The OECD Observer
January 1999, No. 215

 

Russia’s Tax Reform
By Susan Himes and Martine Milliet-Einbinder

 

Taxpayers and tax administrators expect stability in their fiscal systems. But in Russia’s crippled state there can be no stability, only decline, unless difficult tax reforms are forced through. The draft tax code which is still before the Duma offers some guidance as to the way forward.

The challenges Russia faces in transforming its current tax system are enormous. Russia is in the grip of its most difficult economic crisis since the collapse of the Soviet Union, putting the new government in a political and fiscal bind. International lenders have made it clear that they will pull their money out and refuse to make new loans unless they see reforms throughout the economy. Of particular importance is Russia’s tax system and the imperative of improving collection. But any fiscal reforms have to be carefully designed and implemented, especially as Russian citizens, who generally find new taxes repugnant, have already been angered by lost wages and pensions from collapse of the economy and corruption. Adding to their ire is the prospect of rampant inflation as a result of the recent sharp devaluation of the ruble.

Russia’s best hope to restore tax collection and stabilise the economy remains the implementation of the proposals set out in the current draft tax code, whose final approval in the Duma cannot be guaranteed. While far from perfect, the new code would simplify the tax rules by substantially reducing the number and rate of taxes and eliminating numerous exemptions and loopholes. The OECD is working closely with Russia—which has observer status in the Organisation’s Committee on Fiscal Affairs—to ensure that the code being enacted brings Russia closer to international standards, while equipping administrators with new tools for collecting taxes in a non-discriminatory and fair manner.

 

Current Tax situation in Russia

Russia’s tax system has performed very poorly since its creation in 1991 for a number of reasons. For a start, it is a cumbersome system. Today there are about 30 separate federal taxes and over 170 local and regional taxes. Russia has 89 regional tax offices and 2,639 local tax offices employing over 180,000 tax officials. Yet, evasion is endemic as Russians are not accustomed to paying income taxes, which were unknown under the Tsars and communists. The nominal tax rates are very high, but there are numerous exemptions for a wide range of favourably treated taxpayers. Emergency tax collection involves draconian penalties, but these penalties are applied at the discretion of tax officials, leaving the system open to abuse and corruption. Regional authorities routinely issue guidelines that contradict centrally issued instructions, where the latter exist. In the absence of clear legislation and procedures, tax inspectors have tended to act autonomously, leading to a very uneven treatment of taxpayers. And while tax collection did increase before the current crisis, almost half of all average regional budgetary revenue and expenditure is now in some form of money surrogates, particularly barter.

Not surprisingly, the outcome is a tax system which fails to produce adequate revenue to government. Furthermore, it impedes growth, puts off foreign and domestic capital and drives investment under ground. A major comprehensive tax reform is therefore long overdue and represents the only feasible escape from the current trap.

 

New Tax Code

The draft tax code is the embodiment of that proposed tax reform. Successive versions of the code have been under discussion since 1995, but it was only this year that the Duma, the lower house of Parliament, began seriously considering its individual provisions. Part I of the tax code on administration, tax assignments and related materials was passed by the Duma and signed by the president in July 1998. Parts II, III and IV containing the substantive laws have passed the first reading, but further progress in the Duma will be difficult.

The draft tax code represents a significant improvement over the current Russian tax legislation. In general, the aim is to lower the tax burden on businesses, eliminate exemptions and shift more of the tax burden to consumption. It is grounded in practical considerations, with detailed rules to provide guidance to taxpayers and tax administrators, as well as uniformity and transparency. While it adopts many Western practices, the code reflects the laws, experiences and choices of Russian policy-makers. If implemented effectively, it should help administration, boost revenues and reduce evasion, while distributing the tax burden more fairly than is presently the case. The main policy themes and features of the code are discussed here.

