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Illicit Financial Flows and their Developmental Impacts: An Overview

Marc Herkenrath
This article is a translation of:
Unlautere Finanzflüsse und ihre Entwicklungsfolgen: eine Übersicht

Abstract

Illicit financial flows cross-border capital movements for the purposes of concealing illegal activities and evading taxes pose major challenges to developing countries. They deprive the country concerned of urgently needed resources for private and public investment, thereby hampering infrastructure building and economic growth. This research overview shows that illicit financial flows also favour political changes that go hand in hand with the weakening of state institutions and growing corruption and rent-seeking. As yet, there are no empirical quantitative findings as to the exact functioning and significance of these effects. What is clear, however, is that approaches to problem-solving must come not only from the countries where illicit financial flows originate but also from the recipient countries offshore financial centres with a high level of financial secrecy.

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1. Introduction

1Historically, cross-border illicit financial flows (IFFs) that serve to conceal illegal activities and evade taxes are no new phenomenon. With the growing globalization of financial markets, however, their economic and political significance has grown markedly (GFI, 2013a). Both industrialized and developing countries are affected.

2The current scale of IFFs originating in developing countries cannot be measured precisely. There is nevertheless a consensus that for some years now they have been worth more than official development assistance from OECD donor countries. IFFs have therefore been occupying an ever more prominent place in development policy discourse (Herkenrath et al., 2012, Chap. 8). As the OECD underscores, for example, IFFs are perhaps one of the most significant causes of persisting development problems:

‘Every year huge sums of money are transferred out of developing countries illegally. These illicit financial flows strip resources from developing countries that could be used to finance much-needed public services, from security and justice to basic social services such as health and education, weakening their financial systems and economic potential. While such practices occur in all countries – and are damaging everywhere – the social and economic impact on developing countries is more severe given their smaller resource base and markets.’ (OECD, 2013, 15)

3Scientific studies on the economic consequences of IFFs are still rare however. Most common in the specialized academic literature are papers that subsume IFFs into the concept of capital flight and explore primarily the causes of that phenomenon. In contrast, regarding the impacts of IFFs, theoretical reflections and empirical case material can be found almost exclusively in reports by non-governmental organizations and policy commissions, motivated by their advocacy work. The World Bank publication Draining Development? (Reuter, 2012), which in part offers quantitative analyses and in part detailed case studies, is one of the major exceptions to this rule.

4This paper attempts to offer a critical review of the existing academic and non-academic research literature. The central question is how much is already known about the phenomenon from the scientific analyses and research so far conducted by civil society development organizations and think tanks, and where are there still gaps in the research. Besides the causes of IFFs, another main focus of this study will be their implications for political institution building and social development.

2. Conceptual Basis: What are Illicit Financial Flows?

5Whereas the concept of illicit financial flows is already quite well established in the international political discourse, it is still not yet very widespread in the scientific literature, which contains comprehensive theoretical and empirical writings referring to the concept of capital flight. This generally signifies financial transfers taking place under the portfolio choice model for reasons of profit making or for fear of political risks: ‘Generally, capital flight is understood as the movement of funds abroad in order to secure better returns, often in response to an unfavourable business climate in the country of origin.’ (UNECA, 2013, 2) Particularly as these capital movements are rationally motivated and seem to take place in reaction to investment-inhibiting conditions, they are treated to some extent as morally justified.

6Yet it is doubtful whether capital flight does in fact occur mainly for morally legitimate reasons. Ndikumana, (2013), for example, states that the enormous capital outflows from the African continent can hardly be explained any longer by insufficient investment opportunities in the countries of origin or as a reaction to political risks. Local investment opportunities are too many and the risks too negligible. The main reasons for continuing capital flight, according to Ndikumana (ibid., 7f.), are illicit motives such as tax evasion and the concealment of corruption:

‘Studies that use econometric analysis to uncover a relationship between capital flight and indicators of risk-adjusted returns to investment in the case of African countries find no conclusive evidence for the portfolio choice motive […]. This leads to suspect that to a large extent capital flight is driven by illicit motives. Therefore, it cannot be addressed solely by relying on policies aimed at raising the domestic return to investment in African countries.’

