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. Last Updated: 07/27/2016

Taking a Conservative Approach to Projections

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In May, the State Duma approved the government's three-year budget for 2008 to 2010 on first reading. This type of planning is designed to increase the predictability of budgetary and tax policies, decrease the risk of influence of factors like political jockeying ahead of the presidential election in 2008, and to provide a clear understanding of the government's intentions. In this sense, it is a welcome change.

It is difficult, however, to provide a simplistic assessment of the budget after just the first reading. It is not really a conservative budget, as it calls for a departure from a number of policies of recent years, including channeling surplus oil and gas revenues into the stabilization fund and restraining growth of budgetary expenses. This budget includes considerable increases for social investment and an active reduction of infrastructural barriers to economic growth. This is an evolutionary rather than a revolutionary transition. Increased expenditures are tied to anticipated economic growth and improvements in the quality of life over the medium-term. It is also based on obvious expenses related to the transition to the new budgetary model, and playing it safe while increasing spending to the maximum allowable level to satisfy a number of demands.

The character of the proposed changes is clearer when compared to that of recent budgets.

In 2005 and 2006, revenues were just less than 24 percent of gross national product. This has fallen to 18 percent of 19 percent. The sharp fall is attributed to a projected fall in world oil and gas prices, a slowdown in the growth of mining and coal exports, and a strengthening of the ruble. Oil and gas revenues, a major part of budget income, are expected to fall to less than half of current levels -- from 10.9 percent of GNP in 2006 to 5.2 percent in 2010.

Spending is expected to rise significantly at the same time, from around 16 percent of GNP between 204 and 2006 to more than 18 percent for 2008 to 2010. The result is that budget surpluses, which reached 7.5 percent in 2005 and 2006, fell to 2 percent in 2007 and will hit zero in 2009.

This growth in expenses and the departure from previous budget policies stem from the implementation of two groups of initiatives presented during Putin's annual state-of-the-nation address.

The first group involved increased social spending, including raises for public sector employees and those in the military, higher pensions, and support for measures to improve the demographic situation in the country.

The second consists of government investment in the economy, primarily in transportation and energy, along with stimulation of economic innovation in industries like nanotechnology, civil aircraft construction and shipbuilding.

These initiatives will increase social spending from 2 percent of GNP in 2005 and 2006 to 2.5 percent of GNP from 2008 to 2010. Spending in the second group will also rise, from 1.2 to 1.3 percent of GNP to between 2 and 2.1 percent of GNP.

So the new three-year plan sets out to accomplish the difficult maneuver of increasing spending sharply during an expected decline in revenues as a percentage of GNP. This should stimulate development in areas outside the oil and gas sector and decrease economic dependence on world demand for energy resources.

Success here depends on the accuracy of revenue projections. We already know that oil and gas income made up 40 percent of all revenues in 2005 and 2006. Official projections anticipate a drop in the price of Urals blend oil from $55 per barrel at present to $50 in 2010 -- a figure below that of most independent projections. The U.S. Energy Department predicts a price of $57 per barrel in 2008, higher than Russia's budget forecast of $53. But the U.S. forecast calls for a range of from $41 to $58 per barrel in 2010, yielding a mean price of $50, which matches the estimate from the Economic Development and Trade Ministry.

Given the volatility of oil prices and their importance to budget revenues, tax revenues take on added importance -- particularly those taxes not generated from fluctuating raw materials markets. Here, the government's predictions are less than convincing.

The budget foresees reduced profit tax revenues, which were from 1.8 percent to 1.9 percent of GNP between 2005 and 2007, to 1.4 to 1.5 percent of GNP from 2008 to 2010. This trend is based on projected reductions in energy export revenues, but will be partially offset by an increase in Value Added tax revenues, from the current 5.7 percent of GNP to 6.2 percent of GNP in 2008, and not less than 7 percent of GNP for 2009 and 2010.

The introduction of amendments to tax legislation in recent years has meant a fall in VAT revenues. In 2004, the minimum rate was lowered from 20 percent to 18 percent, a list of real estate and other land-related transactions not subject to taxation was introduced. The first four months of 2007 have shown these changes to have had a lasting influence on budget revenues, and not a one-time effect as earlier expected.

There has also been a reduction as a result of a new, faster procedure introduced in 2007 for reimbursement of VAT duties paid. Additionally, revenue projections have not accounted for the probable transition in 2008 to a special system of registering legal entities and individual businesspeople as VAT payers. The discrepancy between actual VAT revenues and projected revenues, according to our calculations, could reach 1.5 percent of GNP. This represents about 8 percent of planned budget revenues for 2008.

Other factors will also play a role in determining whether the three-year project is successful. Because many companies in the oil and gas sector will exhaust current deposits, with a resulting rise in extraction costs, there will be a drop in profits and tax revenues in the sector. Medium-term growth in the manufacturing sector is also likely to be slower, while that in construction and services will pick up pace. This represents expansion in economic sectors in which it has traditionally been more difficult to collect taxes.

Finally, given the long-term character of the numerous "priority" social projects and investment projects, and the difficulty the government has already run into in bringing them into being -- the national health services project is a good example -- it is likely that costs will be higher. This is the case with most transportation infrastructure projects targeted for investment fund support and with deadlines of from three to seven years. It is also unlikely that cost projections will be indexed, and likely rises in costs will only become clear once the projects are underway. This will mean higher spending.

The conclusion from all of this is the following: Increased expenditures can only be covered if world energy prices exceed budget projections and oil and gas revenues account for a larger portion of revenues than budgeted. Further, expenditures have only really been projected for the short term and are tied to the identification of priority projects from the top. The projections do not fully take into account the effect hidden expenses associated with each will have on the economy. Finally, given the volatile nature of world commodities markets, spending increases may merely serve to postpone additional spending or stand in the way of reduced expenditures relative to revenues forecast for 2010.

Ilya Sokolov is the head of the Budgetary Policy Laboratory at the Institute for Economy in Transition. This comment appeared in Vedomosti.