Thursday, 28 June 2012

Exciting Accounting? Country-by-Country Reporting For Transnational Corporations

Yes, it sounds very tedious. Accounting does not interest most people concerned with development. We may agree it is necessary, but we do not think it is very interesting. And most of us do not understand it. How many of us can really read a balance sheet, or understand an income statement?

The accounts of transnational corporations working in developing countries are complex beyond our imaginations. But these accounts really do matter.

What can we learn from the tax returns of transnational corporations?

One result of economic globalisation is that tax authorities in developing countries have to manage enormously complex tax returns from companies that, with increasing frequency, are trading, investing, and transferring money across international boundaries. Those companies can often afford much more professional expertise than the local tax authorities. And we know that transnational corporations use various legal and accounting devices to shift significant profits out of many low income countries.

A great deal of tax money does not stay where it is most needed and where it really belongs.  
This would be less of a problem if companies were faced with a choice between paying, say, a 35% tax on profits in Bolivia and a 25% rate in Belgium. But their actual alternative to 35% is often to pay somewhere between 0% and 5% in one of several dozen tax havens worldwide.

Which corporate finance director could resist shifting money around the world when faced with that kind of choice? Not to do so could be seen as failing in responsibilities to shareholders.

Shifting money around the world is made easier because transnational companies are rarely required to report in detail on their activities, incomes, and profits within the individual countries in which they operate. Their main legal requirement is to provide consolidated financial statements for the whole business group. A group may comprise dozens–or even hundreds–of separate companies operating in dozens of countries.

It would be really helpful to tax authorities worldwide, but especially in developing countries, if transnational corporations were required to provide more detail about their operations and profits in each country in which they operate. But it is hard enough to make a convincing, appealing, popular political case for reform of any dimension of accounting.

How can we generate political interest in tax accounting?

Richard Murphy, an international tax activist, made a major breakthrough in inventing and then popularising the term “country-by-country reporting". This has been a major policy issue for international tax advocacy organisations for some years now and has been seriously debated at the highest international policy levels.

But the demand for country-by-country reporting has not swept all before it. It has met considerable resistance.

Arguments against country-by-country reporting

The private sector, of course, generally opposes a measure that is liable to reduce its scope to avoid taxes. And some of the arguments used can sound quite persuasive: 

  • the cost to companies of obtaining the required information might be very high.
  • it is very unclear what the activists are asking for. Country-by-country reporting is a neat phrase, but could in practice be interpreted in many different ways.
  • the objectives are not clear. Country-by-country reporting is alleged to be a policy solution in search of a problem. Is the objective to give more information to tax authorities? Or is it to empower civil society to hold companies to account? Is that appropriate - should private companies be required to give that information just to make life easier for civil society watchdogs?
  • tax information is confidential.
These objections seem to have prevailed so far. Attempts, particularly at the OECD, to get a substantial consensus over this issue have come to nothing.

The social responsibility agenda is shifting the debate

There are however signs that the terms of the debate are changing. The argument that companies need do no more than comply with the law when filing tax returns is now increasingly challenged by the notion that companies do have some kind of social responsibility to pay the “right" amount of taxes. 

For the larger and more publicly prominent transnational corporations, this has now become a matter of reputation. Just as companies do not want to be associated with employing child labour or despoiling the environment, some now want a reputation for paying their fair share of taxes.  

An acquaintance who works for one of the “Big Four" international accounting firms recently remarked to me that “when I used to work in the private sector, it was a simple matter of shifting nominal profits around to minimise the tax burden. Now, quite a few companies come to us with concerns about their taxpaying reputation".

It is hard to predict what will happen next. There are already a number of international arrangements, starting with the Extractive Industries Transparency Initiative in 2002 to encourage or oblige companies working in the natural resource sector to be more transparent about their payments to governments.  

The natural resource sector, and especially mining, is where many of the cases of very large-scale international tax evasion are located so it’s a good place to start. Companies working in this sector can expect to come under tighter and more powerful regulation. 

Following this lead, within a decade, it is possible we will think it quite normal, and essential, that transnational companies routinely tell us much more about where in the world they are generating their incomes and profits. Now that is something to get excited about.

Wednesday, 20 June 2012

Global Crime II: Powerful illegalities

by Markus Schultze-Kraft

Much has been said and written in the past two decades about the unprecedented rise of organized crime and criminal violence in the Global South or the 'post-colony' in the wake of the Cold War.

