Fiscal institutions matter big time for foreign direct investment in developing economies

Foreign direct investment is a key driver of development, particularly for low-income countries. Nevertheless, low-income countries receive less than 1% of global FDI, and the quality of inflows is often not conducive to broad-based development. This column shows that fiscal discipline and fiscal institutions are strongly associated with higher FDI flows, especially in high-uncertainty settings. Furthermore, stronger institutions attract more R&D-intensive projects, which are more likely to generate productivity gains and spillovers. In sum, the most effective investment promotion strategy is not to grant more generous incentives but to work towards strengthening state capacity and institutions.

Foreign direct investment (FDI) is widely seen as a key driver of development. It can finance productive investment, foster technology transfer, create jobs, and help countries integrate into global value chains. For low-income countries (LICs), these benefits are particularly important. Yet, despite substantial development needs, low-income countries continue to attract very little FDI.

Our new research (IMF 2026) highlights a sobering reality: low-income countries receive less than 1% of global FDI. While broadly in line with their share of global GDP, this volume is too small to aid meaningful economic convergence of the kind witnessed in parts of Asia. Moreover, the composition, or quality, of inflows is not particularly conducive to broad-based development. FDI is increasingly concentrated in low R&D-intensive and less job-creating sectors, such as energy and extractive industries, with limited spillovers to the domestic economy (Figures 1 and 2).

Figure 1 Quality of FDI to low-income countries

Sources: Orbis Cross-border Investments and IMF staff calculations.
Notes: R&D intensity is rated on a scale from 1 to 3, with 1 indicating sectors with the lowest R&D intensity and 3 indicating those with the highest, based on the OECD Taxonomy of Economic Activities Based on R&D Intensity. Within each sector, subsectors may carry different classifications; in such cases, the average intensity score is computed by weighting subsectors by their FDI volume. The size of the bubbles reflects the amount of FDI (in US dollars) low-income countries receive in each sector, illustrating their relative quantitative importance.

Figure 2 FDI by R&D intensity (percent)

Sources: Orbis Cross-border Investments and IMF staff calculations.

This raises a related set of questions: why do low-income countries receive so little FDI, why is its quality often low, and what policy levers can low-income countries use to attract more FDI, especially in the context of elevated economic uncertainty? A common policy response on the part of low-income countries has been to rely on fiscal incentives, such as tax holidays or special economic zones (SEZs). However, our empirical analysis points to a different emphasis: what matters more is not the generosity of incentives, but the credibility of fiscal policy — anchored in strong fiscal institutions.

The puzzle of low investment

For investors, what matters is risk-adjusted returns. Standard theory predicts that capital should flow to poorer countries, where capital is scarce and thus the marginal product of capital — a proxy for the pre-tax return on investment — is expected to be higher. In practice, however, low-income countries remain marginal recipients of global capital flows, amid increasingly constrained external financing.

Part of the explanation is that, once weak infrastructure to support investment and other constraints on productive capacity — such as limited human capital, shallow financial markets, and institutional weaknesses — are taken into account, the effective marginal product of capital in low-income countries is often lower than expected and has diverged further from that in advanced economies over time. In addition, policy uncertainty, implementation risks, and high compliance costs further reduce risk-adjusted returns.

Fiscal institutions as a key determinant of FDI

To identify domestic ‘pull’ factors for FDI, our analysis combines two complementary empirical approaches. First, a gravity model exploits bilateral FDI flows to identify within-country variation over time, controlling for standard determinants (market size, distance, common official language), macroeconomic conditions, statutory top corporate income tax (CIT) rates, and time, host-, and source-country fixed effects. Second, local projections trace the dynamic response of FDI to policy changes.

Four main findings emerge:

• First, fiscal discipline and fiscal institutions are strongly and statistically significantly associated with higher FDI inflows. Countries with more sustainable fiscal positions, stronger revenue administration, and more effective public financial management tend to attract more FDI. Interestingly, these relationships are economically meaningful and stronger in low-income countries than in emerging markets (EMs) (Figure 3).

Figure 3 Gravity model estimates of fiscal drivers of FDI to low-income countries and emerging markets

Notes: Estimates show percent changes in expected FDI (US dollar) for a one-standard-deviation increase in each variable (standardised over the pooled LIC–EM sample). 90% confidence intervals are shown.

• Second, fiscal institutions matter not only for the quantity of FDI, but also for its quality. Emerging and developing economies (EMDEs) with stronger institutions tend to attract more R&D-intensive projects, which are more likely to generate productivity gains and spillovers. By contrast, low R&D-intensive projects — such as mining and energy — appear to be driven more by location-specific advantages, such as natural resource endowments, than by fiscal policy or the institutional environment.

Figure 4 Emerging and developing economies: Institutions and quality of FDI (in percent)

Notes: Bars show coefficients that are statistically significant at the 10% level; missing bars indicate estimates not statistically different from zero. Regressions are estimated using a gravity model with Orbis project-level data. The sample is limited to emerging and developing economies, as low-income country data are too sparse for sector-level analysis. Host- and source-country fixed effects are excluded due to limited within-country variation at the sectoral level.

