Gray schemes and black holes: the Atlantic's informal finances
The shadow economy, which incorporates a wide range of financial activities, has now become one of the important criteria of investment attractiveness of countries. Deeply connected with corruption and an inefficient legislation, gray schemes represent a huge interest for large transnational capital, which needs to ease the tax burden. The more Atlantic countries invest in the financial and insurance activities of underdeveloped countries, the more successful they are in reducing the amount of informal money in their country by bringing it into the shadows.
The curse of the poor
In the broadest sense, informal finance forms such a concept as "shadow economy" or, according to the definition of the Organization for Economic Cooperation and Development, "unrecorded economic activity". The OECD refers to unregistered enterprises, underreporting of business income, overstatement of non-taxable expenses, use of forged documents to obtain benefits, one-day firms and unregistered "ghost" firms, black and gray wages, shadow employment, VAT evasion, smuggling of goods, creation of offshore zones and money laundering.
Analysis by the Boston Consulting Group, based on IMF data for 150 countries, has shown that states with lower GDP per capita have larger shadow economies. It typically accounts for more than 30% of GDP per capita. In contrast, in higher income countries, the shadow economy hovers around 7-8% of official GDP. Among the latter are the US, Germany, Australia and Japan. Shadow economy of 20-30% of GDP is recorded in South Africa, Italy, Greece, Turkey, Turkey, Argentina, Morocco, Tunisia and Ecuador. In Ghana, Côte d'Ivoire and Congo the volume of informal finance tends to 50%, which, according to World Economics, approximately corresponds to $16 billion.
An analysis of financial activity on the African continent by researchers at the University of Ibadan in Nigeria has shown that the existence of the shadow economy is directly related to access to credit and the level of urbanization of a society. The less developed the financial institutions, the more malleable an economy is to informal finance, and the more urbanized a society is, the stronger its ability not to participate in shadow schemes. However, for underdeveloped countries, it is unrecorded activity that becomes the stimulus for the development of the economy as a whole. According to the IMF, ⅔ of informal finance goes back into more traditional transactions, such as purchases in retail stores. This dependence of the formal economy on its shadow sector poses a serious problem for states.
In the shadow of uncontrollability
Tax evasion is the main reason why societies turn to the underground economy. On the one hand, this unregulated economic activity can reduce tax revenues and economic growth. On the other hand, the underground economy can be a powerful force for promoting institutional change and stimulating overall production. For example, the rapid growth of the shadow financial system in China was driven by the construction industry, which found it difficult to obtain bank loans due to the effects of the global crisis. The construction industry is crucial for national economic and social development because it provides the necessary infrastructure and consumes a large amount of resources, provoking the development of other areas of production. Thus, the lack of transparent financing forced non-banking financial institutions to lend to developers with higher returns.
The demands of banks are often unaffordable for the private sector and individual entrepreneurs, which also forces them to use unsupervised finance. A survey conducted by the State Administration for Industry and Commerce of China (SAIC) among more than 2,500 private enterprises in 2002 showed that nearly 60 percent of firms took loans from banks or the informal market.
Despite the obvious obstacles that arise when trying to analyze the underground economy, studies say that it employs 61.2% of the world's labor force aged 15 and older, and 47.2% of all employment is in the service sector - tourism, outsourcing and domestic work, street vending, and transportation. The 2009 FinAccess national survey showed that the majority of Kenya's adult population utilizes informal financial resources. This is equally true in Asia, the Middle East, the Balkans and India, where a combined 70% of the working-age population is involved in bazaars and markets. Store and stall owners can get a loan from a wholesaler without having to put up collateral, and without interest for delayed payment. Thus, 30% of the world's GDP generated in markets is largely generated through informal finance, bypassing the tax system.
It is believed that one of the representative indicators of the underground economy can be the volume of cash. In this case, the surge in cash circulation after the global financial crisis may indicate the presence of informal finance not only in developing countries like Mexico, but also in the United States, the EU and South Korea, where the share of cash increased by 52%-180%, respectively. Estimates covering data from 2010 to 2017 suggest that the average size of informal finance as a percentage of GDP in advanced economies is 14.2%, suggesting that black market mechanisms are universal.
Gifts of Atlanta
Economic studies draw different conclusions about the impact of the shadow economy on foreign direct investment. Thus, on the one hand, informal finance and poor quality of the institutional environment, such as high levels of corruption, undermine investor confidence and discourage the flow of transparent investment. On the other hand, higher taxes encourage transnational corporations to move their capital to countries with strong shadow economies and greater potential for tax evasion. This process may be facilitated by the lack of control mechanisms, including transfer price documentation requirements or undercapitalization rules. Even if such rules do exist, they are usually poorly enforced, which contributes to the withdrawal of income.
One way is to reallocate loans within multinationals: low-tax affiliates lend to subsidiaries in high-tax countries. Interest payments are deductible for the high-tax affiliate and increase the taxable income of the low-tax subsidiaries. This strategy allows multinational companies to shift taxable profits from high-tax countries to low-tax countries, which reduces the overall tax burden of the group.
Corporate taxes directly affect investment, employment and economic growth, and provide a significant portion of government revenues, helping to finance basic government services to its population. For example, according to the World Bank, the top 5 countries with high levels of shadow economy in 2018 were Georgia (56% of GDP), Bolivia (53%), Nigeria (48%), Guatemala (46%) and Ukraine (45%). Meanwhile, Georgia received $1.2 billion in investment in the same year 2018, with the UK being the second largest contributor. The UK's Milner Capital planned to invest about $2 billion in Bolivian hydrocarbon production alone. The UK was also the main source of investment in Nigeria in 2018. That said, the high level of informal finance this year did not prevent the country from attracting 37% more investment than a year earlier. Foreign direct investment in Guatemala totaled $16.3 billion in 2018, mostly from the US, up 1.5% from 2017. At the same time, just 4 years after the coup attempt, despite the ongoing armed conflict in eastern Ukraine and a high rate of informal finance, the US State Department assessed Kiev as an attractive option for investment, particularly in the agricultural sector.
Characteristically, in all the above examples, the sectors of financial and insurance activities, transportation, construction and trade received the largest inflow of investments. On the one hand, the development of financial institutions contributes to the formation of transparent monetary policy. However, insurance and financial activities based on accumulation of cash flows can be used for legalization of shadow incomes. In this regard, it seems unsurprising that the largest investors from the UK and the US invest their capital in the development of such corruption-prone areas of the economy in countries with high levels of informal finance.
It is notable that the Association of Chartered Accountants predicts that Nigeria and Ukraine will again be among the leaders of shadow economies by 2025, having generated about 46% of their GDP through uncontrolled finance, while their level in the UK and the US will be reduced by 1-2%. All this demonstrates that financing of strictly defined sectors of the economy, where it is easiest to conduct unaccountable activities, on the one hand helps depositors to bring finances into the gray or often completely black zone, and on the other hand in no way contributes to reducing the volume of informal finance in countries with a high level of gray schemes.
