1 – Introduction

1There is an emerging consensus among scholars and practitioners of development policy that capital flight in the form of illicit financial flows (IFF) has “devastating effects on developing countries” (OECD 2013: 1). As the Organisation for Economic Co-operation and Development (OECD) puts it, IFF “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” (ibid.: 15; see also AfDB/OECD-DC 2010: Part II).

2In his contribution to this volume, Léonce Ndikumana analyses the effects of illicit capital flight on economic growth in Africa. He shows that by reducing domestic investment, IFF from African countries cause significant economic losses. In the present comment, I will seek to complement these findings in two ways. On the one hand, I will highlight the important role of “tax havens”, or secrecy jurisdictions, as facilitators of IFF. On the other hand, I will emphasize the social and political implications of such flows rather than just their direct economic consequences.

3There are at least two reasons why an assessment of the social and political dimensions of IFF is important. The first is that social and political changes are not by-products, but core elements of development. The effects of IFF on society and politics are therefore significant policy and research issues in their own right. The second reason is that the social and political consequences of IFF may again impact economic growth. As I will argue at the end of this contribution, IFF not only have a direct effect on the level of domestic investment, but also an indirect impact on the efficiency of investment. They contribute to a social and political environment that renders investment less productive.

2 – “Tax havens undermine necessary political changes”

4Financial sector representatives in secrecy jurisdictions often emphasize that capital flight from developing countries is a morally legitimate reaction to corruption and oppression. Banking secrecy, discretionary trusts and anonymous shell companies are argued to provide “financial asylum” to hard-working foreigners who want to protect their assets from predatory and despotic regimes. According to Nicholas Shaxson (2010: URL), however, this is “only true in a very narrow sense.” The problem is that only the wealthiest and most powerful citizens in developing countries seem to have access to offshore financial services. Capital flight to secrecy jurisdictions can therefore be argued to undermine political progress. As Shaxson emphasizes, “… to provide an escape route for a small, wealthy and powerful elite – the only constituency with the political strength to drive reform – is to undermine pressure for change” (ibid.).

3 – “Tax havens erode good governance and distort economic policy”

5In a similar vein, it seems reasonable to assume that secrecy jurisdictions undermine good governance and encourage distortions of public investment decisions in developing countries. As a Norwegian government commission has pointed out, secrecy legislation in tax havens provides a hiding place for various kinds of players who want to conceal the proceeds of their activities, including the proceeds of economic crime and rent seeking (Commission on Capital Flight 2009: 11f.). By helping kleptocratic leaders and corrupt officials hide the real sources of their income, secrecy legislation in tax havens provides notable incentives for these persons to engage in corruption and embezzlement in the first place. Political elites in turn may reorient public investment towards projects and areas that offer the greatest opportunities for such illicit activities. The most likely result is a potentially massive distortion of public investment decisions. Tanzi and Davoodi (2002), for instance, observe that corruption correlates with larger public expenditures, but with smaller maintenance expenditures and lower infrastructure quality.

4 – “Tax havens weaken social and political stability in developing countries”

6Moreover, secrecy jurisdictions benefit persons engaged in crimes such as human trafficking, prostitution, illegal arms trade etc. These crimes, in turn, undermine the very social fabric of society, and the proceeds are often used to finance terrorism or civil war. It thus seems fair to say that secrecy legislation in tax havens also weakens social and political stability in developing countries.

5 – “Tax havens encourage tax-related capital flight”

7Last but not least, secrecy jurisdictions encourage tax-related capital flight. Important to note, this includes corporate tax avoidance based on legal forms of international profit shifting and aggressive tax planning. Legal forms of tax avoidance, however, are not usually included in the definition and measurement of illicit financial flows. Studies based on the usual IFF measures therefore underestimate the actual magnitude and effects of tax-related capital flight.

8In order to grasp the social and political effects of tax-related capital flight, let us first have a look at the four core functions of tax systems. Usually called the “4 Rs” of taxation, these core functions are (Cobham 2012: 350):

• revenues – i.e., the creation of public income for domestic development financing;
• repricing (or regulation) – i.e., the repricing of goods and services in order to reduce socially undesirable behavior (e.g. tobacco taxes) or foster socially desirable behavior;
• redistribution in order to achieve equity and social coherence;
• representation: as highlighted in the African Economic Outlook 2010, “taxes are also the primary platform for political negotiations amongst a country’s stakeholders [and] part of the social contract between a state and its citizens” (AfDB/OECD-DC 2010: 81). As citizens want to know, and to have a say about, what happens with their tax money, they ask for more representation.

9Tax-related capital flight undermines these essential functions. In particular, it deprives states – including states with high levels of good governance – from revenues that could be used to foster pro-poor development and to finance infrastructure. In order to fill the gaps, states have to either take up loans or raise taxes that are hard to evade, such as value-added and consumption taxes. These tend to be regressive, however, or less progressive than income taxes and may lead to increased inequality.

6 – Conclusions

10The impact of illicit capital flight on development is inherently difficult to evaluate, as the evaluation “is necessarily based on a counterfactual assessment of what would happen if the illicit capital flow in question could hypothetically be blocked” (Blankenburg/Khan 2012: 24). Moreover, to grasp the overall impact of IFF on economic growth, researchers will need to take into account both direct and indirect effects. As Blankenburg and Khan (ibid: 58) put it, “we are asking what would directly happen to growth if a particular flow could be blocked, and then we are asking what would happen after the indirect effects arising from adjustments by critical stakeholders to the new situation have taken place.”

11Let us assume, then, that it was indeed possible to block the transfer of illicitly earned assets from developing countries to foreign secrecy jurisdictions. It seems reasonable to argue that this would have three main consequences:

1. Former flight capital, or at least a part of it, would be invested domestically. The countries in question would therefore show higher levels of investment.
2. Corrupt leaders, tax evaders and other criminals would no longer be able to hide the proceeds of their activities. As discussed above, the countries in question would therefore show less corruption, better institutions, more and better infrastructure, and greater social stability.
3. Better infrastructure and institutions, in turn, would boost the productivity of domestic investment. As shown by various authors, infrastructure and institutions matter for economic growth in at least two ways. Not only do better infrastructure and institutions lead to more domestic investment, but they also make investment more productive (Dort et al. 2013).

12In his contribution to this volume, Léonce Ndikumana is mainly concerned with the first of these three consequences – that is, with illicit capital flight’s direct impact on the levels of investment and GDP growth. He concludes that in African developing countries the potential additional GDP growth due to investing flight capital domestically might be as large as 3%. It is important to note, however, that this finding may be quite conservative. In the absence of illicit financial flows to offshore secrecy jurisdictions, African developing countries would most probably not only have higher levels of investment; provided that IFF negatively affect infrastructure and institutions, investment would also have a larger growth effect. In short, additional GDP growth might be even larger than 3%.