The International Tax and Financial Architecture and its impact on Economic

and Political Development in Africa

Nicolas Meisel (meiseln@afd.fr) 2 April 2014

Mo Ibrahim Governance School on Governance for Development in Africa

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Outline• Introduction: provide a few analytical tools to

understand key mechanisms and insertion of SSA in FG.• Framework: Capitalism and financial globalisation (FG)• Assessing the impact of FG on economic and political

development: theory & evidence• Concerning features of FG: tax competition, capital flight

and tax havens• Conclusion: Way forward • Bibliography• Discussion

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Capitalism & Financial Globalisation (1)• Capitalism is based on market economy but came much

later and is more than market economy• Market economy paradigm = exchange among equals. Price

signals S=D. Markets self regulating in competitive equil. Engines of growth=Division of labour ; economies of scale ; technological progress. Main policy recommendation: separate econonomic sphere from politics.

• Capitalism = force of accumulation. Because money = power & No limit to desire of power, capitalism is not self regulating. Not converging to any ideal model. Inequality is its essence (social well-being not an obj). Separation of econ and pol impossible objective = effective regulation.

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Capitalism & Financial Globalisation (2)• Development trajectory determined by interaction between

organisations (firms, states, etc) and institutions (formal = rules of the econ & pol game; informal = representations & beliefs) at all scales.

• Capitalist growth is global in its logic of accumulation AND enshrined in local structures. Possible to have acceleration in one part of the world AND deceleration in another

• A historical process fed by its own contradictions (expansion, crises, innovation…).

• Instability is the rule, stability the exception. • Finance = central mediation of capitalist history, must resort to it to

borrow, invest, employ labour, expand K; dominant financial centres capture value (power shifting between Venice, Antwerp, Amsterdam, London, New York, Hong Kong…). Financial markets = money making money. Pb: greed has no bound. Self regulation cannot exist.

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Capitalism & Financial Globalisation (3)• 1944: Bretton Woods monetary system. Obj = stability. Fixed parities

+USD-gold convertibility. Finance under state controls in segmented national financial systems. Control of key prices= wages (w), goods, interest rates (i), x-rates.

• 1960s: increasing tensions due to end of reconstruction + accumulation of USD outside US

• 1971: Start of FG with the exit of BW by Nixon (end of dollar-Gold convertibility) floating exchange rates & full K mobility

• 1970s: recycling of petro-dollars overlending to 1st & 3rd world (public and private loans). Race between p, w & i in Western World stagflation.

• 1980: Dramatic rise in US i to curb p and definitely transfer power from borrowers to lenders Debt crisis structural adjustment plans: macro ‘stabilisation’ ; liberalisation of K account; and privatisation of public util.

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Rationale & theoretical benefits of FG• Standard justification for FG: if free to circulate, K flows from

S-rich-low-growth to S-poor-high-growth countries. • LICs need foreign K to grow because S-constrained (same

fundamental justification since the 1950s!) • Financial opening will

– Raise S, reduce financing costs (better risk allocation and increased liquidity reduces cost of K)

– Develop domestic financial market (entry of foreign banks, increased competition, better credit allocation)

– Smooth output and consumption volatility– Introduce market discipline in all macro policies: spur fiscal

discipline, monetary policy, and institutional reforms – Attract FDI (intl markets confidence & business climate)– Raise domestic investment and growth

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Evidence (1): Saving and investment rates have actually declined with financial integration in SSA (source: WDI)

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1960 1970 1980 1990 2000

Epargne bruteInvestissement

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1960 1970 1980 1990 2000

Epargne bruteInvestissement

Gross S and I in LA (% of GDP) Gross S and I in SSA (% of GDP)

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But not in ASIA

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1960 1970 1980 1990 2000

Epargne bruteInvestissement

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1960 1970 1980 1990 2000

Epargne bruteInvestissement

Gross S and I in South Asia (% of GDP)

Gross S and I in East Asia (% of GDP)

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Evidence (2): No relationship between growth and FG

Rodrik and Subramanian (2009) find no correlation between long-run growth and intensity of cross-border capital flows, neither in level …

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… nor in growth

Confirming (Prasad et alii, 2007 ; Gourinchas and Jeanne, 2007) : Countries that have grown most rapidly are those that rely less, not more, on foreign K! « For any given level of I, the more that is financed by domestic savings, the greater the long-run growth » Rodrik (2009)

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Evidence (3): doubts on benefits of FG• Facilitated external borrowing may actually relax, not increase,

macro discipline and fiscal constraint for longer periods than possible otherwise; ↑ future adjustment costs

• Y, C and income volatility ↑ with FG (Kose et al, 2007)• Insufficient absorption capacity Risk of overborrowing through

domestic financial institutions Poor I perf + Speculative asset bubbles → priv & public debt → boost C inflation + CA deficit ↑ risk of K flow reversal (sudden stops) and financial crises (Mex 1994, Thai 1997, Arg 2001)

• Classic answer: “inappropriate regulatory, prudential, supervisory structures”

• Pb: endless list; unfeasible; not strategic : ignores trade-offs & resource constraints (other reforms may be more urgent) ; historically unjustified (post-45 Europe, Korea, China).

