Farming for Rats: Perverse Incentives and Illicit Financial Flows

flickr / timparkinson

In the words of two of my personal heroes: “Economists love incentives. They love to dream them up and enact them, study them, and tinker with them.”

For good reason; incentives make the world go round. They are the reason we get up in the morning, the reason we go to work, and definitely the reason we brush our teeth. They are dictate the speed we drive, the groceries we buy, and the pace of our work. Sometimes they are negative (the prospect of getting a cavity or a speeding ticket) and sometimes they are positive (a raise, or a hug from a child). But they are always at work in hundreds of ways, sometimes conscious and sometimes not.

Politicians like incentives almost as much as economists do. Federal and state governments incentivize all sorts of things, from milk production to renewable energy, and everything in between. The problem is though, that incentives are often difficult to design and, even more importantly, result in a whole new set of incentives that the designer never intended.

These are called perverse incentives and history is replete with them. Take nineteenth century China, for example, when paleontologists looking for dinosaur fossils paid peasants for handing over pieces of dinosaur bone. Later they discovered the peasants were digging up the bones, smashing them into many pieces to maximize their payments, and greatly diminishing their scientific value in the process. Others have pointed out that structuring bonuses for company executives around earnings encourages them to artificially inflate profits and make decisions targeting short-term gains at the expense of long-term profitability.

My favorite example of a perverse incentive, though, has got to be from Hanoi during French Colonial Rule. The French officials, so appalled by the plethora of rats in the city, started a program placing a bounty on rat tails. Their intention was to exterminate the vermin in the city. Instead, the people of Hanoi started rat farms.

This all brings me to foreign direct investment. It’s not as big of a leap as you might think.

Foreign Direct Investment, or FDI, is a mechanism by which a company can invest into production or business in a foreign country, either by buying a company or expanding operations of an existing business in the target country. When applied properly, particularly in developing countries, FDI is a powerful tool of development.

India and China, for example, are two of the developing world’s largest recipients of FDI. Many have pointed to FDI as a factor that’s strongly contributed to China’s respectable GDP growth over the last five years, particularly in the context of the world’s ailing economy. India meanwhile has had a politically complicated relationship with FDI. Some political groups are staunchly against it—pointing to the tendency of foreign investment to crowd out local businesses. But generally the political trend in India has been toward allowing more in—and in some cases—incentivizing it with tax breaks.

What makes this complicated—and sometimes perverse—is illicit financial flows. The point of creating incentives for FDI is to bring in foreign capital, often in the hopes of creating economic growth. For example, government authorities in developing countries grant subsidies to foreign-investment projects for positive externalities, such as managerial and worker training or technological learning. The benefits of this subsidy are only reaped, however, if the investing company is foreign, and brings in resources that might not have entered otherwise.

Illicit financial flows change the incentives. With illicit financial flows, domestic companies in countries like India can send their cash out—undetected—to secrecy jurisdictions like Mauritius and then send it back home as FDI, with a tax break. It’s called round tripping and it means the government of India gets hit twice; first losing the taxable income as the money is transferred out and then losing again when the domestic-disguised-as-foreign money comes back as FDI. These perverse incentives are likely one of the reasons India’s biggest foreign investor is a tax haven (Mauritius). And so is China’s (Hong Kong). And Russia’s (Cyprus). And Brazil’s (Netherlands).

Which brings me back to the vermin. Illicit financial flows create incentives so perverse that instead of exterminating the rats, we’re farming them. That’s a problem for India, it’s a problem for China, and it’s a problem for all of us. Except the rats of course.