Addressing Illegal Export of Honestly Acquired Capital
This is part 2 of a five-part series, drawn from Political Economy Research Institute (PERI) working paper No. 361, “Strategies for Addressing Capital Flight,” by James K. Boyce and Léonce Ndikumana, available here. The paper is forthcoming in Capital Flight from Africa: Causes, Effects and Policy Issues, S.I. Ajayi, and Leonce Ndikumana, eds. (Oxford University Press, 2014), accessible here.
Encouraging “home bias” in investment
The development of profitable investment opportunities not only helps keep capital onshore, but also can help attract private capital held abroad, including remittances from the African diaspora. In the case of African countries, there is considerable scope for reducing the costs of production and trade through increasing the quantity and quality of infrastructure—especially power, transportation, and communication. Measures to accelerate the development of domestic and regional financial markets could also help to shift African investors’ preferences in favor of domestic markets. Domestic-currency government infrastructure bonds, for example, have provided an important source of financing for public infrastructure in Kenya (Brixiova and Ndikumana, 2013).
Many African countries have resorted to fiscal incentives to promote domestic investment. These include tax allowances on capital investment, tax exonerations on investment-related imports, and generous tax holidays for major investment projects. A major drawback of this strategy, however, is that it can entail significant tax revenue losses in a continent where most countries face large financing gaps. A second problem is that the implementation of investment tax incentives is plagued by corrupt practices that result in an inefficient allocation of investment as well as excessive foregone revenue. A third concern is that tax incentives often are skewed in favor of foreign direct investment, putting domestic investors at a competitive disadvantage.
Capital controls work best when they are seen as an integral component of macroeconomic and industrial policy, rather than a measure of “last resort” instigated by financial crisis (Epstein, 2012; Gallagher, 2012), and when they are used to achieve well-specified goals. Even if they are temporary, they can signal that the government is ready and capable of utilizing them when circumstances dictate it.
Traditionally, capital account controls have been used to address four main problems, sometimes referred to as the “four fears” (Magud and Reinhard, 2007): 1) “fear of floating,” the fear that large capital inflows will cause undesirable appreciation of the national currency, damaging the country’s tradable goods sectors (Calvo and Reinhard, 2002), 2) fear of “hot money,” speculative short-term capital flows that are subject to massive and sudden reversals, 3) the fear that large capital inflows can have disruptive consequences for financial markets and the economy, promoting asset bubbles and excessive risk-taking by banks, and 4) fear of the loss of monetary policy autonomy that may accompany unrestricted inflows and outflows.
For the sake of our discussion, two results stand out from studies of the effectiveness of capital controls (Epstein, 2012; Gallagher, 2012; Magud and Reinhard, 2007). First, capital controls have successfully influenced the composition of capital flows in favor of long-term capital. Second, capital controls have increased monetary policy independence. These two results are especially important for African countries as they seek to attract growth-enhancing foreign capital and manage aggregate demand. The limited available evidence suggests that capital controls also can be an effective instrument for reducing capital flight.
International banking transparency
The saying that “it takes two to tango” holds for capital flight. Most of Africa’s capital flight is domiciled in what are commonly referred to as offshore financial centers—mostly New York, London, and other European banking centers (Shaxson, 2011). Capital flight is facilitated and perpetuated by the complicity of banks in these countries that systematically turn a blind eye to suspicious transactions by Africa’s political and economic elites.
Strategies to stem capital flight must include efforts to improve transparency in international banking operations. This involves two broad policy actions: strengthening and enforcing existing banking laws in western countries, and closing gaps and loopholes arising from inconsistencies and inadequate harmonization of laws across countries. Regarding the first area of policy intervention, the onus is on western governments, legislative bodies, and specialized agencies to strengthen and enforce their own laws. The second area of policy intervention is the harmonization of legislation on banking secrecy and financial transparency across countries. Corporations and individuals are able to exploit gaps and inconsistencies in legislation across countries as well as loopholes in national legislation to move money across borders and conceal the identity of the owner of assets from African national authorities.
For Africa to make progress in fighting capital flight, its western counterparts need to commit to combating complacent banking and tax evasion. It is quite possible that helping African countries to keep their wealth onshore could generate substantially higher returns than much official development assistance.
Tackling tax evasion
Tax evasion by individuals, national businesses, and multinational enterprises operating in Africa is a major impediment to domestic resource mobilization for infrastructure investments and social expenditure (Kedir, 2014; OECD, 2013b). As in the case of tracking capital outflows, tackling tax evasion requires a collective effort between African countries and the international community.
A central focus of such efforts is the cross-country exchange of information on investment income, including interest, dividends, and capital gains. In addition to financial data, this requires information on beneficial ownership, so that the recipients of income are not able to conceal their identities behind shell companies and trusts. Banks and other financial institutions, including brokers and insurance companies, would be required to report this information to their own governments, who could then share it with the governments of the income recipients.
Brixiova, Z. and Ndikumana, L. (2013). The global financial crisis and Africa: The effects and policy responses. In G. Epstein and M. H. Wolfson (Eds.), The Oxford Handbook of the Political Economy of Financial Crises (pp. 711-735). Oxford: Oxford University Press.
Calvo, G. A. and Reinhard, C. R. (2002). Fear of floating. Quarterly Journal of Economics, 117 (2), 379-408.
Epstein, G. (2012). Capital outflow regulation: Economic managemnt, development an transformation. In K. P. Gallagher, S. Griffith-Jones and A. J. Ocampo (Eds.), Regulating Global Capital Flows for Long-Run Development (pp. 47-58). Boston: Boston University, Pardee Center for the Study of the Longer-Range Future.
Gallagher, K. P. (2012). Capital account regulations for stability and development. In K. P. Gallagher, S. Griffith-Jones and A. J. Ocampo (Eds.), Regulating Global Capital Flows for Long-Run Development (pp. 1-12). Boston: Boston University, Pardee Center for the
Study of the Longer-Range Future.
Kedir, A. (2014). Capital flight and Tax Evasion In I. Ajayi and L. Ndikumana (Eds.), Capital Flight from Africa: Causes, Effects and Policy Issues. London: Oxford University Press (forthcoming).
Magud, N. and Reinhard, C. R. (2007). Capital controls: an evaluation. In S. Edwards (Ed.), Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences (pp. 645-674). Chicago: University of Chicago Press.
OECD. (2013b). A Step Change in Tax Transparency: OECD Report for the G8 Summit. Lough Erne, Enniskillen: OECD.
Shaxson, N. (2011). Treasure Islands: Tax Havens and the Men Who Stole the World. London: Bodley Head.
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