Public Choice (2008) 136: 269–282

DOI 10.1007/s11127-008-9295-9

The institutions of economic freedom

and entrepreneurship: evidence from panel data

Kristina Nyström

Received: 26 November 2007 / Accepted: 27 February 2008 / Published online: 19 March 2008
© Springer Science+Business Media, LLC. 2008

Abstract This paper provides new evidence on the determinants of entrepreneurship across
countries. The paper investigates the relationship between the institutional setting, in terms
of economic freedom, and entrepreneurship, measured by self-employment, in a panel data
setting covering 23 OECD countries for the period 1972–2002. The measure of economic
freedom includes five aspects: size of government, legal structure and security of property
rights, access to sound money, freedom to trade internationally, and the regulation of credit,
labour and business. The empirical findings show that a smaller government sector, better
legal structure and security of property rights, as well as less regulation of credit, labour and
business tend to increase entrepreneurship.

Keywords Entrepreneurship · Self-employment · Institutions · Economic freedom

JEL Classification M13 · O50

1 Introduction

During the last decades, entrepreneurship has been the object of increasing attention from
researchers and policymakers. Why are they so interested in entrepreneurship? The obvi-
ous answer is that entrepreneurship has been acknowledged as the key driving force for
the incredible growth miracle of capitalism (see e.g., Baumol 2004; Wennekers and Thurik
1999). According to Reynolds et al. (1999) and Zacharakis et al. (2000), about one-third
to one-half of the differences in national growth rates can be explained by variations in
entrepreneurship rates. However, entrepreneurship can be expected to vary both over time

K. Nyström
Division of Economics, The Royal Institute of Technology, Drottning Kristinas väg 30,
100 44 Stockholm, Sweden

K. Nyström ()
The Ratio Institute, P.O. Box 3203, 103 64 Stockholm, Sweden
e-mail: kristina.nystrom@ratio.se
270 Public Choice (2008) 136: 269–282

and across countries. According to Wennekers et al. (2002), culture and institutional varia-
tions seem to be very important for explaining cross-country variations in entrepreneurship.
Nevertheless, as noted by Freytag and Thurik (2007), the determinants of these differences
in entrepreneurship across countries are still relatively unexplored. Given that we expect a
positive relationship between entrepreneurship and economic growth, improving the institu-
tional conditions for entrepreneurship must be regarded as crucial by policymakers.
Institutions are usually defined as the rules of the game and may be informal or formal.
Informal institutions may be, for example, customs, norms and social networks. Among the
formal institutions we find political and economic prerequisites such as polity, judiciary and
bureaucracy. Institutions are highly influential for the incentive structure in a society and
hence affect economic performance (North 1991, 1994). The literature shows indisputably
that the quality of institutions is crucial for creating economic growth in a society (e.g., Ace-
moglu et al. 2001; Rodrik et al. 2004). Given the important role institutions play in shaping
the incentive structure in a society, institutions can obviously be expected to be influential in
a person’s decision to become an entrepreneur. But which, more specifically, are the institu-
tions that can be expected to influence entrepreneurship and economic growth? The idea that
economic freedom is important for economic growth has been a cornerstone in economic
theory for a long time and was emphasised already by Smith (1776), who introduced the role
of “the invisible hand“ for well-functioning markets, and Ricardo (1821), who endorsed free
trade as crucial for economic development. In several empirical studies, the economic free-
dom index published by the Fraser Institute (Gwartney et al. 2006) has been used to relate
the institutions of economic freedom to variables such as growth and income inequality (see
e.g., Doucouliagos and Ulubasoglu 2006; Berggren 1999, 2003; Carter 2007). Recently, we
have seen attempts to combine the microeconomic perspective in terms of entrepreneurship
with the role of institutions.
If the institutions of economic freedom can be related to economic growth at the macro
level, can the same relationship be found at the micro level, thus providing a link to entrepre-
neurship? Unfortunately, the relationship between entrepreneurship and the institutions of
economic freedom is still relatively unexplored in the empirical literature. Exceptions are the
recent contributions made by Bjørnskov and Foss (2008) and Sobel et al. (2007).1 However,
these studies are cross-country studies using measures of economic freedom and entrepre-
neurship for one single year. Hence, there is a need to validate these results in a panel data
setting. Moreover, both studies use data on entrepreneurship from the Global Entrepreneur-
ship Monitor (GEM). This dataset provides an overall measure of entrepreneurship and does
not distinguish between entrepreneurship aimed at, for example, agricultural sectors. Since
industry structures can be expected to vary across countries this might influence the results.
In addition, the GEM data do not distinguish between formal and informal entrepreneur-
ship, i.e., if the entrepreneurs actually decide to formally register a firm.2 This difference is
interesting to elaborate on, since it could be argued that the institutions reflecting economic
freedom also influence the individual entrepreneur’s choice between formal and informal
entrepreneurship (Baumol 1990).
This paper uses self-employment as a measure of entrepreneurship. As noted by Blanch-
flower (2000), work linking institutional factors to self-employment is relatively scarce in

