By Dr. Dev Kar
Dr. Dev Kar is Chief Economist Emeritus of Global Financial Integrity, a think tank in Washington DC, and a former Senior Economist at the International Monetary Fund.
Governments around the world as well as international organizations such as the International Monetary Fund (IMF), use the terminology “illicit financial flows” for what is popularly known as “black money” in India. Global Financial Integrity (GFI) was instrumental in defining illicit financial flows as funds which have been illegally earned, transferred, or utilized. Research at GFI found that the extent of illicit flows is directly linked to a country’s state of governance, with weakly governed states tending to drive more illicit flows than strongly governed ones. These studies estimated the volume of illicit flows to and from countries, ranking these outflows in terms of their sheer volume and in relation to GDP and total trade.
The role played by tax havens and banks in sheltering these funds were also studied, pointing out the data gaps where concerted international action to promote greater transparency is required. Highlighting the macroeconomic and governance-related drivers of illicit flows, the studies analyzed their impact on economic development. As a result, economists and government officials were able to discuss the global extent of the problem and the policy measures needed to curtail such outflows of scarce capital.
Measurement of illicit flows
Economic methods to estimate illicit flows or black money typically focus on two sources—leakages from a country’s external accounts (that is, the balance of payments) and the deliberate misinvoicing of external trade. On average between 2005-2014, deliberate misinvoicing accounted for around 87 percent of total measurable illicit outflows from developing countries. The word “measurable” is stressed because no data are available on illicit flows that are generated through drug and human trafficking, illegal arms trade, cross-border smuggling of cash, trade in contraband, etc. Hence, the estimates generated through economic methods based on balance of payments and trade data reported by countries to the IMF, are conservative.
Nevertheless, there exists a large gap between inflows and outflows of illicit funds that are measurable through economic methods, and the amount of such funds actually interdicted. The following chart explains why that is the case.
There are three databases that researchers typically use to estimate trade misinvoicing, the largest component of black money transfers. These are a detailed transaction-by-transaction database on exports of imports of a particular country (say, India) vis-à-vis each advanced country (such as provided by GFTrade), the United Nations Commodity Trade database (UN COMTRADE) that is at a higher level of commodity aggregation and is not transaction-by-transaction, and the IMF’s Direction of Trade Statistics (DOTS) that compares exports and imports against advanced countries on a bilateral basis. Estimates of misinvoicing are typically based on a developing country’s trade with advanced countries because the latter serve as “true price data” against which deviations are measured.
The program to estimate misinvoicing at the transaction-by-transaction level can be adjusted by the extent to which the implicit price deviates from the world or arms-length price for the commodity in question. The larger the deviation, the greater is the risk that a particular transaction is deliberately misinvoiced. So, a lower standard deviation (SD) would allow a greater number of transactions to be flagged as misinvoiced while a higher SD would restrict more transactions are being misinvoiced.
The law of large numbers dictate that the more detailed transactional database would yield larger estimates of misinvoicing. Hence, the misinvoicing estimates obtained by using the IMF’s DOTS would be far less than those obtained using the GFTrade, which in turn would produce larger estimates than UN COMTRADE.
While large misinvoicing estimates would attract the attention of Customs authorities, not all estimates would be officially flagged. Typically, the flagged transactions would be passed up the chain of command at Customs where a decision is made to interdict the most egregious ones. Even, at this level, the interdicted transactions are subject to negotiation with the exporter or importer. It is not as if traders would readily acquiesce to whatever charges the Customs brings against that trader. If the trader is unable to defend the price—and by implication, the value and/or volume of the transaction in question—the transaction is then subject to a penalty that is determined by Customs. Hence, the volume of penalized misinvoicings are less than the volume of interdicted misinvoicings.
Now, the trader in question may simply pay the penalty and clear the goods. However, if the penalty is large or if the trader feels that the penalty is unfair and unlikely to stick in court, he may decide to challenge it. In that case, the transaction is not considered to be misinvoiced until and unless a judge renders a verdict to that effect. That is why the total volume of large court-established misinvoicings is likely to be less than the sum of all penalties on smaller value trade transactions. The important point to note is that the Customs does not take every case of misinvoicing to court, the cost of which will be prohibitive. It takes the trader to court only on those cases where it deems there is sufficient evidence pointing to deliberate misinvoicing and an attempt to defraud the government.
There are good reasons for a large gap to exist between the black money estimates of economists and the amount that are actually interdicted and penalized by a government. The volume of illicit funds actually penalized by a country is no more an indicator of this problem than, say, the number of drug traffickers caught on the U.S./Mexico border is an indicator of the extent of Mexico’s drug problem.
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