest in mitigating the extent to which informal activity
comprises any given economy through institutions. Yet, we
also suggest that in addition to draining human and natural
resources away from socially desirable formal activities,
informal activities also detract from formal activity by
providing economic returns to those not playing by the
game. This causes entrepreneurs engaged in formal activities to question why they do the right thing, thus
undermining institutional effectiveness (North 1990).
Entrepreneurship in Different Institutional
Environments
Scholars have typically focused on how institutions maximize productive entrepreneurship (i.e., formal activity)
(Eggertson 1990; North 1990). Viewing entrepreneurs as
rational actors, policy makers utilize both incentives and
punishments to encourage entrepreneurs to choose those
economic activities that are the most beneficial to society.
Technology innovation, building infrastructure, developing
new resources, and efficient use of resources are all
examples of economic activities that raise living standards
(Teece 2010; Yam et al. 2011). Many socially desirable
forms of economic activity require considerable investment
and time to develop specialized resources, capabilities, and
knowledge. However, entrepreneurs tend to pursue economic activities that promise the greatest returns in the
shortest time with the least effort. To resolve this dilemma,
policy makers have tended to limit or ban entrepreneurs
from pursuing unproductive entrepreneurship. Entrepreneurs pursuing these banned unproductive forms of entrepreneurship face the loss of capital, time, and potentially
freedom. Theory suggests that entrepreneurs take these
costs into account when deciding which economic
activities to pursue (Apressyan 1997; Webb et al. 2009).
This makes the hard work of socially beneficial entrepreneurship seem more attractive than the punishment that can

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potentially come from taking the easy returns of unproductive entrepreneurship.

We theorize that while enabling institutions are likely to
make formal, productive entrepreneurship more attractive
through incentives (and conversely informal activity less
attractive), constraining institutions are likely to lower the
attractiveness of formal activity and garner greater pursuit
of informal activities through disincentives. Our proposition diverges from prior research in that, rather than suggesting a complementary effect (i.e., all institutions lower
informal activity), we propose certain institutions in combination accrue a contradictory effect (i.e., some institutions lower informal activity, while others raise informal
activity). We develop these ideas further below, by identifying how different institutions can act as enabling and
constraining institutions, and therefore, exhibit both negative and positive relationships with the obstacles entrepreneurs face with respect to informal activity.
Specifically, we suggest that enabling institutions
encourage more complex, and new types of economic
exchange by providing productive entrepreneurs with stability, self-empowerment, and/or incentives (Eggertson
1990; North 1990; Williamson 1995). That is, we propose
that the presence of effective and well-enforced enabling
institutions encourages entrepreneurs to pursue productive
entrepreneurship. Alternatively, constraining institutions
limit, ban, and/or disincentivize activities that appear detrimental to productive entrepreneurship (Williamson
1995). Effective and well-enforced constraining institutions bring the coercive power of government upon individuals engaged in informal activity (DiMaggio and Powell
1983). We unpack these premises, and offer specific
research hypotheses related to their impact.
Enabling Institutions
We are particularly interested in two broad classifications
of institutions: enabling and constraining. Although we
introduce this description, the concepts of enabling and
constraining institutions evolved out of two separate
schools of economic thought. Enabling institutions largely
emerged out of property rights economics, whereas constraining institutions came out of I/O economics. Within
these two classifications of institutions, a multitude of
individual institutions exist. For example, property rights
are one of many enabling institutions, whereas anti-trust
laws would be an example of a constraining institution.
Enabling institutions are those formal and informal
institutions that facilitate and encourage entrepreneurs to
engage in productive entrepreneurship. Such institutions
encourage productive entrepreneurship through two primary mechanisms: individual control and cooperative
action (Bruton et al. 2010; Demsetz 1988). Individual

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control enables entrepreneurs to make decisions on how

best to employ their resources and capabilities, whereas
cooperative action involves entrepreneurs ability to organize production through governance. Effective and wellenforced enabling institutions provide entrepreneurs the
resource and capability control necessary to engage in
productive entrepreneurship and the freedom to self-govern
those activities (Foss and Foss 2008; Li and Zahra 2012).
We utilized property and social rights as measures for
individual property rights and cooperative action. Demsetz
(1988) identified individual property rights and cooperative
action as the two key components of what we describe as
enabling institutions.

