Illicit financial flows from the Least Developed Countries: 1990–2008

MAY 2011

UNITED NATIONS DEVELOPMENT PROGRAMME: DISCUSSION PAPER

E-mail: [email protected] and [email protected]

Web site: http://www.undp.org/poverty and
http://www.undp.org/governance

ACKNOWLEDGEMENTS

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

This paper 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 issue has been recognised by the UN as important for development and achievement of the Millennium Development Goals (MDGs). Illicit capital flight, where it occurs, is a major hindrance to the mobilisation of domestic resources for development. In many cases, it significantly reduces the volume of resources available for investment in the MDGs and productive capacities. Through the United Nations, the international community has committed to strengthen national and multilateral efforts to address it. As the deadline for achievement of the MDGs draws closer, it is vital understand more about the nature of this problem and to explore possible policy solutions, especially for those countries furthest off-track towards the MDGs.

The study's indicative results find that illicit financial flows from the LDCs have increased from US$9.7 billion in 1990 to US$26.3 billion in 2008 implying an inflation-adjusted rate of increase of 6.2 percent per annum. Conservative (lower-bound) estimates indicate that illicit flows have increased from US$7.9 billion in 1990 to US$20.2 billion in 2008. The top ten exporters of illicit capital account for 63 percent of total outflows from the LDCs while the top 20 account for nearly 83 percent. Trade mispricing accounts for the bulk (65-70 percent) of illicit outflows from the LDCs, and the propensity for mispricing has increased along with increasing external trade. Empirical research on illicit flows indicates that there are three types of factors driving illicit flows — macroeconomic, structural, and governance-related.

The ratio of illicit outflows to Gross Domestic Product (GDP) averages about 4.8 percent but there is wide variation among LDCs. Of the top 10 countries with the highest illicit flows to GDP ratio, four are small island countries, two are landlocked, and four are neither. In some LDCs, losses through illicit capital flows outpace monies received in official development assistance (ODA).

Estimating illicit flows from some LDCs is problematic because the underlying macroeconomic or partner-country trade data are either non-existent or spotty due to widespread on-going or recent conflict and/or weak statistical capacity. Complete macroeconomic and partner-country trade data were available for 34 LDCs, while 11 report partial data to the IMF and 3 are non- reporters. The report thus presents an estimate of illicit flows from some of the non-reporting and partially reporting countries based on the assumption that illicit flows from these countries are in the same proportion to GDP as are outflows from other reporting LDCs with complete data.

The results of this study are indicative but demonstrate a clear need for further research in this area given the scale of the development challenges which currently face the Least Developed Countries and the need to 'think outside the box' and find innovative development solutions.

The paper presents a number of useful measures LDCs may wish to consider to curtail the generation and transmission of illicit financial flows. The international community must also play its part. However, even where policy measures are well designed and targeted, lasting improvements in this area can only be achieved when there is the sufficient political will and leadership to tackle corruption and some of the root causes of illicit financial flows.

For the Least Developed Countries, policy recommendations include measures to address trade mispricing through for instance systematic customs reform and the adoption of transfer pricing regulations with commensurate increase in enforcement capacity. The implementation of specialised software which helps governments to identify possible incidences of transfer pricing may also be useful to some governments. Measures to reform the tax base through the progressive strengthening and widening of the tax base in order to reduce dependence on indirect taxes which are more difficult to manage and have built-in incentives for tax evasion may also be beneficial. Ultimately tax is the most sustainable source of finance for development and the long-term goal of poor countries must be to replace foreign aid dependency with tax self-sufficiency. However taxation reform must be seen as equitable and fair and must not unduly burden the poorest.

The international community must also support LDCs' efforts to curtail the illicit outflow of capital. This includes specific measures to support LDCs to improve the systematic exchange of tax information between governments on non-resident individuals and corporations while the adoption of globally consistent regulations for transfer pricing could encourage multinational companies to modify their behaviour towards more transparency and accountability. The UN's Model Income Tax Treaty refers to the importance of automatic exchange of information between national tax authorities in different jurisdictions. In order to stem tax avoidance by multinational corporations, the international community could support the development of an international accounting standard requiring that all multi- national corporations report sales, profits, and taxes paid in all jurisdictions in their audited annual reports and tax returns.

UNDP stands ready to support LDCs and other developing countries in their efforts to curtail illicit financial flows in support of the MDGs. In particular, it can support countries to exchange practical information, experience and lessons learned on ways to tackle this problem.

1. INTRODUCTION

This paper explores the possible 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 intellectual interest has arisen over the extent to which such flows may have development, governance or other consequences for both developed and developing countries (e.g., Baker (2005); Ndikumana and Boyce (2008), among others).

