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How should Russia manage its oil wealth?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
November 2004
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Strong economic growth and windfall revenues from oil as a result of higher prices (see chart below) are posing new challenges for fiscal policy in Russia. With basic public services still inadequate and much of the infrastructure run down, pressures to spend oil revenues have intensified. But with signs of rising inflation and tightening labor markets, fiscal policy should not add stimulus to the economy at this stage. In fact, it may have to be tightened. In this article, Goohoon Kwon, an IMF representative in Moscow, discusses the challenge of carrying out necessary—but expensive—social reforms while preserving macro-economic stability.

High growth, not least thanks to oil

1The Urals are the main oil-producing region in Russia. The price of Urals crude is quoted separately on world oil markets.

Data: Rosstat and Reuters

The current system of social entitlements, a remnant of the Soviet era, is severely underfunded, highly inefficient, and prone to abuse. In its draft 2005 budget, the government is proposing to increase social spending by some ¾ of 1 percent of GDP, associated with an ambitious social benefit reform. The reform, which will affect tens of millions of beneficiaries, aims to downsize entitlements to affordable levels, ensure full funding of remaining benefits, delineate the social spending responsibilities of federal and local governments, and replace in-kind benefits with monetary compensation.

In addition, the government is proposing to cut the social security tax, a measure that would reduce revenue by nearly 1¼ percent of GDP in 2005. The social security tax, levied mostly on payrolls, is the government’s single most important source of revenue, collecting what amounts to nearly 8 percent of GDP. This revenue is earmarked for pensions, health care, and disability benefits.

Reducing the social security tax is not in itself a bad thing. The tax represents a burden on business and is holding back the growth of small and medium-sized businesses by impeding investment and encouraging tax evasion. Advocates of the tax cuts believe that any adverse effect on revenue will be offset by better tax compliance and positive supply effects. But the extent of such revenue gains is uncertain. Experience with previous tax cuts suggests that stronger tax administration is essential for broadening the tax base.

Government finances would be in deficit, were it not for higher oil prices

(percent of GDP)

Note: Shaded area indicates projections.

Data: Russian Ministry of Finance and IMF

Cutting the social security tax—combined with the proposed increase in social spending—will therefore most likely leave a big hole in the budget. And while the government is expecting to raise additional revenues through other taxes—including on personal property, dividends, and mixed income—these gains are likely to be minor. This leaves oil taxes. According to the government, these will become steeply progressive, with marginal rates increasing at high oil prices. The government expects this will boost tax revenue by some ½ of 1 percent of GDP at oil prices over $30 a barrel (there will be almost no gains, though, at $20 a barrel). The 2005 budget expects to raise additional revenue totaling ¾ of 1 percent of GDP mostly through windfall taxes on the oil sector.

The tax cut also brings to light the urgency of a comprehensive pension reform. Public pension expenditures are projected to rise by as much as 4 percentage points of GDP by 2040 (owing mainly to a rapidly aging baby-boom generation) unless benefits are scaled back and the retirement age is increased. The pension fund will receive an additional ¼ of 1 percent of GDP as a result of a planned diversion of some pension contributions from the fully funded system to the pay-as-you-go system. But this still leaves a substantial deficit for 2005, which the government is proposing to cover by drawing 75 billion rubles from the oil stabilization fund. According to the government, this is a one-off measure, and comprehensive pension reform—including an extension of the retirement age—will be needed to restore the long-term solvency of the public pension system.

Avoiding oil-induced booms and busts

In the short term, given the very strong oil price outlook, gains from oil taxes will probably more than offset losses from the tax cut, helping the government maintain a budget surplus while carrying out its planned reforms (see chart, page 332). But over the longer term, the proposed changes will expose government revenues to the vagaries of changing oil prices. Revenue volatility has already increased substantially since the 1998 crisis because of the heightened importance of the oil sector in the economy and the changes in tax laws.

This makes it all the more important for the government to institutionalize a system of saving revenue windfalls by maintaining the oil stabilization fund that was set up in 2004. The fund has begun accumulating revenue windfalls, defined as oil taxes arising from Urals oil prices over $20 per barrel, and is expected to reach its cap of 500 billion rubles (about 2¾ percent of GDP) before the year is out. After that, current legislation allows the government to spend any surplus, removing statutory safeguards against a fiscal policy that will amplify—rather than attenuate—oil-induced booms and busts.

To remedy some of these problems, the finance ministry recently proposed to increase the cap of the oil stabilization fund—possibly by as much as 4½ percent of GDP—and to use surplus revenue to repay external debt and finance a moderate increase in infrastructure projects. It also proposed to discontinue the use of windfall revenues to finance pension deficits.

Russia should think hard about what it does with its oil riches. If used unwisely, the country’s oil wealth could quickly undo years of hard work in bringing down inflation and putting the economy on a sounder footing. The finance ministry’s proposals would help preserve these hard-earned gains.

Copies of IMF Country Report No. 04/316, “Russian Federation: Selected Issues,” are available for $15.00 each from IMF Publication Services. See page 335 for ordering information. The full text of the report is also available on the IMF’s website (www.imf.org).

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