Illicit Financial Flows from Africa: Causes, Consequences, and Curtailment

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(Photo Credit: Darin House, Flickr Commons)

(Photo Credit: Darin House, Flickr Commons)

Despite Africa’s vast natural resources and youthful labor force — what the International Monetary Fund (IMF) refers to as a “demographic dividend”— the continent still suffers from extreme poverty.[1] Africa is one of the world’s fastest growing regions, and yet economic growth in Sub-Saharan Africa lags due to endemic corruption and illicit financial outflows.[2] Between 2003 and 2012, outflows from Africa averaged 5.5 percent of GDP per annum, which was significantly higher than the average 3.8 percent of GDP per annum of other developing countries.

In resource-poor countries, trade misinvoicing by private companies is considered a major source of illicit financial flows, as are outflows related to criminal activities such as drug trafficking. While illicit flows through trade misinvoicing can be estimated, outflows due to criminal activities cannot be captured in economic models.

Economists can monitor two channels through which illicit funds are transferred from a country—leakages from the balance of payments and the deliberate manipulation of customs invoices on external trade. Outflows through the first channel are estimated using unrecorded private sector outflows (a major component of “net errors and omissions” in the official balance of payments accounts). Outflows also result from the under-invoicing of exports and the over-invoicing of imports. Because economic data and methods cannot capture the proceeds of all illegal activities, most of which are settled in cash and can be transferred by physical means, or the misinvoicing of trade in services, estimates of illicit flows from countries are far more likely to be understated rather than overstated.

The volume of illegal capital flight from Africa has serious implications for the continent’s development. The Report of the High-Level Panel on Illicit Financial Flows from Africa notes that had Africa been successful in retaining illicit financial outflows, the continent’s capital stock would have been about 60 percent higher – boosting its income per capita by up to 15 percent.

Illicit flows tend to take stronger root in countries experiencing non-inclusive growth. Not only do illicit flows exacerbate income inequality, they also undermine a nation’s fiscal capacity, the degree to which the government can credibly enact revenue, expenditure, and monetary policies to achieve socially desirable outcomes. As a result, nations find it more difficult to stem, if not reverse, the vicious cycle of illicit financial flows and inequality.

Illicit flows also represent a major drain on the resources of African countries. Global Financial Integrity carried out a joint study with the African Development Bank and found that Africa was a net creditor to the world to the tune of up to $1.4 trillion over the period from 1980 through 2009, with the most conservative estimate of the capital loss being around $600 billion. Thus, despite the inflow of international aid into every region of Sub-Saharan Africa, outflows of illicit capital continue to result in a net loss of resources that overwhelms any salutary economic effects of recorded capital inflows.

In North Africa, transfers of recorded resources turned sharply negative over the past decade, as large outflows from Algeria and Libya (due to reserve placements and other outward transfers) exceeded inflows into other countries in the region. Meanwhile, Morocco and Tunisia held on to a small balance of inward-recorded transfers. Given these large illicit outflows, North Africa has suffered a massive loss of resources on a net basis – though still not to the extent that Sub-Saharan Africa has. The cumulative loss of net resource transfers in Sub-Saharan Africa between 1980 and 2009 amounted to $370 billion, outstripping the $262 billion loss in North Africa.

The above-mentioned study makes a number of policy recommendations focused on improving Africa’s business climate, curtailing illicit financial flows, and restricting the absorption of these flows into advanced countries and tax havens. The business climate could improve through measures that further political and economic stability and that promote specific business-friendly measures to improve infrastructure, rationalize corporate taxation, and strengthen governance. Reducing red tape to obtain the necessary permits for establishing businesses could help foster a better business climate that encourages private investment and generates employment.

The second policy objective—curtailing illicit financial flows from the region—requires governments to implement measures to reduce corruption, strengthen regulatory oversight, improve government effectiveness, increase accountability, increase political and economic stability, and strengthen the rule of law. For instance, in order to curb tax evasion, African countries should enter into automatic exchange of information (AEI) agreements with countries where the proceeds of tax evasion are lodged. A lack of good governance makes it difficult for citizens to monitor related revenue collection and use. Governments should foster greater transparency and accountability by implementing open and transparent budgeting processes, such as the Open Budget Initiative and the Extractive Industries Transparency Initiative (EITI). Governments should also require multinational companies to publish annual financial reports that explicitly detail their activities in the resource sector of the country in question.

Meanwhile, given the growing volume of illicit flows due to misinvoicing, the regulatory capacity and oversight of African countries’ customs administrations need to be strengthened. Customs reform should include removing ad hoc exemptions from customs duties, streamlining clearance and document control procedures, and digitizing payment and collection procedures. Also integral are measures that promote capacity-building and training to detect and investigate the under- and over-invoicing of goods entering and leaving a country.

The prominence of the informal economic sector, which for the most part remains outside of the tax net, is also a key structural characteristic of developing countries. As a result, these nations—including many in Africa—typically have a narrow tax base, with only a small portion of the labor force paying income taxes. Implementing well-designed tax reforms to widen the tax base and ensure greater tax compliance in a fair and equitable manner is imperative to overhauling the system. The current system of indirect taxes is unwieldy to manage, costly to administer, and lends itself to evasion. A narrow tax base can lead to “tax fatigue,” as the burden of taxation falls on a sliver of the work force. Thus, a narrow tax base can drive the tax evasion component of illicit flows, if tax rates should increase for any reason.

Lastly, stemming the absorption of illicit financial flows into advanced countries and tax havens would require institutions in those countries to regularly report to the Bank for International Settlements (BIS). Presently, financial institutions are not required to collect any information on the actual (i.e., human) owners of financial accounts. The utter lack of such information allows holders to “ring-fence” or hide their illicit assets in tax havens and banks in developed countries. Hence, the lack of information on beneficial ownership of companies, trusts, and other legal entities is a huge loophole in the world’s shadow financial system that must be addressed if we are to curtail illicit financial flows. Domestic laws governing financial institutions should be strengthened to make it illegal for one to open an account without giving personal information.

The magnitude of illicit outflows from Africa strongly suggests that the region can boost the effectiveness of the external aid and other transfers that it receives by curtailing the leakage of illicit capital. The continent should adopt a range of policy measures to counter this phenomenon that are sequenced and implemented in a manner best suited to the nature and sources of each country’s illicit flows. Carefully designed measures to strengthen governance, transparency, and regulatory oversight can significantly reduce the volume of illicit outflows. With the right reforms, Africa is poised to see an increase in government revenue generation – effectively allowing additional resources to be devoted to poverty alleviation and improving the business climate for sustainable economic growth.

 

Footnotes:

[1] Africa consists of 49 countries in the Sub-Saharan region and 9 countries in North Africa. The GFI-AfDB joint report on net resource transfers covered 44 Sub-Saharan African countries due to lack of balance of payments and bilateral trade data on Djibouti, Mauritania, Somalia, South Sudan, and Sudan.

[2] Illicit financial flows are funds that are illegal in the way they are generated, utilized, or transferred across borders.

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Dev Kar, a former Senior Economist at the International Monetary Fund, is Chief Economist at Global Financial Integrity (GFI), a think tank and advocacy group in Washington DC.

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