Russia's Crony Capitalism

by Anders Aslund

  The liberals also lost in the crash of 1998. They were blamed for the “damned nineties,” as the Russian shorthand of that decade later became. The many opinion polls help us understand the public view. Most Russians forgot that it was the communist leadership that had brought about the collapse of the Soviet Union and its economy. Instead, they cherished the Soviet Union as a respected superpower, sparring with the United States. They blamed Yeltsin for the collapse of the Soviet Union, Gaidar for hyperinflation, and Chubais for the emergence of the oligarchs, and all three for corruption, while they gave them no credit for building the market economy that delivered the decade of unprecedented growth. As Lev Gudkov, director of the renowned Levada Center, writes: “The people can neither forget nor forgive the reformers, whom they blame for the catastrophic collapse of living standards, loss of savings, unemployment, and months-long delays in wages in the 1990s.”19

  The big winners of the crash of 1998 were the state, the federal government, and Putin, who happily arrived at a laid table, as well as benefiting from the commodity boom that took off in 2003. As the independent political analyst Dmitri Oreshkin observed in 2017: “We liberals of the Gaidar type have fulfilled our function, to form a liberal market economy, and society has no need for us any longer.” Centralized political power returned, and the Federal Treasury assumed control over public finances.20

  The lasting policy effect was a strong commitment to macroeconomic stability among the ruling elite. The state was back, and Putin as its leader received great freedom of action, which he used with cunning political skill. He had learned the wisdom of conservative macroeconomic policies: “A competent macroeconomic policy remains one of the state’s most important regulatory functions.” Although he has abandoned most promarket positions, he continues to defend a conservative macroeconomic policy.21

  After the crash of 1998, the weakened President Boris Yeltsin had little choice but to sack the reformist but hapless Kirienko government. In came a government consisting mainly of left-wing old-timers, led by former communist intelligence chief Yevgeny Primakov. In spirit, however, the Kirienko program survived, because little money was available for expensive public investment programs, industry, or social transfers. Moreover, some liberals remained in the government, particularly Mikhail Zadornov, who was minister of finance from 1997 to 1999.

  The default forced severe expenditure cuts and vital reforms on the country. Russia’s prior political inability to balance its budget ended because the alternative was hyperinflation, which was unpalatable to all. The Russian government focused on two major expenditures: enterprise subsidies and pensions. It cut direct subsidies and quickly eliminated indirect supports by demanding that everyone pay taxes in cash rather than in services. More controversially, the government reduced real pensions by not indexing them to the high inflation. In contrast to the young reform ministers who preceded him, the old communist Primakov was politically able to cut pensions, which slumped by about half in real terms from the summer of 1998 to early 1999.

  Russia cut public expenditures in an extraordinary fashion. In spite of falling output, the government slashed total consolidated government expenditures by no less than 17 percent of GDP in three years, from 48 percent in 1997 to 31 percent in 2000. Russia went from public expenditures on a Western European level to less than in the United States, and it has continued to maintain these levels. Thanks to the large expenditure cuts, Russia switched from chronic budget deficits to persistent budget surpluses until 2008 (fig. 3.2).22

  A group of World Bank economists calculated that in 1998 the Russian government spent the extraordinary amount of 16.3 percent of GDP on enterprise subsidies, of which 10.4 percent were direct subsidies and 5.9 percent were indirect subsidies through barter. The new government responded by forcing all taxpayers to pay their taxes in real money. It eliminated the individually negotiated taxes that oil and gas companies had enjoyed. The government started pursuing its claims with a new aggressive bankruptcy law passed in 1998. The novel hard budget constraints cleared up chains of arrears, leading to creative destruction. The enterprise surveys of the Russian Economic Barometer show that barter payments between Russian industrial enterprises fell precipitously from a peak of 54 percent of all inter-enterprise payments in August 1998 to 14 percent in the fall of 2001. Barter ceased to be a problem.23

  Fig. 3.2 Consolidated government revenues and expenditures, 1998–2017. Source: IMF (2018)

