gain. However, in the case of illicit capital flows, both the outward and inward transfers typically involve a loss to the government or the official economy rather than a gain. In order to assess total loss or the adverse impact of illicit flows on an economy, we should add inflows and outflows rather than net them out. There is no question of a net benefit accruing from illicit flows. Applying the netting out procedure that is relevant for licit flows to flows that are illicit in nature can lead policy makers, economists and others to make serious errors and draw damaging conclusions (such as illicit flows are not important in countries where drug trafficking is rampant). Second, it is unlikely that inflows of illicit capital (that are essentially unrecorded) can be taxed or utilized for economic development. After all, how can a government tax capital that is unrecorded? How can such capital add to the productive capacity of the official economy? Often, these so-called inflows are themselves driven by illicit activities to evade import duties (by under-invoicing imports) or value-added tax (VAT) or the over-invoicing of exports to collect on VAT refunds. Money funneled through the hawala system is similarly not recorded, and is similarly untaxed. The loss of applicable customs duties and VAT tax significantly hampers the collection of government revenues in many developing countries. Hence, there is no reason to believe that money brought into a developing country through illicit channels will be declared as taxable income or can be used for economic development. Rather than add to productive capacity, inflows of illicit capital can drive a speculative real estate boom, create a housing bubble and push the country towards economic instability. The implication is clear. Traditional models of capital flight such as the World Bank Residual method cannot capture genuine reversals of illicit flight capital. A return of flight capital typically follows credible economic reform on a sustained basis and may be detected in a significant increase in recorded FDI or recorded inflows of private portfolio capital. In contrast, the inflows indicated by the residual method and those identified by trade misinvoicing, are also unrecorded. Why would an investor smuggle in capital from abroad if that capital in fact represents a genuine return of funds? As the Indian and Chinese experiences show, outward transfers of illicit capital could come back to a country through a process known as “round tripping”, but these inflows would show up as an uptick in recorded FDI and would not be captured by the capital flight models as unrecorded inflows. Instead, such flows into developing countries are symptomatic of illicit activities that drive their underground economies, skewing the distribution of income and hampering poverty alleviation. Therefore, it makes no sense to treat illicit inflows as a benefit and net them the same way as one would an inflow of legitimate capital that is recorded on the books. Third, a number of studies have explored the link between “hawala” (or, currency substitution) transactions and trade misinvoicing. The hawala system is run by a network of hawala brokers, or hawaladars, in various countries. Hawaladars allow cash to be transferred between countries without restrictions on the amount of money, with no paper trail, and usually at a lower cost than what banks and other official channels charge. However, for hawaladars to maintain their hawala business, they must have huge reserves of cash available for immediate cash transfers. This need also prompts many hawaladars to engage in international trade which they conveniently misinvoice to bring in the needed funds. Kar (2008) found that during 2002-2006, an average of US$17.8 billion 4
Global Financial Integrity