7Exponents of the IFF concept therefore turn the perspective around. To them it is clear that the originators of such capital outflows are not reacting primarily to unfavourable investment conditions but are playing a significant role in helping to trigger them. At the same time, the terminological shift from the concept of capital flight to that of IFFs underlines the shared responsibility of those industrialized countries that, as tax havens or so-called secrecy jurisdictions, not only facilitate such flows but actively encourage them.1Raymond Baker, who is frequently credited with the authorship of the IFF concept, describes this new understanding of capital flight as follows:

‘We particularly want to address the transition from the term illegal flight capital to the term “illicit financial flows”. […] Flight capital is an expression that places virtually the whole of the problem upon the developing countries out of which the money comes. It suggests, without quite saying so, that it is almost entirely their responsibility to address and resolve the concern. The expression illicit financial flows does a better job of clarifying that this phenomenon is a two-way street. The industrialized countries have for decades solicited, facilitated, transferred, and managed both licit and illicit financial flows out of poorer countries. This reality is becoming increasingly understood, and the growing global use of the term illicit financial flows contributes toward this end.’ (Baker, 2008, 6)

8The concept of IFFs is nonetheless vague and its content controversial. It is ‘marred by a lack of terminological clarity, which somewhat limits the emergence of effective policy options.’ (UNECA, 2013, 2) According to the OECD, a conceptual consensus has gradually emerged over recent years to the effect that IFFs are cross-border capital transactions either concealing illegal activities or facilitating them: ‘There are various definitions of illicit financial flows, but essentially they are generated by methods, practices and crimes aiming to transfer financial capital out of a country in contravention of national or international laws.’ (OECD, 2013, 16) This is a specific reference to transactions with assets that originate from crimes such as human trafficking, corruption, etc. or which are helping to fund such criminal activities, including even terrorism. In addition, there are transactions that serve to transfer legally obtained assets abroad unnoticed in order to evade taxes in the country of origin.

9Of course, equating illicit flows with illegal flows, which has largely been propagated by the OECD and numerous other bodies, is not without its problems.  It specifically overlooks the phenomenon of intra-firm profit shifting, whereby transnational corporations engage in so-called aggressive tax avoidance. Such transactions are not illegal in that they take account of the considerable room for interpretation existing in the international transfer price regime and exploit regulatory lacunae in national legal systems. This fact notwithstanding, they do lead to considerable losses in public revenues in the countries hosting the corporate groups concerned. When illicit financial transfers are equated with illegal transfers, the concept thus underestimates the overall scale of all capital flows that ultimately have a development-inhibiting effect.2

10Another problem with equating illicit and illegal financial flows is that the motivation to undertake prohibited transactions may sometimes depending on one’s ethical standpoint seem morally justified. As Blankenburg and Khan (2012) explain, equating illegal and illicit financial flows implies the existence of a legal system that reflects an overall societal consensus and which is sufficiently developed to represent central social and economic interests. In the case of some developing countries, this assumption applies only partially or not at all.

11It must be stated, however, that the illegal transfer of assets abroad affords privileged population groups the opportunity to circumvent the existing legal system whilst doing nothing politically to bring about improvements. As such, IFFs are detrimental to social and political advancement. As we will see in greater detail, IFFs contribute to preserving unequal power relations and to further weakening already weak state institutions. This also negatively impacts economic development opportunities.

12Blankenburg and Khan (ibid.) therefore define IFFs more broadly as financial flows that have a direct or indirect negative impact on (long-term) economic growth in the country of origin (depending on the particular national development situation). IFFs are defined here in terms of outcomes: ultimately, financial flows are only deemed illicit if they demonstrably hamper economic growth. This is precisely the problem with this alternative definition. The impact of a financial flow must already be known before it can even be deemed to be illicit. In empirical quantitative research at least, it is hardly possible, however, to gauge the impact of a phenomenon when that phenomenon cannot be circumscribed beforehand. Hence, there are no international comparative datasets with IFF estimates that correspond to this definition.

13Despite the aforementioned conceptual concerns, this review will therefore be based on a conceptual understanding that defines IFFs in reference to illegal activities. This definition was put forward by the Global Financial Integrity (GFI) research institute and is now in current use in various international organizations. It describes IFFs simply as ‘cross-border transfers of funds that are illegally earned, transferred, or utilized’ (GFI, 2013a). The principal advantage of this definition is that it also inspires the various datasets that measure IFFs quantitatively (ibid.; Henry, 2013; Ndikumana, 2013). The main feature common to these datasets is that they are based principally on financial flows that are unregistered in the country of origin. The basic operating premise here is that the transfers in question take place via unregistered channels because their background or purpose is illegal.3 The aforementioned definition also underlies all empirical studies that will be subsequently discussed.4

3. Empirical Trends: Illicit Financial Flows since 2000

14The scale and regional composition of IFFs out of developing countries are a matter of controversy. In the view of the OECD, however, there is general consensus that these flows not only surpass official development assistance, but even the sum of those aid flows and foreign direct investment (OECD, 2013, 15). Development experts are therefore largely agreed that on average developing countries are experiencing net capital outflows. This means that these countries are losing more money through loan repayments, interest payments, IFFs, and in particular through the formation of currency reserves than they are receiving in the form of new loans, development aid, direct investment, etc. (AfDB and GFI 2013; UNDESA, 2014, 65ff.).

