How Does FDI Respond to the Size of Shadow Economy: An Empirical Analysis under a Gravity Model Setting

Using a panel study under a gravity model setting focusing on data from 1999 to 2007 for Organization for Economic Co-operation and Development countries, we show that the size of the shadow economy in the host economy relative to the investor economy can play a significant role in attracting Foreign Direct Investment (FDI) inflows. We further explore nonlinearities in how shadow economy differentials affect incoming FDI. Our results match the theoretical predictions which highlight that opportunities for tax evasion can have an impact on the activities of Multinational Corporations.