Shadow Economy and Foreign Direct Investment Inflows: Evidence from Malaysia

Abstract

Despite Malaysia’s reputation as one of the most attractive destinations for foreign direct investment (FDI) in Asia, the nation has experienced a downward trend in FDI flows since reaching a peak in 2011. This sustained decline warrants a critical examination of the shadow economy, a lesser-explored determinant of FDI, impeded by measurement challenges. By focusing on the roles of smuggling and tax evasion − two key components of the shadow economy − this study examines their impact on Malaysia’s attractiveness to foreign investors. Our research utilises data from Malaysian Customs annual reports from 1999 to 2018 and employs the autoregressive distributed lag technique to analyse the relationship between the shadow economy and FDI inflows. The findings reveal a significant negative impact: the uncertainties created by smuggling and tax evasion impose additional costs on investors, thereby deterring FDI. This study underscores the urgent need for Malaysia to enhance its investment climate through the establishment of transparent and unambiguous laws, rules and regulations,
thereby reducing investor uncertainty and revitalising FDI inflows.