III Priorities for the Modernization of the Tax System
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

Abstract

Like other countries undergoing systemic transformation, Russia has experienced a radical contraction in the scale of the public sector as well as fundamental changes in the role of the state in the economy. A key element of the transition has been the move from an economy characterized by a “hyperactive state which sought to control all activity in society” (Kornai, 1992, p. 5) to one in which, increasingly, production and employment are being generated by a rapidly emerging private sector and in which the public sector no longer has the preponderant role as the chief intermediary of economic activity.

Like other countries undergoing systemic transformation, Russia has experienced a radical contraction in the scale of the public sector as well as fundamental changes in the role of the state in the economy. A key element of the transition has been the move from an economy characterized by a “hyperactive state which sought to control all activity in society” (Kornai, 1992, p. 5) to one in which, increasingly, production and employment are being generated by a rapidly emerging private sector and in which the public sector no longer has the preponderant role as the chief intermediary of economic activity.

Factors Underlying the Decline in Revenues

The sharp contraction of revenues observed in virtually all economies in transition in Central and Eastern Europe has also manifested itself in Russia. As shown in Table 1, federal tax revenues in relation to GDP fell from 16.6 percent in 1992 to 11.9 percent in 1996.9 Although the decline in local government cash revenues was not as pronounced, total revenue nevertheless fell from 28.4 percent of GDP in 1992 to 24.8 percent in 1995 and to some 23½ percent of GDP in 1996 (Figure 1). Given the sharp drop in real output, the drop in revenues is even more pronounced when measured in real terms.

Table 1.

Total Tax Revenue

(In percent of GDP)

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Sources: Ministry of Finance; World Bank; and IMF staff estimates.

Excluding extrabudgetary funds.

Of which, 0.4 percent of GDP collected in noncash form.

Of which, 1.8 percent of GDP collected in noncash form.

Of which, 3.1 percent of GDP collected in noncash form.

Excluding federal transfers.

Figure 1.
Figure 1.

Total Tax Revenue

(In percent of GDP)

Source: Ministry of Finance.

Many of the same forces that led to the erosion of revenues in other countries in the region have also been at play in Russia. During 1991–96, Russia suffered a cumulative output decline of 42 percent, one of the largest in the region, and this decline had the expected impact on revenue (Table 2 and Figure 2). In the past several years, the Russian economy and, in particular, its industrial sector have been exposed to supply and demand shocks on a scale that may have no precedent in recent economic history (Table 3 and Figure 3). On the demand side, the emergence of a new political climate for international relations in the late 1980s led to a major crisis in the military-industrial sector and a permanent drop in the purchases of military hardware and other defense-related equipment through the budget, as well as to reductions in capital spending. Given the magnitude of the industrial sector in the former Soviet Union (as late as 1990, over 50 percent of output originated in industry) and the prominence of military production within it, this demand shock was proportionally far more severe in Russia than the one that affected defense output elsewhere in the industrial world. The magnitude of this demand shift may be gleaned from one key indicator: arms exports by the Soviet Union, financed mainly through export credits to developing countries, fell from $20 billion in 1988 to less than $3 billion by 1992. In the military sector during 1992–93, cumulative output declined by 57 percent, and employment dropped by 51 percent.

Table 2.

Selected Indicators of Economic Activity

(Real percent change over previous period)

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Source: Goskomstat.
Table 3.

Real Gross Industrial Output by Sector1

(Real percent change over previous period)

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Source: Goskomstat.

Data for medium and large enterprises.

Starting from 1996, chemical and petrochemical industries are combined.

Cumulative decline for petrochemicals excludes 1996.

Figure 2.
Figure 2.

Selected Indicators of Economic Activity

(1989 = 100)

Source: Goskomstat.
Figure 3.
Figure 3.

Real Gross Industrial Output by Sector

(1990 = 100)

Source: Goskomstat.