In the Andes, Central America and Mexico, and in West and Southern Africa, the Balkans, Russia and South and Central Asia, violent crime is often perceived as threatening democratic governance, development and the state – and even the international system.

Surfing on the wave of globalization, local-global networks trafficking in illicit drugs, guns, humans, political resources and nuclear material - among many other commodities - have been identified as being responsible for fostering violent conflict, state fragility, corruption, terrorism and coups d’├ętat and for inhibiting development.

Crime, illegality and the violence they create are serious threats to societies and states around the world. And the threat is by no means confined to the 'periphery'.

Crime and illegality aren’t outside; they are embedded in states, societies and governance arrangements

But organized crime and illegality don’t happen outside existing states, societal structures and governance arrangements. Each day, political, economic and social systems across the globe are taking on more distinctly illegal and criminal contours.

Illegality and criminality derive their ultimate power from being institutionally, politically and socio-economically embedded. In other words, illegality offers gains, incentives and profits that those engaged in legally regulated activities can only dream of.

In the many countries with weak or corrupt justice systems, disputes can often be resolved more quickly and effectively through illegal means than through official courts.

To put it crudely, it can be easier and cheaper to hire a contract killer or sicario to take care of a politically taxing situation than it is to introduce a bill in Congress. You might be more likely to succeed in having someone killed than in changing the law, although the outcome of the killing may not be sustainable in the long-term. But in the logic of all things criminal and illegal, the long-term may not matter very much.

If this is true, why should we expect the law to be king, particularly in the eyes of the powerful and those who contest existing power structures? These actors tend to have access to political and economic resources that are well above and beyond the law.

'When the indices of governance are fine… the municipality has been captured by criminal-illegal interests'

My point is when criminality is combined with tolerated illegality, it can actually create a form of governance that is effective and efficient. But this governance is a thousand miles from 'good governance'.

Colombia is a case in point. Contrary to the common belief that criminality and illegality spawn 'bad governance', violence and the demise of public authority, there is evidence that in countries with a weak and fragmented national state, or where the state has a 'differentiated presence' (presencia diferenciada del Estado, Spanish language doc), it can become routine to handle public affairs in a way that undermines constitutional and legal frameworks. But the weakness of the state can at the same time allow public goods, including security, to be provided and can contain violence at the local and regional levels.

As one interlocutor told me during a recent visit to Colombia, 'when the indices of governance are fine in a given municipality we have to assume that that municipality has been captured by criminal-illegal interests'.

This implies that, if the municipality hadn’t been captured, groups including state security forces and insurgent, criminal and drug-trafficking organizations would violently struggle for control of local drug crops, trafficking corridors, social security and health systems, oil and natural gas royalties and votes.

Governance can’t ignore criminality and illegality. So how will we deal with them?

So, what do we do about criminality and illegality when they turn into essential governance factors? Is there a way to resuscitate the 'good governance agenda'? Or, as crime and illegality seem to be gaining the upper hand in many locales, should we look for alternatives that stand a better chance of surviving?

Criminality and illegality have thus far been mostly ignored in the science and practice of governance. Now the question is urgent: how will we deal with them?
Keep an eye on the Governance and Development blog for more Global Crime posts

Friday, 15 June 2012

Professional Services and the Poor 2: The poor use markets. Can direct payments help them to work better?

In my previous blog post, I established that most of the world’s poorest people live in countries where they have to pay (formally or informally) for professional services. They pay even when services are provided by governments. For better or worse, the poor are participating in markets for health, education, veterinary medicine and other services.

In the remaining posts in this series, I will ask: What can be done to make these markets work better for the poor? This post looks at what happens when payments are made to individual professional practitioners. The next post will look at what happens when payments are made to organisations.

The problem with markets for professional services: Information inequality

My earlier post showed that information inequality is a big problem in markets for professional services. The people paying for services know much less than the provider about the quality of what is being offered. The consequence is that quality goes into a downward spiral – because the purchasers don’t want to pay a ‘quality’ price for what might be inferior services and the professional providers can’t afford to provide quality services if they aren’t paid more for them. Both parties to the transactions lose.