1 An additional empirical study worth mentioning is the study by Kreft and Sobel (2005), which focuses on
the institutional differences in economic freedom across US states.
2 Some of the entrepreneurs identified by the GEM-study may be entrepreneurs active in the informal sector
of the economy, others are entrepreneurs that in the end did not decide to start a firm.
Public Choice (2008) 136: 269–282 271

the literature. Self-employment rates from the COMPENDIA database, a harmonised mea-
sure of self-employment, are used in the empirical analysis. Self-employment is reported
biennially for the period 1972–2002 and the panel includes 23 OECD countries. A fixed
effects panel data model is estimated to test the importance of the institutional setting in
terms of economic freedom on entrepreneurship rates. In the empirical analysis, total self-
employment rates and self-employment rates excluding agriculture are used. The empirical
evidence shows that a smaller government sector, better legal structure and security of prop-
erty rights, as well as less regulation of credit, labour and business tend to increase entrepre-
neurship. However, the results for legal structure should be interpreted with some care since
they are somewhat sensitive with respect to excluding certain countries.
The paper is organised as follows: Section 2 provides a description of the variables and
econometric method used in the empirical analysis. Section 3 discusses previous empirical
findings related to these five aspects of economic freedom and entrepreneurship. In Sect. 4
the empirical results are presented and finally conclusions and suggestions for future re-
search are presented.

2 Data and econometric method

This section provides a description of the measures of entrepreneurship and economic free-
dom index used the empirical analysis. In addition, some econometric issues are discussed.

2.1 Self-employment rate as a measure of entrepreneurship

The different strands of literature define different roles for the entrepreneur in an economy.
Glancey and McQuaid (2000) summarise the role of the entrepreneur from different perspec-
tives and distinguish between the role of the entrepreneur as a risk taker, resource allocator
and innovator (Schumpeter 1934, 1942). These three perspectives all focus on the economic
function of the entrepreneur. In addition to these perspectives, an entrepreneur can be re-
garded as a person with certain behavioural and individual characteristics that make him/her
a provider of new goods or services. An additional definition considers an entrepreneur to be
someone who creates a new organisation. Regardless of which of the above roles one wants
to assign to the entrepreneur, his/her ability to function as an entrepreneur is affected by the
institutional environment.
Nevertheless, the multidimensional aspects of entrepreneurship make it particularly dif-
ficult to find a measure that covers all of these dimensions. Frequently used measures are
self-employment rates, new firm formation or innovation (measured by, for example, R&D
or patents) in small firms. Different measures tend to reflect different aspects of entrepre-
neurship, e.g., the role of the entrepreneur as a risk taker may be captured by measures of
self-employment, while measures of new firm formation and innovation may be more con-
sistent with the view of the entrepreneur as an innovator or someone who creates a new
organisation.
Since the empirical focus of this paper requires a cross-country panel covering suffi-
ciently many years, we are unfortunately rather limited in our choice of measures of entre-
preneurship. One frequently used source for cross-country comparisons is the Global Entre-
preneurship Monitor (GEM), a research project initiated in 1999. Unfortunately, this survey
does not provide enough observations to conduct a panel data study. Furthermore, the GEM
study does not distinguish between formal and informal entrepreneurship. The GEM study
has been criticised for overestimating the rate of entrepreneurship since very few of the re-
spondents who claim to be in the process of starting a firm actually generate real start-ups
272 Public Choice (2008) 136: 269–282

(Hoffmann 2007). Instead, we have decided to use self-employment as a measure of entre-

preneurship. The advantage of using self-employment as a measure of entrepreneurship is
that these data are available across countries for a long period. Self-employment must now
be considered a well-established proxy for entrepreneurial activity (see e.g., Blau 1987;
Storey 1991; van Stel 2005). However, this measure is not without drawbacks. Since it re-
flects the stock of self-employed, this measure must clearly be regarded as a static measure
of entrepreneurship, compared to, for example, new firm formation (Wennekers et al. 2002).
Wennekers and Thurik (1999) indicate that the size of the discrepancy between the definition
of entrepreneurship and the proxy self-employment is unknown and may even be quite large.
They stress that the number of self-employed in an economy may be very dependent on var-
ious institutional, historical and structural factors. Hence, the level of self-employment may
be related to the level of economic development. For a further discussion on the definition
of entrepreneurship and the self-employment proxy, see Wennekers and Thurik (1999).
In this paper we use harmonised self-employment rates for OECD countries, where
self-employment rates refer to the number of self-employed in relation to the total labour
force. The dataset is provided by the COMPENDIA research group.3 Non-harmonised
OECD statistics on self-employment are not comparable across countries, mainly due to
the fact that the inclusion of owners/managers of incorporated businesses is not consis-
tent between countries. The harmonised COMPENDIA database addresses this problem by
including owners/managers of both unincorporated and incorporated businesses. Further-
more, the harmonised self-employment rate excludes unpaid family workers and those that
have self-employment as a secondary activity (van Stel 2005). Excluding workers with self-
employment as a secondary activity may of course exclude some entrepreneurial activities.
On the other hand, focusing on self-employment as a primary activity ensures that the self-
employment measure reflects real economic activity.
The COMPENDIA dataset is biennial and covers the period 1972 to 2002. An addi-
tional advantage of using the COMPENDIA dataset is that this database distinguishes be-
tween total self-employment rates and self-employment rates excluding agricultural sectors.
This distinction is important, since the size of the agricultural sector may be highly influ-
ential for self-employment rates in some countries.4 Further details on the COMPENDIA
dataset are available in van Stel (2005). Table 1 presents total self-employment rates and
self-employment rates excluding agriculture respectively at four different times for the 23
countries included in the study. Greece is the country with the highest self-employment rates,
if we consider both total self-employment rates and self-employment excluding agriculture.
The consequence of including agriculture is particularly apparent in countries like Greece,
Ireland and Portugal, where the difference between these two measures are significant.