  The financial crash reinforced the economic power of the federal government. The monetization made it possible for the central government to collect its lawful share of taxes. The devaluation of the ruble raised the value of foreign trade taxes in rubles, and the government hiked export tariffs on natural resource companies, resulting in the windfall from rising global oil prices going to the Federal Treasury. Federal revenues more than doubled, from 9 percent of GDP in 1998 to 20 percent in 2002, approximating the US level.24

  The Federal Treasury had been established in 1992, but only beginning in 1999 did it acquire real powers of budgetary oversight reinforced by the new Budget Code of 2000. The government also improved its financial control by banning the placement of public money in interest-bearing commercial bank accounts, demanding that all government agencies make all their transactions from one account at the Federal Treasury.25

  Of all the reforms carried out under President Putin, none has been more acclaimed than the radical reform of the tax code. Since the early 1990s, the Russian reformers had wanted to introduce a comprehensive new tax code, but the recalcitrant Duma blocked all significant reforms.

  Until 1999, taxation was almost arbitrary. Russia’s tax system was unwieldy, inefficient, and poorly enforced. The country had more than 200 taxes: approximately 30 at the federal level and more than 170 at the local and regional levels. In the absence of an effective federal government, the regions had invented strange local taxes. The proliferation of taxes and high tax rates encouraged both exemptions and tax evasion. Multiple tax agencies were competing with one another over the same revenues.26

  The enforcement of the tax laws was as haphazard as it was brutal. Until the reforms, the tax inspection agency and the tax police were the state organs causing businesses the greatest suffering, pursuing actual tax farming. The more taxes a businessperson paid voluntarily, the greater risk he or she ran of being extorted. The notorious tax police often preyed on the most honest or weakest businesses to extract additional payments. A rational business operator responded by cutting a corrupt deal with the tax authorities.

  A draft tax code had been lying in the State Duma since reform attempts in 1997. Key provisions of tax reform were incorporated into the government-IMF crisis plan of July 1998, but the Duma promulgated only parts of it. In January 1999, the first procedural part of the tax code came into effect. Tax reform was a key part of the Gref program of 2000. The second part of the tax code, comprising major reforms of key federal taxes, such as the value-added tax (VAT), the personal income tax, the excise tax, and the new unified social tax, came into force in 2001. Last, the new corporate income tax was introduced in 2002. The principles were clear: the tax system should be fair, simple, stable, predictable, and efficient.27

  The number of taxes was slashed, eliminating small and inefficient nuisance taxes. Another ambition was centralization. Ten of the remaining sixteen taxes (down from the former two hundred) were federal. This reform reduced the far-reaching regional autonomy that had developed during the Yeltsin years. The Kremlin secured steady federal revenues, liberalized the Russian economy, and strengthened federal control over the state.28

  The most popular tax reform was the abolition of the progressive personal income tax of up to 30 percent. Russians knew that the really wealthy did not pay taxes. In the summer of 2000, the progressive personal income tax was replaced with a flat income tax of 13 percent, notwithstanding opposition from the IMF, which feared that tax revenues would fall. The inspiration came from Estonia, which had introduced
a flat personal income tax in the 1994, though Estonia’s was twice as high at 26 percent. The flat income tax was a major breakthrough. It eliminated the disincentives to work and encouraged citizens to reveal their earnings, reducing illegality and corruption. Its positive shock expanded the tax base. The revenues from personal income tax rose from 2.4 percent of GDP in 1999–2000 to 3.3 percent in 2002. Over one year, wrote several economists in the Journal of Political Economy, “the Russian economy grew at almost 5 percent in real terms, while revenues from the personal income tax increased by over 25 percent in real terms.”29

  In 2001, Russia reduced the corporate profit tax from 35 percent to 24 percent. Far more important for taxpayers was the expansion of deductible business costs. Previously, only “material costs,” wages, amortization, insurance, and other production and sales costs, had been deductible in a Marxist fashion, but not repairs, technical services, natural resource exploration, research and development, advertising, and personnel training costs, as well as interest paid on loans. Thus, according to the Institute of the Economy in Transition in Moscow, “practically all necessary business expenses are considered deductible from the tax base.” As the tax burden on companies fell, their interest in exemptions declined, and taxation became more equal for all companies.30

