Effect of Governance Quality on Level of Start-Up Creation

Introduction

There is extensive literature on the importance of new businesses in driving economic prosperity. New businesses are the catalyst for economic growth as their entry increases market competitiveness, leading to a rise in firms’ productivity (McMillan et al. 2002). Previous research also shows small new enterprises account for more job creations than larger businesses. (Neumark et al. 2008).

This is supported by a recent study that reveals start-ups contributed to 3 million new jobs annually in the US from 1992–2005, hence playing a significant role in creating net positive job growth (Kane, 2010). Schumpeter also argues that the entry of new firms supports the process of creative destruction by promoting competition and innovation (Schumpeter, 1942).

After the 2008 Financial Crisis, the rate of business creation in many developed countries dropped tremendously and is yet to recover. The number of start-ups registered in the UK shrunk significantly, from 452,135 in 2007 to 364,131 in 2009 (World Bank). This is a worrying trend as new firms play a prominent role in promoting competitiveness, job creation, and a country’s dynamism. Hence, the ability of government to create a suitable environment for business creation is critical, especially for economic recovery.

This paper will contribute to the literature by analysing the influence of governance quality as a barrier to entry on business creation following the 2008 Financial Crisis.

Research Question, Motivation and Hypothesis

This paper investigates the impact of governance quality on the level of start-up creation in 21 European countries after the 2008 Financial Crisis. The analysis is done by developing a model that relates the level of start-up registrations to governance quality, while controlling for other impactful variables on new businesses. This paper tries to address three main questions:

1. To what extent does the quality of governance affect the level of start-up creation during and following a recession?
2. If the quality of governance is important, which of the six indicators is most significant in predicting the level of business creation? 
3. Hence, what are the policy implications for supporting start-ups in an economic recovery?

This paper hypothesises that a higher quality of governance improves the number of start-up registrations.

Data

This paper uses the World Bank’s “New Business Density” as a measure of the dependent variable entry density. This is defined as the number of new limited liability companies registered in a year (per 1,000 working age population (ages 15-64)).

The primary source of data is obtained from the World Bank’s Worldwide Governance Indicators (WGI) to measure the independent variable governance quality.

The data for credit availability is taken from World Bank’sdomestic credit to the private sector (as a percentage of GDP).

Strength of Investor Protection Index from the World Bank Doing Business (WBDB) is used to measure private sector regulation.

This paper uses the World Bank’s Database to get the data on tax rate (as a percentage of total profit), employment levels, level and growth of GDP, for the regression’s macroeconomic controls.

Methodology

This paper will analyse the drivers of start-up registration following the financial crisis. The methodology is inspired by Chambers et al. (2017) who analyse the impact of regulations and institutional quality on entrepreneurship.

A panel data and cross-country model will be applied, where dimension (t) represents the year 2006-2016. The preliminary model is:

entry densityt = 1 Govt + 2 Creditt + 3 Taxt + 4 PRt + 5 EGrowtht + 6 lg(GDPt) + 7Employmentt +8 Countries +9 Recessiont +  +   (1)

entry densityis the natural logarithm of the New Business Density for each t year. Independent variable Gov is the mean value of the six WGI indicators: Regulatory Quality; Voice and Accountability; Political Stability and Absence of Violence/Terrorism; Government Effectiveness; Control of Corruption; and Rule of Law.

There are six control variables for barriers of entry that are included: (1) Credit availability which is proxied by the natural logarithm of domestic credit to the private sector as a percentage of GDP; (2) Tax rate as a percentage of business profit; (3) Private regulation using the measure of Strength of Investor Protection Index (PR); (4) Economic growth which is proxied by GDP growth per capita; (5) Economic development is proxied by the natural logarithm of the real GDP per capita in PPP-adjusted 2006 dollars; (6) Employment levels. is a constant term, and   is the error term.

This model also includes two dummy variables: (1) recession, which is 1 for positive GDP growth and is 0 otherwise; (2) country, for each of the 21 European countries.

The dummy variable recession helps us to account for fluctuations in the business cycle in this model.

I will first examine the relationship between entry density and each of the six indicators of governance quality using a scatter plot. I predict a positive relationship between entry density and each of the six indicators. Secondly, I examine if there is a causal relationship between entry density and each of the six indicators using the Huber-White robust standard errors test on regression model (1).

I further examine which of the six indicators is most significant in predicting the level of start-up creation by comparing the respective coefficients.

Limitations and Robustness

There is potentially anendogeneity problem arising from entry density and the current GDP. An additional instrumental variable will be added to solve this issue.

Literature review

Influence of governance quality on business creation

According to the World Bank Group Entrepreneurship Snapshots (WBGES), there is a positive correlation between firm entry density and high institutional quality, supported by Chamber et al. (2017)’s empirical work based on data from 119 countries. Boettke et al. (2009) explain that institutions can support entrepreneurship activity by providing a high payoff in economic opportunities (arbitrage). With a higher payoff (such as low corporate tax), entrepreneurs are more motivated to start businesses.

Interestingly, contrary to the previous literature, Dreher et al. (2011) found evidence from 43 countries, that corruption (low institutional quality) aids firm creation in highly regulated countries by the “greasing effect”. In highly regulated countries, corruption (almost) offset the negative effect of high bureaucracy by providing a more efficient way to start a business. However, this paper lacks prominent control variables that influence firms’ creation, and this may lead to a biased result.

Chamber’s (2017) previous studies employs a similar underlying model (although with fewer controls) but does not analyse how the relationship varies throughout a business cycle. Hence, this paper aims to contribute to the literature by providing a more comprehensive model, including the additional features employment and business cycle fluctuation.

Influence of financial development on business creation

According to the existing literature, access to credit is one of the main drivers of business creation (Aghion et al. 2007). This finding is supported empirically by Klapper et al. (2006) using data from European countries. Despite the importance of access to finance for starting businesses, start-ups often face difficulty in obtaining credit, especially after a recession. This can potentially be explained by banks’ unwillingness to finance small businesses due to their highly uncertain nature(Beck et al. 2005) and a lack of capital for collateral.

Influence of tax rate, private regulation on business creation

Prior research suggests that corporate tax has a significant and harmful effect on business creation levels (Djankov et al. 2010; Da Rin et al. 2011). This is supported by the empirical work of Belitski et al. (2016) using data on 72 countries. With higher profit and capital, incumbents have a comparative advantage over new firms, hence can limit entry into the market by potentially setting low price that new entrants cannot compete with. On the other hand, a progressive marginal tax rate deters potential entrepreneurs from starting businesses at a higher level since they would receive lower profit (Gentry et al. 2000).

A study by Rajan and Zingales (2003) found that regulations which protect investors could prove to be a major stimulus for business creation.

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