Illicit Financial Flows and the Three Ts of the G-8 Agenda – Alex Cobham

The day before we recorded this Wonkcast news broke of an agreement between the United Kingdom, France, Germany, Italy, and Spain to pilot “multilateral automatic tax information exchange.” My guest, research fellow Alex Cobham, explains why this is so important, why financial secrecy and international tax law seem suddenly to be at the top of the global economic policy agenda—and why this could be especially good news for developing countries.

Alex, who joined us recently as a CGD research fellow based in our European office in London, is an expert in trade, tax and transparency—the so-called “Three Ts” that UK prime minister David Cameron has said will be his priorities during the 2013 UK presidency of the G-8. I tell Alex that while Cameron’s plan to push on these issues is understandably news in the UK, I haven’t seen much evidence that the issues are gaining traction in the United States.

“Give it time,” Alex replies. “It’s an agenda that’s been building slowly and it’s finally starting to be appreciated—not only for developing countries but for places like the UK and the US.”

To explain why trade, tax, and transparency matter so much for developing countries, Alex offers a story about research he conducted for the World Bank, and the findings with respect to Zambia which were featured in the Why Poverty documentary Stealing Africa.

A few years ago Zambia was on the brink of crossing into middle-income status, but eight out of ten people still lived on less than $2 a day and Zambia was—and remains—heavily reliant on earnings from the country’s main export, copper. For complex reasons involving the three Ts, Zambia has reaped only a fraction of the potential benefits from its copper exports.

“In 2008, if Zambia had received the price for its copper that Switzerland declared on re-exporting the exact same copper, then Zambia’s GDP would have nearly doubled,” Alex says. In fact, the vast majority of the copper never even transits Switzerland.

What seems to have been happening is this—though the process is far from transparent: A Zambian company, or a Zambian subsidiary of a Swiss company, sells the copper it mines to a Swiss-registered company at prices greatly below the market value. The Swiss-registered company then resells the same copper at world prices (and in some cases declares a price far above the world price), taking the difference as profit in low-tax Switzerland, and in the process depriving Zambia of both export earnings and tax revenue on the sale.

Despite the efforts of a new Zambian government to strengthen enforcement of trade and tax laws, Alex says, this sort of tax evasion continues to be rampant. “Zambia is still losing an enormous amount of corporate tax revenue,” he says. Although there are now controls on export prices, other avenues of profit shifting remain. Of the many copper mining companies in the country, only two have declared profit in the last two years, a time of booming copper prices. “Prices are at the highest they’ve ever been,” Alex says. “If these companies aren’t making a profit now there’s no reason for them to be in Zambia at all.”

This Zambian case is but one example of trade mispricing, a widespread problem that is attracting growing attention across the globe, Alex says. In recent blog posts on tax haven secrecy and anonymous company ownership, Alex explains how these problems are exacerbating the fiscal problems of rich countries. “That’s why we’re starting to see interest in this,” Alex says. “It’s not just a development issue; it’s an issue for all of us and I think we’re going to see real progress in the next year or so,” he adds.

The promise of progress is exciting, especially given the scope of the problem and the impact it has on developing countries. Though estimates of the size of illicit flows through mispriced trade vary widely—the practice is after all secret and illicit by nature—Alex suggests that illicit outflows from developing countries are about eight to ten times larger than official development assistance (ODA).

I’m astonished. On one hand, many development advocates focus their efforts on maintaining and increasing foreign assistance, arguing that foreign assistance is both the right thing to do and the smart thing to do. Yet on the other hand, there is a lively debate among development economists—and a general lack of consensus—about whether or not aid boosts growth or otherwise helps countries to develop (for a recent chapter on this debate, see this award-winning CGD paper.

But if what Alex is saying is true, then foreign assistance is but a tiny fraction of the wealth that flows out of developing countries through financial secrecy jurisdictions often under the control of the very countries that pride themselves on being generous aid donors—for example, the UK has responsibility for Crown Dependencies and Overseas Territories including Jersey, Guernsey, the British Virgin Islands, and the Cayman Islands.

I ask Alex: “Does this mean we in the rich world are assisting it the pillaging of developing countries, even as we pride ourselves on giving aid?”

Historically, Alex says, that isn’t far from the truth. Taking the UK as an example, Alex explained that 30 to 40 years ago, the UK encouraged small island states under its control to pursue the tax haven route to economic growth, fearing that without growth the islands would always be dependent on the UK. What happened, he says, was the opposite: the City of London, the UK financial hub, became very dependent on the large financial flows coming through those island states.

A similar relationship exists today between India and Mauritius, Alex says. Unilateral efforts to increase transparency could lead to short-term volatility for a number of developed and emerging countries, he says.

Given the interests at stake, I ask, is there any hope for reform? After all, recent US history shows that the financial sector has been extremely effective in fighting off unwelcome regulation, even after overly risky practices set off at financial crisis that placed the global economy in jeopardy and required billions of dollars in public funds to bail out struggling financial institutions.

Alex replies that he is nonetheless optimistic. “What we’re seeing now is a combination of the problem being very well recognized in developing countries, and rich countries increasingly feeling fiscal pressures themselves,” he says. “This combination of interests … has the potential to overcome … all of the interests on the other side.”

Alex points out that some of America’s biggest companies—he named Google, Amazon, and Starbucks—have recently been criticized for the impact of their tax practices. US-based multinationals in total declared nearly half their profits in five tiny jurisdictions with limited transparency and advantageous tax rules: Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland. This sort of activity, he says, is prompting public criticism and pushing rich countries to reconsider international tax rules.

The solution? A further movement towards unitary taxation is one option we discussed. Under this approach, a multinational company would be treated as a single entity and it’s global earnings would be taxed based on the location of economic activity, rather than where it may choose to declare profit. Other options and solutions are being considered by the Organisation for Economic Cooperation and Development (OECD) and the G-8, Alex tells me.

Looking ahead, Alex tells me he plans to delve deeper into these issues, in blogs and forthcoming research. Stay tuned.

My thanks to Alex Gordon for editing the Wonkcast and Catherine An for providing a draft of this blog post.