Property Rights
Property rights are defined as the extent to which individual
action is relied upon to utilize and allocate resources in a
country (Agrawal and Ostrom 2001). The more control
individual entrepreneurs have over the resources in a given
society, the greater the level of individual control. Individual control can range from complete individual control
(pure private ownership) to complete state (public) or
communal (socialist) control (Demsetz 1967). In most
societies, individual control typically lies somewhere
between these extremes.
Property rights, or regimes of appropriability, specify
the level of individual control in a society (Alchian 1965;
Alchian and Demsetz 1972; Demsetz 1988). Property
rights enable entrepreneurs to engage in productive entrepreneurship by providing control of, and the rewards from,
their resources and capabilities (Foss and Foss 2008). In
societies with state or communal property control, mainly
unproductive forms of entrepreneurship are available to
individual entrepreneurs. Individual control over property
allows actors to develop more complex and specified products and services, and the ability of actors to appropriate
rents provides the incentive to do so (Barzel 1994; Burgelman and Grove 2007; Foss and Foss 2008). The extent to
which well-enforced private property rights exist affects
entrepreneurial activity type, level, and range. High property control levels encourage entrepreneurs to engage in
return-maximizing activities given their basket of resources
and capabilities. Alternatively, as individual property
control is increasingly constrained, informal activity
becomes more viable, and correspondingly, informal
activity can present greater challenges for entrepreneurs.
We submit that strong individual property rights are
negatively related to informal activity in a society. Strong
individual property rights protect entrepreneurs resources
and capabilities from opportunism and misappropriation
from other actors (Dollinger et al. 2010; Foss and Foss

Informal Activity

2008). Entrepreneurs should face greater levels of opportunism without state protection and subsequently, greater
transaction costs (Williamson 1985, 1995). The powers of
the state protect the resources of entrepreneurs who engage
in socially desired forms of economic activity, keeping
transaction costs low (Brouthers 2002; Meyer 2001).
In order to pursue informal activity, entrepreneurs would
have to forego state protection of their resources and
capabilities. Higher levels of risk and transaction costs
make informal activity opportunities less economically
viable compared to productive entrepreneurship with state
protected individual property rights. Put differently, strong
individual property control incentivizes productive entrepreneurship while making informal activity less economically attractive. By rendering informal activity less
attractive, individual property control alters the competitive landscape by reducing, or perhaps even eliminating,
the competitive advantages derived from operating informally, thereby guiding more entrepreneurs toward formal
rather than informal activities. If fewer individuals pursue
informal activity, then the obstacles faced by entrepreneurs
from the informal economy are likely fewer. Thus, we
predict:
Hypothesis 1 Individual property regulation leads
entrepreneurs to view informal activity as less of a competitive obstacle.
Social Regulation and Cooperative Action
Enabling institutions also provide entrepreneurs the means
to self-govern during cooperative action (Williamson
1991). While property rights allow entrepreneurs to control
their resources and capabilities, cooperative action enables
entrepreneurs to transform those resources into economic
value (Demsetz 1988; Ketchen et al. 2007). We define
cooperative action as the extent all members of a society
are freely allowed to engage in economic activity. The
more cooperative action freedom in a given society, the
more entrepreneurs are able to effectively organize for
productive entrepreneurship.
Cooperative action enables productive entrepreneurship
by empowering all members of societyregardless of their
backgroundsto engage in economic activities. In societies where some members are limited or excluded from all
forms of economic activity for political, social, or religious
reasons, informal activity becomes the only viable means
of economic activity. The more members of society are
enabled to engage in productive entrepreneurship, the less
they are forced to engage in informal activities. For
example, recent research demonstrates that through social
inclusion and empowerment, policy makers in India can
continue to create a legal and political environment that

255

encourages womens access to resources to launch and

grow new businesses while protecting the organizations
they launch from family or political manipulations (Datta
and Gailey 2012; Kabeer 1999).
The benefits cooperative action has for enabling formal
entrepreneurship are twofold. First, cooperative action
opens the door for previously disenfranchised or discriminated members of a society to pursue formal entrepreneurship. In other words, by reducing the discrimination
associated with entrepreneurship, cooperative action
encourages individuals who previously were not entrepreneurs to become formal entrepreneurs. Second, cooperative
action provides a viable means for informal entrepreneurs
to transition into the formal economy by reducing or
eliminating any potential repercussions of operating formally. Together, institutions fostering cooperative action
work to incentivize formal activity, thereby driving down
informal activity and reducing the challenges informal
activity presents to formal entrepreneurs. Thus, we predict:
Hypothesis 2 Cooperative action leads entrepreneurs to
view informal activity as less of a competitive obstacle.
Constraining Institutions
Constraining institutions dissuade, limit, and/or ban certain
economic activities. Although these institutions play an
important role in lowering opportunism (Williamson
1985), fostering more and more complex economic
exchange (North 1990), and enabling the orderly flow of
business (Eggertson 1990), constraining institutions also
have the ability to increase the economic rewards of
informal activity, leading more entrepreneurs to pursue
informal over formal activities. We identify two primary
types of constraining institutions: economic and financial
regulation.
Economic Regulation
Economic regulations are the laws and policies regarding
the trade, financial, and other forms of economic exchange
that are vital to the functioning of a nations economy
(Williamson 1985; World Bank 2012). Without such policy
frameworks, trade relations would be tenuous, access to
finance would be challenging, and employment laws would
be suspect. Although such policies have an important place
in the free market system, many view this institutional
involvement as interference rather than a facilitator of
economic activity (Platteau 2000). The impact of business
and financial laws and regulations on the economy has, and
will likely continue, to be debated in the spheres of finance,
economics, management, entrepreneurship, and public
policy; however, the influence of structural policies on the