15There is also some agreement that the IFF data from the aforementioned research organization GFI provide a relatively solid basis for time and country comparisons (for a critical discussion: Henry, 2013). Not least, the GFI estimates constitute the most comprehensive dataset, which, in addition to cross-national comparisons, also allows for longitudinal comparisons over longer time periods. A series of basic empirical statements can therefore be derived from this data, statements which, as stylized facts, would hardly elicit too much opposition.

16The most important finding from the GFI estimates is that IFFs from developing countries have been showing certain annual fluctuations since the turn of the millennium but are trending sharply upwards. Between the years 2000 and 2010, the overall volume grew from around USD 370 million (GFI, 2011) to around USD 860 billion (ibid., 2012). The estimated value for 2010 however is based on a more conservative calculation method than that for 2000. Had the same method as for the year 2000 been used, the value at the end of the 2000s would even have reached around USD 1,110 billion (ibid.). What is clear is that the over 10 per cent average annual growth rate of IFFs from developing countries considerably surpassed economic growth in the countries concerned (GFI, 2013b).

17What is also remarkable is that there has been growth in IFFs in all developing regions to date, though at markedly different rates. For the 20022011 period, GFI concludes that ‘[t]he Middle East and North Africa (MENA) region registered the fastest trend rate of growth in illicit outflows (31.5 per cent per annum) followed by Africa (19.8 per cent), developing Europe (13.6 per cent), Asia (7.5 per cent), and the Western Hemisphere (3.1 per cent).’ (Kar and LeBlanc, 2013, 21) As regards the absolute scale of illicit financial outflows from developing countries, Asia topped all regions in 2011 with an outflow of around USD 285 billion. It was followed by the developing European countries (200 billion), Latin America and the Caribbean (116 billion), and by the MENA region (87 billion). With 52 billion altogether in 2011, sub-Saharan Africa’s developing countries showed the lowest illicit financial outflows (ibid., 9 [Table 2]).

18When these figures are weighted by the respective gross domestic product (GDP) however, the picture becomes inverted. With a 5.7 per cent share of regional GDP, IFFs in Africa would be clearly more substantial than, for example, those in the developing countries of Europe (4.5 per cent) or Asia (4.1 per cent). As regards IFFs from the MENA region and from Latin America and the Caribbean, GFI figures show similar relative values, but differing dynamics: ‘[L]eakages of illicit capital from MENA and the Western Hemisphere equal about 3.5 per cent of regional GDP. However, in the case of MENA, outflows as per cent of GDP increased significantly from 1 per cent in 2002 to 6.8 per cent in 2009, before declining to 3.9 per cent in 2011. In contrast, barring a few upticks, outflows from the Western Hemisphere as a share of regional GDP have declined steadily from 4.1 per cent in 2002 to 2.6 per cent in 2011.’ (ibid., x). In the 48 least-developed countries, IFFs made up on average 4.8 per cent of GDP for the 1990–2008 period (UNDP, 2011, 3).

19There are also some regional differences with respect to the composition of IFFs. In the 2001–2010 period, for example, for all developing countries on average, some 80 per cent of all IFFs was attributable to what is called ‘trade misinvoicing’, in other words over-invoicing or under-invoicing of the goods traded between companies (whether associated or not). In the MENA region in contrast, financial transfers in the context of corruption and bribery were the main component of all IFFs, business-related IFFs by comparison being only 37 per cent. The share of trade-related IFFs was at least 65 per cent in Africa, and as much as 94 per cent in Asia (Kar and Freitas, 2012, j f.).

20It can therefore be affirmed on balance that there are indeed regional differences when it comes to the scale and composition of IFFs. As pertains to GDP-weighted IFFs, there is also a clear intraregional variance.  In the Republic of the Congo, for example, IFFs accounted for over 25 per cent of GDP, in Chad, some 20 per cent, and in Angola just under 10 per cent (AfDB and GFI, 2013, 26 [Chart 5b]; see also UNDP, 2011). What these intra-African differences show is that regional dynamics play a smaller role in the creation of IFFs than do country-specific factors. It would therefore be misleading to attempt to explain existing regional differences by content. It makes much more sense to look for country-specific explanatory factors. Conversely, the general increase in IFFs across all developing regions shows that these flows are a global phenomenon. As such, it should be clear that IFFs are not exclusively dependent on intra-societal factors, but also on factors external to the societies concerned.  

4. Determinants of Illicit Capital Flight

21Empirical studies that subsume IFFs into the concept of capital flight are generally based on the aforementioned portfolio choice (PC) model when it comes to explaining those flows. This implies that the massive capital outflow from developing countries is by and large the result of aversion to risks such as expropriation and currency losses and a reaction to comparatively low (risk-weighted) profit expectations (Collier et al., 2001). The transactions concerned are motivated by ‘incentives to move assets out of environments with relatively low and risky returns.’ (Ibid., 2004, ii16). These transactions are illegal only because the governments concerned are attempting to stop the financial outflow by means of capital export restrictions and similar measures.