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• Appreciation of the real exchange rate (overvaluation) hampering diversification in tradables

• Increase of real x-rate loss of profitability and competitiveness of tradable goods sector which is the key sector to foster endogenous growth Disincentive to invest in non traditional tradable sectors I demand for tradables diminishes and productive capital accumulation actually recedes

Real risks with capital inflows (2)

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Net private flows (loans, FDI, portfolio) and

overvaluation 1970-2004. Source: Rodrik (2009)

Undervaluation of the real exchange rate and growth (panel of 5-year averages

1980-84 & 2000-04)

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Decomposition of growth into‘within sectors’and structural change between sectors, 1990-2005

SSA: Growth-reducing structural change - Constrast with Asia

• Economic development requires systematic reallocation of factors of production from low-productivity, low skill & technology, decreasing returns sectors to higher-productivity, increasing returns sectors.

Disindustrialisation in SSA: Manufacturing Value Added (% du GDP)

1980 1990 2000 2009PMA 12,7 11,0 9,8 9,5PMA africains 12,1 10,7 7,4 6,6PMA asiatiques 14,2 11,8 12,7 14,4Autres PED 21,1 22,1 23,0 24,8

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FG hampering industrialisation: trickle down effects

• Impact on cost of capital: Atrophy of tradable sectors may worsen current account deficits and trigger a lasting dependence on foreign K to cover them, hence reinforcing perceived vulnerabilities and increasing cost of K.

• Impact on labour and demand for democracy: Historically industrialisation has promoted wage earners, formalisation and taxation of labour incomes, & contributed to develop welfare state

• If desindustrialisation slows down middle class formation, it may well suppress an essential historical constituency behind the D for democracy

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Conclusion on impact of FG • Increased instability • Overliquidity, esp. since 2000s

(see graphe)• Boost in consumption ; • Appreciation of real x-rate

even in countries with large CA deficits! contrary to Mundell Fleming std model

• Reduction of domestic I in tradables (decreasing returns on domestic I)

Impact on growth = O Sounds familiar?

Variation of real exchange rate horizontally and current account vertically for 30 emerging countries (2003-2007). Source: WEO, IBS.

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Net Capital Flows towards 30 emerging Countries (USD 2010)

Source : Institute of international finance (2010)

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Explanation: LICs suffer more from investment constraints than from saving constraints

• If an economy suffers from a lack of I demand, financial opening is not likely to impact domestic I positively because I is not responding to market conditions (decreasing function of r)

• Low demand for domestic I in tradables may be due to:– Low social return of K bec. human K, skills, infras and

social welfare limited by inadequate gov capacities– Poor I appropriability due to weak institutions (eg

property rights) or enforcement capacities of the state•Tradable sectors suffer the most from weak institutions & learning externalities (implicit tax, on top of x-rate appreciation) Putting the emphasis on I rather than on S as a main constraint entails completely different prescription =

invest in public infras, public goods and public services

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Harmful feature of FG: Tax competition

• Tax rebates ; 5-year holiday... schemes encouraged by WB (DB) to attract FDI

• Esp & ironically recommended “because you do not provide investors with key public infras” so they won’t come unless offered tax breaks

• Individual ad hoc treatments that increase fiscal policy complexity (IMF opposition)

• Race to the bottom in corporate income tax (no limit to the process)

• Pb: Not part of integrated fiscal, employment, skill devt, and industrial strategy.

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Harmful feature of FG: Capital flight (1)

• FG reduces returns on domestic I in tradables but ↑ incentives for K flight (returns on foreign I ↑)

– Certain skills imported with FG = fin., legal, fiscal and private banking.

– Much easier to send money abroad than invest in risky industrial venture for export markets.

– Much safer to protect assets abroad from predation, taxation, expropriation, competitors, etc.

– NB: origin of funds may be licit or illicit : proceeds from privatisations; kickbacks on gov loans; procurement contracts; transfers from public accounts…

– Csq: tax evasion by elites (reduced fiscal space) and inequality

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Stock of capital flight by country, 2008

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Harmful feature of FG: Capital flight (2)• KF figures by Ndikumana & Boyce 2011 > Henry 2012• KF = BoP residual (K inflows – uses) + trade misinvoicing

(underinvoice X– overinvoice M) + unrecorded remittances.• 2010: accumulated stock (39 African countries) since 1970 =

$1700bn >> Debt = 280bn. Collier (2001): 40% of Africa’s private wealth is held abroad.