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informal activities of firms remains an open and a relatively

unexplored topic. In the following paragraphs, we outline
two reasons why the implementation of structural policies
could foster informal activity.
First, economic regulation elicits avoidance, or evasion,
on the part of entrepreneurs and their respective firms. That
is, individuals engage in informal activities to avoid governmental policy, such as taxes, license payments, or
employee restrictions. By nature, laws and regulations are
imperfect. Most policies possess gaps and loopholes that
even the most well-developed and astute governments and
economies have difficulty closing. As such, each enacted
policy opens the door for new opportunities as entrepreneurs take advantage of the imperfections in both the creation and enforcement of laws and regulations (Webb et al.
2009).
For some firms, access to legal advice or tax professionals provides the medium through which they can take
advantage of these policy imperfections and remain
legal and operating in the formal economy. However,
for other firms, who either lack access to the necessary
financial or human capital to find gaps/loopholes or voluntarily elect to evade such policies, these regulations
likely move them into the realm of the informal economy.
To be sure, avoidance is a choice involving opportunity
costs. Firms choose whether to comply with the structural
policies and regulations of their respective local and
national governments (DiMaggio and Powell 1983), or
they can risk government reprisal by avoiding these policies and engaging in informal activity. As regulations
become more stringent (i.e., significant tariffs, improved
labor conditions, quality regulations, and production limits), the costs of remaining in (or joining) the formal
economy are heightened and participating in the informal
economy becomes more attractive (Soto 2002).
Economic regulation can also create new opportunities
in the informal economy. Through economic regulation,
national governments set the boundaries for the locus of
opportunity; put differently, formal institutions determine
what is legal and what is illegal in a given country, state, or
local area. As explicated by Webb et al. (2009), legislative
efforts (i.e., structural policies) have the ability to shift
formal and informal institutional boundaries. For example,
consider Prohibition, a legal act prohibiting the manufacture, transport, and sale of alcohol. On the one hand, Prohibition shifted opportunities from the formal sector and
into the informal economy. In the United States, Prohibition spawned the development of speakeasies, a paradigm
of informal activity. On the other hand, some laws and
regulations can move opportunities operating in the
informal sector into the formal sector. For example, many
local, state, and national governments around the world
have embraced gambling (i.e., lottery, casinos, online

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gambling), thereby, legalizing what once was an illegal

activity in many areas.
Still, by often constraining what is considered formal
activity, institutions, through laws and regulations, open up
opportunities in the informal economy (Ahlstrom and
Bruton 2006). Neither the repeal of Prohibition nor the
legalization of gambling (in some areas) has ended informal activities operating in the alcohol or gambling industries. Even a move in deregulation (e.g., the repeal of
Prohibition) creates another series of laws and regulations
to monitor and control the now formalized activity.
Regarding the alcohol industry, decisions on what days
alcohol be sold, where can it be sold, to whom and at what
age, and how much can be produced without the need for
licenses, all involve the establishment of new formal/
informal boundaries. Differences in local, state, or national
policies, or differences that preclude (or encourage) some
individuals from participating and not others, can create
both advantages and disadvantages for individuals and
their respective firms. In other words, laws and regulations
can generate competitive advantages (and disadvantages),
and correspondingly, opportunitiessome formal, and
many more informal in nature. In sum, we submit that
economic regulations have the ability to constrain the
formal activities of large organizations and nascent entrepreneurs alike. By enhancing the attractiveness of avoidance strategies and creating opportunities for informal
activities, economic laws and regulations can provide disincentives for entrepreneurs to join the formal economy,
thereby fostering informal activities. Formally stated:
Hypothesis 3 Economic regulation leads entrepreneurs to
view informal activity as more of a competitive obstacle.
Financial Regulation
Financial regulationthe laws and regulations regarding
macroeconomic management, fiscal policy, and debt policycan minimize budgetary risks, insure short- and longterm fiscal and debt sustainability, and provide stability and
economic growth (Easterly and Rebelo 1993; World Bank
2012). For existing companies operating in the formal
economy, factors such as favorable exchange rates and
long-term financial viability, contribute significantly to the
decision of whether to open new operations, or simply
continue operations, in a given country (Lim et al. 2010).
Like economic regulations, financial regulations are certainly necessary for the functioning of the state, but they
can also constrain formal activity by crowding out private
investment and lowering the demand for legally produced
goods and services, thereby, encouraging informal activity.
First, public spending, such as monies spent on transportation, defense, healthcare, and education, can crowd

Informal Activity

out private investment (Aschauer 1989; Wright 2008).