Price liberalization and the move to a more transparent system of resource allocation also resulted in significant supply shocks, as the enterprise sector was gradually deprived of producer subsidies, foreign exchange at highly appreciated exchange rates, and raw materials—particularly energy—at a fraction of the world price. The easy access to credit on preferential terms was also phased out. The military sector, which during the Soviet era had been largely exempt from paying taxes as a way of enhancing its competitiveness, gradually began to be taxed. Consumer and producer subsidies (budgeted and unbudgeted and including subsidies on imports; see Section IV), which amounted to nearly 23 percent of GDP in 1992, were also drastically cut, thus adversely affecting household demand for goods.10 Reforms in Eastern Europe—including external liberalization—resulted in sharp cutbacks in Soviet exports to traditional export markets, and declining oil production further undermined output growth.11 The collapse in trade among members of the CMEA in 1991 (which more than offset the registered improvement in the terms of trade for the Soviet Union) and, subsequently, disruptions to trade and financial relations among the former members of the U.S.S.R., which were especially pronounced in the early part of the transition period (1992–93), also contributed to the contraction of output in Russia. It is to the combination of these elements, adding up to a structurally induced drop in output, that the GDP losses must be mainly attributed (versus, say, the presence or absence at various times of a restrictive monetary policy) and that resulted in rising unemployment, a retrenchment of investment plans, cuts in production and a corresponding sharp erosion in the profitability of the enterprise sector, and the concomitant decline in revenue.12 Barbone and Marchetti (1995) argue that the decline in revenues seen in virtually all countries in the region must be seen in the context of the interconnection between expenditures on subsidies and profit taxes. They note that the net contribution of the enterprise sector to the budget, defined as profit taxes net of producer subsidies, has remained relatively stable and that the fiscal crisis is largely explained by a drop in turnover taxes and a relatively large increase in government expenditures (other than producer subsidies), mainly directed to the social sphere. In Russia, profit taxes, net of producer subsidies, amounted to about 4 percent of GDP in 1992; assuming that the bulk of producer subsidies had been phased out by 1994, net profit taxes had risen to some 7 percent of GDP by 1994. However, in Russia a large share of producer subsidies were off-budget.

Two other factors that may have influenced output are (1) the disorderly conditions that characterized the transition, as managers and workers found them-selves operating in uncharted territory where they learned through trial and error, with the associated inefficiencies; and (2) significant political instability and conflicting signals from the authorities as to the general direction of economic policy, involving, at times, sharp disagreements at senior policy levels that most likely undermined confidence in general. In addition, both measured output before the transition period and the initial output decline in the initial phase of the transition may have been overestimated (see Koen and Phillips, 1993).

While the output losses may explain a significant share of the real revenue decline, other forces have clearly been at work as well. The fall in the ratio of revenue to GDP has clearly reflected the different ways the transition has affected various sectors of the economy and, hence, the tax base. The much faster contraction of the industrial sector, for instance, has led to a relatively faster contraction of Russia’s largest and traditionally most important tax base: enterprise profits. To the extent that the output contraction was also accompanied by increases in unemployment (and, hence, reductions in consumer demand), there has been a concomitant contraction of the base of other important taxes, such as taxes on wages and indirect taxes. In addition, tax rates have been reduced. The profit tax rate was reduced from 45 percent in 1991 to 35 percent in 1992; the VAT was reduced from 28 percent in 1992 to 20 percent in 1993; and other reductions also affected export duties and import tariff rates. In addition, the tax base has shrunk further, partly in response to legislative changes that—in the case of the profit tax—broadened the coverage of deductible expenditures, such as contributions to enterprise investment funds, and permitted higher depreciation allowances. Furthermore, the absence of an adequately hard budget constraint for the enterprise sector has led at times to payments arrears, especially during 1992–93, and a corresponding increase in tax arrears. At end-1995, tax arrears amounted to Rub 55 trillion (3½ percent of GDP); these had grown to Rub 125 trillion by end-1996 (equivalent to some 5½ percent of GDP), of which nearly Rub 70 trillion was due to the federal budget (Table 4 and Figure 4). The growth of tax arrears also reflects discretionary government action, particularly in the context of the introduction of the “30/70 rule.” 13 Moreover, arrears in employer contributions to the Pension Fund have also grown and stood at over 2 percent of GDP by end-1996.

Table 4.

Tax Arrears

(In trillions of rubles)

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Sources: State Tax Service; and Goskomstat.

Excluding in the military.

Figure 4.
Figure 4.

Tax Arrears

In trillions of rubles)

Source: State Tax Service.

