Published on Pambazuka News, by Dev Kar, June 2, 2011.
This paper, commissioned by the UNDP, explores the scale and composition of illicit financial flows from the 48 Least Developed Countries (LDCs). Illicit financial flows involve the cross-border transfer of the proceeds of corruption, trade in contraband goods, criminal activities and tax evasion. In recent years, considerable interest has arisen over the extent to which such flows may have a detrimental impact on development and governance in both developed and developing countries alike.
This Discussion Paper has been commissioned by UNDP as a contribution to the United Nation’s IV conference on the Least Developed Countries (LDCs), Istanbul, Turkey in May 2011. UNDP warmly welcomes feedback from interested stakeholders on any aspect of the research and conclusions drawn. It has been written by Dev Kar, formerly a Senior Economist at the International Monetary Fund (IMF), and now Lead Economist at Global Financial Integrity (GFI), Center for International Policy.
EXECUTIVE SUMMARY: … //
… 2. WHY LEAST DEVELOPED COUNTRIES ARE VULNERABLE TO ILLICIT
In his Keynote Address at a senior Policy Seminar on Implications of Capital Flight for Macroeconomic Management and Growth in Sub-Saharan Africa, South African Reserve Bank, October 2007, Prof. Njuguna Ndung’u, Governor, Central Bank of Kenya noted that:
Paradoxically, the accumulation of external liabilities in the region is mirrored by massive outflows of resources in the form of capital flight — the voluntary exit of private residents’ own capital for safe haven away from the continent. The latest estimates published by UNCTAD suggest that capital flight from Sub-Saharan Africa is fast approaching half a trillion dollars, more than twice the size of its aggregate external liabilities.
While Governor Ndung’u was referring to developing countries in Sub-Saharan Africa, most LDCs share certain characteristics which may be facilitating the cross-border transfer of illicit capital. A lower domestic savings rate relative to more developed emerging market countries mean that they are even more dependent upon external sources of capital to finance economic development and to fund poverty reduction efforts. Some researchers have also found a significant link between the growth of external debt and capital flight — the so-called revolving door effect.
On the one hand, most LDCs have poorly diversified economies and rely extensively on a few commodities to generate revenues, which are in turn subject to large price fluctuations internationally. On the other, LDCs tend to import a wide variety of goods due to the poor diversification of domestic industry. Customs duties on imports and on extractive mineral exports (where applicable) therefore contribute significantly to government revenues particularly given that direct income taxes are low due to a narrow tax base. This has led the IMF to conclude that: “For the foreseeable future, in any event, the central lesson is clear: for many developing countries, and especially the poorest of them, tariff revenue will continue to be a core component of government finances for many years to come”.
The IMF report notes that smuggling, defined as importation or exportation contrary to the law and without paying (or underpaying) applicable duties, will continue as long as tariffs are levied. The continuing importance of trade taxes in developing countries, particularly in the LDCs, thus creates a significant risk of smuggling.
Furthermore, LDCs typically have limited fiscal space to mitigate the impact of crises on the poor (such as increasing joblessness), nor the resources to launch large-scale new investments in infrastructure to stimulate the economy when there is an economic downturn. Additionally, significant fiscal deficits may spur the tax evasion component of illicit financial flows because higher deficits signal to private markets and high net worth individuals that taxes would probably have to be raised to close the revenue gap in the near future. The threat of higher taxes may result in larger tax evasion through illicit financial flows from LDCs into tax havens. However, as Sheets (1997) and others have noted, the empirical evidence on the adverse impact of fiscal deficits on illegal capital flight is not very clear.
There are other drivers of illicit financial flows from LDCs that are by no means unique to them. Kar (2011) found that a skewed and worsening distribution of income can drive illicit flows because of the expanding number of higher net worth individuals in economies with a relatively narrow tax base and weaker or more corrupt tax collection agencies compared to those operating in developed countries. The high net worth individuals then resort to the cross-border transfer of illicit capital in order to not only shield their growing assets from applicable taxes but to accumulate, in a clandestine manner, wealth far in excess of what declared incomes could have generated.
The other important driver of illicit flows is the size of the underground economy. A recent comprehensive study of the underground economy by the World Bank found that it is quite large in many LDCs. These estimates are likely to be understated because they typically do not include criminal activities such as burglary and robbery or trade in contraband goods such as drugs. Nevertheless, available empirical evidence point to the fact that the underground economy in LDCs can be a significant driver of illicit financial flows … (full long text).