FDI Flows and the Effects of the Shadow Economy: Evidence from Gravity Modelling

This paper analyzes the question of if the size of the shadow economy affects foreign direct investment (FDI) flows and what effects, if any, there are. Since about 1990, FDI has become the second crucial pillar of economic globalization in OECD countries and worldwide; such FDI inward and outward flows contribute to higher per capita income and international technology transfer. To analyze this question, both fixed effects, as well as dyadic fixed effects gravity models, are used on an OECD-only dataset that allows for data on bilateral, bidirectional FDI flows for the years from 1992-2018. The empirical results suggest a positive effect of the shadow economy for FDI target countries and a negative effect for FDI origin countries. Additional findings via an interaction term show that the shadow economy can counteract the negative effects of an increase in government size on FDI inflows. From a policy perspective, changes in the size of the shadow economy – typically taking place in periods of recession, in a high taxation environment, or in the context of a pandemic shock – should be carefully monitored by economic policymakers as well as by policy monitoring international organizations such as the IMF and the EBRD. If a group of (OECD) countries decides to adopt anti-shadow economy economic policies, there will be pressure on other (OECD) countries to also adopt similar policies since the difference between the size of the shadow economy in the source country and the host country has a negative impact on FDI inflows. Thus, FDI could indirectly be a catalyst for reforms.