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Illicit Money: Can It Be Stopped?

On May 4, the Obama administration announced a plan to crack down on offshore tax havens, which it said are costing the United States tens of billions of dollars each year. The President’s proposals were primarily aimed at finding ways to increase revenue from wealthy companies and investors who use loopholes in the law and offshore subsidiaries to reduce their US taxes. But the administration is largely missing a far more devastating problem related to offshore finance: money gained from criminal and other illicit sources. With the use of tax havens and other elements of an increasingly complex “shadow” financial network, vast sums of illegal money are being shifted throughout the global economy virtually undetected.

Illicit money is usually generated by one of three kinds of activities: bribery and theft; organized crime; and corporate dealings such as tax evasion and false commercial transactions. Be- cause they are largely invisible, flows of illicit money across borders are difficult to measure. The World Bank estimates that they range from $1 trillion to $1.6 trillion annually, of which about half—$500 billion to $800 billion—comes out of developing countries ranging from Equatorial Guinea to Kazakhstan to Peru.

Friedrich Schneider, an Austrian economist, suggests that money laundering on behalf of organized crime and other illegal sources in just twenty OECD countries amounts to some $600 billion per year. Global Financial Integrity, an organization in Washington, D.C., finds that illegal flows of money from developing countries to banks in Western countries may reach more than $1 trillion annually. While there are different ways to quantify the problem and obtaining reliable data is difficult, these estimates are within a surprisingly narrow range.1 Taken together, they suggest that trillions of dollars of illicit money are flowing through international financial markets. Where is this money coming from?

Drug trafficking, racketeering, and terrorist financing are among the leading causes of money laundering, while in recent years the financial corruption of rogue political figures such as General Sani Abacha of Nigeria, Vladimiro Montesinos, the former intelligence chief of Peru, Pavlo Lazarenko, the former prime minister of Ukraine, and others has received much attention in the press. In fact, however, organized crime accounts for only about a third of illicit money flows, while money stolen by corrupt government officials amounts to just 3 percent. The most common way illicit money is moved across borders—accounting for some 60 to 65 percent of all illicit flows—is through international trade.

According to the World Trade Organization, the total annual global trade in goods and services before the current economic crisis was approaching $40 trillion2; but as much as $2 trillion of the total may be illicit money that has been illegally moved out of a country, or has been used to provide illegal kickbacks to corrupt executives or officials.

Russia has experienced what is probably the greatest theft of resources ever to occur in a short period of time, some $200 billion to $500 billion since the early 1990s. Almost all of this was accomplished by the deceptive underpricing of exports of oil, gas, diamonds, gold, tin, zinc, nickel, timber, and other resources. Oil was ostensibly sold abroad for as little as $10 a metric ton, with the balance of the real value paid into European and American bank accounts of Russian oligarchs. China has experienced a similar drain of financial assets, again accomplished through underpricing exports of, at first, consumer goods and now a widening range of technology products.

Of any major country Nigeria has probably had the highest percentage of its gross domestic product stolen—largely by corrupt officials—and deposited externally. Since the 1960s, up to $400 billion has been lost because of corruption, with $100 billion shifted out of the country. Of the population of about 150 million, some 100 million live on $1 to $2 a day. Unrest in the poverty-ridden Niger Delta is so severe that oil production has dropped from a peak of 2.6 million barrels a day in 2006 to 1.7 million today.

Venezuela’s state-owned oil company, Petróleos de Venezuela S.A., has abused transfer pricing to shift enormous wealth abroad. Crude oil is underpriced and sold to Petróleos’s twenty-three foreign refineries in the United States, Europe, and the Caribbean, which then sell gasoline and other products at normal prices; the profits are thereby largely kept outside the country, for the use of corrupt officials. Hugo Chávez recently appointed his sixth managing director as he attempts to wrest control of the company, which is the state’s principal provider of revenue, while at the same time running a government as corrupt as its predecessors.

In these and other cases, a common strategy for hiding and moving large sums of money is falsified pricing in international trade. Prices are falsified in one of two ways. In the first, the invoice from the exporter is sent to an office in a tax haven where it is rewritten with an altered price. Then the new invoice is forwarded on to the importer. Alternatively, a false price may appear on the invoice sent directly by the exporter to the importer after they have agreed, usually verbally, to deposit a portion of the payment in a foreign account. Unlike invoices that are rewritten, this second form of mispricing is invisible in recorded international trade statistics but can be detected by comparing major and consistent deviations in pricing from normal world market prices. For example, research by Simon Pak and John Zdanowicz has shown systematic underpricing on invoices for US exports, including car seats exported to Belgium that were invoiced for $1.66 each; ATM machines exported to El Salvador for $35.95 each; and forklift trucks exported to Jamaica for $384.14 each. By this strategy, the US exporter drastically reduces its US tax burden, while presumably receiving much larger sums from the buyer that may then be hidden in offshore banks.