The paper has been commissioned by UNDP as a contribution to the United Nations IV High Level Conference on the LDCs in 2011. Its objective is to assess the extent to which illicit financial flows may represent a significant problem in some LDCs, and if so, to consider more broadly the policy options available to governments and the international community to curtail such flows. It is intended to stimulate further public policy discussion and its results are indicative only given numerous difficulties associated with robust data collection and divergent views over which methodological approach best captures the true scale of illicit financial flows.

The outcome document from the United Nations 2010 Summit on the Millennium Development Goals (MDGs) recognises the importance of this issue for development and the MDGs and commits the international community to “implement measures to curtail illicit financial flows at all levels, enhancing disclosure practices and promoting transparency in financial information.” The recommendations made in the outcome document of 2010 are in line with the UN's Monterrey Consensus and Doha Declaration, which recognise the importance of domestic resource mobilisation in countries' efforts to raise more resources for the MDGs and commits governments to address the problem of illicit financial flows through multilateral and national efforts.

Since the 1960s, the UN has recognised the particular weaknesses, vulnerabilities and development challenges faced by the LDCs. There are currently 48 countries classified by the United Nations as LDCs, 33 of which are in Sub-Saharan Africa, 14 in Asia and one in Latin America and the Caribbean. Many LDCs share similar structural characteristics, for instance 16 LDCs are landlocked, 10 are small islands, while 22 are neither (Appendix III, Table 1). LDCs satisfy three separate criteria: (i) an income per capita of less than US$905 per annum (ii) a low level of 'human assets' based on indicators of nutrition, health, education and literacy (iii) and a high degree of economic vulnerability measured in relation to population size and remoteness, dependency on agriculture, forestry and fisheries, exposure to natural disasters, export concentration and instability in exports.6 The three criteria together seek to capture the multifaceted nature of development and underscore the many diverse challenges faced by the world's poorest governments to develop their economies and improve the lives of — and opportunities for — their citizens. For several reasons, many LDCs are lagging behind in achieving the UN's MDG targets.

Intuitively, one can argue that the outflow of illicit capital may hamper governments' abilities to marshal resources for economic development, to fund important social programmes, and to bring better balance between government expenditures and tax revenues. In addition, illicit flows are typically absorbed into developed country banks and offshore financial centres. This paper also explores the issue of potential net resource transfers out of LDCs — the very same group identified by the United Nations as most in need of special support measures from the international community to develop. While the magnitude of the problem of net resource transfers varies from one LDC to the next, there is strong evidence that net transfers from the group are significant and present a serious challenge for fostering economic development.

2. WHY LEAST DEVELOPED COUNTRIES ARE VULNERABLE TO ILLICIT
FLOWS

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.

4. ILLICIT FLOWS AND THE LEAST DEVELOPED COUNTRIES

(To view entire selection of charts, please see the full report at
Global Financial Integrity)

EXCERPT FROM CHART 4: TOP 20
CUMULATIVE IFFS FROM LDCS BY COUNTRY, 1990-2008 (US$ MILLION)

1. Bangadesh 34,790
2. Angola 34,046
3. Lesotho 16,823
4. Chad 15,436
5. Yemen 11,979
6. Nepal 9,128
7. Uganda 8,757
8. Myanmar 8,535
9. Ethiopia 8,354
10. Zambia 6,800
11. Sudan 6,732
12. Equatorial Guinea 6,503
13. Laos 6,062
14. Liberia 5,863
15. Guinea 4,928
16. Malawi 4,171
17. Djibouti 3,885
18. Mozambique 3,773
19. Madagascar 3,746
20. Congo (DRC) 3,499

4.11. Chart 6 analyses the net cumulative resource transfer from LDCs to the rest of the world over the period 1990-2008 by estimating the relevant capital inflows and outflows from LDCs as recorded in countries' balance of payments. The totality of net recorded transfers (inflows and outflows) is then compared to unrecorded outflows of illicit capital.

Cumulative inflows and outflows from LDCs vis-à-vis the rest of the world (keeping signs intact) can be estimated as:

Net recorded transfers = Net Financial Account Balance, FDI, New loans, Repayments of principal (+US$94 billion)
+ Remittances (+US$118 billion)
– Debt Service payments (US$162 billion)
= +US$50 billion (inflow)

4. 12. If illicit outflows of US$246 billion are 'netted-out', LDCs show a net resource transfer of about US$197 billion into the rest of the world (mainly developed countries) over this period. This is a serious loss of resources which may be accentuating the development challenge in many LDCs.

5. THE DRIVERS AND DYNAMICS OF ILLICIT FINANCIAL FLOWS

The policy recommendations for curbing illicit financial flows from a country must necessarily flow from an in-depth study of the drivers and dynamics of these flows that are specific to each individual country. This section analyses the broad drivers and dynamics of illicit financial flows based on empirical research and is followed by an overview of policy measures governments may wish to consider in order to restrict the generation and cross-border transmission of such capital.

