Foreign Policy: Russia’s Taxing Problem

Foreign Policy
Fall 1998

Russia’s Taxing Problem _*

By Daniel Treisman _**

Russia’s worsening financial crisis has many causes—a plummeting oil price, the Asian contagion, overextended banks, to name a few. None of these would have had such a devastating impact on markets, however, if it were not for one all-important weakness of the government—its inability to collect taxes.

Since economic reforms began in 1992, federal tax revenues have fallen from about 18 percent of Russia’s GDP to less than 10 percent in 1997—compared with about 31 percent in Austria, 27 percent in Germany, and 18 percent in the United States. To fill the gap, the government sold treasury bills to banks and foreign investors at high interest rates. Its difficulties servicing these helped to trigger the current panic.

Why are tax revenues dwindling? Some attribute this to a postcommunist distrust of the state or an undeveloped respect for legality. But these are hardly new in the last few years. Evidence suggests the growing importance of another set of factors—perverse incentives created by the way Russia’s evolving federal system divides tax revenues and control over tax collection between central and regional governments.

Russia’s tax crisis is much more of a crisis for the federal government than for its regional counterparts. According to tax service figures, arrears to the regional budgets doubled between 1995 and 1997. However, during this same period, arrears to the federal budget more than tripled. By the end of 1996, STS collectors recovered about 50 percent of the federal arrears owed at the beginning of the year. During the same period, they managed to recover 68 percent of arrears to the regional budgets.

The bulk of federal tax revenues comes from a few taxes—value added tax (VAT), corporate profit tax, and several others—that are officially shared between federal and regional governments according to formulas fixed by the annual budget law. In many regions, a few large enterprises contribute most of the revenue from these taxes. A regional governor eager to please his voters or line his own pockets has an obvious incentive to collude with such enterprises at the federal budget’s expense. If a company can keep money off its books, the region will not have to share tax on that money with Moscow.

Methods for keeping rubles in the region come in various guises. Enterprises can reduce their taxable profits by spending on social services or by “contributing” to off-budget government funds for local development. Alternatively, enterprises can avoid holding onto cash and instead settle their regional tax debt in local bills of exchange or even commodities—forms of payment the federal government cannot usually accept. Regional governments can also simply write off enterprises’ regional tax obligations in return for services provided. The proportion of taxes actually paid to regional budgets in cash fell in 1996 to about 50 percent on average in 33 sampled regions.

The federal government is the obvious victim of such schemes. But the system does not always work to the regions’ advantage. Enterprises with operations in several regions can play local officials against one another, promising to realize their companies’ profits in the region that offers the most attractive tax deal. Legislation has been introduced to fight this but is not yet effectively enforced. Moreover, large enterprises with the political weight to make themselves heard in Moscow can exploit the vertical competition between city, regional, and federal governments.

Governments at all levels try to make up for the shortfall by increasing the burden on more vulnerable, smaller enterprises—the startup firms essential to growth. As a result, many of these firms have gone underground. Moreover, the Duma permits regions that collected lower taxes in previous years to retain a larger share of VAT to help cushion their losses. In response to better tax collection, regional governments adjust downward the proportion of tax that cities can retain. Weaker incentives to support the growth of economic activity—and thus taxable revenue—are hard to imagine.

Better enforcement of legislation to stop enterprises from shifting profits between regions would help reduce the competition that favors large enterprises at the expense of small ones. A reversal of the decline in federal revenues, meanwhile, will hinge on better protection of the federal budget from collusive alliances of regional governments, enterprises, and tax collectors. Here, two changes might make a difference.

First, the most important feature of a federal tax in Russia today should be ease of collection. Some tax bases are more readily concealable than others. About 70 percent of the drop in federal tax revenues between 1994 and 1996 represented falling profit tax receipts. The federal budget’s VAT receipts, however, remained quite stable. A reassignment that gives the federal budget 100 percent of VAT, and the regional budgets 100 percent of profit tax along with various others, would reduce the center’s vulnerability to regional collusion.

The second change should expand on the first. If tax sharing in Russia were eliminated altogether, and each tax base assigned to just one level of government, the collusion problem would evaporate. Reassigning taxes would also narrow the scope for higher governments to reduce punitively the tax retention shares of municipalities that do a better job of collecting taxes.

Similar proposals have been floated several times in Russia’s recent past, but they all failed to compensate regions for the VAT revenues they could expect to lose. To get political support for such a change, taxes must be added to the regional pile until regional governments are compensated. International organizations might condition future loans not simply on tax collection targets but on changes to the system of tax assignment.

A tax reassignment would not solve the immediate problems of sinking confidence and inadequate currency reserves. And the middle of a storm is probably not the best place to try to repair the ship. But in the longer term, changing the incentives in Russia’s tax collection system may be the only way to secure the economy against future financial tempests.

Fyodorov’s Fix

Boris Fyodorov, the 40-year-old economist whom President Boris Yeltsin appointed in early June to head Russia’s State Tax Service, is the latest to try his hand at a job most consider fit only for political masochists. Few of his recent predecessors have lasted long or left with their reputations enhanced.

Fyodorov has made it clear he welcomes the challenge. For him, tax collection—like politics—is fundamentally a matter of political will and personal resolve. The reason for poor payment discipline, he told me a year ago, is simple: “The authorities have not made it clear to people that they have to pay.” An admirer of former British prime minister Margaret Thatcher, he once suggested inviting her to talk sense into striking Russian coal miners. Fyodorov served as finance minister during one of Yeltsin’s pendulum swings toward reform in 1993–94. He also worked brief stints at the European Bank for Reconstruction and Development and the World Bank. More recently, he has combined the jobs of parliamentary deputy and prominent investment banker.

Since his appointment as Russia’s chief tax collector, Fyodorov has talked tough. He threatened to audit the 1,000 wealthiest Russians—among whom he includes himself—and to send offenders to prison. Foreign business people have also been put on notice. He has promised to cut off access to oil pipelines for companies that have tax arrears and has temporarily seized the assets of Gazprom.

To Moscow insiders, all of this is depressingly familiar. A year ago Fyodorov’s predecessor, Aleksandr Pochinok, was holding forth at press conferences, announcing plans to fire regional tax collectors and target everyone from oil companies to street traders. Collections stagnated. Fyodorov may need more than a forceful personality to reverse such trends.

—D.T.

References

Christine Wallich, ed., Russia and the Challenge of Fiscal Federalism (Washington: World Bank, 1994)

Ekatherina Zhuravskay’s Incentives to Provide Local Public Goods: Fiscal Federalism Russian Style (forthcoming)

Alexander Morozov’s “Tax Administration in Russia” (East European Constitutional Review, Spring/Summer 1996)

Richard Bird, Robert Ebel, and Wallich, eds., Decentralization of the Socialist State: Intergovernmental Finance in Transition Economies (Washington: World Bank, 1995)

European Bank for Reconstruction and Development’s Transition Report 1997 (London: EBRD, 1997)

OECD Economic Surveys: Russian Federation (Paris: Organization for Economic Cooperation and Development, 1997)

Andrei Shleifer and Daniel Treisman’s The Economics and Politics of Transition to an Open Market Economy: Russia (Paris: OECD Development Centre, 1997)

Treisman’s “Russia’s Tax Crisis: Explaining Falling Revenues in a Transitional Economy” (forthcoming).

Endotes

**: Daniel Treisman is assistant professor of political science at the University of California, Los Angeles and the author of After the Deluge: Regional Crises and Political Consolidation in Russia (forthcoming). Back.