22It is hardly surprising that the financial sectors in the countries of destination of illicit capital flows in other words, tax havens or secrecy jurisdictions also regularly invoke the assumptions of the PC model. After all, the model gives a veneer of moral legitimacy to the acceptance of illicit, fiscally undeclared financial flows from developing countries. Financial secrecy in all its forms, ranging from strict bank secrecy, to certain trust provisions, to the offer to set up bogus companies, appears as a protective measure for respectable citizens attempting to place their assets safely beyond the reach of corrupt and incompetent governments.5

23Yet the PC model leaves much unexplained. It falls short more specifically when it comes to explaining IFFs originating in economically successful industrialized countries and fast-growing emerging countries, flows that mainly serve the purpose of tax evasion. It would make seemingly little sense to assume that these capital movements are mainly related to the explanatory factors central to the PC model namely, flight from economic stagnation, political instability, or the risk of expropriation. While tax flight from prosperous countries may well be regarded as economically rational, it goes beyond the theoretical scope of a model in which illegal capital movements in essence seem to be a morally justified response to investment risks. The fact that IFFs could serve their originators as a means of escaping their civic duties under democratic and legitimate fiscal legislation is clearly not taken sufficiently into account here.

24Yet, when developing countries alone are analysed, the empirical quantitative research would seem to support the assumptions of the PC model to a certain point even though no single explanatory factor has proven robustly significant across all the studies concerned (for a research overview in table form: Ndikumana and Boyce, 2003). Much would seem to indicate that capital flight from developing countries depends, inter alia, on currency exchange risks, perceived growth opportunities, government instability, the danger of civil strife, and various other political risks (Lensink et al., 2000; Collier et al., 2001, 2004; Le and Zak, 2006).6

25It must be noted however that, on the whole, the factors mentioned have only limited explanatory power. They too are hardly suitable for explaining the long-term overall growth of IFFs. Le and Zak (2006), for instance, lay claim to having carried out the most comprehensive test of the PC model to date. Yet the explained variance of their final empirical model (ibid., Table C1 [p. 325], models 810), with an R2 of 0.39 to 0.43, lies clearly below 50 per cent. Besides, the model's explained variance again falls drastically (to 0.090.25) if, instead of just a cross-comparison of various countries, a longitudinal comparison is also made (ibid., Table 1 [p. 317], models 810). This would suggest an alteration in the overall volume of IFFs over time, which can be explained less by the internal factors examined, but principally by external trends.

26Proponents of the IFF concept therefore assume a radically different explanation for the phenomenon of (illicit) capital flight. Their view is that the general growth of IFFs is ultimately a reaction to the advancing global integration of the financial system and the readiness of numerous offshore financial centres to provide help in concealing illegally acquired, untaxed assets. Moreover, proponents of the IFF concept underline that the originators of such flows in the countries of origin are hampering economic growth and weakening state institutions. From this perspective, therefore, IFFs are not just a consequence, but also a key cause of development-inhibiting circumstances (see, for example, Shaxson, 2010; Moore, 2012). Lastly, the IFF discourse stands for a theoretical model that implies a circular relationship between IFFs and development-inhibiting economic, political and social conditions (Moore, 2012).

27This circular relationship is also supported not least by the findings of a more recent quantitative country comparison carried out by Cerra et al. (2008). In it, the authors show that at a particular point in time IFFs would seem to be influenced only relatively negligibly by other factors, as soon as the research model also checks the level of IFFs at an earlier point in time. In this study, the level of IFFs at the beginning of the investigation period even proves to be the strongest predictor of subsequent IFFs. It may therefore be assumed that there is a causal link between IFFs and social ills, which themselves in turn trigger further IFFs.

5. Economic Consequences of Illicit Financial Flows

28There is broad consensus amongst multilateral development banks that most developing countries are unable to mobilize enough domestic investment capital to ensure robust, long-term economic growth (cf. Ndikumana, 2013; critical: Easterly, 1999). Not least, public investment funds are scarce for the funding of infrastructure and social policy measures for poverty alleviation (AfDB et al., 2012, 69ff.). As the African Development Report 2012 underlines, one of the major impacts of IFFs is that they further widen these funding deficits:

‘Investment is one of the most important conduits through which capital flight affects human development. If flight capital was saved and invested in the domestic economy of the country of origin it would increase income per capita and help to reduce poverty. In Nigeria and Angola, for example, this would imply additional investment of USD 10.7 billion and USD 3.6 billion per year, respectively in the period 2000 to 2008.’ (Ibid., 79)

29It would be a mistake to assume, however, that there is a one-to-one relationship between IFFs and investment losses. IFFs sometimes facilitate round-tripping and immediately return to the country of origin supposedly as foreign direct investment (TJN, 2007, 18f.).7  As stressed by Blankenburg and Khan (2012), some types of IFF can moreover lead to additional capital inflows into the country of origin. Examples of this would be IFFs that facilitate labour migration and ultimately increase inflows of remittances.