State spending activities induce shifts from the formal into
the informal economy. In part, greater state spending often
results in greater tax burdens and transfer payments (i.e.,
welfare, social security, subsidies), which introduces moral
hazard into the economic system (Petersen 1982). By
moving from the formal to the informal economy, firms
and individuals can circumvent increasing tax burdens,
while reaping the benefits of the social security system
(Petersen 1982). Thus, extensive growth, power of institutions, and discretionary spending may encourage shifts
from the formal to the informal economy.
Public spending can also increase the chances for briberythe more a government spends, the more lucrative the
opportunities for government corruption (Hines 1995;
Mauro 1997; Shleifer and Vishny 1993). Although government officials and firms may be deterred from malfeasance in
nations with strong enforcement of institutions, in nations
with substantial fiscal budgets, the use of informal gifts or
payments to win sizable contracts may outweigh the perceived risks and repercussions. As such, greater economic
institutional control can promote informal activities, such as
bribes and kickbacks to government officials.
Taken together, greater public spending and financial
regulation can crowd out private investment and promote
bribery tactics. Those entrepreneurs with resources, such as
established social relationships with government officials
and/or substantial financial resources needed for bribery,
may impart considerable challenges to those formally
operating entrepreneurs who either do not have access to
such social or financial resources or are not willing to
compromise their integrity for a competitive advantage. In
other words, financial regulations can foster an environment that promotes informal activity and presents major
obstacles to formally operating entrepreneurs. Thus, we
expect:
Hypothesis 4 Financial regulation leads entrepreneurs to
view informal activity as more of a competitive obstacle.

Method

257

urban centers. The sampling methodology is designed to

generate the necessary sample sizes per country, industry,
and size to conduct statistically robust analyses.
Typically, the ES initiative garners wide publicity and
the full support of the local business community, such as
through newspaper advertisements or publicized parties,
before launching the survey in an area. Once appropriate
publicity has been carried out, teams make initial contact
by an introduction letter, and follow up with a telephone
discussion to screen potential respondents. After the
screening process and an appropriate interviewee is determined, the ES is administered in face-to-face interviews
with owners, managing directors, accountants, human
resource managers, or other relevant company staff. The
ES contains two major sections. The first deals with the
characteristics of the business and the investment climate
in which it operates. The second section deals with facts
and figures specific to the transactions establishments make
to operate. More specifically, these sections contain questions on production costs, investment flows, balance sheet
information, and workforce statistics. The essential feature
of the ES is its ability to make international comparisons
and, where possible, sub-national inter-regional comparisons. The most recent dataset for the ES includes a total of
60,838 firms (one respondent per firm), represents 106
countries (primarily low- and middle-income nations), and
spans from 2006 to 2010.1
Out of the 60,838 firms, 13,670 responses were used
roughly 22 % of the original sample. We omitted 2,019
firms due to nonresponse on informal activity questions,
which seems appropriate given the relatively sensitive
nature of the topic. We excluded the remainder of the firms
because institutional environment (i.e. regulation) indicators were unavailable for 47 of the 106 countries in the
dataset. Thus, our final sample included 13,670 firms,
located across 59 countries. T test comparisons of the
average size (measured via annual sales revenue) and
informal activity levels (to compare those firms dropped
due to the absence of regulatory indicators) revealed no
statistically significant differences (p [ 0.10) between
firms included and excluded from our dataset (Armstrong
and Overton 1977). Table 1 provides the summary statistics and correlation matrix for this study.

Sample
Measures
The World Bank conducts Enterprise Surveys (ES) that
provide data from key manufacturing and service sectors in
every region of the world. The ES use standardized survey
instruments and a uniform sampling methodology to minimize measurement error and to yield data that are comparable across countries. The ES target a particular set of
firmsmanufacturing and retail/wholesale establishments
with five or more full-time employees, located in major

Obstacles of Informal Activity

The World Bank Enterprise Survey contains a few items
related to informal activity. Such activities were defined in
1

Additional information on the design, implementation, and distribution of the survey is available at www.enterprisesurveys.com

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Table 1 Summary statistics and correlation matrix