• Third, when fiscal discipline, fiscal institutions, and broader institutional settings are considered jointly, fiscal institutions emerge as a more important correlate of FDI (Figure 5). This suggests that, alongside macroeconomic stability and broader institutional quality, investors place particular weight on the fiscal institutions that shape how policies are implemented in practice — especially through tax administration and public financial management.

Figure 5 Relative importance of fiscal discipline, fiscal institutions, and broader institutions to FDI to low-income countries

Notes: The figure reports estimates from a gravity model in which institutional variables are grouped into three composite indices — fiscal institutions, fiscal discipline, and broader institutional settings — constructed using principal component analysis (PCA) from the underlying indicators presented earlier. Each point shows the estimated percent change in expected FDI associated with a one standard deviation increase in the respective index, with horizontal lines indicating 90% confidence intervals. For fiscal institutions, International Survey on Revenue Administration (ISORA) indicators are excluded from the PCA due to limited time coverage, ensuring consistent and sufficiently long time series.

• Fourth, fiscal incentives — such as special economic zones and tax reductions — appear to be effective, if at all, only where fiscal discipline and institutions are already strong. In countries with weaker institutional capacity, such incentives have little or no statistically significant impact on FDI (Figure 6). In some cases, they can even be counterproductive, eroding revenues without attracting additional investment.

Figure 6 Dynamic impact of special economic zone (SEZ) legislation on FDI to low-income countries

Notes: The figures show impulse response functions estimated using Jordà local projections, assessing the heterogeneous impact of special economic zone (SEZ) legislation on FDI across countries with above- and below-median ISORA-based revenue administration operational strength or CPIA fiscal policy ratings. Solid lines denote point estimates, and shaded areas represent 90% confidence intervals. Year 0 corresponds to the timing of the shock.

Why credibility matters more in uncertain times

These findings are particularly relevant for low-income countries in today’s global environment, marked by heightened geopolitical tensions, a more challenging landscape for financing, and elevated policy uncertainty. As investors become more selective, credibility takes on added importance.

The evidence shows that the effects of fiscal discipline and institutional strength on FDI are stronger in high-uncertainty settings. Using country-specific measures of political and economic uncertainty from the World Uncertainty Index (WUI; Furceri et al. 2023), we find that the estimated effects of fiscal discipline and institutions are generally larger — and often statistically significant — when interacted with uncertainty, indicating a state-dependent relationship (Figure 7). In such environments, investors place a greater premium on predictability, transparency, and administrative capacity — favouring countries with stable, rules-based policy frameworks.

Figure 7 Gravity model estimates of fiscal drivers of FDI to low-income countries by uncertainty

Notes: The figure reports marginal effects from gravity regressions that interact each fiscal or institutional variable with country-specific uncertainty (measured by the World Uncertainty Index, WUI). Effects show the impact of a one–standard-deviation increase in each variable on expected FDI (US$), evaluated at low uncertainty (10th percentile of the standardised WUI) and high uncertainty (90th percentile). Regressions include baseline gravity controls and fixed effects. Bars denote 90% confidence intervals (see Annex VI for more details). Differences between high- and low-uncertainty marginal effects are formally tested; red symbols (*, **, ***) indicate statistically significant differences at the 90% confidence level. The Open Budget Index (OBI)–based fiscal transparency measure also shows a statistically significant difference, but with the opposite sign. Estimates based on IMF (2026).

From incentives to institutions

The policy implications are clear. While countries often rely on fiscal incentives to attract FDI, their effectiveness is conditional on institutional strength. In practice, incentives and institutions are complements rather than substitutes: incentives can operate at the margin, but only in environments where credibility is already established. This aligns with a broader lesson from the fiscal policy literature — that policy frameworks deliver results only when supported by strong institutions — for example, in the effectiveness of fiscal rules (Fatás et al. 2025).

Accordingly, policymakers should prioritise strengthening fiscal institutions and macro-fiscal frameworks before considering offering generous incentives that might bring in few benefits while resulting in revenue losses, both direct and indirect (by creating tax loopholes that are exploited by unintended beneficiaries). This need not involve sweeping reforms. Practical, incremental improvements — such as modernising tax administration, simplifying compliance procedures, enhancing the transparency and reliability of budget processes, and strengthening public investment management — can make a meaningful difference by reducing uncertainty, lowering compliance costs, and improving the overall investment climate.

Bottom-line message: There is a more credible path for low-income countries to attract development-enhancing FDI!

FDI has the potential to play a transformative role in low-income countries — but only under the right conditions. The central lesson from our research is that credibility, anchored in strong fiscal institutions, is a key determinant of both the volume and quality of foreign investment.

In a world of heightened uncertainty and more selective capital flows, this insight is particularly important. Low-income countries that invest in strengthening fiscal institutions and improving policy predictability will be better positioned to attract not just more FDI, but the kind of investment that supports long-term growth and structural transformation.

In short, the most effective investment promotion strategy is not to grant more generous incentives but to work towards strengthening state capacity and institutions.

Source : VOXeu