30The amount of capital that flows back into the countries of origin would on average be markedly less than the original outflows however. In an empirical study of thirty-nine African developing countries from 1970 to 2010, Ndikumana (2013) demonstrates that IFFs (weighted according to the size of the economy concerned) have a robust and despite the problems of measurement plaguing IFF estimation in all cases a statistically significant investment-inhibiting effect. What is, however, interesting is that this effect concerns private investment first and foremost, whereas the impact on public investment turns out to be insignificant. According to Ndikumana, the reason for this difference is that the funding gaps IFFs create in public investment can sometimes be offset by foreign development funding and in particular by further public borrowing.

31By and large, it may be considered an empirical fact that there is a close connection between IFFs and the public debt ratio. The connection works both ways, of course (Ndikumana and Boyce, 2003; Beja, 2006). Hence, IFFs can force the governments concerned to resort to flight-driven external borrowing. Conversely, foreign loans can also serve to trigger debt-fuelled capital flight. In this case, loans that have been contracted or guaranteed by the government flow immediately and directly into foreign private accounts. In both cases, IFFs compound government indebtedness and hence dependence on foreign aid together with its implicit and explicit policy conditionalities.

32To gauge the extent to which the investment-inhibiting effect of IFFs impacts economic growth, Ndikumana (2013) used data from a number of African developing countries to conduct an econometric simulation. The central question of the counterfactual study is how much additional growth the affected countries might have achieved without illicit financial outflows. The findings are of course plagued by a number of uncertainties, but the trend is impressive.8  Ndikumana concludes that the thirty-nine countries studied over the period from 2000 to 2010 might have been able to achieve on average 3 per cent more economic growth had there been a radical stop to all IFFs. In oil-exporting countries, which are especially prone to illicit financial outflows, that additional growth might even have been 3.9 per cent.

33Ndikumana’s simulation makes the basic assumption that IFFs could be 100 per cent productively invested in the country of origin. This seems just as unrealistic as the assumption that all IFFs could be radically stopped. In this regard, the simulation could overestimate the growth effect that would actually result from drastic measures to limit IFFs. At the same time, the author overlooks the fact that a significant reduction in IFFs could lead to significant improvements in the quality of infrastructure and public institutions (see below). This would positively impact not only the level of domestic investments, but also the growth they would bring about. In his model’s calculations, Ndikumana nevertheless assumes that there is a constant growth yield from each unit invested. Hence, his simulation could also markedly underestimate the additional growth that would result from effectively halting IFFs.

6. Social and Political Consequences of Illicit Financial Flows

34The investment- and growth-inhibiting impact of IFFs also indirectly hampers potential progress in the realm of human development and the guarantee of basic human rights. Hence, the African Economic Outlook 2012, using the example of African developing countries, underscores that without IFFs those countries could have made appreciably more headway than they have so far in poverty reduction:

‘[C]apital flight out of Africa is undermining the continent’s efforts to reduce poverty. If the lack of financial resources was the only constraint to human development, investing flight capital from Africa with the same efficiency that has characterized real investment would have reduced headcount poverty by an additional 4 to 6 percentage points. With this performance, African countries as a group would halve extreme poverty by 2015 in line with the MDGs.’ (AfDB et al., 2012, 77)

35It is nevertheless important to note in this context that IFFs do not impact the social development of the populations concerned through their financial effects alone. Rather, IFFs affect social development also through their impact on the quality of political institutions, tax systems, and social cohesion (Maton and Daniel, 2012; Moore, 2012; OECD, 2012; Torvik, 2009). Hence, using various historical and contemporary examples (the Philippines, Indonesia, Malaysia, Zaire, etc.), the Norwegian Commission on Capital Flight (2009, 82ff.) discusses how national and local governments systematically undermine existing state institutions in order to amass private fortunes and secretly transfer them abroad. Case studies by Tax Justice Network Africa (e.g. Waris, 2009; Prichard, 2009) also show how widespread tax evasion complicates the task of the government to provide basic public services and move ahead with urgently needed institutional reforms. The rapidly increasing opportunities for secretly transferring assets abroad therefore go hand in hand with development trajectories that in essence are leading to the worsening of existing political ills (Moore, 2012).