Mean

SD

1. Age

15.61

13.59

2. Size (ln log)

2.91

1.22

0.29

3. Gender

0.33

0.47

0.09

0.07

4. Tax rate

57.12

51.21

-0.01

-0.22

5. Country munificence

1,617

1,424

0.08

0.04

0.01

0.10

6. Court system fairness

2.20

1.03

-0.06

-0.05

-0.01

-0.05

0.00

7. Economic regulation

3.53

0.39

0.13

0.06

0.08

-0.27

0.20

-0.06

8. Financial regulation

3.85

0.53

0.08

0.13

0.07

-0.25

-0.06

0.02

0.52

9. Cooperative action

3.45

0.39

0.14

0.18

0.18

-0.20

0.12

0.04

0.59

0.69

10

-0.04

10. Property rights

3.23

0.38

0.08

0.07

0.11

-0.44

-0.03

0.08

0.70

0.67

0.61

11. Informal activity

1.64

1.42

0.07

-0.03

0.02

0.06

0.03

-0.14

0.12

0.08

0.70

0.02

N 13,670 correlations at or above 0.02 are significant at the 0.01 level

terms of informal payments and gifts to government officials.

For example, some items captured the % of annual sales is
made/expected in informal payments or gifts? and others
captured When you applied for a construction-related permit
was a gift or informal payment expected?. Given that the
World Bank defined informal activity in terms of informal
payments and gifts, we selected the most reliable and least
intrusive measure of competitors informal activity included
in the Enterprise Survey: To what extent do you think that the
practices of competitors in the informal sector are an
obstacle to the current operations of this establishment? This
five-point item indicates the extent to which informal activity
is perceived as an obstacle to an entrepreneur.
The perception of informal activities as an obstacle is a
useful measure for multiple reasons. First, perceptions are
highly important because individuals base their entrepreneurial actions on impressions, views, and perceptions
(Kaufmann et al. 2009). Second, respondents are unlikely
to honestly respond to their own informal activities. Asking
participants perspectives of other entrepreneurs informal
activities as an obstacle does introduce a measurement
validity issue, however, when asking respondents socially
sensitive questions in an emerging economy context, perception of others behavior is a better measure simply
because most participants will not respond truthfully about
their own activities (Bullough 2013). Third, the collective
responses about others informal activities largely negate
individual bias. When determining the level of informal
activity relative to institutional factors, the respondents
would have to be systematically biased to introduce significant measurement validity issues.
Institutional Environment
The World Banks World Development Indicators
measure the institutional environment. These indicators

123

rate countries each year on a continuous scale from 1 (low)

to 6 (high) based on characteristics of the nationwide
regulatory environment. Although typically little variation
in these indicators exists from year-to-year, we selected the
three-year trailing average that corresponded with the year
the ES was conducted. For example, for an ES conducted
in Bhutan in 2009, we selected Bhutans regulatory average
for 20072009. We used a three-year average because we
found 31 recent (20102012) papers from the Journal of
Business Ethics, the Journal of Management, the Academy
of Management Journal, and Strategic Management Journal using a rolling cross-sectional design, and 23 of the 31
(74 %) studies used the three-year rolling window for
independent variable assessment. Additionally, we applied
robustness checks by using two-year and four-year averages (20072008, 20082009, and 20062009) for the
independent variables, and replicating their impacts on the
2010 dependent variable measures. No hypothesized
effects evidenced changes in significance or directionality;
thus, we harbor few concerns as to the length of the window as a source of unintended causality.
Individual property rights were measured by respondents assessments of property rights and rule-based governance, quality of budgetary and financial management,
efficiency of revenue mobilization, quality of public
administration and transparency, accountability, and corruption in the public sector. Collective action includes
respondents assessments of gender equality, equity of
public resource use, building human resources, social
protection and labor, and policies and institutions for
environmental sustainability. Economic regulation
includes respondents assessments of trade integration,
financial sector monitoring, and the business regulatory
environment. Financial regulation includes the macroeconomic management (i.e., the quality of the monetary/
exchange rate and aggregate demand policy), the short- and

Informal Activity

medium-term sustainability of fiscal policy, and debt

policy.2

259

were nonsignificant among these countries. Thus, we

excluded these control variables from our final model.