• Nigeria, Algeria, Morocco, Egypt, Angola, Cote d’Ivoire…• Csq: Africa net creditor to the rest of the world • However important difference: public L but private A!• Negative impact of K flight on domestic I• Negative impact on growth = -2.4% (average) ; -0,8 (median) • On tax = 1700bn*3%=51bn (earnings per year)*30% (marginal

income tax rate) = 15Bn per year of lost revenues

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Harmful feature of FG: Capital flight (3)• KF from SSA = equal to the sub-continent’s total GDP• Equal to 10 years of Africa’s infrastructure investment needs• Equal to the wealth of Africa’s 100,000 “High Net Worth

Individuals”• Direct impact on inequality: rich do not pay tax ; real distribution

of income and even more of wealth far more skewed than current inequality stats (underestimation of Gini) as very rich underreported in both HH surveys & tax accounts

• Indirect impact on inequality and democracy : rich do not contribute to public infrastructure provision ; do not create local demand ; do not push for better institutions.

• Elites’ incentives disconnected from ordinary citizens: do not have to account for their deeds and can increase their wealth independently of their people’s fate.

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Harmful feature of FG: Capital flight (4)• 60% of KF due to debt = debt fueled KF ; and debt fuels KF as well = KF

and external overborrowing = twin problems• Zaire: ‘(…) In this office [the Presidency], no distinction is made

between state expenditures and personal needs. (…) Impossibility of control of frauds means that there is not any – I repeat any – chance on the horizon that the numerous creditors of Zaire will recoup their funds.’ E. Blumenthal (1982), Zaire: Report on its international financial credibility.

• FT, 12 May 1997: Senior banker quoted: ‘How Mobutu built up his $4bn fortune: Zaire Dictator plundered IMF loans’

• Mobutu: the first African president received by Bush Sr• WB loans to Nigeria 1984-94 = $4.6bn • Responsibility of lenders “Odious debt” by odious gvt• Today: KF accelerating ; China’s 2004-2010 $14bn Resource backed non

transparent loans + IMF optimistic projections

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Public foreign borrowing now conditional to IMF Debt sustainability analysis

IMF stress tests of debt sustainability in poor indebted countries recognizing lenders’ responsibility to prevent new crises green, yellow, red.

Limits: only external public D, missing donors; IMF position

Growth hypotheses are a key parameter of debt dynamics : dt = bpt + dt-1 (1+i)/(1+g) ; and easy to control

Annual average growth rate of GDP (historical, source WEO) and DSA hyp.

SENEGAL1986-2006 1994-2006 2000-2006 2007-2012 2013-2027

3,2 3,9 4,0 5,5 5,0

MADAGASCAR1986-2006 1996-2006 2001-2006

2,3 3,3 2,12007-2027

7,0

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• Off-shore secrecy jurisdictions• About 80 such places • With between USD 20 and 30.000 bn of accumulated

assets from developing countries under management (thus with hyp of 3% of return= 600-1000 Bn incomes)

• Hyp = 30% Marginal income tax 180-300Bn annual lost tax revenue

• 50% of banks cross border deposit and credit operations ; 1/3 of FDI

• Organised and controlled by 50 largest banks

Harmful dimension of FG: Tax havens

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The Way Forward: Democracy and capitalism

• Main effective governance scale until today = national. Largely ineffective in front of today’s global challenges

• « As long as the world economy remains politically divided among different sovereign and regulatory authorities, global finance is condemned to suffer from deformations far worse than those of domestic finance » (Rodrik).

• Incompatibility triangle: democ – econ integration (globalisation) - sovereign nation-states

• Global financial capitalism requires global regulation to protect itself from its excesses. Regulatory institutions need to be protected from market mechanisms. Politics must rule finance.

New forms of governance required and emerging: multi-scale, from national to global, to help democracy survive

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References

• P. Gourinchas & O. Jeanne (2007), Capital Flows to Developing Countries: The Allocation Puzzle, NBER Working Paper.

• E. Prasad, R. Rajan, A. Subramanian (2007), Foreign Capital and Economic Growth, Brookings papers on economic activity

• A. Kose, E. Prasad, M. Terrones (2007), Growth and Volatility in an Era of Globalisation, IMF Staff Papers

• D. Rodrik & A. Subramanian (2009), Why did Financial Globalisation Disappoint, IMF Staff Papers

• J. Henry (2012), The Price of Offshore Revisited, Tax Justice Network• L. Ndikumana & J. Boyce (2011), Africa’s Odious Debts: How foreign loans and

capital flight bled a continent• N. Shaxson (2011), Treasure Islands: Tax havens and the men who stole the world• R. Baker (2005), Capitalism’s Achille’s Heel: Dirty Money and How to Renew the

Free Market System• T. Piketty (2014), Capital in the 21st Century