Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Draining Development? from Developing Countries Developing from ofIllicitFunds Flows Controlling Peter Reuter Peter edited by DRAINING DEVELOPMENT? DRAINING DEVELOPMENT? Controlling Flows of Illicit Funds from Developing Countries Edited by PETER REUTER THE WORLD BANK © 2012 International Bank for Reconstruction and Development / International Development Association or The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org 1 2 3 4 15 14 13 12 This volume is a product of the staff of The World Bank with external contributions. The fi ndings, interpretations, and conclusions expressed in this volume do not necessarily re- fl ect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Offi ce of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: [email protected]. ISBN (paper): 978-0-8213-8869-3 ISBN (electronic): 978-0-8213-8932-4 DOI: 10.1596/978-0-8213-8869-3 Library of Congress Cataloging-in-Publication Data Draining development? : controlling fl ows of illicit funds from developing countries / edited by Peter Reuter. p. cm. Includes bibliographical references and index. ISBN 978-0-8213-8869-3 — ISBN 978-0-8213-8932-4 (electronic) 1. Tax administration and procedure —Developing countries. 2. Money laundering— Developing countries. 3. Tax evasion—Developing countries. 4. Transfer pricing— Taxation—Law and legislation—Developing countries. I. Reuter, Peter, 1944– HJ2351.7.D73 2011 364.1’33—dc23 2011039746 Cover design by Drew Fasick of the Fasick Design Group. Contents Foreword ix Acknowledgments xi Contributors xiii Abbreviations xv 1. Introduction and Overview: The Dynamics of Illicit Flows 1 Peter Reuter Part I. The Political Economy of Illicit Flows 19 2. Governance and Illicit Flows 21 Stephanie Blankenburg and Mushtaq Khan 3. The Political Economy of Controlling Tax Evasion and Illicit Flows 69 Max Everest-Phillips 4. Tax Evasion and Tax Avoidance: The Role of International Profi t Shifting 109 Clemens Fuest and Nadine Riedel Part II. Illegal Markets 143 5. Illicit Capital Flows and Money Laundering in Colombia 145 Francisco E. Thoumi and Marcela Anzola v vi Contents 6. Human Traffi cking and International Financial Flows 171 Pierre Kopp Part III. To What Extent Do Corporations Facilitate Illicit Flows? 203 7. Transfer Price Manipulation 205 Lorraine Eden 8. The Role of Transfer Pricing in Illicit Financial Flows 235 Carlos A. Leite 9. Accounting for the Missing Billions 265 Richard Murphy 10. Trade Mispricing and Illicit Flows 309 Volker Nitsch Part IV. Policy Interventions 335 11. Tax Havens and Illicit Flows 337 Alex Cobham 12. How Well Do Anti–Money Laundering Controls Work in Developing Countries? 373 Michael Levi 13. The Kleptocrat’s Portfolio Decisions 415 James Maton and Tim Daniel Part V. Conclusions and the Path Forward 455 14. The Practical Political Economy of Illicit Flows 457 Mick Moore Contents vii 15. Policy and Research Implications of Illicit Flows 483 Peter Reuter Boxes 8.1. A Trading Intermediary: A Case of Management Foresight? 238 8.2. A Trading Intermediary: Redux 240 8.3. A Measure of Tax Evasion in the United States 250 8.4. Zambia: Tax Collection in the Copper Sector 256 12.1. A Suspicious Activity Report Leads to a Transnational Corruption Investigation 402 Figures 2.1. Defi nitions of Capital Flight 36 2.2. Choosing Attainable Benchmarks for Policy Design 60 3.1. The Political Economy of an Eff ective State and Tax System 85 3.2. The Political Economy Model of Tax Evasion Driving Illicit Capital Flows 87 5.1. Colombia: Outward Foreign Direct Investment, 1994–2010 160 6.1. Human Traffi cking: Supply and Demand 194 7.1. Estimating Trade Mispricing from International Trade Data 219 9.1. Corporate Tax Rates, Initial Results, 1997–2008 273 9.2. Corporate Tax Rates, Weighted by GDP, 1997–2008 275 9.3. Corporate Income Tax, Africa, 1980–2005 279 9.4. Top 20 Subsidiaries by Secrecy Jurisdiction, Population, and GDP 300 11.1. Intensity of Economic Exposure: Implied Ratios of Secrecy Jurisdiction Shares to GDP, by Income Group 361 11.2. Intensity of Economic Exposure: Implied Ratios of Secrecy Jurisdiction Shares to GDP, by Region 362 11.3. Zambian Trade: Swiss Role, 1995–2008 363 12.1. The Case of Montesinos : Laundering Maneuvers If Monies Were Collected in Peru 391 viii Contents Tables 1.1. Crossborder Flows of Global Dirty Money 3 2.1. Logical Framework