Control Variables
Analytical Techniques
We included six control variables in our analysis. First is
firm size, measured as the natural log of the total number of
employees of the firm as provided by the respondent from
the World Bank ES. We included firm size because past
research has demonstrated that firm size is critical to
understanding informal activity (e.g., Feige 1990). In fact,
extant research has shown that not only can the number of
employees influence the decision to engage in informal
activity (Marcouiller et al. 1997; Rauch 1991), but it also
can impact entrepreneurs perceptions of informal activity
(Webb et al. 2009). Second is firm age, which is measured
as the number of years the firm has been in business. As
firms age and grow, they may find it increasingly difficult
to hide all their actions from formal authorities; however,
they might also possess the resources to bribe or coerce
officials. Thus, firm age and size are likely related to
informal perceptions. Third is gender, which captures
whether at least one of the owners of the firm is female.
Marcouiller et al. (1997) reveal that in some countries
women are more likely than men to be in the informal
sector, and thus, may have different perceptions of informal activity. The fourth control variable is country-specific
rather than firm-specific, the tax rate of the country. In line
with the previous studies (e.g., Dabla-Norris et al. 2008;
Schneider 2002), we controlled for tax rate because it
seems plausible that firms may elect to engage (or not
engage) in informal activities depending on the tax implications of their actions. Fifth is country munificence, which
measures per-capita income (PCI). Although the World
Bank ES draws primarily from more modest-income
countries, significant variation exists among the sample.
For example, Burundi is one of the poorest countries in the
world (PCI = $170), whereas, Mauritius is classified as an
upper middle income level country by the World Bank
(PCI = $7,750). These income discrepancies could likely
impact activities associated with entrepreneurship and the
informal economy (Stel et al. 2005). Finally, we included
fairness of court system, which measures individuals
perception of whether their governing court system is fair,
impartial, and uncorrupt. Due to their potential importance
to informal activity, we also included the level of domestic
and foreign competitiveness faced by the firm. However,
competitiveness data was only available in nine of our
countries of interest, and we found that these two variables

Additional information on these measures can be found at http://

www.worldbank.org/ida.

Three typical approaches exist for examining panel data:

cross-sectional analysis (i.e., examination of a slice of data
representing a fixed period of time); the rolling crosssectional analysis (examining the impacts of an average of
time periods of effects on a fixed-time dependent measure);
and longitudinal (time-series) panel analysis. In essence,
the choice among the three types of panel data analyses
stems from the theoretical nature of the questions being
investigated, as well as tradeoffs between methodological
strengths and weaknesses (Rindfleisch et al. 2008). Pure
cross-sectional analyses (single time period) are most
appropriate for studies of phenomena occurring in relation
to some timed external event (i.e., the examination of posthire job attitudes), but suffer from common method variance (CMV) which concerns more so than other analytical
forms as a tradeoff for convenience. Alternatively, the
time-series approach is most aligned with studies where the
researcher is concerned with the change in a DV over time
as the result of changes in IVs over a similar time (either
concurrent or lagged); CMV is minimized and causal
inference is heightened, but proxy variables often diminish
explained variance (if the data are archival) and/or the data
are unwieldy to collect (if surveys are repeatedly administered) (Doty and Glick 1998). However, neither of these
situations is reflective of the research hypotheses we are
interested in examining. Our research is most concerned
with how the development of institutional environments
over time impacts the informal activities of entrepreneurial
firms in a single, lagged time period. Thus, the hybrid
approach of the rolling cross-sectional analysis is the most
appropriate form for the current study, as it aligns best with
the phenomena of interest. With this approach, CMV
concerns are diminished due to the multiple measures of
the IVs, which are then associated with a single, later
measurement of the DV (i.e., providing temporal separation, per Podsakoff et al. 2003). Thus, we selected ordinary
least squares regression (OLS) to examine our rolling
data.
Due to our high correlations between measures of the
institutional environment, we conducted tests to check for
mulitcollinearity. All variance inflation factors were well
below the acceptable limits (i.e., VIF \ 3) as recommended by Hair et al. (1998). Thus, mulitcollinearity does
not appear to be a concern for the data. We also tested for
violations of standard assumptions in OLS, including
autocorrelation and heteroskedasticity. Our tests revealed
no violations.

123

260

B. D. Mathias et al.

Results
Table 2 presents the OLS regression results for our study.
Model 1 includes the six control variables included in the
study (i.e., firm age, firm size, gender, tax rate, country
munificence, and court system fairness). Each variable is
significant at the (p \ 0.05) level and firm age, firm size,
country tax rate, and court system fairness are significant at
the (p \ 0.001) level. The overall model is also significant
at the (p \ 0.001) level. These results, however, should be
viewed cautiously. In part, each variable likely maintains
statistical significance due to the large sample size; thus,
the practical significance of these variables, particularly,
gender and country munificence, in contributing to perceptions of informal activity should be considered. Perhaps, only those variables significant at the (p \ 0.001)
level represent characteristics of practical importance.
Model 2 tests the institutional environment-informal
activity relationships by including each of the four regulatory variables in addition to the six control variables. All
of the control variables are significant at least at the
(p \ 0.01) level and each of the regulatory environment
variables are significant at the (p \ 0.001) level. The
overall model is also significant (F = 81.7, p \ 0.001)
level. Hypothesis 1 contends that the property regulation
environment and perceptions of informal activity are negatively associated. Our results provide support for this
assertion (b = -0.34, p \ 0.001). Supporting Hypothesis
2, our results demonstrate that the social regulation environment is negatively associated with perceptions of
informal activity (b = -0.31, p \ 0.001). Hypothesis 3
suggests that the structural regulatory environment exhibits
Table 2 Regression analysis results: informal activity as obstacle
Model 1