2.2 The economic freedom index

The economic freedom of the world index, published by the Fraser Institute, contains mea-
sures of institutional quality for 123 countries. The index is an attempt at measuring the

3 The dataset is available at www.eim.net.

4 An additional argument for excluding the agricultural sector is that since self-employment is the “natural”
type of employment in this sector, it is structurally different from other sectors (van Stel 2005).
Public Choice (2008) 136: 269–282 273

Table 1 Total self-employment rates and self-employment rates excluding agriculture (in parentheses) 1972,
1982, 1992 and 2002

Country 1972 1982 1992 2002

Australia 0.169 0.200 0.197 0.184

(0.126) (0.161) (0.169) (0.164)
Austria 0.189 0.120 0.110 0.115
(0.093) (0.065) (0.069) (0.083)
Belgium 0.133 0.118 0.127 0.124
(0.105) (0.099) (0.114) (0.113)
Canada 0.109 0.112 0.127 0.132
(0.079) (0.090) (0.109) (0.122)
Denmark 0.131 0.105 0.081 0.079
(0.082) (0.070) (0.058) (0.067)
Finland 0.174 0.132 0.125 0.111
(0.066) (0.062) (0.075) (0.079)
France 0.179 0.144 0.121 0.096
(0.113) (0.100) (0.096) (0.081)
Germany 0.104 0.082 0.083 0.094
(0.076) (0.066) (0.073) (0.086)
Greece 0.381 0.367 0.323 0.289
(0.161) (0.186) (0.202) (0.193)
Iceland 0.192 0.143 0.160 0.157
(0.111) (0.086) (0.117) (0.123)
Ireland 0.240 0.191 0.199 0.161
(0.077) (0.083) (0.111) (0.112)
Italy 0.221 0.209 0.211 0.203
(0.143) (0.158) (0.179) (0.183)
Japan 0.190 0.174 0.140 0.113
(0.125) (0.129) (0.110) (0.092)
Luxemburg 0.170 0.116 0.082 0.063
(0.107) (0.082) (0.064) (0.054)
New Zealand 0.188 0.168 0.175 0.175
(0.106) (0.101) (0.123) (0.135)
Norway 0.155 0.125 0.107 0.085
(0.097) (0.086) (0.078) (0.065)
Portugal 0.270 0.222 0.231 0.229
(0.113) (0.118) (0.150) (0.137)
Spain 0.214 0.175 0.168 0.154
(0.118) (0.108) (0.129) (0.129)
Sweden 0.099 0.099 0.090 0.092
(0.074) (0.074) (0.072) (0.081)
Switzerland 0.087 0.087 0.092 0.101
(0.066) (0.066) (0.070) (0.076)
The Netherlands 0.128 0.103 0.107 0.122
(0.100) (0.081) (0.089) (0.108)
274 Public Choice (2008) 136: 269–282

Table 1 (Continued)

Country 1972 1982 1992 2002

United Kingdom 0.088 0.091 0.116 0.113

(0.078) (0.082) (0.105) (0.107)
U.S. 0.106 0.118 0.117 0.104
(0.080) (0.099) (0.103) (0.095)
Average 23 OECD countries 0.170 0.148 0.143 0.135
(0.100) (0.098) (0.107) (0.108)

Source: COMPENDIA

extent to which an economy can be characterised as a market economy (Berggren 2003). It

should be acknowledged that other indices that measure similar aspects of institutional qual-
ity are available, but the economic freedom index is usually regarded as the most ambitious
index in terms of coverage, since it includes data from as far back as 1970. Nevertheless, it
should be emphasised that a composite index like the economic freedom index can always
be criticised, as it includes a large variety of variables. Therefore, the weights of each vari-
able as well as the selection of which variables to include (and exclude) could always be
discussed (Berggren 2003).
The economic freedom index contains measures of institutional quality for five main
components: size of government, legal structure and security of property rights, access to
sound money, freedom to trade internationally and regulation of credit, labour and business.
Each component of the index ranges from zero to ten, where zero corresponds to little eco-
nomic freedom and ten corresponds to the highest level of economic freedom. During the
period 1970–2000, the index was published every fifth year. Since 2000, the index is pub-
lished annually. In order to match the biennial dataset on self-employment, the economic
freedom index time series was interpolated. Each of the five main components consists of
additional components. However, data on these additional components is far from complete
for several countries for the first years the economic freedom index was published. A further
decomposition in the empirical analysis would therefore substantially decrease the number
of observations.
In addition to the economic freedom index, control variables are used in the empirical
analysis. The control variables are GDP per capita, a measure of income levels, and the
unemployment rate. Purchasing power parity as of 1990 is used to make the GDP measure
comparable across countries. Both of these variables are also retrieved from the COMPEN-
DIA database.5 Income levels can be expected to affect demand and hence entrepreneurship,
but they also influence the amount of capital available in an economy, which may be crucial
for a potential entrepreneur (Reynolds et al. 1994). The GDP per capita variable is used in its
logarithmic form in order to reduce problems with non-normality. The relationship between
unemployment and entrepreneurship may have contradictory effects. One the one hand, the
unemployment rate reflects the macroeconomic conditions and hence the demand-side of
an economy. On the other hand, unemployment affects the supply-side of entrepreneurship

