How does the impact of foreign direct investment on institutional quality depend on the underground economy?

Abstract

ABSTRACT This study sheds light on the impacts of FDI inflows and underground economy on institutional quality, as well as the moderating effect of underground economy on FDI – institutional quality nexus in 43 developing countries worldwide during 2002-2009. By using FGLS and SGMM for estimation, we find that FDI inflows have a positive impact on institutional quality, while underground economy and the interaction term between FDI and underground economy have negative impacts on institutional quality. Our results indicate that FDI inflows initially help improve institutional quality, but the presence of underground economy reduces this effect until the underground economy reaches a threshold, then above this threshold, the total impact of FDI on institutional quality turns negative. The findings imply that to foster the role of FDI in ameliorating institutional quality, governments in developing countries must control the underground economy at certain levels below the threshold. Highlights FDI inflows improve institutional quality in the host countries. The underground economy reduces institutional quality. The impact of FDI on institutional quality depends on the underground economy. There is a threshold of the underground economy. Below this threshold, FDI inflows enhance institutional quality; but FDI inflows jeopardize institutional quality when the underground economy is above this threshold.