Model 2

Control variables
Firm age

0.008***

0.006***

Firm size

-0.069***

-0.066***

Gender

0.063*

0.079**

Tax rate

0.001***

0.002***

Country munificence

0.000

0.000***

Fairness of court system

-0.192***

-0.165***

Predictor variables
Property rights

-0.338***

Cooperative action

-0.312***

Economic regulation
Financial regulation

0.665***
0.337***

Model R2

0.030

Adjusted R2

0.030

Model F

70.727***

* p \ 0.05; ** p \ 0.01; *** p \ 0.001

123

0.056
0.056
81.715***

a positive relationship with perceptions of informal activity. Again, our results provide support (b = 0.67,
p \ 0.001). Finally, Hypothesis 4, which suggests that the
economic regulatory environment has a positive relationship with the perceptions of informal activity, is also
upheld (b = 0.34, p \ 0.001). Together, the results from
our regression analysis provide support for each of our four
hypotheses.

Discussion
The practice of informal activities, such as payments and
gift-giving to government officials, has a long history (Belk
1979), and the recent estimates suggest that such activities
comprise a substantial portion of economic activity across
the globe (Godfrey 2011; La Porta and Shleifer 2008;
Schneider 2002). Although most extant research focuses on
how institutions encourage productive entrepreneurship via
legitimate commerce (e.g., Bruton and Ahlstrom 2003; Xin
and Pearce 1996), we sought to investigate how institutions
affect less productive entrepreneurship (Steidlmeier 1999).
We developed several hypotheses describing how institutional environments shape informal activity, and then
offered supportive empirical evidence.
In doing so, we offer two clear theoretical contributions.
First, we answer the call for the theoretical advancement
of institutional theory by studying the informal economy
across different countries (Webb et al. 2009, p. 505506).
Specifically, we leverage institutional theory to help
improve our understanding of the informal economy.
Although considerable work has examined how institutions
affect formal activity, few efforts have explored their
impact on informal activity. This shift enables scholars and
policy makers alike to understand the unintended consequences of policies intended to encourage formal, productive entrepreneurship.
Second, we further institutionalize theory by exploring
how two basic institutional mechanisms (i.e., incentives
and disincentives) can align societies and entrepreneurs
interests, thus, enabling or constraining informal activity.
Specifically, our empirical investigation supports both of
our basic assertionsenabling institutions stymie, while
constraining institutions advance, informal activities.
Enabling institutions provide incentives for entrepreneurs
to engage in formal activity. That is, these institutions open
up additional opportunities for formal activity to more
individuals, which in turn, lowers engagement in informal
activity. Conversely, constraining institutions provide disincentives for entrepreneurs to engage in formal activity.
Although intended to limit informal activity, these actions
appear to reduce the number of formal opportunities
available to individuals and heighten the attractiveness of

Informal Activity

informal action, thereby increasing the challenges entrepreneurs face from informal activity. For example, our
results reveal that if a country increased their economic
regulations by one unit, on average, this yields a 16 %
increase in the perception of informal activity as an
obstacle. Stated differently, informal activity becomes a
much greater obstacle for entrepreneurs.
Thus, our results have clear implications for policy
makers and society. Our findings suggest that policy
makers should consider further implementing enabling
institutions, while reducing and/or removing constraining
institutions. Our insights show that developing and implementing effective enabling institutions can reduce the
extent to which entrepreneurs engage in illegal activities
and encourage entrepreneurs currently operating in the
informal economy to transition into the formal economy.
By empowering entrepreneurs through enabling institutions and removing restrictions imposed by constraining
institutions, policy makers may foster more formal, entrepreneurial opportunities, especially for those who may not
currently have access to such opportunities. For example,
implementing policies that grant women the ability to own
property and businesses (i.e., enabling institutions) might
not only motivate women operating in the informal economy to transition to the formal economy (Datta and Gailey
2012), but such policies also might encourage more women
to pursue a career in (formal) entrepreneurship. In turn, the
potential benefits these enabling institutions could have on
entrepreneurs (e.g., opening up new revenue streams to
female entrepreneurs) as well as the governments who
implement them (e.g., new sources of tax revenue through
increased formal activity) suggest broad benefits to local
communities and society at large.
To reduce corruption and informal activity, policy
makers should also emphasize making formal activities
more economically attractive, rather than solely on banning
bribery. For example, creating free trade zones reduces
both tariffs and customs approvals, limiting both the
opportunity and pressure for bribing government officials
involved in importing and exporting goods (Godfrey 2011;
Vogel 2006; Wright 2008). Such policies also offer lower
barriers and greater efficiency for entrepreneurs interested
in engaging in international trade. In other words, to promote formal activity and curb informal activity, policy
makers should look to carrots, and not necessarily to
sticks. Although our findings shed some light on how
policy makers can mitigate informal activity and encourage
formal activity, several research questions with important
implications for theory and policy remain.
First, future scholarship should identify what current
enabling and constraining institutions exist. We used representative measures of enabling and constraining institutions in our study; however, this was by no means a

261

complete list of existing entrepreneurship policy options.