5 Additional control variables may be considered. However, we choose these two variables, which are fre-
quently used in the empirical literature, also because they are available for all countries over the entire period
and from the same source. Remember that the fixed effects approach implies that we control for country- and
time-specific effects.
Public Choice (2008) 136: 269–282 275

since unemployment may increase entrepreneurship if entrepreneurship is regarded as an

alternative activity to unemployment. Hence, we may expect both a positive and negative
effect of unemployment on entrepreneurship. Carree (2002) summarises the empirical evi-
dence and the relationship between unemployment and new firm formation and concludes
that cross-section studies tend to find a negative relationship, while time-series studies tend
to find a positive relationship. In summary, the dataset includes data for 23 countries and
16 years. Due to some missing observations for Austria and Iceland for the first year that
the economic freedom index was available, the total number of observations is 362. A table
including descriptive statistics for all variables in the empirical analysis is presented in the
Appendix.6

2.3 Econometric method

As previously mentioned, the data used in the empirical analysis is panel data, i.e., it com-
bines a cross-section and a time series. Panel data techniques have the advantage that they
allow us to control for individual heterogeneity, i.e., that each country has specific character-
istics (unobservable country-specific effects) that we are unable to measure with the set of
variables included in the empirical model. These unobservable country-specific effects may
be assumed to be either random or fixed. The choice between a random and a fixed effects
model depends on the nature of the data (Baltagi 2001). If observations are randomly drawn
from a large population, a random effects model is most suitable, but if observations corre-
spond to a specific country, a fixed effects model is more appropriate. In our case, the fixed
effects model can be expected to be the appropriate choice. A Hausman specification test
can be used in order to verify the choice of fixed or random effects model (Baltagi 2001).
A two-way fixed effect model, i.e., a model that includes both unobservable individual-
specific effects and time-specific effects is estimated.

3 Previous empirical findings

In this section, the five components of the economic freedom index are presented, together
with some previous empirical findings relating institutional quality to entrepreneurship. Note
that the content of the economic freedom index described herein refers to the economic
freedom index’s present content and may therefore not be applicable for all countries and
years.7

3.1 Size of government

This part of the economic freedom index measures the degree of government intervention
and includes, for example, measures of government consumption spending, the amount of
subsidies and transfers, government enterprises and investment, and top marginal tax rates.
There are several reasons why we should expect to find a link between the size of a govern-
ment and entrepreneurship. Firstly, a large public sector may decrease the scope of the mar-
ket available for potential entrepreneurs. Secondly, a large government sector characterised

6 Since it is possible that the correlation between some of the explanatory variables may cause problems in the
empirical analysis, correlations were calculated. The strongest correlation among the explanatory variables
was found for GDP per capita and some of the measures of economic freedom. However, the correlations
cannot be regarded as being so strong that they might indicate severe problems with multicollinearity.
7 A description of the content of the index for the period 1970 to 2005 is available at www.freetheworld.com.
276 Public Choice (2008) 136: 269–282

by a generous social security system also influences the incentives to become an entrepre-
neur. Finally, it is argued that an extensive social security system also reduces the incentives
for wealth formation, which are important for enabling entrepreneurship (Henrekson 2005).
Bjørnskov and Foss (2008) use data on entrepreneurship from GEM and use the eco-
nomic freedom index as an explanatory institutional variable. Their study is a cross-country
study covering 29 countries during the year 2001. Their results show that a large govern-
ment sector tends to decrease entrepreneurship. Sobel et al. (2007) studied the relationship
between the entrepreneurship index provided by GEM for 2002 for 21 OECD countries and
the aggregate economic freedom index and find a strong relationship. Among the compo-
nents of the economic freedom index, government size is the one with the strongest rela-
tionship to entrepreneurship.
More specifically focusing on taxes, the tax rate may have two contradictory effects on
entrepreneurship. On the one hand, high taxes may decrease the reward of becoming an
entrepreneur. On the other hand, entrepreneurship and self-employment can be used as a
strategy to evade taxes. Higher taxes on wages tend to stimulate people to become self-
employed, since self-employment offers greater flexibility to realise or even hide incomes
(Hall and Sobel 2006). In addition, self-employment may provide untaxed non-pecuniary
returns, for example, flexible working hours or status (Hamilton 2000). Empirical research
has found that the tax-evasion effect dominates (Bruce 2000, 2002).

3.2 Legal structure and security of property rights

This component of the economic freedom index is strongly interrelated to how contractual
and property rights are defined and enforced. It reflects, for example, judicial independence,
the extent to which courts can be regarded as impartial and the protection of intellectual
property. We now have a large base of empirical literature showing that economic freedom in
terms of private property rights is crucial for wealth creation (Berggren and Karlson 2005).
Hence, it can be expected that the institutions of legal quality also provide an important link
to entrepreneurship. Specifically focusing on entrepreneurship, Davidsson and Henrekson
(2002) found a positive relationship between the institutional environment, in particular the
institutions of ownership rights, and the start-up and growth of Swedish firms.