Income Tax: Lower, Broader and Simpler

The new code keeps to the trend set internationally over the past two decades, and seeks to reduce the number of federal taxes and lower the top marginal tax rate on profits from 35% to 30%. The ability of regional governments to grant specific exemptions has been restricted, a move which outlaws tax competition between the regions. Because there is a shift in the tax burden from companies to individuals, the cut in the rate should increase incentives for companies to save and invest and draw more economic activity into ‘legitimate’ markets. To finance this rate cut and simplify the tax structure, the draft code aims to broaden the tax base substantially, particularly with respect to personal income tax. For example, current exemptions for housing allowances and cars would be abolished as well as the exemption for bank deposit interest and insurance proceeds, which are at the heart of many tax avoidance schemes. Similarly, to reach the large though untaxed bartering market, the government has proposed a new tax of 0.8% on promissory notes known as vekseli.

Another important simplification is the new forfait tax system1 for small businesses. Enacted this summer as part of the government’s anti-crisis tax package, the new system requires small businesses to pay an advance tax of 20% of their imputed income. Like imputed income systems in other countries, the amount of income expected to be earned by a business would depend on a number of objective criteria, such as staff levels, sales, size of business and so on. Using such criteria to determine the amount of tax should simplify the calculation and payment of income taxes, particularly for start-up and less sophisticated businesses. On the other hand, such arbitrary taxation formulae could over-tax many start-up businesses and may under-tax those with the most ability to pay.

Modern Accounting Rules

One of the main tasks has been to displace the antiquated accounting laws used to determine the tax base. To a large extent, these old accounting rules and administrative procedures, which were inherited from the Soviet era, were designed primarily to control and monitor physical production rather than to measure the tax base accurately and facilitate compliance with tax laws. For example, the old rules disallow the carrying forward of losses and the deduction of many common business expenses, such as advertising, resulting in an overstatement of the tax base relative to modern accounting systems, while exaggerating the profits tax rate.

The draft tax code is more up to date. Under it, all reasonable and necessary business expenses, including advertising, research and development, would be deductible unless a specific provision disallowed the deduction. In a similar step, tax depreciation would approximate economic depreciation and large enterprises would be required to use the accrual method of accounting, which should reduce incentives for deliberately running arrears. Barter would become less attractive and loss-making firms would be identified more quickly. The new accounting rules would bring Russia’s profit tax system in line with Western standards by taxing real profits only.

Combating Capital Flight

The current tax system with its many exemptions, underdeveloped international tax rules, and dubious treaties with tax havens has resulted in substantial capital flight. The devaluation of the ruble is likely to make it worse. Part I of the code includes new transfer pricing rules modelled, in principle, on the OECD guidelines. If consistently applied, these rules would help Russia collect tax from large enterprises while ensuring that the same income is not taxed by more than one jurisdiction, including from other countries. Another promising development is the government’s plan to re-negotiate its tax treaties with international offshore locations. Most assume the initiative is primarily directed at tightening up the Russia-Cyprus tax treaty of 1982, which is commonly used in Russia to avoid tax.

Again following the trend in OECD countries, the tax code would shift the burden from income to consumption taxes. The shift could increase the incentive to save by reducing the difference between pre- and post-tax returns on savings. And consumption taxes should be less easy to avoid or evade than income taxes.

True, consumption taxes do tend to place a higher burden on lower income earners, whose savings ratio is small compared with higher earners and who through their daily expenditure end up paying tax on virtually all of their disposable income. But as most of the evasion and avoidance takes place in higher income brackets, the shift to what are generally seen as regressive consumption taxes may ironically turn out to be relatively progressive in Russia’s case. After all, even the most elusive of top earners would have to pay at least some tax when spending their income on goods and services.