36It should also be borne in mind that, depending on context, IFFs can have a range of motives and consequences (Blankenburg and Khan, 2012). In the review of policy impacts that follows, a distinction is drawn between two typical forms of IFF. On the one hand are IFFs that are fuelled from illegal sources – namely, corruption and the embezzlement of public funds, and on the other, those that actually come from legal activities, but which serve tax evasion purposes. The distinction is important in that IFFs from illegal sources are more frequent in less developed countries with generous raw material endowments and weak institutions, whereas IFFs for the purposes of tax evasion are mostly found in middle-income countries with relatively well-developed tax systems.9

6.1. Illicit Financial Flows from Illegally Acquired Assets

37Not only are IFFs closely bound up with the funding of terrorism and transnational organized crime (human trafficking, drug crimes, the illegal arms trade, etc.), they also have a symbiotic relationship with political (‘grand scale’) corruption. As Moore (2012, 474) underlines, the opportunity to secretly transfer abroad the proceeds from illegal activities and escape justice increases the risk premiums of such activities: ‘The potential to hide illicit capital securely in tax havens is a direct stimulus to corruption and other illicit activities such as transfer mispricing. It decreases the chances of detection and therefore increases the likely returns.’ This is why the OECD (2012) describes illicit financial flows as one of the main international drivers of corruption.

38In terms of a secondary effect, the opportunity to transfer assets from illicit sources abroad also leads to distorted public and private investment decisions. Corrupt members of governments and administrations will make every effort to enact regulations and channel public investments towards sectors that offer the best opportunities for bribery (Commission on Capital Flight, 2009). Tanzi and Davoodi (2002), for example, show that corrupt governments channel public funds with above-average frequency into massive infrastructure projects, but hardly invest in the upkeep of that infrastructure, upkeep that offers far less opportunity for corruption. With companies on the other hand, the danger is that rather than promoting economically productive activities, they could devote considerable amounts of money to maintaining good political relations with a view to obtaining economic privileges. The consequence of the corruption that goes hand in hand with massive IFFs is therefore perhaps the emergence of a veritable rent-seeking economy (UNECA, 2013, 10).10

39What is clear is that corruption and rent-seeking are particularly frequent in commodity-rich countries. Commodities do, after all, offer political elites excellent opportunities to appropriate earnings from them and transfer them abroad. IFFs are also one of the key reasons why earnings from raw materials only rarely translate into sustainable developmental progress (the ‘paradox of plenty’). On the basis of Bank of International Settlements data, Andersen et al. (2013) demonstrate that commodity earnings in the case of countries with weak political institutions lead to a marked increase in private bank holdings in well-known tax havens. The effect moreover is significant not just statistically, but also in economic terms: Andersen and his co-authors maintain that in autocratically governed countries, at least 8 per cent of state oil revenues become private assets held abroad.

40Case studies furthermore show that the discovery of raw materials is frequently followed by a clear weakening of existing political institutions (Maton and Daniel, 2012; OECD, 2012). As Moore (2012, 474) emphasizes, one of the key reasons for this weakening is most likely that it makes things even easier for those in power to appropriate raw materials earnings and transfer them abroad:

‘Especially in polities characterized by high degrees of socioeconomic inequality and little or no effective institutionalized popular control of the actions of political elites, those fractions of the political elites that are able and willing to participate in this nexus of corrupt internal accumulation and illicit capital outflows are also motivated and able to create or change the rules of the game to ensure that they can continue playing it in a rewarding way. In practice, this is likely to mean tax agencies that collect enough money to run basic government services, but have low overall capacity, especially in dealing with complex international issues such as transfer pricing; police services that lack investigatory powers; court systems vulnerable to corruption; weak public audit offices that lack independent authority; legislatures that lack collective cohesion and authority; fragile, unstable political parties motivated by money and patronage; and public services that lack a collective, professional ethos.’

41It may therefore be said on balance that IFFs are closely tied up with weak political institutions. On the one hand, they are a consequence of weak institutions (Cerra et al., 2008) and on the other, they also contribute to weakening them even further. Not least, they are partly responsible for the fact that the commodity wealth of many least developed countries has not translated into developmental progress, but into a veritable ‘resource curse.’

6.2. Tax Evasion

42According to calculations by the International Monetary Fund (IMF, 2011, 12ff.), the average tax ratio (tax revenues as a percentage of GDP) of developing countries has risen slightly over the past 1015 years. The main factors behind this increase are the more widespread use of VAT, and the commodity boom, which led to a slight increase in corporate tax revenues. Despite this, the average tax ratio of developing countries continues to be too low around 17 per cent (versus over 30 per cent in OECD countries). Countries such as Burundi, Ethiopia, and Guinea-Bissau recorded tax revenues of just over USD 35 per capita and year in 2009 (Atisophon et al., 2011, 19).

43The reasons for these low tax revenues lie most of all within the countries concerned. Many developing countries lack the necessary financial, administrative, and human resource capabilities for building up and enforcing effective tax systems (Herkenrath et al., 2012, 4f.). But like industrialized countries, which have well-equipped tax authorities and sophisticated laws in this field, developing countries too suffer from the consequences of international tax evasion. In addition to income tax on natural persons, it also affects corporate profit taxes in particular.

