specification 2, in which both dependent and independent variables are subject to one-period lags in order to provide relatively more robust results. Although changes in the size of the underground economy explain changes in illicit flows to a lesser extent (adjusted R2 of 0.63), the underground economy still remains highly significant in explaining changes in the latter.
c. Macroeconomic Drivers of Illicit Flows Regarding macroeconomic factors, one would intuitively expect economy-wide conditions to mainly influence the behavior of licit private sector flows. But the reasoning may not be so straightforward because macroeconomic instability can also create conditions for the transfer of illicit capital. After all, holders of illicit capital may also not like to suffer a loss of principal on their illicit capital through high inflation (which reduces the real value of illicit funds) or exchange rate depreciation even if they may not be seeking to maximize rates of return on illicit assets. Hence, we examine the relationship between macroeconomic drivers and outflows of licit and illicit capital. The results presented in Appendix A show that macroeconomic variables are somewhat better at explaining licit private sector flows than illicit flows. In other words, a larger number of macroeconomic indicators explain licit flows at the 1 percent confidence level than explain illicit flows at the same level.
d. Structural Drivers of Illicit Flows In our case studies on India and Mexico, we found that structural drivers, like non-inclusive growth, high income inequality, trade openness with lax oversight or a weak customs administration, and high unemployment can also drive illicit flows. For instance, non-inclusive growth, which creates many high-net-worth-individuals (HNWIs), also creates the conditions for increased tax evasion. After all, HNWIs are effectively connected to the globalized economy, and can therefore take advantage of the global shadow financial system for sheltering illicit capital. Non-inclusive growth inspires the vast majority of citizens to improve their standards of living without creating the conditions for attaining them. Increasing trade openness in the presence of weak governance can increase the opportunities for trade misinvoicing. High unemployment can drive the underground economy as the unemployed resort to illegal activities to make a living. Given that structural drivers can drive illicit flows, we included unemployment rate and real GDP growth in regression equations to explain illicit flows.
Russia: Illicit Financial Flows and the Role of the Underground Economy
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