Nadine Riedel
15 October, 2012

Capital flight by high net worth individuals is a serious problem for many developing countries. Although the quantification of offshore wealth holdings and the associated overall revenue losses is difficult, they are generally considered to be sizable.

While not necessarily all capital relocations from developing economies are illegal and motivated by tax purposes, many offshore wealth holdings likely pursue the purpose to evade taxes. To strengthen the tax authorities’ capacity to uncover this type of evasion, NGOs and academics have called for more information sharing in tax matters across countries for some time, especially concerning the developing world.

As most tax information exchange agreements (TIEA) are bilateral in nature, the question is whether and to what extent developing countries will manage to strengthen their network of bilateral TIEAs in the future. From a theoretical perspective, it is a priori unclear if it is in the best interest of countries to exchange information in tax matters at all – as, by providing tax information, source countries deter tax-evading foreign investors and have to bear the administrative costs of information provision suggest that information sharing can be sustained in situations with repeated interaction where non-cooperative behavior today will be punished by non-cooperative behavior of the partner in the future. Empirical work confirms these considerations and stresses that bilateral information exchange between tax authorities is strongly reciprocal. Thus, even conditional on the existence of an information exchange agreement, countries tend to provide information when they get something back in return. If the flow of information becomes too asymmetric, information requests otherwise end up at the bottom of the pile.

Following these considerations, many developing countries are unattractive partners for bilateral information exchange. The capital flow between them and countries in the developed world tends to be asymmetric, implying that most benefits accrue in the developing economy while the costs incur with the industrialized partner. Of course, even if it’s not in their best rational interest, the latter countries may want to engage in information sharing because they think it is “good” behavior, particularly towards economies in the developing world. Or they may benefit indirectly if the developing economy strengthens its tax revenue base enough that aid payments can be reduced. However, experience shows that politics are mainly driven by rational incentives. Moreover, indirect benefits, like reduced aid payments, are likely small and diminished by free-rider problems.

Most TIEAs moreover account for information sharing upon request only. Thus, even armed with TIEAs, developing countries may lack the expertise and means to make effective requests for information. New empirical research suggests that information sharing upon request furthermore hardly raises the perceived detection probability of tax evaders and is not effective in significantly lowering wealth holdings in tax havens. As promoted by many NGOs, this may call for more extensive use of automatic information exchange agreements. But automatic information exchange is far from being a magic bullet, too, as tax authorities in the developing world likely lack the capacity to make use of the huge amount of data passed on automatically (which already imposes a big challenge for sophisticated tax authorities in the industrialized world). In the absence of a common international tax payer number, it is for example already far from straightforward to merge the provided information to national tax data. Thus, more extensive use of automatic information exchange in the developing world can only be successful if it comes with increased capacity building in national tax authorities, potentially through technical support by industrialized countries.

But recent empirical research also highlights the likely limitations of automatic information exchange as mobile capital investors react to new TIEAs by relocating their funds to other (tax haven) locations which are not covered by information exchange agreements in their host country. In line with theoretical suggestions, this strongly calls for multilateral agreement and coordinated international action against tax haven economies.

- See more at: http://www.ictd.ac/en/commentary/information-sharing#sthash.BtumlZr2.dpuf