3.3 Access to sound money

Access to sound money emphasises the importance of a stable monetary environment. The
index includes measures of the growth of money supply, inflation variability, recent inflation
rate and freedom to own foreign currency and bank accounts, both domestically and abroad.
The view of the entrepreneur as a risk taker can clearly be related to financial stability. As
pointed out by Bjørnskov and Foss (2008), this might be less of a problem for some entre-
preneurs that can be characterised as “risk–lovers”. However, previous empirical evidence
on the relationship between sound money and entrepreneurship must be regarded as scarce.
However, Bjørnskov’s and Foss’s (2008) previously mentioned study finds that access to
sound money is positively related to entrepreneurship.

3.4 Freedom to trade internationally

Freedom to trade internationally includes measures of taxation on international trade, regu-

latory trade barriers, the size of the trade sector, differences between official exchange rates
and black market exchange rates, and international capital market controls. The opportu-
nities to engage in international trade influence an entrepreneur’s market potential. It also
Public Choice (2008) 136: 269–282 277

reflects the costs associated with engaging in international trade. Sobel et al. (2007) have
shown a negative relationship between barriers to international competition, measured by
tariff barriers, and entrepreneurship. On the other hand, Bjørnskov and Foss (2008) did not
find any significant relationship between freedom to trade internationally and entrepreneur-
ship.

3.5 Regulation of credit, labour and business

Regulation of credit, labour and business includes a rather large variety of aspects. It in-
cludes credit market regulations, which comprise, for example, measures of ownership and
competition in the banking sector. Regarding labour market regulation, the index includes,
for example, measures of the ease of hiring and firing workers and the extent of unemploy-
ment benefits. Business regulation measures, for example, the ease of starting a business and
the bureaucracy associated with running a business.
Regulation is perhaps the aspect where most previous studies on the relationship between
entrepreneurship and institutions have been carried out. Van Stel et al. (2006) find that both
the minimum capital requirements needed to start a business and labour market regulations
tend to lower entrepreneurship rates. Kanniainen and Vesala (2005) find that labour mar-
ket regulations in terms of, for example, unemployment benefits, employee protection and
labour union power have negative effects on the self-employment rate in OECD countries.
Alfaro and Charlton (2006) find that lower bureaucratic quality tends to decrease entrepre-
neurship. Klapper et al. (2006) find that regulations associated with new firm start-ups tend
to decrease entrepreneurship and in particular small firm start-ups. In addition, Desai et al.
(2003) show that entry regulations influence new firm formation. A study by Scarpetta et al.
(2002) finds that product and labour market regulations are negatively correlated with the
number of new small and medium-sized companies. In particular, entry regulations seem
to have negative effects on entrepreneurship. Ciccone and Papaioannou (2006) investigate
the relationship between the time needed to start a new firm and new firm formation. Their
results show that low barriers to entrepreneurship in terms of the number of procedures re-
quired to start a new business are particularly important for new firm formation in industries
characterised by fast technological change and expanding global demand.
Regarding access to credit, an influential article by Evans and Jovanovic (1989) estimated
that credit rationing prevented more than 1% of the American population from engaging in
entrepreneurship. This finding is questioned by Parker (2004). He emphasises that even
though many empirical studies have found a positive relationship between personal wealth
and windfall gains and the probability to become self-employed, this does not necessarily
imply that potential entrepreneurs experience problems gaining access to loans. Instead,
Parker (2004) refers to empirical evidence from bank loan rejections and argues that credit
rationing in practice is very rare. Using the economic freedom index, Bjørnskov and Foss
(2008) did not find any significant relationship between entrepreneurship and regulation.

4 Empirical findings

Table 2 presents the results of the fixed effects model estimation for the two measures of
self-employment. Hausman specification tests confirm the choice of the fixed effects model.
Focusing on total self-employment, three out of five components of economic freedom have
statistically significant coefficients: size of government, legal structure and security of prop-
erty rights and regulation of credit, labour and business. Note that higher values for the
278 Public Choice (2008) 136: 269–282

Table 2 Regression results

Total self-employment Self-employment

excluding agriculture

Constant 0.874* 0.023

(0.111) (0.090)
GDP per capita −0.086* −0.003
(0.011) (0.009)
Unemployment −0.002* 1.035 × 10−4
(3.969 × 10−4 ) (3.241 × 10−4 )
Size of government 0.006* 0.005*
(0.001) (0.001)
Legal structure and security of property rights 0.003* 0.002*
(0.001) (0.001)
Access to sound money −3.259 × 10−4 1.916 × 10−4
(0.001) (0.001)
Freedom to trade internationally −0.003 0.002
(0.002) (0.001)
Regulation of credit, labour and business 0.012* 0.008*
(0.003) (0.002)
R 2 (adjusted) 0.959 0.917
Hausman specification test 54.12 42.87
Observations 362 362

