Definition and scope of illicit financial flows
Illicit financial flows (IFFs) have long been placed at the foreground on the international agenda and are essentially “generated by methods, practices [...] aiming to transfer financial capital out of a country in contravention of national or international laws.” (UNODC). As of 2014, they are said to represent between USD 1.4 to 2.5 trillion of the global economy (Global Financial Integrity).
World banks involved in illicit financial flows.
Source: Redman, 2016
Facilitators of IFFs practices
Every year, large sums of money are transferred out of countries illicitly. The current literature identifies three main practices: money laundering, tax havens, and trade mispricing and misinvoicing (OECD). Money laundering is the most common practice in financial crime and IFFs, and fighting it has been on the international agenda for two decades. Although the OECD defines tax havens, and mispricing and misinvoicing as independent practices, they are interconnected with money laundering.
1. Money laundering. The Financial Action Task Force (FATF) defines it as the processing of […] criminal proceeds to disguise their illegal origin” in order to legitimise the ill-gotten gains of crime” (OECD). It is “notable for its diversity of forms, participants and settings [...] involving the most respectable of banks unwittingly providing services to customers with apparently impeccable credentials [...] or even small nonfinancial businesses knowingly providing similar services to violent criminals” (Levi & Reuter, 2006). It represents between USD 800 billion to 2 trillion of the global economy annually (UNODC).
The process of money laundering.
Source: OECD
The process follows three steps (Levi & Reuter, 2006):
Money laundering does not necessarily have to be transnational, it can happen within the national border of one single country.
2. Trade mispricing and misinvoicing. Mispricing entails that “exporters may understate the export revenue on their invoices, and importers may overstate import expenditures, while their trading partners are instructed to deposit the balance for their benefit in foreign accounts” (Volker, 2012). Misinvoicing is a “form of customs and/or tax fraud involving exporters and importers deliberately misreporting the value, quantity, or nature of goods or services in a commercial transaction” (Forstater, 2018). They mostly affect developing countries and drain USD 800 billion annually (Forstater, 2018).
The process of misvoicing.
Source: Risk Screen
3. Tax havens. They are an integral part of modern business practices. They are “places or countries that have sufficient autonomy to write their own tax, finance, and other laws and regulations” (Palan et al., 2013). The 2007 capital placed through offshore companies in tax havens reached a value between USD 5000 to 7000 billion (Radu, 2012). Individuals or companies have three basic approaches to tax strategy:
What is the impact of IFFs?
Main drivers include “the overriding imperative to move wealth into harder currencies (i.e. US dollars), evade tax and/or customs duties, launder the proceeds of criminal activity, circumvent currency controls and shift profits offshore” (Global Financian Integrity). All components constitute serious threats to international security and contribute to financial instability. As their tax systems suffer from weak capacity and corruption, developing countries present a much higher level of corrosion. These IFFs could instead be used for much needed financing for public service improvement, countering international security threats or basic social services, whereby the most immediate impact is a “reduction in domestic expenditure and investment” (OECD).
References
Palan, R., Chavagneux, C., & Murphy, R. (2013). Tax havens : how globalization really works (Ser. Cornell studies in money). Cornell University Press.