for Identifying Illicit Flows from Developing Countries 53 2.2. Illicit Financial Flows in Diff erent Contexts 58 3.1. Proposed Typology: Illegal and Illicit Capital Flows and Capital Flight 71 5.1. The Results of Anti–money Laundering Eff orts: Number of Seized and Forfeited Assets 156 6.1. The Financial Flows Generated by Human Traffi cking 182 9.1. Summary Data: Corporate Tax Rate, Including Secrecy Jurisdiction Locations, 2008 276 9.2. Summary Data: Corporate Tax Rate, Excluding Secrecy Jurisdiction Locations, 2008 277 9.3. Summary Data: Tax Rate on Foreign Source Income, Selected Secrecy Jurisdiction Locations, 2008 278 9.4. Multinational Corporations Surveyed by the Tax Justice Network 297 9.5. Secrecy Jurisdiction Locations of Multinational Corporation Subsidiaries 298 10.1. Asymmetries in Australia–European Union Trade: A Statistical Practitioner’s Assessment 316 10.2. Motives for Mispricing in International Trade 320 10.3. Examples of Product Categories in the U.S. Tariff Schedule, 2009 324 10.4. Largest Trade Gaps, 2004 328 10.5. Underreporting of Exports by Country, 2002–06 330 10.6. Correlation of Exporter-Specifi c Average Trade Gaps 331 12.1. Vulnerabilities in Financial Intermediation 386 14.1. Summary Statistics on Sources of Government Revenue, by Country Category 469 14.2. Major Political, Institutional, and Policy Characteristics Aff ecting Decisions on the Location of Large-Scale Private Capital 472 Foreword The subject of Draining Development? is one that we feel very strongly about. Estimates on the magnitude of illicit fi nancial fl ows from developing countries vary enormously, but even the most conservative suggest that the total outfl ow exceeds signifi cantly the amount of offi cial development assis- tance from the Organisation of Economic Co-operation and Development countries. When we look at the fi nancing needs of the developing world— what it will take to achieve the Millennium Development Goals—it is clear that development aid alone is insuffi cient. To have any hope of reaching the Millennium Development Goals, poor countries must attack the illicit out- fl ow of monies and recover what is now illegally held abroad. Nigeria’s experience illustrates the challenges. In the early 2000s, the Nigerian government made a concerted push to recover the funds that ille- gally fl ed their country. They encountered problems both in Nigeria and abroad: outdated rules and poorly trained staff at home, and overseas there was bank secrecy, opaque corporate and trust vehicles, and time consuming procedures precluding cooperation. The playing fi eld was tilted against Nigeria’s national interests. No developing country should have to repeat what Nigeria had to go through to recover funds that rightly belong to its citizens. The effort required thousands of hours of investigative work to locate where the money was hidden, and then the government had to pay millions of dollars in legal fees to recover just a portion of it. Although recovery is becoming easier, too many obstacles remain. Laws governing trusts and corporations in many countries still provide anonym- ity to asset holders. Even where the laws are up to date, enforcement often ix x Foreword continues to lag. A recent Global Witness report on banks and money laun- dering provided a damning indictment of the enforcement efforts of many nations. No matter how successful we are in reducing barriers to asset recovery, it will continue to be a time-consuming and expensive proposition. Differ- ences in legal systems, the demands of due process, the need to respect prop- erty rights—all of these factors ensure that recovery will never be a straight- forward affair. That is why Draining Development? and the information and analysis it provides on illicit fi nancial fl ows are so important. Far better than reducing barriers to asset recovery is to not have to recover the assets in the fi rst place. If we can fi nd ways to stop the illegal outfl ow of money, developing coun- tries can refocus their energies on development. But as the chapters in this volume show, money fl ows out illicitly for many reasons, including tax evasion, the smuggling of illegal goods, the traf- fi cking of human beings and other organized crimes, the manipulation of transfer prices and trade mispricing, customs fraud, the failure of money laundering controls, terrorist fi nancing, and bribery.