* Significant at the 5% level. Robust standard errors (Whites heteroscedasticity-consistent estimator) in paren-
thesis

size of the government sector indicate a smaller government sector and a lower tax rate.
Hence, the positive sign of the coefficient implies that a smaller government sector tends to
increase self-employment rates. This result is consistent with Bjørnskov’s and Foss’s (2008)
results. A better legal structure and security of property rights are also found to be positively
related to entrepreneurship. In addition, better regulation environments, i.e., less regulated
credit, labour and business sectors, have a positive effect on entrepreneurship. This result
differs from those obtained by Bjørnskov and Foss (2008), who did not find any statistically
significant effect of regulatory quality on entrepreneurship or legal structure and security
of property rights. Regarding the magnitude of the coefficients, regulation of credit, labour
and business has the largest effect on self-employment. An improvement in regulation by
one standard deviation results in an increase in the self-employment rate of just above 1
percentage point. An improvement in the size of the government and legal structure by
one standard deviation increase the self-employment rates by about 0.8 and 0.4 percentage
points respectively. The two control variables, GDP per capita and the unemployment rate,
are also statistically significant and both variables have a negative effect on entrepreneur-
ship. The negative effect of GDP per capita on self-employment contradicts our theoretical
expectations, but is actually similar to Bjørnskov’s and Foss’s (2008) findings regarding the
relationship between GDP per capita and necessity entrepreneurship.8 A possible explana-

8 Necessity entrepreneurship refers to entrepreneurship where the prime motivation behind starting a business
is to make a living.
Public Choice (2008) 136: 269–282 279

tion for this finding is the previously mentioned hypothesis that self-employment rates may
decrease with the level of economic development.
Regarding the impact of regulation, van Stel et al. (2006) propose that an explanation
for the absence of statistical significance of regulation (in particular business regulations)
on nascent and young entrepreneurship is that regulation rather influences the distribution
between productive and unproductive entrepreneurship, but not the total amount of entre-
preneurship. Both studies by van Stel et al. (2006) and Bjørnskov and Foss (2008) use data
from the previously mentioned GEM study. Remember that this dataset does not distinguish
between informal and formal entrepreneurship. The different results between this study and
the two aforementioned studies therefore indicate that the quality of regulation has an im-
pact on formal entrepreneurship (as measured by the number of people formally registered
as self-employed). It might well be the case that the quality of regulation has less impact on
the very dynamic measures of entrepreneurship, such as the GEM measure, and that regula-
tion is more important in a later stage of the process when the entrepreneur decides in what
form he/she prefers to run his/her entrepreneurial activity.
When using the specification of self-employment excluding agriculture as a dependent
variable, the results are similar to the previous estimation, i.e., the size of the government
sector, legal structure and security of property rights and regulation of capital, labour and
business showed statistically significant coefficients with the same signs as in the previous
estimation. Hence, a smaller government sector, a better legal structure and better regulation
tend to be positive also for this measure of entrepreneurship. Again, the regulation effect is
the largest. For the specification excluding agricultural sectors an improvement in regulation
by one standard deviation results in an increase in the self-employment rate of about 0.7
percentage points, while an improvement of government size and legal structure by one
standard deviation results in increases of 0.6 and 0.2 percentages points respectively, in self-
employment rates. Note that the control variables, GDP per capita and unemployment, are
not statistically significant in this specification.
In order to check if the results are consistent for some alternative specifications, a number
of robustness checks were performed. First, a fixed effects panel regression was performed
using an alternative method of interpolation. For this specification, the value of the closest
preceding year for which the economic freedom index was available was used instead of
linear interpolation. The results remained qualitatively the same. The quantitative changes
in the estimated coefficients must also be considered small.9 In addition, some alternative
model specifications were estimated by only including the significant variables and by ex-
cluding the control variables one at the time. The results for these re-estimations also re-
mained qualitatively the same. A further robustness check was performed by excluding one
country at a time from the analysis. This procedure was undertaken in order to make sure
that outliers do not drive the results. In particular, this robustness test showed that the results
concerning the size of the government sector and regulation are very robust to excluding
particular observations. Regarding the variable reflecting legal structure, the results were
somewhat sensitive to the exclusion of a few countries.10 Therefore, the results for legal

9 In the estimation with total self-employment as the dependent variable the size of the estimated coeffi-
cients decreased to 0.001 and 0.009 for the legal structure and regulation variables respectively, but remained
quantitatively the same for the government size variable. In the estimation with self-employment excluding
agriculture as the dependent variable the coefficients are 0.004, 0.002 and 0.009 for size of government, legal
structure and regulation respectively.
10 The variable turned statistically insignificant (at the 10% level) in four cases in the estimation with total
self-employment as the dependent variable. These four countries are Canada, Greece, Italy and Luxemburg.
280 Public Choice (2008) 136: 269–282

structure should be interpreted with some care. A final robustness check was performed by
excluding one year at a time in the analysis in order to check if the inclusion of particular
year drives the results. Legal structure was the only variable that turned out to be somewhat
sensitive to the exclusion of certain years.11

