Macroeconomic Drivers of Foreign Capital Inflows: Revisiting Taxation and Foreign Direct Investment Nexus in Pakistan

Abstract

Foreign direct investment plays a critical role in the economic development of emerging economies, including Pakistan, by fostering job creation, industrialization, and the transfer of technology. Tax policy is a central determinant in shaping investor confidence and influencing the inflow of foreign direct investment. This study examines the impact of taxation policy on foreign direct investment in Pakistan, while also considering gross domestic product growth, exchange rate, and domestic interest rate as control variables. Annual time-series data from 1975 to 2024, sourced from the World Bank, the Economic Survey of Pakistan, and the State Bank of Pakistan, are utilized for empirical analysis. The findings reveal that both the tax rate and exchange rate exert statistically significant and negative effects on foreign direct investment inflows, indicating that higher tax burdens and unfavorable exchange rates act as deterrents to foreign investors. In contrast, the domestic interest rate exhibits a strong positive association with foreign direct investment, while gross domestic product growth does not show a significant impact. Diagnostic tests confirm the robustness of the model and indicate the absence of major econometric issues. The results underscore the pivotal importance of an investor-friendly tax regime in attracting and sustaining foreign direct investment in Pakistan. Policymakers are therefore encouraged to reduce the overall tax burden and maintain macroeconomic stability to enhance Pakistan’s attractiveness as an investment destination on the global stage.