The real black money

Print edition : May 26, 2017

THERE are many misconceptions about how flows of black money are generated. One prominent misconception is the apparent belief among policymakers that much of it is because of the existence of the “informal economy”, which relies heavily on cash-based transactions. By contrast, it is believed that the formal economy, in which payments are made through cheque or in the digital mode, is somehow much less amenable to corruption and tax evasion. Indeed, this is the chief justification provided for the aggressive pushing of cashless exchange that is now being touted as the main “achievement” of the drastic demonetisation exercise.

This simplistic equation between non-formal, cash-based activities and some sort of tax evasion or criminality is a complete misunderstanding of the nature of the informal economy in India. The formalisation of the economy is a desirable goal (although it cannot be achieved almost at gunpoint), but lack of it hardly indicates that all those who are not lucky enough to be employed in formal, registered economic activities are thereby engaged in some subterfuge or corrupt or criminal activities. In India, close to half of the national income is generated by informal activities, and more than 90 per cent of the workers in the economy are either self-employed or working on informal contracts. The close, symbiotic interdependence between the formal and the informal sectors also means that a strict dichotomy between the two cannot be made.

Further, most illegal or tax-evading strategies do not necessarily rely on “informal” economic arrangements—rather they are based on manipulation and misstatement of recorded activities, mostly within the formal sector. All the major scams that have occurred in India over the past decade provide justification for this.

Indeed, an anti-corruption approach defined by clamping down on cash transactions rather than dealing with the plethora of non-cash methods can hardly be justified even within the government. The fact that it persists at all speaks volumes about the poor institutional memory that characterises policy discussion in India today. After all, just five years ago, in 2012, a White Paper of the Ministry of Finance made it clear that one of the main ways in which black money in the form of tax evasion is generated is by hiding, or wrongly reporting, transactions and then seeking to hide the audit trail. This occurs through various methods such as underreporting revenues or receipts or production; inflating expenses; and not correctly reporting workers employed so as to avoid statutory obligations for their welfare. For companies involved in imports and exports, trade misinvoicing is a major source of financial wrongdoing. Note that none of these is dependent in any way on cash transactions—indeed, they can be easily and effectively carried out in cashless modes.

Just how significant such commercial chicanery is, and how damaging for the economy, is apparent from a new report on illicit financial flows (IFFs) from Global Financial Integrity ( Illicit Financial Flowsto and from Developing Countries: 2005-2014, Global Financial Integrity (GFI), April 2017). The report is based an in-depth study of balance of payments data as well as estimates of trade misinvoicing derived from the bilateral direction of trade data that yield estimates that can be applied to total exports and imports of a country. It presents a depressing picture.

It found that “over the period between 2005 and 2014, IFFs likely accounted for between about 14.1 per cent and 24.0 per cent of total developing country trade, on average, with outflows estimated at 4.6 per cent to 7.2 per cent of total trade and inflows between 9.5 per cent to 16.8 per cent”. Over the decade, it is estimated that total illicit flows increased at an average annual rate of 8.5 to 10.1 per cent. In terms of absolute values, the numbers are quite striking: as much as $2 trillion to $3.5 trillion in 2014, with estimates of illicit outflows at between $620 billion and $970 billion, and inflows at between $1.4 trillion and $2.5 trillion.

Money laundering

The GFI study finds that IFFs stem from two main sources: deliberate misinvoicing in merchandise trade (the source of GFI’s low and high estimates); and leakages in balance of payments (also known as “hot money flows”). Trade misinvoicing essentially occurs when either the value or the volume of a shipment is wrongly stated on a customs invoice. This is effectively money laundering, and it is possible because those engaged in trade either write their own trade documents, which they then show to the national authorities, or arrange to have the documents prepared in a third country like a tax haven or a country with some bilateral double taxation agreement with one of the trading countries. This can allow large amounts of funds to be shifted across international borders fairly quickly and almost always undetected.

The fact that most national customs authorities do not share information and that there is no international mechanism for doing so makes this a relatively smooth way of moving money across borders, whether this is money resulting from criminal or illicit activity, or it is simply a means of evading taxes in any particular jurisdiction.

The GFI report argues that trade misinvoicing is the primary measurable means for shifting funds in and out of developing countries illicitly. Even on the basis of its own lower estimate, the study finds that fraudulent misinvoicing of trade accounted for around 87 per cent of illicit financial outflows. (Of course, it is recognised that many other forms of IFFs cannot really be captured through available methods and so other forms may also be important.)

What is more, the study shows clearly that for most developing countries, this is a greater problem with respect to inflows (overinvoicing of exports and underinvoicing of imports) than outflows (underinvoicing of exports and overinvoicing of imports). This probably reflects the structure of taxes and tariffs in these countries. The largest amounts (and proportions of trade values) of trade misinvoicing—and thereby of IFFs—are to be found in Asia.

What is more, the report makes it clear that the numbers it provides are likely to be significant underestimates for most countries. First, they are based only on the recorded trade data, which must be only a relatively small part of IFFs, albeit the easiest to measure. Second, even within trade, the calculation relies only on merchandise trade data rather than trade in commercial services, which probably offers even more opportunities for misinvoicing. Third, it assumes only one-way misinvoicing— that is, if the two parties to a transaction (the exporter and the importer) collude in providing the same fake invoice, this would not show up as misinvoicing.

If this represents only one part of the IFFs, then the full extent of such flows must be truly mind-boggling. It is obvious that these represent substantial losses of tax revenues that most developing countries can ill afford. The inadequacies of the global financial and fiscal architecture that enable such illicit flows and that reduce the capacity of governments to control them or to garner the resources that are being evaded in this manner are now well known. But it is also true that most developing countries do not make full use of their existing powers to monitor, control and ensure tax revenues from such transactions.

What of India? According to the report, trade misinvoicing accounts for 100 per cent of IFFs in India—although that could simply reflect the sheer difficulty of estimating hawala flows that are unrecorded in balance of payments data. And the numbers involved are definitely significant, ranging from a low of 6 per cent to a high of 14 per cent of total trade values, and accounting for anything between $4.2 trillion and $9.8 trillion over the decade. As for many other countries, misinvoicing of inflows dominates and is also estimated to have grown more rapidly than misinvoicing of outflows over the period. This clearly indicates very substantial tax revenue losses through the decade.

If the government is truly serious about cracking down on tax evasion and the generation of black money, it should focus on such issues first. The positive examples of countries like Ecuador have shown how it is possible to increase tax revenues dramatically by actually tracking costs and sales properly. In the case of trade flows, the fact that real-time world market price data are now available at the detailed commodity level should enable customs officers (who must of course be appropriately trained) to detect intentional misinvoicing of merchandise exports or imports. This should be possible even with some services that are widely traded.

Of course, such work would be low-key and would require patience, persistence and attention to detail. That clearly makes it less attractive to a regime that prefers grandiose and sweeping measures undertaken in a blaze of publicity. That such measures are less effective in achieving the declared goals is presumably not an issue.