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Stemming illicit fund flows

November 30, 2017 00:00:00


What is illicit financial flow?

While many definitions of illicit financial flow (IFF) are out there, IFF can be broadly defined as financial flows which include, but are not limited to, "cross-border transfers of the proceeds of tax evasion, corruption, trade in contraband goods, and criminal activities such as drug trafficking and counterfeiting" (Kar 2011). IFFs have become a common phenomenon across the globe - in developed, transitional and emerging countries alike. IFFs from the developing countries are leaving a deep scar in the investment regime of these nations. The United Nations (2013) classified IFFs into three main forms: "(i) the proceeds of theft, bribery and other forms of corruption by government officials; (ii) the proceeds of criminal activities including drug trading, racketeering, counterfeiting, contraband, and terrorist financing; and (iii) the proceeds of tax evasion and laundered commercial transactions".

Curiously, laundered commercial money through multinational companies constitutes the largest component of IFF, followed by proceeds from criminal activities and corruption. While every dollar leaving one country would end up in another, illicit moneys from developing countries end up either in banks of developed countries or in tax havens. A recent Global Financial Integrity (GFI) report suggests that about 45 percent of IFFs cater to offshore financial centers while 55 percent are channeled to developed countries.

With the operational presence of a range of illicit financial flow channels (diagram above), developing country authorities have been somewhat vigilant towards combating and preventing IFFs. Enforcement of stricter restrictions as regards capital flows in recent years, agents of IFF have resorted to trade-based money laundering through trade misinvoicing and mispricing. The graph below shows the different levels of IFFs in South Asian countries (with India and Bangladesh plotted in the secondary axis). It can be observed that IFFs in these developing countries are in the range of billions - even if we do not want to make an assumption about the increasing trend of respective IFFs, a sustained outflow of capital can be definitely inferred from this graph.

Tax evasion and Illicit Financial Flows: Tax systems in developing countries are plagued with poor capacity, corruption and lack of any reciprocal link between tax and public and social expenditures. In essence, tax authorities of developing countries face a plethora of constraints to build more effective domestic tax systems and ensuring compliance. In this context, the first constraint to better tax revenue generation is weak tax administration. The second constraint is low taxpayer morale. Low tax payer morale is likely to be in attendance in economies with corruption and poor governance (weak rule of law and political instability)."Hard to tax" sectors or the informal economy including agriculture, small businesses and professionals is the third constraint to higher tax collection. Although estimates of the informal economy stand at 40 to 60 per cent of GDP in developing countries, it is not the presence of the informal economy to solely account for the burden of low tax collection; it is the attitude of non-compliance which is a greater malevolent contributing to this facet.

Arbitration and Illicit Financial Flows: Arbitration here refers to the illegal capital outflow from the host country to some other destination with fewer banking regulations and opportunity to earn higher returns on capital. The main actors behind arbitration being corporations, these businesses are less prone to exchange rate risks and at times of exchange rate fluctuations; they are well capable of withstanding exchange rate risks. Corrupt and/or weak institutional mechanisms and weak law enforcements are the main reasons behind arbitration from the developing economies.

The graph below plots IFFs as a percentage of trade- it can be seen that Bangladesh is leading in this ratio (not considering Nepal and Maldives) followed by Sri Lanka. While India was observed to have maximum IFF in absolute numbers, India is not featuring prominently in this graph when we consider IFF as a percentage of its trade. Hence, Bangladesh is faring poorly as compared to India (also Sri Lanka) when we are deflating individual country's IFFs with their respective trade bases.

How to Stem Illicit Financial Flows?: In some cases, this might involve preventing criminal activity while in other cases; it could involve identifying and sanctioning serious and substantial illegal tax evasion. Tax policies should be made more transparent -- such as requiring all tax holidays to be publicly disclosed. This would likely increase tax revenues while reducing the risk of corruption and the potential for firms to abuse tax holiday provisions in ways that could contribute to IFFs. On the trade-related front, there should be a renewed and reinvigorated approach around key issues and players, including the private sector, government, international organizations and civil society towards greater coordination and cooperation for curbing IFFs.

Developing and developed countries need to work toward a common goal to tackle Illicit Financial Flows (IFFs), which will require collaborating on management and regulation of finances, governance and transparency, natural resources, trade, and proactive cooperation on proceeds of crime and tax. While the developed countries need to take the lead on preventing inflows of illicit money, developing countries must address weaknesses in their legal and regulatory regimes that make them susceptible to the activities that lead to IFFs. Incentive for firms to engage in illegal behavior is strong when they believe their competitors are receiving unfair advantages. Initiatives like Publish What You Pay are beginning to develop mechanisms to increase transparency around financial arrangements between governments and firms, which is essential for constructive engagement.

Policy Options: South Asian countries are still facing the problem of taxing multinational corporations effectively, building effective transfer pricing regimes, systematizing tax incentives to attract international investors and establishing and using information sharing arrangements to obtain tax information about their taxpayers from other countries. Regardless of how IFFs are demarcated, it's clear that these flows are an impediment to development. What's most important is to understand how and why money flows out of developing countries and to devise strategies to stem these flows.

A range of policy options to curb and forbid IFFs would be inclusive of the following: (i) Harmonising anti-money laundering regulations globally; (i-a) By automatic exchange of tax information; (i-b) By automatic exchange of financial accounts information; (i-c) By exchange of corporate reports between countries; (i-d) By exchange of corporate beneficial ownership information; (ii) Reform of international tax rules so that taxable profits of multinational corporations are aligned with the location of their economic activities; (ii-a) through preventing tax arbitrage by multinational corporations by strengthening tax cooperation, increasing transparency in international trade and finance statistics; (iii) Requiring public reporting of funds paid to governments for the sale of natural resources such as oil, gas, metals, and minerals, and the use of those funds; (iv) Significantly increase developing country tax authority capacity; (iv-a) By strengthening anti-money laundering laws and practices; (iv-b) By inducing tax compliance; (iv-c) Through capacity building in taxation and financial intelligence; (v) Require that all governments carry out clear, reliable, frequent, open, participative, transparent and timely public fiscal reporting; and (vi) Impose tougher sanctions, including jail time, on those who facilitate illicit financial flows.

Mashfique Ibne Akbar is an economist. [email protected]


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