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This paper presents an empirical study investigating the effect of entrepreneurship on the incidence of informal employment. It builds upon economic models exploring the determinants of informal economy by analyzing the role played by institutions and policies and their effect on the informal sector. Among policies examined are payroll and severance taxes, labor and product market regulations, unemployment benefits, firing and hiring costs, enforcement of financial contracts and financial costs. The empirical analysis is based on a panel data approach. The main result of the paper supports the view that the informal sector is an “unregulated micro-entrepreneurial sector.” The findings suggest that differences in the level of entrepreneurial activities across developing countries are associated with variance in the incidence of informal employment, and that entrepreneurship has a positive effect on the informal sector. The incidence of informal employment is strongly affected by the public perception of government performance, role, accountability and effectiveness, as well as labor market and business regulations.

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