Illicit Wealth and Enormous Tax Dodging Fuel Inequality

March 28th, 2013

Brad Plumer had a great article in The Washington Post today on the consequences of economic inequality in the United States. As inequality increases, all sorts of crazy things might happen: politicians may ease credit regulations, allowing middle class citizens (who are less wealthy due to inequality) to borrow from the future in order to keep up short term consumption, leading to bad long term consequences like increased bankruptcy, divorce, housing bubbles, etc.

What drives inequality? Plumer takes a shot:

One possibility is that in areas with high top-end inequality, politicians are more likely to favor policies that allow middle-class Americans to borrow more so that they can keep up. Another possibility, though, is that high inequality at the top is driven by a growing financial sector — and so politicians are more willing to loosen credit to placate the banks.

These are perfectly plausible causes of inequality, along with other usual explanations (globalized industry, technology, the ‘superstar economy’, etc). But I don’t think they really do a great job of internationalizing. A quick look at Wikipedia’s Gini index page shows the United States in the middle of the pack in Gini coefficient globally, and quite a lot of variation in between:


What’s going on here? There seems to be some clustering (Southern Africa, Northern Europe, South America), but little consistency. Growing financial sectors doesn’t explain why, for instance, the United States is significantly more unequal than the United Kingdom, or why Malaysia and India are so different.

GFI Lead Economist Dev Kar took a stab at the same question earlier this week on TrustLaw, and came up with an answer:

One likely reason income inequality has worsened in developing countries more than in developed countries is unrecorded illicit financial flows.

The cross-border transmission of such capital means that high-income groups in developing countries have amassed illicit wealth abroad. These incomes are obviously not reported in official surveys, leading one to believe that official measures of income inequality such as the GINI coefficients, would in all probability understate income inequality.

Proliferation of illicit wealth, the proceeds of crime, corruption, and tax evasion, is a major inequality driver, and likely distorts efforts to measure it. Gini, for example, is compiled using survey data, and people are unlikely to declare their ill-gotten-gains to an interviewer. It drives inequality by allowing the well-connected, well-resourced wealthy person to secretly move their money out of the country, while the poor guy on the street is unable to evade the (newly-raised, since the wealthy guy isn’t paying it) VAT. This kind of illicit wealth is facilitated by the global shadow financial system, including anonymous shell corporations, tax havens, and financial opacity.

This sort of illegal activity probably isn’t the major cause of inequality in the United States. There may be hundreds of illicit billionaires, but something similar is causing U.S. equality: enormous offshore tax dodging, specifically by corporations. Another Washington Post article earlier this week reports that the average tax bill as a percentage of corporate income among Dow-30 companies has been in structural decline since 1969, in many cases declining by 50% or more. Huge, profitable, aged companies like McDonalds and ExxonMobile are paying single-digit rates. Combine this with record-high profits and you get a lot of created wealth that is untaxed. Those who own McDonalds and ExxonMobile reep a huge windfall, relative to what they would have gotten forty years ago. Ending offshore tax deferral would raise $60 billion per year in taxes, almost all of it coming out of the pockets of the world’s biggest corporations and their shareholders.

To make matters worse, like the poor guy who can’t move his money to a secret bank account in Mauritius, most U.S. corporations are unable to profit-shift their earnings to Bermuda. Small-to-medium sized businesses pay the highest headline corporate tax rates in the world. While they do find some deductions and credits to get them down off 35% a little bit, they certainly aren’t getting it down to single digits.

If other theories about the rise of income inequality are correct, such as globalization, finance, and technology creating a stronger preference for capital over labor, then lowering taxes on wealthy people owning capital in MNCs is only going to make the problem worse. I’d suspect that this pattern holds up globally as well.

We can solve both problems: abusive tax avoidance by MNCs, as well as illicit financial flows by corrupt public officials, criminals, and tax evaders, the same way: by breaking down the system of financial opacity through tax havens and secrecy jurisdictions that facilitates it.

Written by EJ Fagan

Follow @FinTrCo