Wednesday, November 27, 2002

Russia's tax revolution: A model or mistake?

According to an editorial ("The Putin Curve") for The Wall Street Journal, Russia has recently undergone a tax revolution. The Russian reforms began in 2001, when a 13 percent flat tax on individual income replaced a convoluted system with a marginal rate of 30 percent. Then the tax on corporate profits was cut nearly one-third to 24 percent, corporate tax loopholes were closed, and social security levies were simplified and payroll tax rates reduced. Tax revenues immediately began rising as citizens decided it was easier to pay taxes than to avoid them -- a classic Laffer Curve effect of an enlarged tax base and a surge in tax revenues.

Russia's economy grew 9 percent in 2000 and 5 percent in 2001 and is expected to expand by more than 4 percent this year. Meanwhile, as other stock exchanges shudder under the threat of self-fulfilling doom prophecies, the Moscow stock exchange is galloping. The tax reforms have provided a solid basis for economic growth and investment. As important, they have signaled to Russian individuals and businesses that the government is serious about creating incentives to productive work and risk-taking. Worthy of remark is the political effectiveness of Putin's economic team in expediting these reforms, which were only predicted to start in 2004 or 2005.

Another tax going on the Russian scrap heap is the "road user" tax. At about 1 percent of corporate revenues (not profits), the tax was highly regressive, a disincentive to investment that pushed a lot of business into the black market. "The Russian example shows that this is precisely the right time for tax reforms to spur economic growth in the United States," concludes the Journal. The National Center for Policy Analysis concurs, as it has been agitating for tax reform to stimulate economic growth quite consistently.

I'm not sure whether the current economic success in Russia is best attributed to tax policy reform. Though tax reform certainly increased investor confidence by providing a modicum of transparency and increased Russia's competitive opportunities for foreign investment, the Russian tax "miracle" has been a long time in the making. Russian tax policy certainly played a significant role in the failure of the Washington approach, as man-handled by Clinton, Summers, and Sachs, to facilitate Russia's economic transition to a mixed market economy. By 1995, tax policy in Russia had undergone so many modifications and changes that neither tax-payers nor tax inspectors could make sense of it. As a result, Vladimir A. Samoylenko cautioned that "the rights of tax bodies in interpreting the provisions of the tax laws became so broad that any revision by the tax inspectorate resulted in the arrest of a tax-payers' account and unconditional recovery of taxes in arrears, as assessed by the opinion of a taxinspector, together with fines and penalties". Confusing tax policy combined with the pro-investment strategies of Yeltsin and the Washington consensus to create an environment ripe for corruption, as many tax officials began interpreting and manipulating tax codes in ways favorable to certain oligarchs. Even in 1998, Russia's tax policies continued to be cited as main impediments to economic reform.

Surely, however, Putin's cool, calculated, pro-Western foreign policy should also be credited with stimulating Russia's economy, especially to the extent that American investors have been eyeing his relationship with the Bush administration to see how smooth US-Russian relations might be in the aftermath of last year's terrorist attacks and last month's NATO accession summit in Prague. What Nikolai Sokov calls Putin's "pro-Western pragmatism" has strengthened Putin's hand vis-a-vis Europe, where his political style and manner is greatly appreciated-- which only serves to solidify his popular base and political legitimacy at home. So far, I think that this, more than anything, has contributed to keeping the disgruntled Russian hawks in the military and intel communities from posing a destabilizing threat to Putin's detached diplomatic intimacy and intricacies. Economists are overlooking the role of Putin's pragmatic foreign policy in creating the conditions for economic prosperity.

For more interesting commentary on the Russian tax reform, see articles and essays by the Hoover Institution's Alvin Rabushka. Also worth noting are the scholars and talks given at a summer 2002 conference "Taxation in Russia and the CIS" hosted by the Adam Smith Institute. The best easy, breezy break-down is one by Deroy Murdock for Citizens for a Sound Economy.