Empirical research on illicit financial flows (see Appendix II) indicate that the factors that drive such flows can be broadly classified into three categories — macroeconomic, structural, and governance-related.

5.1 MACROECONOMIC FACTORS

Owners of illicit capital, which comprise of the proceeds of crime, bribery, kickbacks, asset stripping, tax evasion, and illegal activities such as drug trafficking, are typically more interested in hiding their wealth than in maximising rates of return. They are also not likely to be worried about future taxation implied by a rising government budget deficit. That said, overall macroeconomic conditions do impact a country's overall business climate which prompts domestic businesses to retain more capital at home while attracting foreign direct investment into the country. Ultimately, whether macroeconomic factors drive illicit flows is an empirical question which needs to be settled within the context of specific country case studies.

5.2 STRUCTURAL ISSUES

Illicit flows are much more likely to be driven by structural factors like rising income inequality, faster rates of (non- inclusive) economic growth, increasing trade openness without adequate regulatory oversight, etc. Where economic growth in non-inclusive, it may worsen the distribution of income and the resulting larger number of high net worth individuals may seek to evade higher taxes if overall governance does not improve.

Hence, fiscal policy measures to fund a social safety system, combined with investment in health, education and infrastructure need to be implemented so that growth benefits all income groups and not just a privileged minority. At the same time, tax reform needs to focus on widening the tax base and improving compliance (with an eye on equity) in order to reduce the tax evasion component of illicit flows. However, tax reform alone will not succeed in curtailing tax evasion if the quality of government services does not improve, that is if tax payers feel that they are not getting their money's worth in terms of better infrastructure and better access to health, education, and social services.

5.3 GOVERNANCE AND CORRUPTION

Corruption distorts public policies in that resources are allocated not based on efficiency or internal rates of return but in favor of those who are willing and/or able to bribe or pay kickbacks to public officials. Weak governance spawns public corruption and encourages corporate malfeasance. Public corruption typically involves the abuse of authority or trust for private benefit. But this is a temptation indulged in not only by government officials but also by rent-seekers in private enterprises and nonprofit organisations. In general, poor governance provides greater latitude for corruption, both in the public and private sectors, so long as the corrupt are convinced that they are likely to get away with the loot. The misallocation of resources also hurts the private sector because infrastructure tends to get neglected even as the corrupt enrich themselves at the expense of the state. The impact on the poor is particularly harmful because the siphoning of funds reduces resources for social programmes and investments in the MDGs.

The state of governance and the extent and type of corruption will vary considerably from one LDC to the next depending upon institutional weaknesses, cultural and historical propensities, economic structure and policies, state of bureaucracy, etc. Hence, the policies needed to strengthen governance and curtail the generation of illicit funds would also vary depending on these factors.

7. CONCLUDING REMARKS

This paper argues that certain structural characteristics such as low domestic savings and the resulting aid dependence and growth in external debt may be driving illicit flows in some LDCs. The poorest developing countries will continue to rely on tariff revenues as a major source of revenues given weak domestic taxation, and as long as such duties are levied, smuggling will continue. In addition, the significant fiscal deficits in many LDCs may well be driving tax evasion as higher deficits signal to private markets that direct and indirect taxes may have to increase in the medium term in order to close the gap. Even higher rates of economic growth achieved by some LDCs in recent years could act as a driver of illicit capital if growth is not accompanied by a better distribution of income.

The method used to estimate illicit financial flows from LDCs is based on the World Bank Residual model adjusted for trade mispricing — a methodology widely used among economists. This approach was modified in two important ways. First, illicit inflows are not netted out of outflows. Second, a higher and lower estimate of illicit flows for each LDC was derived corresponding, respectively, to those that do not meet certain conditions and those that do.

Based on this methodology, the study found that illicit financial flows from many LDCs are significant, both in US dollar terms and as a percent of GDP. In some LDCs, illicit financial flows outpace ODA. The results are indicative given difficulties associated with reliable data collection and the fact that various methodological approaches exist to measure and quantify illicit flows. Nevertheless, given the scale of the development challenges which face the LDCs, these preliminary results demonstrate a clear need for further work in this area, especially by the LDCs themselves in collaboration with relevant multilateral bodies. UNDP stands ready to support LDCs and other developing countries in their efforts to curtail illicit financial flows in support of the MDGs. In particular, it can support countries to exchange practical information, experience and lessons learned on ways to tackle this problem.

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* The report was first published on Global Financial Integrity (GFI).
* Dev Kar, formerly a senior economist at the International Monetary Fund (IMF), is now lead economist at Global Financial Integrity (GFI), Center for International Policy.
* Please send comments to [email protected] or comment online at Pambazuka News.