But there are solutions: reconfiguring institutions can overcome the ‘information asymmetry problem’ and can benefit both parties.

Why is it hard to recognise quality professional services in markets?

In order to look at potential institutional solutions, we need to recognise that purchasers are interested not only in the quantity of professional services they receive but in their quality as well. With preventive human and animal health the big challenge is to reach large numbers and remote locations.  Such quantity problems are much easier to manage, which is one reason that even poorly governed countries usually do an adequate job of providing them. (And this is all the better because people are more willing to buy cures than immunisations.) But quality matters in curative medicine and education.

The quality of a service is made up both of competence (capacity to meet a need) and the effort made to apply that competence well. The problem is that clients will not pay for competence and effort if they do not know they exist. Before they are willing to pay appropriately clients need reliable signals so they know the quality they are being offered.

Some signals of competence can be observed. You can look for a diploma on the wall of your doctor’s office. Competence tends to be regulated moderately well even in countries with poor governance. And once obtained, competence tends to persist.

But competence alone isn’t enough. Good quality services depend on effort as well. There is often a substantial gap between what practitioners are capable of doing and what they do in practice. Effort is transitory, hard to observe and difficult to regulate, so this is the dimension on which it is hardest for consumers to know what they are getting.

When professional services are acquired through markets, it can have a long-term effect on competence. But it has an immediate impact on effort.

Can user payments to individuals help improve the quality of professional services?

Sometimes governments or donors make direct payments to professionals for the quantity of services delivered to individual clients. The literature investigates when happens when such payments are made for immunisations, maternities, pupils and exam passes, for example.

At other times, service recipients themselves provide payments to providers. Even when these payments only supplement much larger investments by governments or donors, they still provide incentives for service providers to apply effort.

Individual user fees create greater effort only if they add to the income of the professional or contribute to the budget of the organisation. If they are transmitted into the national budget or substitute for it they are not inducements. And this is the way most user fees in government facilities have been used in practice.

Even when fees go directly to individual providers, however, they may not lead to better quality services. They may stimulate quantity of effort, but not better quality. For example, we have evidence that physicians provide a greater quantity of primary care under fee-for-service payments compared with capitation or salary. Financial incentives also can stimulate delivery of services for which demand is insufficient, such as the delivery of immunizations or screening tests.

But when they are used widely, financial incentives can have unintended effects. They can induce corruption and make consumers wary of the motives of service providers. By stimulating quantity alone they contribute to the ‘race to the bottom’ among most service providers; they incentivize them to take activity at the margin that is of limited or no value, rather than stimulating higher quality.

Avoiding a ‘race to the bottom’ in professional services: Examples from traditional healers and midwives

In some settings, direct payments do avoid a ‘race to the bottom’. One way to do this is through ‘outcome contingent contracts’. Much of the work of traditional healers in African countries on wounds, broken bones and animal health has been found to be quite effective. Healers are stimulated to provide quality care because they charge only a small initial fee for their services and expect most of the payment to come much later, once patients know there has been a cure. But these contracts usually exist only in rural areas, where the practitioner and patient know each other.

A related example concerns midwives in Cameroon. Since patients can usually tell whether child delivery was successful shortly after birth, they are expected to pay an ‘appreciation’ for a good outcome before leaving. And this payment has a clear effect on the quality of service.

Both of these examples are exceptional because the results (and the quality of the service) are clearly visible before payment is made. This significantly reduces the information inequality and creates incentives that are more responsive to quality. But the circumstances in which such ‘contracts’ are possible are not common. Something close to the same effect is achieved, however, when there are repeat transactions between the parties over a considerable period, so the client can assess whether the service provider is delivering quality.

More to come on providing quality professional services for the poor...

We’ve seen that payments to individual service providers have strong limitations. Except in a limited set of circumstances, they don’t overcome the unequal information problem.  In the next post in the series, we’ll see that making payments to organisations offers better institutional solutions to the challenges of providing services for the poor.

This blog draws on a paper currently under consideration with WORLD DEVELOPMENT -- Institutional Solutions to the Asymmetric Information Problem in Services for the Poor by David Leonard, Gerald Bloom, Kara Hanson, Juan O’Farrell, and Neil Spicer.

Tuesday, 12 June 2012

Ignore informal institutions at your own risk

Informal institutions across the world have considerable influence over their communities. They can determine how poorer groups and rural citizens interact with governance processes, donor projects and local governments. They also influence what information they access and even to what extent they participate in deliberative forums.

