Negative impact of illicit financial flows (III)

By Kevin Tutani | Dec. 13, 2024

Reducing the scale of IFFs would likely result in a stable local currency.

ILLICIT financial flows (IFFs) have been described fully in the past two articles, which were published in the previous two weeks. They refer to cross-border movements of funds, which are either illegal or harmful to society.

They are usually facilitated by multi-national corporations (MNCs), ultra-wealthy individuals, politicians and also outright criminals. Most technical processes pertaining to IFFs were already described in the previous articles.

Today's column will provide extra detail on the negative impact of illicit financial flows. Additionally, methods in which they can be curtailed will be offered.

Negative impact

When companies decide to illicitly transfer profits from the home country, in which they were generated, that is bound to result in overall economic decline and premature de-industrialisation (especially in Zimbabwe's case).

Illicit financial outflows may be one of the main causes of the shrinking manufacturing sector, which has declined from 23% of total economic activity (gross domestic product) in the 1980s to the current 9%.

If the companies and individuals behind IFFs had not illicitly transferred funds to other countries, then Zimbabwe would have had sufficient capital to fund existing and emerging businesses.

The owners of the funds could have directly invested in the expansion of their existing businesses or established new enterprises altogether. Even if the owners were to simply keep their funds as cash deposits in the banking sector, those abundant funds would have kept interest rates low and enabled other local businesses to access abundant and cheap loans.

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This would have contributed to Zimbabwe's own economic growth and job creation aspirations. Curbing IFFs may, therefore, be one of the most effective ways of achieving robust economic growth.

Reducing the scale of IFFs would likely result in a stable local currency, lower interest rates in the banking sector, and higher domestic investment.

So, governments should move away from a narrow minded focus on low-inflation and budget and trade surpluses to include the issue of IFFs as well.

When companies under-declare their profits due to IFFs, the government will collect much less revenues than it would have collected, if the companies had chosen to be honest.

This limits the government's ability to provide social services (public healthcare, education) and critical infrastructure, among other things. The aforementioned set of circumstances can be expected to slow down the country's economic growth.

Workers will also find it difficult to negotiate for higher wages if their company has secretly and illicitly shifted profits to its subsidiaries in other countries.

Minority company shareholders, who are likely to be unaware of illicit financial flows being facilitated within the company, are also likely to be prejudiced of the income and dividends, which should have been due to them.

It is also important to note that, by their nature IFFs tend to encourage errant firms to favour sourcing their inputs in the global market, instead of domestically.

This will also disrupt domestic industry value chains. So, profit shifting through IFFs can disrupt the integration of domestic supply chains, their upgrading and diversification, which is needed in order to improve domestic value addition and build robust local production systems.

Underreporting of profits and payment of lower tax, enables firms involved in IFFs to have a competitive advantage over their existing rivals and potential new entrants into their industry.

This is because such firms, although they feign to be making lower profits, will likely be more profitable than firms which are not involved in IFFs.

Smaller and other large and honest domestic firms are likely to be negatively affected by this. IFFs grant an uneven tax benefit (reduced tax payments) to errant firms. These tax benefits may also block new entrants from joining a particular industry since they may even be deterred by prevailing product prices which may appear too low or seem unfeasible.

In essence, this means that IFFs tend to make domestic industries less competitive, since they tend to repel new entrants from joining. The ultimate result of reduced competition within industries is a slowdown in innovation and reduced global competitiveness on the part of local industries.

This may eventually lead to the dominance of more competitively priced and better quality imports, within the economy.

IFFs tend to worsen a country's tolerance for corruption. The lucrative nature of IFFs usually drive corrupt individuals and businesses to commit significant resources and time towards capturing government institutions (and their respective civil servants), which are supposed to regulate them.

Such institutions include the police, courts and banking officials. The State's capacity to regulate, oversee, monitor and discipline entities involved in IFFs should remain uncompromised, if the illicit outflows are to be curtailed.

In some cases, governments may end up ignorantly investing in companies, which are involved in IFFs. The challenge with this is that the under-declaration of profits by errant firms means that the government's investments will take too long to be recouped.

Government's investments in companies, which facilitate IFFs, may even be lost altogether if such companies become insolvent or divest. So, pension schemes for government employees and development finance, which is provided through local institutions, such as Empower Bank, Agribank, the Infrastructure and Development Bank of Zimbabwe and the Industrial Development Corporation should not be invested in entities, which are a high risk, pertaining to IFFs.