44To date there are no official statistics from the UN, OECD, or World Bank regarding the amount of revenue losses occurring in developing countries as a result of tax evasion by private persons and companies (Henry, 2013). Estimates by international non-governmental organizations would however suggest that these losses are considerable. Cobham (2005), for instance based on Tax Justice Network data from the year 2005 concluded that developing countries are losing some USD 51 billion in potential tax revenue annually owing to tax dodging by well-to-do private individuals. In a study commissioned for the development organization Oxfam in 2009, James Henry already estimated this amount to be USD 64124 billion (Henry, 2013). As pertains to corporate tax evasion, Oxfam concluded for the year 2000 that trade mispricing was costing developing countries additional tax revenue losses of about USD 50 billion per annum (ibid.) Christian Aid (2009), by contrast, estimated such losses for the 20052007 period to be as much as USD 122 billion and for the year 2008 to be around USD 160 billion (Christian Aid, 2008) an estimate that was recently confirmed by Murphy (2012) in a comparatively rigorous empirical test.11

45Yet taxes mean significantly more than government revenues for development funding. Numerous studies from the field known as New Fiscal Sociology suggest that tax systems also exert considerable influence on the dynamics of State building and the perception of social income and power relations. In the specialized literature on the developmental implications of taxes there is broad agreement that taxes fulfil at least four central social functions (the so-called ‘4 Rs of taxation’; see Cobham, 2012). Alongside revenue creation, these include the redistribution of income and assets, and the curbing of socially undesirable behaviour, for example by means of tobacco and alcohol taxes (repricing). Also of pivotal significance is the role of taxes in the realm of democratic State building (representation).

46Tax evasion therefore simultaneously undermines the usual workings of tax systems in many respects. Not only does it reduce state revenues, it also limits the ability of the countries concerned to balance out conflict-laden inequalities through taxation. Lastly, as the authors of the African Economic Outlook 2012 acknowledge with refreshing directness, tax evasion is a privilege of the economic and political elites:

‘Capital flight also deepens inequality. The people benefiting from capital flight are the elites who engage in trade mispricing of imports and exports or those who have the power to unlawfully appropriate and transfer resources abroad. Almost all the people engaging in capital flight in Africa are among the 10% richest segment of the population […]. Even in countries where capital flight is mainly driven by portfolio considerations, it is the wealthy who benefit as they have access to foreign investment instruments that average citizens do not.’ (AfDB et al., 2012, 73)

47As such, it is no surprise that ‘personal income tax commonly accounts for less than 10 per cent of all tax revenue in low-income countries – compared to an average of more than 25 per cent in OECD countries – and is widely recognized as essentially a tax on the labour income of those working in the public sector or large private enterprises’ (Keen, 2012, 10). Those actually paying income tax must often also face relatively high VAT, which tends to be regressive in effect, with which the state attempts to offset tax losses in the higher income brackets and in the taxation of corporate profits.

48Tax evasion by well-to-do individuals and transnational corporations therefore ultimately also undermines social cohesion. On the one hand it hampers the performance of basic state functions and thereby undermines the legitimacy of the political system. On the other, it gives rise to a certain shifting of the costs of public services and infrastructure to small and medium-size local enterprises and the low- and middle-income brackets. The consequences of this burden shifting are, inter alia, that in some developing countries the tax system is the subject of insufficient social consensus; it is perceived as forced upon society, and calls for a suitably well-equipped enforcement machinery (D'Arcy, 2012).

7. Summary and Conclusion

49The direct economic impacts of illicit financial flows from developing countries cannot be precisely quantified. It may however be considered empirically proven that not only are they negative, but also of great consequence. There is broad consensus in the political and economic literature that IFFs deprive the affected countries of appreciable amounts of investment funds, which could otherwise spur economic growth and usefully complement foreign loans and aid payments in funding the public sector.

50As pertains to the political consequences of IFFs, there has been to date a certain lack of empirical scientific studies. More specifically, there is a lack of quantitative country comparisons that could provide detailed empirical findings as to the significance and size of the effect of the impacts being posited. This notwithstanding, there are good grounds for assuming that IFFs are by no means merely a reaction to unfavourable business conditions, bad governance, and political instability. In point of fact, case studies and theoretical analyses suggest that the opportunity to transfer capital unnoticed and untaxed abroad provides powerful incentives for organized crime, corruption, and rent seeking all of which are irregularities that in turn fuel even more IFFs. At the same time, IFFs serve private individuals and companies for tax evasion purposes, they deprive the affected country of potential public revenues, exacerbate inequalities, and also undermine social cohesion and political stability. On balance, therefore, there may well be a circular relationship between IFFs, development-inhibiting economic policy environments, and weak political institutions.

51With this in mind, it would also be wrong to dismiss international policy measures designed to curb IFFs as merely combating the symptoms in development policy terms. The problem should indeed be tackled at the root. Hence, there is undoubtedly greater need for international financial and technical cooperation, for example, in combating corruption and in reforming fiscal systems. IFFs are not merely a symptom, however, but also a causal component of pressing developmental problems. It is therefore incumbent on offshore financial centres, which make such flows possible in the first place by means of various secrecy mechanisms, to take countermeasures in their own spheres of influence.  

