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. Last Updated: 07/27/2016

Not the Right Tax to Cut

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The government's new medium-term economic program includes a proposal to cut the value-added tax from 18 percent to 13 percent by 2009. Given a combination of sustained high oil prices, large budget surpluses and slowing growth, it is not difficult to see why the government is considering further tax cuts. The business community can always be counted on to support lower taxes, and many in the government appear to see tax cuts as a way to boost economic growth.

The authorities, however, should proceed cautiously. The steady growth of budgetary spending commitments and uncertainty about oil prices both argue against moving too quickly to adopt permanent tax cuts. There may, nevertheless, be a case for some further easing of the tax burden, but VAT may not be the right tax to cut. Certainly, a cut as radical as that now being proposed raises important questions.

A VAT cut would stimulate consumption, which is already booming. At the same time, there is evidence that capacity constraints are starting to affect industrial growth. This raises doubts about the ability of domestic producers to respond to further domestic demand growth. Stimulating consumption would probably just fuel the growth of imports and add to inflationary pressures.

It would make sense therefore to cut taxes so as to stimulate investment in Russia, rather than consumption. The government might want to consider lowering the rate of profit tax, for example, or re-establishing some sort of investment tax break within the framework of the profit tax. The latter would, of course, have to be done carefully, so as to minimize opportunities for evasion.

There are also other considerations suggesting VAT is not the right tax to cut. It is well known that the enormous role played by export-oriented natural resource sectors in Russia's economy makes it vulnerable to "Dutch disease." What is often overlooked is that an economy facing such a risk is likely to benefit from greater reliance on indirect taxes like VAT, rather than direct taxes on capital and labor. VAT applies to all goods and services sold in the country, whereas taxes on capital and labor are levied only on domestic producers.

Thus, while it is often argued that a lower average tax burden could help compensate somewhat for ruble appreciation, this is not really true of a cut in VAT. Cutting VAT means making imported goods cheaper, as well as local ones.

In contrast, a cut in direct taxation (in the profit tax or payroll taxes, for example) reduces domestic producers' costs relative to those of their foreign competitors. Indeed, a shift toward greater reliance on indirect taxation could actually help combat Dutch disease. An increase in VAT financed by a cut in direct taxes could be revenue-neutral and yet still improve manufacturing competitiveness. By making domestically produced goods cheaper relative to imports, it would offset to some extent the effects of ruble appreciation.

VAT is in any case a relatively "good" tax for Russia, since it is the most important source of government revenue that is not highly sensitive to fluctuations in oil and gas prices. Moreover, VAT does not distort markets or incentives in the way that taxes on labor and capital can do. Under a VAT, it makes no difference what factors of production are employed to produce a good, how many times it is traded, how the production chain is organized or where the good is produced.

Russia's chronically low investment rates constitute a further reason for thinking that any changes to the tax system should aim at stimulating capital formation rather than consumption. Russia needs to modernize its aging capital stock, and therefore has a strong interest in a tax system that will attract capital, not drive it away. And, as Russia's recent history shows all too well, capital is the most mobile factor of production and thus the one that can most easily "flee" taxation.

If the government nevertheless opts for a VAT cut, it will need to consider carefully what steps can be taken to prevent such a cut from simply fueling inflation and import growth and undermining competitiveness. It might be prudent to opt for a relatively modest VAT cut and to combine this with measures to reduce the tax burden on investment.

To put it bluntly, Russia has too much consumption growth and too little investment growth. If taxes are to be cut, therefore, priority should be given to stimulating the latter, not the former.

Christian Gianella and William Tompson are economist and senior economist for Russia and the NIS in the economics department of the Organization for Economic Cooperation and Development. The views expressed are their own. They contributed this comment to Vedomosti.