  The social payroll taxes paid by the employer had been the highest taxes, and they had been collected by four separate extrabudgetary funds. The small Employment Fund was eliminated, while the three remaining funds (Pension Fund, Medical Insurance Fund, and Social Insurance Fund) were combined into a unified social tax, which was to be collected by the Tax Ministry. Problems created by ineffective and competing tax authorities disappeared. In 2001, the payroll tax of 39.5 percent became a unified Single Social Tax, which was reduced to 26 percent in the mid-2000s, though it has varied since then.31

  Before the reform of the tax code, the tax inspection and the tax police were the state organs that posed the greatest hazards for businesses. A presidential decree of March 2003 abolished the tax police, which had represented the arbitrary power of the bureaucracy over business. The stated motivation for the elimination of the agency was that the tax police were not “detecting, preventing or interdicting tax crimes” but instead were extorting money from businesses that paid taxes. The abolition of the tax police and the other tax reforms removed taxation from businesses’ chief complaints.32

  The fewer, lower, and simpler taxes left less room for discretion for the authorities, and the tax burden became bearable. Small-scale tax violations were decriminalized and became subject to civil rather than criminal law and were punished with moderate fines. The tax system became effective in raising revenue, without placing undue burden on individuals or companies. The lower tax rates actually raised public revenues as a share of GDP, since Russians were happy to pay taxes legally.

  However, “large” and “especially large” violations of tax laws still resulted in criminal proceedings under the Russian criminal code. A company executive found guilty of “especially” large-scale tax evasion could face imprisonment for up to six years. This left a large loophole, and the Yukos affair numbed the tax police reform.33

  Russia’s decade of high economic growth greatly improved public finances. The consolidated budget recorded persistent surpluses from 2000 to 2008 (fig. 3.3). The main advocate of using these large budget surpluses to pay off the public debt was Putin’s economic adviser Andrei Illarionov, and Putin accepted his view. As a result, Russia saw a stunning decline of its public debt. In the spring of 1999, the debt corresponded to Russia’s GDP in US dollars, but by 2008 it had plummeted to just 6 percent of GDP, thanks to a combination of the write-off of the domestic treasury bonds, the appreciation of the ruble, high economic growth, and steady budget surpluses (fig. 3.4).

  Russian consumers benefited amply. The Russian middle class measures its income in US dollars because of the far-reaching dollarization of the Russian economy, and the average monthly wages rose, incredibly, twelve times from just $79 in 2000 to a high of $946 in 2013 (fig. 3.5).

  Fig. 3.3 Consolidated government budget balance, 2000–2017. Source: BOFIT (2018)

  Fig. 3.4 Public debt, 1999–2017. Source: IMF (2018)

  Fig. 3.5 Average monthly US dollar wage, 2000–2017. Source: BOFIT (2018)

  Employment patterns in the former Soviet Union have differed from those in the Western world. Russian workers in the provinces tend to stick to their places of work, even when they are not being paid or real wages plummet. As a consequence, unemployment has never been dramatic, and it varies surprisingly little over time. It fell from 10 percent in 2000 to 6 percent in 2007, and in recent years it has lingered around 5.5 percent (fig. 3.6).

  Russians went through hyperinflation in the early 1990s, and inflation remains a much greater concern than unemployment. Inflation has been somewhat high by international comparison, falling from 20 percent in 2000 to 2.2 percent in early 2018 (fig. 3.7).