Within multinational corporations, the practice of mispricing can also be used as a tax-avoidance strategy. Take the following simplified example: a company in country A makes photocopy machines that have a production cost of $1,000. The company establishes a dummy corporation in a tax haven that buys the copiers at cost for $1,000 apiece. Since the company has not made any profit on the sale, no taxes are owed. The dummy corporation in the tax haven then sells the copiers to another subsidiary in country C, at a price of $2,000 each. Now the company in country A is making a profit of $1,000 on each machine sold, but since the sales are through the offshore dummy corporation, the company pays only those marginal taxes that are charged in the tax haven. The subsidiary in country C may in turn sell the copiers on the open market for $1,500 each, allowing it to claim, for tax purposes, a $500 loss on the $2,000 purchase price. But since the company in country A owns all of the parties involved in the transaction, it is actually making a $500 profit on each sale.

The Global System of Illicit Finance

Falsified pricing and other money-laundering techniques have been facilitated by the rapid growth of tax havens and secrecy jurisdictions ranging from Monaco to the Cayman Islands. By welcoming disguised corporations, anonymous trust accounts, fake foundations, and other entities for hiding money, these offshore financial centers create the space in which many billions of dollars in unseen and unrecorded proceeds can be shifted across borders.

Minor parts of this system were in existence earlier, but the 1960s marked the takeoff point for two reasons. First, from the late 1950s through the end of the 1960s, forty-eight countries gained independence from colonial powers. Many leaders in these new countries, sometimes influenced by domestic instability and cold war politics, wanted to take money abroad; bankers in Western countries responded by devising creative strategies such as the use of secret accounts and false invoices for moving large sums across borders. Leaders including Mobutu Sese Seko in the Congo, Ferdinand Marcos in the Philippines, Suharto in Indonesia, and others made use of dozens of overseas banks competing for their millions of dollars of ill-gotten gains.

Second, during the 1960s a number of large corporations became multinational, establishing hundreds of locations across the globe, sometimes even moving corporate headquarters offshore. “Tax planning”—devising creative ways to reduce or avoid corporate taxes—became a normal practice.

Thus, decolonization and the growing international reach of corporations propelled the development of a whole system of offshore finance that was designed to avoid taxes and regulation. In the process, the system also obscures the origin and destination of the increasingly large sums of money passing through it.

Of course, some financial activities in tax havens are perfectly legal, and many individuals and corporations may use them simply to move funds offshore to reduce their tax exposure in their country of residence. But by enacting privacy laws and allowing corporations and individuals to be represented by trustees, many such havens permit companies and foundations established in their jurisdictions to mask the true identity of their owners. This enables all types of depositors to circumvent standard accounting and reporting requirements on transactions and profits simply by routing them through a tax haven. In recent years, the Swiss bank UBS created offshore accounts for thousands of US clients, violating US law in the process. The bank is paying a $780 million fine on the resulting criminal charge and is being forced to provide the names of 4,450 of its US clients in settlement of a civil action by the US.

Through the combination of low or no taxes, little or no financial reporting requirements, lax regulation, and well-defended secrecy, tax havens have grown to the point where they control an estimated $6 trillion in assets. Many now cater to particular market niches. The Isle of Jersey serves companies such as Bank of America and Morgan Stanley that are active in the London market, just as Panama, which is used by AIG and American Express, among other companies, serves the US market, and Vanuatu the Australian market. Mauritius is a channel for investments into India. Cyprus is a preferred center for Russian money laundering, and the British Virgin Islands have become especially favored by Chinese businesses shifting illicit capital in and out of their home country.

Providing the highest level of secrecy are Liechtenstein, Singapore, Dubai, and the Turks and Caicos Islands. Bermuda and Guernsey use favorable tax laws to draw in billions of dollars in reinsurance funds from firms such as Scottish Re. The Cayman Islands, which hold nearly $2 trillion in foreign-owned cash and other liquid assets, are home to more than ten thousand “collective investment schemes” such as hedge funds.3 Banks in Switzerland, London, and New York, among them Credit Suisse, Barclays, and Citigroup, serve very rich clients by directing transactions through more than twenty Caribbean tax havens.4

  1. 1

    See “Stolen Asset Recovery (StAR) Initiative: Challenges, Opportunities, and Action Plan (World Bank, 2007); Friedrich Schneider, “Money Laundering and Financial Means of Organized Crime: Some Preliminary Empirical Findings,” Johannes Kepler University of Linz working paper (July 2008), p. 24; and Dev Kar and Devon Cartwright-Smith, “Illicit Financial Flows from Developing Countries: 2002–2006” (Global Financial Integrity, 2009), pp. 21–22.

  2. 2

    World Trade Organization data puts global exports and imports of goods and services at $33.8 trillion in 2007 and $39.1 trillion in 2008.

  3. 3

    Cayman Islands Monetary Authority, “Regulatory Framework: Statistics” (June 2008), available at www.cimoney.com.ky/section/regulatoryframework/sub/default.aspx?section=PD&id=666.

  4. 4

    Richard Murphy, “Tax Havens: Creating Turmoil” (Tax Justice Network UK, 2008), p. 24.

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