A major area for reform is the value-added tax (VAT). By decree, the government expanded the tax base by cancelling the reduced rate of 10% for socially significant goods, including some food products and children’s items, such as clothes. On the question of moving to an accruals system, however, the tax code provisions are flawed. The system is not a full accruals system, but a hybrid; VAT refunds will be paid on a cash basis, while the tax itself will be paid on a deferred basis. True reform of VAT would involve moving to a full accruals system and requiring the retail sector to adopt a credit invoicing system to monitor VAT refunds.2

One of the changes which has already come into force allows regional governments to place a retail sales tax of up to 5% on top of the VAT in lieu of minor local taxes. Not surprisingly in the present environment, the current 4% local turnover taxes would be retained, making Russia a unique jurisdiction in applying potentially four separate consumption taxes: a 20% VAT, excise tax which is applied on a unit basis, a 4% turnover tax and a 5% retail sales tax. While the new sales tax is expected to raise $17 billion annually, there is a question mark over the wisdom of so many layered consumption taxes. They are likely to apply to the same tax base, and once their sums are done, taxpayers could end up paying their consumption taxes to as many as four different government bodies. They would also run the risk of being audited for one or more consumption taxes twice in the same fiscal period, once by the State Tax Service (STS) and once by the region.

 

Changes to Administration Rules

Until now, certain legal rights and powers that are widely used by Western tax authorities to facilitate collection have not been available to their Russian counterparts. Part I of the tax code would provide many of these important legal powers. For example, the code would provide the legal basis for a general taxpayer identification number, or ‘TIN’. The number would allow the authorities to computerise tax collection and pension payments and improve payroll tax compliance. Widespread use of TINs would help the authorities to compile a master file containing details on every taxpayer. The code would also provide authority to the STS to allocate income, deductions and credits among and between related taxpayers based on comparable transactions. In cases of non-payment of tax by liquidated companies, the STS would be able to sue the owners for the debts.

Part I, however, also contains provisions which would substantially restrict the ability of the STS to collect taxes and seem to be constructed to protect the interests of the taxpayer. It includes a provision allowing the taxpayer to correct mistakes and avoid prosecution. Another article provides that all ambiguities and inconsistencies in tax legislation, of which there are many, be resolved in favour of taxpayers. Other provisions prohibit the tax authorities from auditing a taxpayer more than once per year, and limit the period during which the tax authorities may freeze a taxpayer’s bank account.

The penalty and interest regimes have also been substantially revised. While Russian current tax penalty and interest provisions are severe by Western standards, the new law tips the balance far more in the taxpayers’ favour. Even in situations where arrears remain unpaid, the amount of nominal payments is capped and liberal deferral provisions are included to allow taxpayers to delay payments without incurring interest and penalty charges. The taxpayer is also helped by the demand that the tax authorities obtain court orders before enforcing any collection action against a physical person and before collecting penalties from juridical persons.

 

Small-scale Reforms Would be a Useful Start

Despite the clear need for a new, modern tax code, passage of Parts II to IV of the code seems likely to be slow. An alternative plan would be to enact a smaller-scale reform through amendments to some existing tax laws. The amendments could be drawn from the draft tax code and consist of the highest priority reform proposals. While not as comprehensive as the draft tax code, the solution would be a good one. At the very least it would address the most serious problems in the current tax system and help pave the way for passage of the fuller tax code later.

In this climate, the OECD is advising the Russian Ministry of Finance and the State Tax Service on the outstanding design issues and implementation of the most important reform provisions in the code. The OECD is also continuing its practical tax training for STS officials at the Moscow International Tax Centre.

Despite the frustrating setbacks along Russia’s road to economic transformation, now is not the time to give up on tax reform. Overhauling an antiquated and reviled tax system is a formidable challenge for any government, particularly after 70 years of central planning. And the very severe financial crisis and feverish political climate make the obstacles even more daunting. Yet the OECD recognises that in the present fragile conditions, the pressure to raise more revenue for government is set to increase, which makes reform more urgent than ever.

 

OECD Bibliography

OECD Co-operation with the Russian Federation: An Assessment of the 1997 Programme of Work, 1997

OECD Economic Surveys: Russian Federation, 1997. (http://www.oecd.org/sge/ccnm/pubs/cpru3011/present.htm)