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27-01-2020

Local institutional heterogeneity & firm dynamism: Decomposing the metropolitan economic freedom index

Author: Daniel L. Bennett

Published in: Small Business Economics | Issue 1/2021

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Abstract

A nascent body of research suggests that economic freedom is positively associated with entrepreneurial activity. Most of this literature is based on cross-countries analyses, although there is significant regional heterogeneity in entrepreneurial activity and the institutional and policy context within countries. The literature also largely overlooks the potential for the entrepreneurial inducing effects of economic freedom to drive less efficient firms out of the market. Additionally, economic freedom is a multi-dimensional construct comprised of numerous underlying aspects of the institutional and policy environment, but most studies have employed a composite economic freedom measure to assess its impact on entrepreneurial activity. I contribute to these gaps in the literature by decomposing the recently developed Metropolitan Economic Freedom Index into its underlying institutional indicators to explore their potential impact on the firm entry and firm exit rates for a sample of nearly 300 US cities over the period 1972–2012.

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Appendix Table A3 reports the between and within standard deviations of the MEFI and its underlying area sub-indices and component variables. There exists significant variation in economic freedom both between and within MSAs.

Some of these studies used the Economic Freedom of the World Index (Gwartney et al. 2018) and others the Index of Economic Freedom (Heritage Foundation 2019).

There is mixed cross-country evidence, however, on the relationships between economic freedom and informal entrepreneurship (cf., Dau and Cuervo-Cazurra 2014; Saunoris and Sajny 2017) and necessity-motivated entrepreneurship (cf., Angulo-Guerrero et al. 2017; Nikolaev et al. 2018). My measures of entrepreneurship more closely reflect formal and opportunity-motivated entrepreneurship for which the evidence is more consistent, as described above.

One limitation of the current study is that that newly developed MEFI dataset, which provides wide local coverage over a long period of time, does not capture all of the components of economic freedom that may vary across regions and exert an influence on the entrepreneurial ecosystem. Notably absent from the MEFI are measures of legal and regulatory institutions (Braunerhjelm et al. 2015).

Cullen and Gordon (2007) argue that a reduction in personal tax rates can discourage entrepreneurial risk taking for risk-adverse individuals because it implies less risk-sharing with the government. They also suggest that the potential tax savings from going into business as a means to reclassify earnings from personal to corporate income is reduced when personal income tax rates fall.

As an example, the firm entry rate assigned to 1997 is the average annual number of firms created over the period 1997–2001 relative to the total number of firms in 1997. Note that the BDS data series ends in 2014, so the numerator for the measures mapped to 2012 represents the average values over the 3 years spanning 2012–2014.

I ran the Hausman (1978) specification test to determine whether a fixed effects (FE) or random effects (RE) estimator is more appropriate for each dynamism indicator using the most complete model (see model 4 and 8 in Table 2). Under the null hypothesis, both the FE and RE estimators are assumed consistent and the RE estimator is more efficient. The Wu-Hausman test statistic, which has a χ² distribution, is used to test the null hypothesis. If the null is rejected (i.e., p value ≤0.05), then the FE estimator is preferred because it is assumed consistent and the test suggests that the RE estimator is inconsistent (Wooldridge 2010). For all firm dynamism indicators, the p value of the test statistics is 0.000, suggesting that the null be rejected. I omit these results for space. The Hausman test, despite being widely used in applied research, has been criticized for its inability to account for higher-level processes (Bell and Jones 2015). I therefore report analogous results using the RE estimator in Appendix Table A9.

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Title: Local institutional heterogeneity & firm dynamism: Decomposing the metropolitan economic freedom index
Author: Daniel L. Bennett
Publication date: 27-01-2020
Publisher: Springer US
Published in: Small Business Economics / Issue 1/2021
Print ISSN: 0921-898X
Electronic ISSN: 1573-0913
DOI: https://doi.org/10.1007/s11187-020-00322-2

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Springer Professional "Wirtschaft+Technik"

Springer Professional "Wirtschaft"

Other articles of this Issue 1/2021

Entrepreneurial ecosystems: a dynamic lifecycle model

Decisions of firm risk and the role of organizational identity

Operating leverage and profitability of SMEs: agri-food industry in Europe

Public SME grants and firm performance in European Union: A systematic review of empirical evidence

“Don’t leave me this way!” Drivers of parental hostility and employee spin-offs’ performance

Searching for resilience: the impact of employee-level and entrepreneur-level resilience on firm performance in small family firms