5 Conclusions and suggestions for future research

This paper contributes to the empirical literature on the determinants of entrepreneurship

across countries. It investigates the relationship between the institutional setting in terms
of economic freedom and entrepreneurship. This paper contributes to the empirical litera-
ture on this relationship by using self-employment as a measure of entrepreneurship and
by using panel data analysis and thereby aims to validate some previous empirical research
using cross-country data. The economic freedom index consists of five components that
measure the size of the government sector, legal structure and security of property rights,
access to sound money, the conditions for international trade and finally the quality of reg-
ulation of credit, labour and business respectively. The empirical part of the paper uses har-
monised data on self-employment from a database including biennial observations covering
23 OECD countries for the period 1972 to 2002.
The empirical findings confirm the findings of Bjørnskov and Foss (2008) regarding the
effect of government size, i.e., a smaller government sector tends to have a positive ef-
fect on entrepreneurship. In addition, better legal structure and security of property rights
and less strict regulation of credit, labour and business tend to have positive effects on
self-employment. These findings are valid both for total self-employment rates and self-
employment rates excluding the agricultural sector. In general, the results must be consid-
ered as robust, even if the findings concerning legal structure are somewhat sensitive to the
inclusion of certain countries. Hence, those results should be interpreted with some care.
Furthermore, the paper suggests that institutional differences in terms of regulation might
be more influential on entrepreneurship with respect to formal entrepreneurial activities.
This paper has focused on the relationship between institutions of economic freedom and
entrepreneurship, assigning entrepreneurship the role of the dependent variable. It should,
however, be noted that the relationship between institutions and entrepreneurship can be
expected to be interdependent (e.g., Lee 1991; Clark and Lee 2006). In this paper, we have
mainly explored how institutions may affect entrepreneurship. An example of the reverse
relationship is that there are incentives for entrepreneurs to use institutions (for example
economic regulations) against other entrepreneurs to protect their interests. As noted by
Clark and Lee (2006), the social cost in terms of lost prosperity may be very large, but
the political cost for a regulator to impose these institutional changes is in most cases low
since they tend to be dispersed and difficult to identify. Hence, the interrelationship between
entrepreneurship and the institutions of economic freedom is definitely an area that needs
to be further explored. Furthermore, when a sufficiently large time series is available, it
would in the future be valuable to use the subcomponents of the economic freedom index
in order to elaborate more specifically on which institutions are more or less influential on
entrepreneurial activities.

11 The variable turned statistically insignificant (at the 10% level) in one single case (year 2000) in the esti-
mation with total self-employment as the dependent variable.
Public Choice (2008) 136: 269–282 281

Acknowledgements The author would like to thank Niclas Berggren, two anonymous referees, and the
participants at the 2007 Ratio Colloquium for Young Social Scientists, The Ratio Institute, Stockholm, for
valuable comments on previous versions of this paper. The author would also like to thank The Bank of
Sweden Tercentenary Foundation, whose generous support has made this colloquium possible.

Appendix: Descriptive statistics

Mean Std. Dev. Minimum Maximum N

Total self-employment 0.147 0.059 0.063 0.384 362

Self-employment excluding 0.104 0.034 0.054 0.202 362
agriculture
GDP per capita 9.584 0.318 8.583 10.306 362
Unemployment 6.130 3.849 0.100 19.200 362
Size of government 4.732 1.281 2.121 7.629 362
Legal structure 7.658 1.172 2.511 9.625 362
Access to sound money 8.295 1.602 2.114 9.839 362
Freedom to trade internationally 7.527 0.880 3.917 9.098 362
Regulation 6.086 0.865 4.308 8.582 362

References

Acemoglu, D., Johnson, S., & Robinson, J. (2001). The colonial origins of comparative development: An
empirical investigation. American Economic Review, 9, 1369–1401.
Alfaro, L., & Charlton, A. (2006). International financial integration and entrepreneurship. CEP Discussion
Paper No 755, Centre for Economic Performance, London School of Economics and Political Science.
Baltagi, B. H. (2001). Econometric analysis of panel data. New York: Wiley.
Baumol, W. J. (1990). Entrepreneurship: productive, unproductive and destructive. Journal of Political Econ-
omy, 98, 893–921.
Baumol, W. J. (2004). The free-market innovation machine: Analyzing the growth miracle of capitalism.
Princeton: Princeton University Press.
Berggren, N. (1999). Economic freedom and equality: friends or foes? Public Choice, 100, 203–223.
Berggren, N. (2003). The benefits of economic freedom: A survey. The Independent Review, 8, 193–211.
Berggren, N., & Karlson, N. (2005). Äganderättens konsekvenser och grunder. [The Consequences and Foun-
dations of Property Rights]. Stockholm: Ratio.
Blanchflower, D. G. (2000). Self-employment in OECD countries. Labour Economics, 7, 471–505.
Blau, D. (1987). A time series analysis of self-employment. Journal of Political Economy, 95, 445–467.
Bruce, D. J. (2000). The effects of United States tax systems on transition into self-employment. Labour
Economics, 7, 545–574.
Bruce, D. J. (2002). Taxes and entrepreneurial endurance: Evidence from self-employed. National Tax Jour-
nal, 55, 5–24.
Bjørnskov, C., & Foss, N. J. (2008). Economic freedom and entrepreneurial activity: Some cross country
evidence. Public Choice, 134, 307–328.
Carree, M. A. (2002). Does unemployment affect the number of establishments? A regional analysis of US
states. Regional Studies, 36, 389–398.
Carter, J. R. (2007). An empirical note on economic freedom and income inequality. Public Choice, 130,
163–177.
Ciccone, A., & Papaioannou, E. (2006). Red tape and delayed entry. CEPR Discussion paper No. 5996,
Centre for Economic Policy Research, London.
Clark, J. R., & Lee, D. R. (2006). Freedom, entrepreneurship and economic progress. Journal of Entrepre-
neurship, 15, 1–17.
282 Public Choice (2008) 136: 269–282

