draining development.pdf - Khazar University

Governance and Illicit Flows 61Assume that the policy intervention from stage 1 to stage 2 in figure2.2 introduces an industrial policy regime to promote manufacturingexports. This, in turn, provides incentives for some illicit practices, givingrise to stage 3. Despite the presence of the illicit practices arising from theimplementation of the industrial policy introduced in stage 2, the overalldevelopment outcome at stage 3 is reasonably good. There are severalpossible responses to the observation of illicit practices at stage 3. Oneoption is to abandon the export-promoting industrial policies on thegrounds that these create the incentive to underinvoice imports. Thiswould be in line with the portfolio approach to capital flight that adoptscompetitive markets as the benchmark model. However, if critical marketfailures were significant to start with, developmental outcomes atposition 1 may be worse than at position 3. Hence, an immediate responseto the illicit flow problem at stage 3 that does not take account of developmentalproblems at stage 1 may be self-defeating. Indeed, in terms ofour definitions, the financial flows at position 3 are not illicit with respectto position 1, though they are illicit with respect to position 2.An obvious option would be to run a more efficient customs administrationto raise the transaction costs of import underinvoicing, ideally tothe point at which this becomes unprofitable. This is the preferable policyoption: it could shift the policy framework from position 3 to position 4.The result would be a reduction in underinvoicing that then takes usto position 5, a combination of the new policy framework and a new(reduced) level of illicit flows. The developmental outcomes at stage 5would be better than those at stage 3, and, so, this response to the illicitflow problem would be entirely justified. Yet, to get from position 3 toposition 5 requires a careful microlevel analysis of the costs and benefitsof different policies. If import underinvoicing and the illicit profits associatedwith it could be eliminated without jeopardizing the participationof private sector firms in the export promotion program, the policy ofbetter enforcement would be effective and economically justified.In contrast, consider the case (such as Brazil in the 1970s rather thanKorea) in which tolerating some import underinvoicing is an informalincentive to ensure private sector participation in a growth-enhancingexport promotion program. If the extra incomes from this source areimportant to ensuring private sector participation in the policy, an