Scholars have developed several previous conceptualizations of institutions and entrepreneurial behavior that provide a starting point (Busenitz et al. 2000; Hitt et al. 2006),
but a more comprehensive understanding of enabling and
constraining institutions throughout the world, particularly
in developing countries, is needed. Developing a more
extensive and finite list of enabling and constraining
institutions will serve to make future scholarship more
useful to policy makers. Although our current study provides a basic causal understanding of how enabling and
constraining institutions affect informal activity, our measures include broadly defined institutional measures. Thus,
a more in-depth methodological approach may provide
increased clarity regarding the role of institutions in
informal activity as well as provide guidance for institutional reform at the national and state levels.
Second, future scholarship should improve upon what is
known currently regarding enabling institutions, and perhaps, provide direction for developing new ones. After
identifying which specific enabling institutions have the
greatest impact on furthering formal activity, scholars
should examine how to make other institutions behave
more like those successful enabling institutions. For
example, many nations have implemented social policies
aimed at encouraging formal entrepreneurship, such as
providing assistance to female and minority-owned business (Ram and Smallbone 2003). By providing formal
guidance and opportunities for potentially disenfranchised
individuals, institutions have the ability to enact enabling
policies that move individuals from the informal to the
formal sector. Areas of scholarship could increase the list
of policy options available to policy makers when seeking
to encourage formal activity.
Additionally, our findings should be viewed in light of
the work done by Kaufmann et al. (2009) who aggregate a
large number of individual perceptions of institutional
quality into broad indices of governmental effectiveness.
This effectiveness measure captures the quality, competence, and credibility of various facets of civil service
(Kaufmann et al. 2009). While we show that the type of
institution impacts informal activity, the quality (i.e.,
effectiveness) of those institutions also likely influences
informal activities. For example, Singaporethe country
with the highest government effectiveness scoreis well
known for its attention to private property rights, which we
find is negatively related to informal activity perceptions
(Glaeser et al. 2004). Thus, future research that adds the
notion of institutional effectiveness (i.e., good governance)
to our findings could provide additional insight into how
policies impact informal activity.
Scholars should also examine how enabling institutions
create entry barriers. Engaging in formal activity is not

123

262

without costs (Coase 1960). Permitting, licensing, and

insurance requirements all may impede formal activity.
The greater the costs of formally launching a business, the
more likely entrepreneurs will choose informal over formal
activity. For example, the average time and cost of starting
a business in Russia is 97 days and 54 % of per capita
GDP, whereas, in the United States, these numbers are 4
and 1.7 %, respectively (Meyer and Peng 2005). Future
scholarship should empirically examine how formal
entrepreneurship entry costs affect the decision to engage
in formal versus informal activity.
Additionally, scholars should examine how constraining
institutions can be modified to dissuade informal activity
while not creating supply limitations. Institutions should
aim for policies that raise the costs of informal activity
while not restraining the supply of goods or services produced through those informal activities. To the extent that
informal activities might be viewed as transaction costs
(i.e., costs of conducting exchanges : Williamson 1985),
future research that leverages and integrates insights from
institutional and transaction cost theories appear fruitful.
Future research, for example, might determine the extent to
which these costs constrain efficiency across different
institutional contexts (Roberts and Greenwood 1997), and
how these constraints, in turn, shape living standards and
other socially desirable outcomes.

B. D. Mathias et al.

Surroca et al. 2013). Thus, when we compare our explanatory power to other studies, we believe our predictive
effects and overall explanatory power compare favorably
to several other published studies. Still, we acknowledge
that our model leaves much of the variance unexplained,
suggesting that there are several rich opportunities to build
on our findings.

Conclusion
Our findings and their implications serve to advance the
currently sparse theory related to the institutional environment and the informal economy. By leveraging data
from 59 countries, we demonstrate important linkages
between four facets of institutional environments and
competitors informal activity. More specifically, our
results indicate that property and social policies serve to
enable formal activity thereby reducing informal activity,
while structural and financial policies constrain formal
activity thereby increasing informal activity. These findings are important for scholars, entrepreneurs, and policy
makers, and are thus worthy of further discussion.

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