Davidsson, P., & Henrekson, M. (2002). Determinants of the prevalence of start-ups and high-growth firms.
Small Business Economics, 19, 81–104.
Desai, M., Gompers, P., & Lerner, J. (2003). Institutions, capital constraints and entrepreneurial firm dynam-
ics: Evidence from Europe. NBER Working Paper no 10165.
Doucouliagos, C., & Ulubasoglu, M. A. (2006). Economic freedom and economic growth: Does specification
make a difference? European Journal of Political Economy, 22, 60–81.
Evans, D. S., & Jovanovic, B. (1989). An estimated model of entrepreneurial choice under liquidity con-
straints. Journal of Political Economy, 97, 808–827.
Freytag, A., & Thurik, R. (2007). Entrepreneurship and its determinants in a cross country setting. Journal of
Evolutionary Economics, 17, 117–131.
Glancey, K. S., & McQuaid, R. W. (2000). Entrepreneurial economics. New York: Palgrave.
Gwartney, J., Lawson, R., & Easterly, W. (2006). Economic freedom of the world: 2006 annual report. The
Fraser Institute. www.freetheworld.com.
Hall, J. C., & Sobel, R. S. (2006). Public policy and entrepreneurship. Centre for Applied Economics Tech-
nical Report 06-0717, University of Kansas.
Hamilton, B. H. (2000). Does entrepreneurship pay? An empirical analysis of the returns to self-employment.
Journal of Political Economy, 108, 604–631.
Henrekson, M. (2005). Entrepreneurship: A weak link in the welfare state. Industrial and Corporate Change,
14, 437–467.
Hoffmann, A. (2007). A rough guide to entrepreneurship policy. In D. B. Audretsch, I. Grilo, & R. A. Thurik
(Eds.), Handbook of research on entrepreneurship policy (pp. 140–161). Cheltenham: Edward Elgar.
Kanniainen, V., & Vesala, T. (2005). Entrepreneurship and labour market institutions. Economic Modelling,
22, 828–847.
Klapper, L., Laeven, L., & Rajan, R. (2006). Entry regulation as a barrier to entrepreneurship. Journal of
Financial Economics, 82, 591–629.
Kreft, S. F., & Sobel, R. S. (2005). Public policy, entrepreneurship, and economic growth. Cato Journal, 25,
595–616.
Lee, L. W. (1991). Entrepreneurship and regulation: Dynamics and political economy. Journal of Evolution-
ary Economics, 1, 219–235.
North, D. (1991). Institutions. Journal of Economic Perspectives, 5, 97–112.
North, D. (1994). Economic performance through time. American Economic Review, 84, 359–368.
Parker, S. C. (2004). The economics of self-employment and entrepreneurship. Cambridge: Cambridge Uni-
versity Press.
Reynolds, P. D., Storey, D. J., & Westhead, P. (1994). Cross-national comparisons of the variation in new firm
formation. Regional Studies, 28, 443–456.
Reynolds, P. D., Hay, M., & Camp, S. M. (1999). Global entrepreneurship monitor. Kansas City: Kaufmann
Center for Entrepreneurial Leadership.
Ricardo, D. (1821). Principles of political economy and taxation. London: John Murray.
Rodrik, D., Subramanian, A., & Trebbi, F. (2004). Institutions rule: The primacy of institutions over geogra-
phy and integration in economic development. Journal of Economic Growth, 9, 131–165.
Scarpetta, S., Hemmings, P., Tressel, T., & Woo, J. (2002). The role of policy and institutions for productivity
and firm dynamics: Evidence from micro and industry data. Working paper No 329, OECD Economics
Department.
Schumpeter, J. A. (1934). The theory of economic development. Cambridge: Harvard University Press.
Schumpeter, J. A. (1942). Capitalism, socialism, and democracy. New York: Harper and Row.
Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations. Chicago: University of
Chicago Press.
Sobel, R. S., Clark, J. R., & Lee, D. R. (2007). Freedom, barriers to entry, entrepreneurship and economic
progress. The Austrian Review of Economics, 20, 221–236.
Storey, D. J. (1991). The birth of new firms - Does unemployment matter? A review of the evidence. Small
Business Economics, 3, 167–178.
van Stel, A. J. (2005). COMPENDIA: Harmonising business ownership data across countries and over time.
International Entrepreneurship and Management Journal, 1, 105–123.
van Stel, A., Storey, D. J., & Thurik, R. (2006). The effect of business regulation on nascent and young
business entrepreneurship. ERIM Report Series Research in Management Rotterdam.
Wennekers, S., & Thurik, R. (1999). Linking entrepreneurship and economic growth. Small Business Eco-
nomics, 13, 27–55.
Wennekers, S., Uhlander, L. M., & Thurik, R. (2002). Entrepreneurship and its conditions: a macro perspec-
tive. International Journal of Entrepreneurship Education, 1(1), 25–64.
Zacharakis, A. L., Bygrave, W. D., & Shepherd, D. A. (2000). Global entrepreneurship monitor: National
entrepreneurship assessment: United States of America. Kansas City: Kaufmann Center for Entrepre-
neurial Leadership.