And yet, donors and governance studies remain largely unaware of informal institutions and their impact.

In many parts of the world much of what we understand as governance – service delivery, dispute resolution, representation and electoral politics – is influenced heavily by local informal institutions that operate wholly or partly outside formal structures of the state. In some cases they may even actively substitute for the state by providing services (most obviously the resolution of disputes) that the state is not providing, or providing ineffectively.

Some examples of these informal institutions:

  • In Karnataka state in India disputes between village members are rarely taken to formal courts or the police. Instead, customary village councils or panchayats resolve disputes. Jajams in Rajasthan perform the same function for tribal groups living in the Indian state.
  • In Pakistani Punjab, informal village-based akhats resolve local disputes, decide who the village will vote for in the next election, and akhat heads – usually the largest landlord – regularly mediate with the formal state over public service delivery.
  • Jirgas are important informal institutions in local governance in Afghanistan.
  • Semi-formal mesni zajednicis in Macedonia and bashkesia locale in Kosovo play a very important role in negotiating service provision for communities with local governments.
  • In Sierra Leone o’rbais, or chiefs, dominate the lives of rural citizens and no land transactions of any kind can happen without their approval.
  • In Tanzania, informal clan leaders, the mshili, adjudicate disputes, aggregate votes for parties and mediate between the community and the formal state, especially the police and courts.
  • In the favelas of Rio de Janeiro informal local cabo eleitoral play an important role in deciding who the favela residents will vote for, and what services they will receive in return.

Informal institutions will continue to exist, and donors should work with them

I argue that donors should work with informal institutions because of two recent experiences. I presented my research on the nature and role of informal institutions (some of which is contained in the report An upside-down view of governance) at the headquarters of a donor. Throughout the presentation, I was repeatedly asked one question in various forms: "How do you want us to think about these institutions? Are they good or bad?"

That is not a surprising reaction. The words 'panchayat' or 'jirga' can trigger reservations for some audiences. But the question I was asked during my presentation in fact missed the point.

In reality, it doesn't matter how we think of informal institutions. Regardless of our opinion, they will continue to exist. They will continue to determine whether people can access the projects that donors pour money into, including schools for girls, health centres, vaccination programmes, cash transfer schemes and nutrition interventions.

A second recent experience highlights the importance of these institutions for donors' work. I was part of a team studying a donor's support to decentralisation in the Western Balkans. To our surprise, we found that semi-formal governance institutions existed in almost every neighbourhood and community in the region. The semi-formal institutions in the Western Balkans enjoy respect and trust and have high levels of legitimacy. They elect their leaders, who then represent them in regular engagements with local governments.

Yet, despite the donor’s interest in supporting community participation in local government, they were reluctant to engage directly with these semi-formal institutions.

Why are donors and scholars reluctant to acknowledge informal institutions?

In some places, donors' and scholars' reluctance to acknowledge informal institutions is understandable. In South Asia, these institutions are generally thought of as traditional, regressive, unequal. They may contribute to marginalising women and minorities and they are prone to being 'captured' and controlled by dominant elite groups.

But why are we reluctant to acknowledge these institutions in contexts where they appear to enjoy greater respect and trus?

Our research has found that the more similar these institutions are in form and function to their ‘traditional’ manifestations, the less we like or trust them. Conversely, the more they have interacted with formal political and administrative institutions in a pluralist, competitive environment, the more they are likely to merit acceptance and recognition.

How can we engage with informal institutions towards better governance?

What is needed is for donors and scholars to engage informal institutions in order to make them work better.

During our research, a municipal official in the Western Balkans explained: “If we could work more formally with these institutions we could use them to negotiate with communities [such as on paying taxes], raise awareness on issues [such as health issues and environmental protection], facilitate the implementation of projects [such as waste management], and help the municipality manage inter-community relations”.

The problem is that governance reforms provide little space for engaging with informal institutions.

Whether we like them or not, informal governance institutions are here to stay. Why are we afraid of engaging with them? Maybe it's time to get over our fears and ask a more important question: How do we engage with them to improve governance?

*Shandana Mohmand completed her PhD at IDS and is now working as independent researcher together with several members of the Governance team.