Despite large investment and development needs, low-income countries (LICs) continue to attract less than 1 percent of global foreign direct investment (FDI), with inflows increasingly concentrated in sectors such as energy and extractives that tend to generate fewer technology spillovers and high-quality jobs. This reflects the difficult environment LICs face for attracting FDI: global capital is scarce and increasingly selective, uncertainty remains high, and governments feel pressured to offer tax holidays and other incentives to compete for investment.
Against this backdrop, we undertake a detailed empirical evaluation of the role of fiscal policy and fiscal institutions in shaping the volume and quality of FDI in LICs. We find that countries with stronger fiscal discipline and better fiscal institutions—especially revenue administration and public financial management (PFM)—tend to attract more FDI, with these effects stronger in LICs relative to emerging market economies and during periods of elevated economic and political uncertainty. The analysis also shows that stronger fiscal institutions are associated with higher-quality investment, including in more innovation- and technology-intensive sectors, and that they matter more for attracting FDI than broader measures of institutional quality. By contrast, fiscal incentives such as tax reductions or special economic zones (SEZs) appear to be effective only when supported by strong fiscal frameworks and institutions; in weak institutional settings, their impact is limited.
The paper carries important policy implications: rather than trying to attract FDI through fiscal incentives that bring few benefits and create tax loopholes, countries should focus instead on strengthening their core fiscal institutions and maintaining fiscal discipline. This, in turn, underscores the need for sustained capacity development efforts to improve revenue administrations, strengthen PFM systems, and build the fiscal credibility needed to support higher-quality and more resilient FDI.
