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. Last Updated: 07/27/2016

Cost of Fiscal Populism

Prior to the July presidential election, many economists believed Russia's economic performance would radically improve if Boris Yeltsin won. The reasoning behind this optimism was fairly straightforward: The impending elimination of political risks and uncertainties, with inflation under control, would spark an investment boom, financed both from domestic and foreign sources. And lower interest rates on government bonds would result from enhanced portfolio investment.


So far, the post-election economic performance has not borne these predictions out. Share prices actually peaked at the time of the election, before sliding some 25 percent by the beginning of August. Surprisingly, the Yeltsin victory did not favorably change the perception of investment risks. While Treasury bill yields have declined somewhat since the election, they still remain enormous, especially taking into account the recent decline in inflation. Economic growth is expected to be negative for 1996. It is not unrealistic to expect output to decline by as much as 4 to 5 percent, a striking change from the expectation of zero-to-modest growth held by most observers at the beginning of the year.


Was the early optimism unfounded? Most of Communist Party leader Gennady Zyuganov's followers certainly think so. In their view, the optimistic outlook held at the beginning of the year was part of the pre-election ploy to fool voters into supporting the continuation of reformist economic policies, which would "ruin the country." They also said Yeltsin would not carry out his promises and wage arrears would worsen dramatically. Unfortunately, the latter claim appears to bear some truth, as recent events have shown. The communists will be waiting for a chance to capitalize on this in the next elections.


The recent economic setbacks and lack of growth have nothing to do with the general strategy of economic reforms. Rather, they are largely a result of the pressures of the election campaign and of the economic policies designed to cope with those pressures. And yet, by the standards of an election year, Russian economic performance can hardly be called unsuccessful. The rate of inflation has been steadily declining to record post-reform lows despite the pressures exerted on the budget.


But the tactics of reforms in the pre-election period gave rise to a version of populism that may be very damaging even if the inevitable inflationary pressures are not immediately apparent. The decreasing growth and investment prospects is by and large a direct result of what might be called "fiscal populism." The main characteristic of fiscal populism in Russia has been low tax collection. The revenue shortfall has not translated into higher inflation owing to arbitrary budget cuts and reallocations. The monetary effects of the deficit have also been offset or postponed through issuing more government paper. The growing recourse to the government bond market has led to a self-sustained increase in government bond yields. This has crowded out capital investment and bank lending, because investors preferred these high-yield bills to other alternatives. Furthermore, the high yields, coupled with tight monetary policy, have hampered the adjustment of the banking system to new conditions of low inflation.


Low tax collection has also been a blow to the Russian government's credibility and to its ability to raise revenues from enterprises, individuals and local authorities. Numerous tax exemptions and other ad-hoc arrangements have been taken to be permanent concessions from the government. And some of the otherwise desirable structural reforms, such as the replacement of export tariffs by excise taxes last spring, have apparently translated into severe fiscal losses, since the timing of the reforms did not allow for tax compliance at the outset. The long-term cost of these concessions may be very high indeed. Faced with chronically low tax compliance, the government could be forced to increase tax rates, which would hurt honest taxpayers and further stifle economic growth.


Another cost to fiscal populism in Russia stems from arbitrary cuts in budgeted expenditures in areas that are not expected to reap immediate political dividends but are essential for the functioning of the economy. Since those expenditures have to be met, at least partially, at a later stage, budget pressures will intensify later on. This further lowers the government's capacity to meet the overall expenditure commitments in the future, spurring widespread discontent and protests such as the recent strikes in the Far East.


While the damage of fiscal populism to Russia's economic growth may be substantial, it does not account for all of the worsening of Russia's economic prospects in the last months. The disappointing performance of Russian share prices in July is clearly related to the uncertainty generated by fairly mixed signals on the government's future economic policies. This has hurt investor confidence, as has the apparent, but vaguely framed, strengthening of the economic clout of the "power ministries." Another warning sign is continued protectionist rhetoric on foreign goods and investors and the slow progress in liberalizing foreign access to the Treasury bills market. At present, this seems the only quick way to lower bond yields and ease fiscal pressures.


Reversing fiscal populism will not be easy. On the other hand, by resolving major uncertainties over its future macroeconomic and structural policies, the government can already go a long way toward attracting serious investment, which will alleviate most of the pressures in the financial markets. Otherwise, if reforms continue to lag, the Russian economy may have to undergo yet another "deciding" election.





Yaroslav Lissovolik is an expert with the Russian European Center for Economic Policy. He contributed this comment to The Moscow Times.