Financing for Development: Key challenges for policy makers

Added 13 Jul 2015
This paper draws key conclusions for policy makers based on research and major analyses that have been published in the run up to the United Nations’ third Conference on Financing for Development (FfD), which takes place in Addis Ababa in July 2015.

Executive summary

This paper does not shy away from the scale of the problem. Instead it recognises that fundamental changes are needed in the global financial and economic system. It shows how proposals that have been on the table in the run up to Addis can help to create a system that supports, rather than undermines, development.

It highlights four key challenges facing policy makers, and proposes lasting solutions.

Challenge 1: Stem the loss of tax revenues

Developing countries lose very significant, though currently poorly quantified, tax revenues every year, due to failings of the international system. This happens for three main reasons:

International tax evasion. This includes that motivating or resulting from illicit financial flows (IFFs), though there are, as yet, no estimates of the tax lost to IFFs. Tax losses to money already hidden in tax havens are estimated at $190 billion per year. Other estimates for international tax evasion are still needed to fill in gaps in data.

International tax avoidance, where multinationals subvert the spirit, if not always the letter, of the law to avoid tax. Global estimates of the cost are only just beginning to emerge. For example, the United Nations Conference on Trade and Development (UNCTAD) estimates one tax avoidance method alone costs developing countries between $70 billion and $120 billion per year. International Monetary Fund (IMF) researchers estimate that developing countries lose more than $200 billion per year. Some governments assist multinational tax avoidance in order to capture a part of the tax base from activity that, in reality, remains in other countries.

International tax wars, which describes the unhealthy competition between countries to capture private investment, by reducing tax rates, offering incentives or negotiating unfair treaties resulting in sub-optimal outcomes. Again, the evidence on the extent of this problem is only beginning to emerge, although the existing figures suggest the scale may also be very large. For example, ActionAid International estimates that statutory corporate tax exemptions alone cost developing countries $138 billion per year. Ultimately, tax wars fuel a race to the bottom, with governments competing to destroy their tax base, rather than cooperating to fairly tax multinationals.

This is a global problem, affecting all countries. It therefore requires a much greater level of global cooperation and a revision of global tax standards to ensure that the interests of all countries, including developing countries, are represented. Unfortunately, the current global standards are full of loopholes and shortcomings. In many cases they are also clearly not designed to work in countries with low capacity, and in some cases they are outright biased towards the interests of developed countries. This is unsurprising, as they are created by the Organisation for Economic Co-operation and Development (OECD), a developed country grouping, which also includes many of the countries that are major causes of the problem, and whose secrecy makes it a prime target for lobbying by accountancy firms, multinational corporations and others who benefit from the system. This is why it is time for a truly representative, transparent, effective global tax body, placed under the auspices of the UN to ensure that all countries have a say, with the mandate and resources to tackle these serious problems.

Challenge 2: Reduce the risks of private investment and actively manage it to maximise benefits

International private flows have not been rising as a share of Gross Domestic Product (GDP) in developing countries; they remain small compared to domestic private investment. Foreign private financial flows to developing countries offer opportunities to support development, but they also come with substantial risks, which ought to be at the centre of discussions on financing for development. The risks includes volatility – inflows and outflows of private capital can be very destabilising to developing countries, and are often caused by factors outside the recipient country’s control. Recent research shows how developing countries have become more integrated into global capital markets and so are more vulnerable to crises caused by external factors than ever before. In addition, the degree of benefits that developing countries receive can vary widely, with, for example, extractive industry investments typically having relatively low employment impacts, and often high social or environmental costs.

However, policy debates on private finance and development have been dominated by how to ‘leverage’ more international private capital flows to developing countries using public institutions and public financing or guarantees, even though existing mechanisms do not have a great track record. It would be better to focus attention on measures that are needed to help developing countries reduce risks and manage foreign investment to maximise its development potential, including removing obstacles found in trade and investment agreements that prevent developing countries from managing private capital flows to reduce risks, and embracing a new international initiative on responsible financing standards, with strong implementation mechanisms.

Challenge 3: Provide more and better international public resources

Public financing has a unique role to play in supporting development, including in financing essential services and ensuring universal social protection floors. Domestic resources are large and can provide the lion’s share of the funding needed, and would be bolstered by efforts to stop tax dodging. However, there is still a significant public expenditure gap, particularly in the poorest countries. By 2013, donors were less than half way to their decades-long target to provide 0.7% of Gross National Income (GNI) as Official Development Assistance (ODA), reaching only 0.29%. Progress towards other commitments, particularly the provision of $100 billion in climate finance by 2020, has been similarly slow.

A better source of additional international public finance could be innovative taxation, such as financial transaction taxes, although efforts to raise this have so far been limited. Significant additional public resources could be mobilised simply by adopting the UN’s proposals to issue new international reserve assets (known as Special Drawing Rights or SDRs) and to allocate these to developing countries.

Major improvements are also needed in the way donors and international institutions deliver international public finance, to solve the key problems of: donor bad practices that reduce the real value of aid; continued donor dominance, which reduces developing country ownership; and a lack of transparency and accountability. Major new efforts to improve both the quantity and quality of international public finance are needed, with strong timetables, starting with the untying of all aid.

Challenge 4: Reduce and resolve finance and debt crises

Finance and banking crises have become a recurring feature of the international economic system since the breakdown of the post-war Bretton Woods system in the early 1970s heralded an end to strict international control over capital flows and exchange rates. There has been a failure to tackle these issues seriously at international level, with perhaps the biggest problem being the lack of effective mechanisms for preventing damaging sovereign debt crises. Existing mechanisms, where they exist, are dominated by creditors, helping to explain why debt restructuring often takes a long time, rarely leads to reduction of debt to sustainable levels, and often comes with damaging conditions. The UN has started a process that provides a unique opportunity to set up a multilateral legal framework for sovereign debt, an important step towards a fair and development-friendly solution to sovereign debt problems. This will require the creation of a Debt Workout Institution, independent of creditors and debtors, to facilitate debt restructuring processes.

2015 is a unique year for global development, with three crucial UN summits promising agreements on Financing for Development, a new set of Sustainable Development Goals to replace the Millennium Development Goals, and a new climate treaty. However, it is clear that flaws in the way the global economic system is managed are fundamental blocks to progress.

This paper shows, however, that clear proposals are on the table to deal with some of the biggest development challenges of our generation: now is the time to put these into action.

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