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The economic cost of corruption

May 23, 2009

The minister of finance Mansur Muhtar, in an interview with journalists at the end of the IMF and World Bank spring meetings said “One fundamental that came out of these discussions, however, was the key role of infrastructure in stimulating growth of economies at this point in time”.

Nigeria certainly could do with such investments. The country’s infrastructure is horrendous. Developed and developing countries are channelling huge chunks of their stimulus packages into infrastructure upgrades.

The World Bank’s assertion that Africa may lose 10 years of growth if it fails to act like its peers is not an attempt to paint a grim picture. The Bank has upped its infrastructure funding in Nigeria from $600 million to $3.6 billion. Similarly, the Federal Executive Council (FEC) recently awarded contracts worth 373 billion naira for the construction, rehabilitation and expansion of roads around the country.

As a flurry of projects get underway, a boom will ensue – generating consumption and new investments. Yet without transparency and proper scrutiny of bidding processes, allocation of fund and contract awards, investments may end up in a sinkhole. Particularly since the construction sector is one of three focal points of corruption.

Corruption’s epicentres
According to Paul Collier, author of The Bottom Billion, “Among the companies that pay the bribes two sectors seem to stand out: resource extraction and construction.” Banks are the first epicentre. This is where the loot is deposited. Tax havens are known to be popular destinations. Curiously, the government of Ghana will soon grant Barclays bank a license to operate an onshore tax haven; a bus trip or one-hour flight from Nigeria without the need of a visa.

The economic costs of corruption in infrastructure are debilitating – causing a vicious cycle: reduction and delay of infrastructure expenditures; reduction of growth generated by a particular infrastructure, say electricity, forcing consumers to be self-providers; it raises cost of recurrent expenditure and lowers the quality of services and limits access, especially the poor.

Construction’s two features: ‘idiosyncratic’ capital intensity and ‘network’ activity make it prone to corruption. Each infrastructure project is unique ie, designed and built to specification. Thus no two contracts are the same. Standardisation and benchmarking are impossible – it’s easier to price a new truck than a new road.

False info and profits
Then there’s the issue of information asymmetry ie, suppliers – contractors – have more information than buyers; a disparity that gives contractors an upper hand. Hence the tendency to inflate capital costs and bribe corrupt bureaucrats responsible for awarding the contract. If they are not corrupt, laxity in procurement scrutiny aids the rot. Alternatively, fewer projects are awarded where the head of the ministry, department or agency isn’t corrupt. Either way, the citizens, especially the poor, bear the brunt.

When the regulator and contractor are in cohort, resource is thus allocated to projects with higher capital intensity. If building new roads are more capital intensive than maintaining them, more new roads get built or vice-versa. Less capital intensive projects are awarded eg, schools, when bureaucrats are either incompetent or lack critical information. Misallocation of resources contrary to reality: a pining need for bridges, roads, water and electricity.

Corruption’s indirect costs on infrastructure are pronounced. Awarding bloated electrification projects to spurious companies is to damn the manufacturing sector to inexistence. Without electricity, the manufacturing sector – unassailably the best means for productivity and job creation – remains uncompetitive.

The status quo most preferred by a cabal of monopolists: legislators, contractors and regulators; feeding fat off Nigeria’s dysfunctional power sector. Also lip service to the rule of law, enfeebled by law enforcement agencies, that bark more than they bite, help corruption to thrive.

These illicit gains find a haven in offshore financial centres. But there’s more that ends up in those well protected accounts: money gained from tax evasion. False profits: robbing the poor to keep the rich tax-free, a report by Christian Aid International, a UK-based NGO, extensively shows how multinational companies (MNCs) evade tax to the detriment of developing countries. Between 2005 and 2007, Nigeria was the biggest low-income country tax-loser with £502 million.

At $160bn (£80bn, at the exchange rate in May 2008), annual tax lost by developing and emerging countries is greater than the £28-42bn annual budget to meet the millennium development goals (MDGs). Halving poverty by 2015 just got harder by half.

Tricks of the trade
There are several tricks of the trade. Transfer pricing or profit laundering is one. In the oil industry, it is done by ‘loading of costs’ on ‘cost oil’ ie, allowable costs for developing a concession up to, and including, break-even point. ‘Profit oil’ is then split between the international oil company (IOC) and host country.

Examples of loading costs: overcharge for physical assets supplied eg, exploration equipment; a service charge (supply of staff and management services) or financial charge “achieved by something called thin capitalisation, by which a company might put in massive loan facility to finance its operation in Nigeria, which is charged for at a high rate of interest from another part of the same company.”

Mispriced trade gives capital wings. Once in flight it can’t be taxed. Lured by offshore or onshore tax havens and their penchant for secrecy, raising taxes can be tasking in developing countries. Before Obama’s Stop Tax Haven Abuse Act a US company could, after pumping prices of say, management services in Nigeria, can claim deductions against their tax bill before paying taxes on offshore profits (which may be tax-free).

A longish description of one trick used by oil companies, by Andy Rowell, James Marriott and Lorne Stockman, authors of The Next Gulf, is worth quoting. “The price might be much higher than the company would be charged for the same loan in somewhere like the UK, for example. It would be justified by the supposedly high-risk nature of the operation in Nigeria. This increases costs in Nigeria and reduces taxes and profits there. Worse still, the loan will be made from a tax haven like Jersey, and when the interest is paid there, it might be well tax-free.”

Halliburton’s 10-year scam confirms how offshore tax havens eg, in the Cayman Islands (some are onshore eg, in Switzerland and now Ghana), aid, abet and arm corruption. Tax evaders, money launderers and fraudsters take advantage of the banking secrecy of these offshore financial centres.

Tax on reserves: an incentive offered to explore for and locate reserves of oil, is another trick. Tax payable is dependent on amount of reserves found. Thus overstatement of reserves reduces taxes paid. Tax on reserves was behind Shell’s reserves fiasco in Nigeria.

Governments of developed countries are also culpable. To think that before 1999 French companies could deduct bribes paid abroad from their tax liabilities. No coincidence then, Technip, one of the companies in the Halliburton scandal, is French. And the investigation was started by a fraud-buster in France. In the US state of Nevada it takes 1 hour and a no-questions asked approach to register a shell company. Limited information or disclosure is needed – a scanned copy of one’s driving licence will do.

The Internet has exceedingly helped. Not only has it bridged physical distance – making tax havens only a click away – it has confounded the taxman’s ability to apportion tax liability. Under the cover of the Internet, transactions are anonymous. Just as well for tax evaders. If the taxman can’t identify who’s liable, tax collection becomes difficult.

This article originally appeared in BusinessDay, May 20th 2009

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