52A broad range of possible countermeasures are now being discussed internationally. These include the automatic exchange of information in tax matters; extended administrative assistance allowing for supplementary requests for information in addition to the tax data automatically shared; the systematic registration and disclosure of the effective economic beneficiaries of companies, trusts, and foundations; and the detailed breakdown of corporate group accounts by country and by project. Of course, it remains largely an open question whether, when, and in what form these measures may in fact be implemented worldwide.

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Notes

1   Secrecy jurisdictions are deemed to be ‘jurisdictions that deliberately create legislation to ease transactions undertaken by people who are not resident in their domains, with a view to avoiding taxation and/or regulations, which they facilitate by providing a legally backed veil of secrecy to make it hard to determine beneficiaries’ (Palan et al., 2010, 236).

2   Conversely, Blankenburg and Khan (2012) use a series of examples to show that illegal financial flows sometimes lead to an increased inflow of foreign funds and ultimately exert a positive influence on economic development. With this in mind, equating IFF with illegal financial flows could also overestimate their negative developmental consequences.

3   A discussion of the various estimation methods for quantifying IFFs would be beyond the scope of this article (for a critical overview, see Kar and LeBlanc, 2013, and Henry, 2013).

4 Although it could seem useful from a theoretical standpoint to put forward a different definition of illicit financial flows, this would lead to inconsistencies with respect to the empirical findings still to be discussed.  Regrettably, no convincing estimation procedure has yet been developed to gauge the scale of illegal  financial flows that do not entail any illicit activities (or vice versa).

5   Konrad Hummler, the then CEO of Swiss private bank Wegelin & Co., made just this argument in August 2009: 'Just imagine an African country. Meaningful economic activity takes place there because it is possible for those resident there to accumulate the profits somewhere offshore. It would not work any other way.’ (NZZ, 8.8.2009)

6   Generally, no significant effects emanate from perceived corruption and other governance indicators (Collier et al., 2001; Ndikumana and Boyce, 2003).

7   Round-tripping can help local enterprises protect investments from expropriation (in particular if there is an investment protection agreement between the countries concerned), though presumably it serves more often to secure tax advantages for foreign direct investments and other privileges (access to free trade zones or special production zones with particularly good infrastructure). Not least, round-tripping can also serve to recycle illegally gained assets, in other words, for money laundering.

8   Thus, Dort et al. (2013) demonstrate that investments in countries with a robust institutional structure produce significantly more growth than in countries with weak institutions.

9   In poorer countries with massive raw material reserves, tax evasion is less significant than are other reasons for IFFs, as many of these countries hardly collect any income tax. They either have extremely low income tax rates or extensive opportunities for deductions, especially in the higher income bracket. This is so because the governments of these countries have little incentive to levy personal income taxes, but benefit instead from natural resource rents: ‘Governments funded principally through point natural resource extraction tend to treat their citizens badly in terms of civil and political rights, health and education services, and public infrastructure provision because they have so little need of their citizens. (…). Cash from oil and minerals obviates the need for a booming economy and tax revenues and pays for the recruitment of mercenaries and (politically docile) immigrant workers to provide essential skills.’ (Moore, 2012: 464)

10   For critical contributions to the thesis that rents at any rate have adverse economic and political consequences, see Khan and Jomo (2000).

11   As Fuest and Riedel (2009) have rightly emphasized, the various estimates of capital flight-related tax losses of developing countries are plagued with considerable uncertainties and are based on somewhat problematic premises. This notwithstanding, it seems reasonable to assert that tax evasion by wealthy individuals and international companies deprive these countries of considerable government revenues. If we deduct a possible margin of error of 33 per cent in each case from the most recent estimates made by the two relief organizations Oxfam and Christian Aid (tax losses of USD 64 billion in personal income taxes and USD 160 billion in taxes on corporate profits), we would still arrive at an overall tax loss of approximately USD 149 billion (64x2÷3 + 160x2÷3) i.e. more than the roughly USD 135 billion invested by OECD donor countries in 2013 in the shape of official development assistance.

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Cite this article

Electronic reference

Marc Herkenrath, « Illicit Financial Flows and their Developmental Impacts: An Overview », International Development Policy | Revue internationale de politique de développement [Online], 5.3 | 2014, Online since 26 January 2015, connection on 18 December 2017. URL : http://journals.openedition.org/poldev/1863 ; DOI : 10.4000/poldev.1863

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About the author

Marc Herkenrath

Mark Herkenrath is an associate professor (Privatdozent) of Sociology at the Universities of Zurich and Freiburg (CH). He lectures on social movements, globalization theories, and contemporary developmental issues. Dr. Herkenrath’s main activity is with Alliance Sud, the Swiss coalition of development organisations, where he heads the International Finance and Tax Policy division.

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