In South Africa, the government's employee pension fund and other domestic development institutions once invested in dubious companies, which were associated with IFFs and had subsidiaries in tax havens.

This led to government losses of US$333 million in a company called Erin Energy and more than US$100 million impairments (losses) in Smile Telecoms Holdings. Taking lessons from the South African example, Zimbabwe should try to avoid a similar situation.

So, it is critical to assess whether or not the companies, which the government chooses to invest in have tax havens and IFF links.

Curbing IFFs

Zimbabwe needs to build capabilities so that it is able to curtail illicit financial flows. Rules, which outlaw trade mispricing and place limits on interest that should be paid on offshore loans, can be a great place to start.

The government should also aim to have multi-lateral agreements with a number of countries, for the purpose of exchanging tax information and banking details of its citizens, whenever such a need arises.

The exchange of such records proves critical when there are entities that are being investigated for facilitating IFFs. The greater the number of countries, which Zimbabwe has established banking and tax information exchange relationships with, the better.

Joining multi-lateral groups, such as the "OECD/G20 Base Erosion and Profit Shifting (BEPS) initiative", can help in this regard.

Companies, which operate in two or more countries (MNCs) should be mandated to produce country-by-country reporting when presenting their financial statements in Zimbabwe. This can help to show if there are suspicious transactions which need further investigations. It will also discourage the multinational corporations from shifting their profits which were originally generated within Zimbabwe, to any of their subsidiaries in foreign low-tax jurisdictions.

The Zimbabwe Revenue Authority (Zimra) should consider setting up a “large business centre” (LBC). The LBC will be a special department within Zimra, which focuses strictly on large businesses and ultra-wealthy individuals.

This is so that Zimra ensures that the aforementioned entities do not participate in IFFs, nor try to evade the payment of taxes through other unscrupulous means.

The LBC will need dedicated units for dealing with aggressive tax planning, transfer pricing, offshore arrangements (including tax havens), and the use of trusts for the purpose of tax evasion. When South Africa established its own Large Business Centre in 2004, it was so successful that it ended up collecting more than 30% of the country's total tax collections.

However, due to the contestation of organisations and people that were in great opposition to its existence, South Africa's LBC was eventually dismantled in 2014.

It is argued that the LBC in South Africa eventually became a victim of the powerful interests, which it had been regulating. This shows the importance of protecting and monitoring such critical institutions.

A great deal of sophisticated analysis and enforcement can be achieved through the use of Zimra's and the Ministry of Finance's basic records on company income tax, value added tax and customs duties.

The Registrar of Companies may also be roped in to assist. In Zimbabwe, the Registrar of Companies is a government agency tasked with monitoring the compliance of local companies to domestic financial and shareholding standards.

Each year, local companies are obliged to submit their annual financial statements and current shareholding structures. The Registrar can be capacitated to regularly and diligently asses the exposure of local companies to IFFs and tax havens, through verifying if they have links to subsidiaries in tax havens or if they could have possibly shifted profits, which were generated in Zimbabwe, to other countries.

The registrar can also use technology in order to flag (identify and target) companies, which need to be analysed further, on account of their likelihood to be involved in IFFs.

Electronic, publicly accessible and searchable company registers can give the registrar a superior advantage. Local companies may be mandated to provide details on their foreign subsidiaries and affiliate companies, including their beneficial owners, who are typically more difficult to unmask. These details should be uploaded on the aforementioned electronic company register.

Local companies, which need any form of government support, including tariff protection, preferential public procurement, direct funding or even tax holidays, should be required to provide intricate details on their financial records and to report on whether or not they are affiliated to subsidiaries located in tax havens.

Firms, which refuse to provide such information, should be excluded from government support.

The law may also be adjusted to include financial outflows, which are not necessarily illegal, even though they are ultimately harmful to Zimbabwe. Such outflows should be classified as potentially illegal, requiring additional investigations, if it is suspected that they were inappropriate.

The government can also reduce and remove some taxes. For example, corporate income tax can be taken down from 25% to only 15%. This will make it match with other tax havens such as Switzerland, for instance.

The government can also repeal capital gains tax. The reduction and removal of such taxes would provide much less incentive for Zimbabwean companies and individuals to illicitly move any of their funds to other countries or low tax jurisdictions.

The stability of the local currency (Zimbabwe gold) and banking sector, can also promote greater patience among economic participants, such that less of them will consider IFFs a viable option.