Does Informality Deter Investment? An Empirical Analysis of FDI and the Informal Economy in EU and Candidate Countries

Abstract

This study examines the relationship between the size of the informal economy and foreign direct investment (FDI) flows in EU member states and EU candidate countries in the Western Balkans, as part of the wider Mediterranean region. The analysis' central hypothesis is that informality deters FDI, owing to factors ranging from institutional quality to unfair competition. Using data for the period 1996–2020 and employing Ordinary Least Squares (OLS) and Fixed Effects (FE) estimations, our results indicate that a larger informal economy significantly reduces FDI inflows and outflows only in non-EU countries, with no statistically significant relationship found for EU member states. This finding persists even after controlling for institutional quality, suggesting that the documented impact of the informal economy on FDI is not mainly through institutional weakness but rather through other underlying market distortions that prevail in highly informal markets. These insights underline the need for future research to examine more closely how informality affects market conditions and investment behaviour.