  Another idea that arose from the crash of 1998 was that Russia needed large international currency and gold reserves. In March 1999, the reserves hit rock bottom at a paltry $10.8 billion. They gained momentum in 2000, rising to $28 billion. The reserves continued to grow apace, reaching $77 billion at the end of 2003 (fig. 3.8).34

  The Russian liberals had started thinking of institutionalizing the reserves that resulted from the high oil price windfall. They looked at the sovereign wealth funds of various oil-rich countries, chiefly Norway’s pension fund. Putin’s economic adviser Andrei Illarionov and Kudrin cherished this idea, and Putin pushed it through. On January 1, 2004, the Russian government established a Stabilization Fund under the Ministry of Finance. It was meant to be a “rainy-weather” fund for budget support when the oil price fell. All fiscal revenue above a certain oil price level was passed on to the Stabilization Fund.35

  Fig. 3.6 Unemployment rate, 2000–2017. Source: BOFIT (2018)

  Fig. 3.7 Inflation, Consumer Price Index, end of year, 2000–2017. Source: BOFIT (2018)

  Fig. 3.8 Foreign currency and gold reserves, 2000–2017. Source: BOFIT (2018)

  As the price of oil continued to rise, the Stabilization Fund grew. By February 1, 2008, when it had accumulated $157 billion, the Ministry of Finance divided it into two funds, aspiring to get better returns on the reserves. The new Reserve Fund had the same function as the old Stabilization Fund, with highly liquid international bonds yielding poor returns. Initially, it contained $125 billion, peaking at $143 billion on September 1, 2008, but it plunged to $25 billion in January 2012 because of the lower price of oil and budget stimulus spending. Yet it peaked at $92 billion in September 2014. After the fall in oil prices and Western financial sanctions, the Reserve Fund was nearly depleted, and it was merged with the National Welfare Fund at the end of 2017. The variations in this fund were considerable, but it was designed to compensate for low oil prices.36

  The aim of the other sovereign wealth fund, the National Welfare Fund, was to deliver higher returns through riskier long-term investments. In practice, it has become a budget support fund that is used for dubious Kremlin investments, such as the recapitalization of the notoriously loss-making Vnesheconombank (VEB). The National Welfare Fund rose quickly from $32 billion in February 2008 to $88 billion on January 1, 2009, but since then it has hovered around a similar level, declining to $67 billion on December 1, 2017, 4.2 percent of GDP. These assets are not liquid, and presumably they should be written down because of losses.37

  In 2016, a subsidiary of VEB, the Russian Direct Investment Fund (RDIF), was transformed into a third sovereign wealth fund with $10 billion, but its orientation is quite different, being geared toward attracting foreign private equity investments. Increasingly, it has been drawn into the same kind of funny state operations as VEB and VTB (Vneshtorgbank of Russia), which led to its Ukraine-related designation by the US Treasury in July 2015.38

  The Reserve Fund and the National Welfare Fund have granted the Russian government more securit
y and flexibility, as was intended. They have not become particularly large, but is this a sensible way of keeping national wealth? The funds have generated minimal returns and enabled the government to maintain poor economic policies that should be reformed. Most countries do not have sovereign wealth funds, and Russia’s public debt is uniquely low, giving the country plenty of room to increase its indebtedness.

  In September 2008, Russia was hit by the global financial crisis. In hindsight, the Russian government had managed the fiscal crisis of 1998 eminently economically, though not politically. This time, the opposite was true. The crisis was a rude surprise to the Kremlin, blinded by hubris. As late as early September, Putin had called Russia a safe haven, even though Russian stock prices had fallen sharply since May and commodity prices had been dropping since mid-July.

  On September 15, all hell broke loose in global financial markets, as the American investment bank Lehman Brothers went bankrupt, leading to a global liquidity freeze, which hit Russia hard. Suddenly the Russian leaders realized how exposed their corporate sector was to large credits from foreign banks. The international price of oil plummeted to $34 per barrel in December 2008, and the Russian stock market plunged by 80 percent in dollar terms from May to December.

  Unlike the situation in 1998, the Russian government had built up large reserves. In August 2008, its international currency and gold reserves reached $598 billion, making Russia’s the third largest in the world after China and Japan (see fig. 3.8). Confident that these large reserves would carry Russia through the liquidity squeeze, the government opted for an extreme Keynesian policy of overbridging the crisis with fiscal stimulus, as China and India did. Russia launched the largest fiscal stimulus program of all the G-20 countries, turning a budget surplus of 4.1 percent of GDP in 2008 to a deficit of 6.0 percent of GDP in 2009.39