Totally New Tax System

Every summer for the last three years, the government has fought a titanic battle in parliament over new tax laws. In 1998 and 1999, the stakes were depressingly simple: The government had to get new revenue-raising laws on the statute book to persuade the International Monetary Fund to give credits. In both years, the communist-dominated lower house gave the government little or none of what it wanted. In 1998, the result was default and ruble devaluation. In 1999, a new financial collapse was only avoided thanks to recovering oil prices.

This year’s battle has been different in every respect. The aim was not to pass emergency measures, but to establish a whole new tax system, not to secure IMF credits, but to do without them, and not to increase the tax burden, but to reduce it. Most importantly, this time around the government won.

In the second half of July, parliament passed the most controversial chapters of the new Tax Code, which sets out rates and conditions for every sort of taxation. The most revolutionary steps are introduction of a flat 13 percent income tax rate, replacing existing progressive rates from 12 percent to 30 percent; reduction and reorganization of social taxes, levied on the wage bills of companies and used to fund expenditure on state pensions and benefits; and abolition of Russia’s most nefarious tax — a 4 percent levy on the turnover of companies that devastates their financials. The turnover levy will be reduced to 1 percent next year and completely phased out by 2003.

The main aim of the new code is to maintain economic growth, enjoyed by Russia in 1999 and 2000 for the first time since the collapse of the Soviet Union but now under threat as world oil prices turn downward and the positive effect of ruble devaluation in 1998 to 1999 peters out. The necessity of tax reform for growth is obvious. Turnover taxes have sapped capital from loss-making companies and spoiled the performance of profitmakers. The combined effect of social and income taxes has been a 60 percent levy on wages, encouraging most firms to pay their employees in envelope dollars, thus depriving the state of revenue and the firms of state protection.

The million-dollar question now is whether economic agents will react to reform by coming out from under the stones where they have been hiding from the state. It might seem obvious that they will — in order to win protection by the law and save the costs and hazards of cash-based operation. Unfortunately, it might not work like that.

The difference between the new and old tax systems is not a matter of ideology or adaptation to new economic circumstances, as is generally the case when a new government changes tax laws in the West. The old Russian tax system (in force until Jan. 1, 2001) is essentially criminal. Companies that have gotten used to living with a criminal tax system need to be convinced that reform is not a stratagem to lure them into the open and devour them.

How is the old system criminal? Take turnover taxes. Revenue from these taxes is meant for upkeep of roads and housing, and most of it is collected and spent at the regional level under the nation’s federal budget system. The federal center has little control over how regional governors actually use this money. Sums collected for road maintenance in the last few years should have been enough for three east-west highways across Russia, but there is still a 200-kilometer gap in Siberia, which makes the country untraversable for motor traffic. Since 1992, vehicle numbers have grown three times faster than the road network.

The same unaccountability applies to collection and spending of social taxes, most of which are also administered at regional level. Inefficiency of the pension and benefit systems is evident from recurring arrears in payouts. Opacity and inefficiency of tax collection for spending on roads, pensions and unemployment and medical benefits is increased by the fact that collection and spending for each item is administered by an autonomous "fund," which builds screens between itself and the rest of government.

Finally, there is the pernicious system of tax offsets. Instead of paying pension contributions in cash, a power or fuel company goes to the regional governor and local branch of the pension fund and seeks a deal to offset money owed to it by the authorities for supplies to the local public sector. Personal and political interests of the governor decide the recipients and terms of such deals.

The concentration of these abuses at the regional government level makes it clear why tax reform could go through only after the Kremlin broke the power of the governors in the recent fight for the presidency. However, there has also been a wagonload of downright criminality at central government level.

The government permitted the existence of numerous internal tax offshores, which were supposed to nurture growth of the real economy in depressed regions, but in fact merely allowed business oligarchs to cut their tax bills by setting up trading companies in those regions. The bandits and semi-bandits who owned Russia’s aluminum plants exploited the government-backed "tolling" system — they set up foreign-based trading companies, which sent alumina into Russia, where it was processed for a modest fee at the plants, then re-exported, and the operations were freed from VAT because the commodities were never officially owned by an onshore entity. A raft of other VAT exemptions has further undermined collection of this most important tax for the Russian exchequer. Oil companies have been able to reduce export taxes by selling to foreign affiliates at artificially low prices.

In an amazing cleanup, all of these abuses (regional and federal) have been dealt with over the last few months, either by the new Tax Code or by separate government acts, backed by the invigorated, post-Yeltsin Kremlin. By this time next year, it will be clear whether the delinquent economy is capable of playing according to a proper set of rules or whether, as a vodka-drinking banker friend said to me: "It is too late to switch to mineral water."

Ben Hooson writes for RMG Securities. He contributed this comment to The Moscow Times.