Punishment Schedules for Capital Flight

Abstract

W HAT are appropriate penalties to discourage capital flight? Economic punishments can serve as effective deterrents for economic crimes but the penalties themselves are often costly to impose and enforce. Good public policy must take these costs into account in addition to the effectiveness of punishment schemes. In order to construct a deterrent to economically motivated behaviour, the environment that generates this motivation must be well understood. We show that the incentives for capital flight can differ in predictable ways. This difference in incentives implies that, even though standard risk aversion analyses might suggest the opposite, it will often be better to penalise larger transactions in a higher proportion than smaller ones. A common definition of capital flight is the growth in the stock of one country’s claims on non-residents that generates income beyond the control of the domestic authorities (see, for example, Dooley 1988; Rojas-Suarez, 1990; or Razin and Sadka, 1989). This notion is useful because it distinguishes between portfolio motivations for international capital allocation (which are desirable on grounds of economic efficiency) and movements of capital which are motivated by a desire to evade tax liabilities. The latter type of capital movements imposes costs both in terms of lost government revenues and potential distortions in investment decisions. We focus, therefore, on capital movements which are motivated by the (illegal) desire to shelter investment income from domestic taxation. An understanding of capital flight requires a careful and consistent description of the economic environment that generates the motivations for this phenomenon. For the remainder of this paper, the following assumptions are maintained in order to match as closely as possible conditions that must hold for capital flight to exist: