Using Taiwanese firm-level data, we confirm that foreign direct investment and R&D have a positive impact, or spillover effect, on productivity. Furthermore, labour quality, firm size, market structure, and export orientation all affect a firm's productivity. Applying Heckman's [1976] two-stage estimation method, we find that firms self-select into R&D or non-R&D groups. After correcting for this selection bias, we find that foreign direct investment, local technology purchase, and outward foreign investment are substitutes to R&D activity. These results are mainly due to the significant effect of industry-wide technology spillovers. The major policy implications derived from this study are that governments in developing countries may first wish to adopt policies encouraging foreign direct investment to foster technology transfer and industry-wide knowledge spillovers in the short run. However, once the country's technological capability is established it appears critical to switch towards policies that provide a preferred environment to stimulate R&D investment (for example, infrastructure improvement and protection of intellectual property rights) to allow for sustainable economic growth.