Far more important, the massive transfer of economic activity to the private sector has not only eroded the recorded tax bases but also greatly strained the administrative abilities of the tax authorities in a context of rapidly changing tax legislation. The complex institutional setup underlying the operations of a modern tax system, including modern accounting practices, computer facilities, and management expertise, simply did not exist when Russia embarked on reform. Russia’s tax system was mainly set up to collect taxes from the publicly owned enterprise sector and was not equipped to deal with the proliferation of taxpayers that followed the introduction of new, broadly based taxes and the transfer of a growing share of value added to the emerging private sector. For instance, the number of organizations (commercial or otherwise) with a tax identification number and liable to remit individual income tax withheld at source or to pay some other tax stood, at end-1995, at 2.6 million. Of these, about 2.1 million were actually making profit tax payments, compared with 327,000 in 1990, a sixfold increase (Table 5). By the end of 1992, the year the VAT was introduced, 1.3 million enterprises were making payments; three years later, this number had risen to 2.1 million (Figure 5). At the same time, employment at the State Tax Service rose by 130 percent between end-1992 and end-1995.

Table 5.

Number of Taxpayers

(In thousands, end of period)

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Source: State Tax Service.

Organizations (commercial or otherwise) with a tax identification number and liable to remit individual income tax withheld at source or to pay some other tax.

Actually making payments.

Figure 5.
Figure 5.

Number of Taxpayers

(In thousands; end of period)

Source: State Tax Service.

Against the background of such heavy demands on the administrative capacities of the tax authorities, the government has not always acted in a consistent manner. A presidential decree issued in May 1994 that contained a number of tough (and simplifying) administrative measures designed to improve tax compliance was considerably undermined in early 1995 with the issuance of a counterdecree permitting enterprises once again to hold an unlimited number of settlement accounts with the banking system, thereby greatly complicating the ability of the tax authorities to monitor compliance. The new decree went so far as to point out the desirability of “improving the credit positions of enterprises and organizations” by way of justification.14

In addition to the emergence of new enterprises in the private sector, there has also been a massive transfer to the cash economy of previously recorded economic activity by established enterprises. Partly because of the high-inflation environment characteristic of the last several years, but mainly on account of the growing opportunities for tax evasion, enterprises now carry out a large proportion of their transactions on a cash basis, on the margins of the law. Indeed, a cottage industry has emerged in Russia specializing in facilitating and helping hide such transactions; making available, for a fee, large quantities of cash; and, in general, converting deposit rubles into cash rubles and/or foreign exchange. Only recently have the tax authorities begun to take small steps to come to grips with this situation. One aspect of this problem is the incentive that enterprises have had to shift transactions to the cash economy, given the role played by the banks. Under existing legislation, banks are free to dispose of balances in enterprise settlement accounts, for instance, to pay accrued tax obligations. Parallel to this process, the use of noncash forms of payment has increased; thus, not only have revenues declined but they have become less liquid, particularly at the local level, where up to one-third or more of revenue takes the form of in-kind payments, including fuel, utilities, and other commodities, in typically nontransparent arrangements between the enterprises and the local authorities. Furthermore, tax avoidance motivations have led to an upsurge of barter operations more generally.

In addition, there has at times been a visible tendency to apply tax legislation in a discretionary manner, with key sectors, enterprises, and regions enjoying significant exemptions during much of the transition period, as a form of implicit subsidization. Indeed, one of the key characteristics of the Russian tax system before 1992 was the existence of relatively high tax rates, which coexisted with generous tax exemptions and preferences to specific sectors, industries, and/or regions. Recourse to exemptions made the tax system more distortionary and resulted in large amounts of forgone revenue,15 which in turn undermined the government’s ability to respond more effectively to growing needs, particularly human capital investment and infrastructure. Understandably, the uneven distribution of the tax burden, in turn, helped maintain an environment in which tax evasion was rampant, pressures for new and/or broader exemptions were ever present, and the tax base was under constant threat of further erosion.16

The government introduced at times contingency measures during the transition period to offset the larger than expected revenue drop. For instance, in the context of the authorities’ 1994 economic program, the government sought to eliminate VAT exemptions, improve the collection of existing excises on natural gas, repeal import duty exemptions, introduce a withholding tax on personal interest income and a per ton tax on oil assessed in dollars, and in enues. This was particularly the case for a number of measures (for example, including interest in the definition of taxable income) that, while supported by the government, did not receive the support in parliament necessary to change the underlying legislation.

Role of Tax Reform

Before the onset of economic reforms in late 1991 and early 1992, Russia’s tax system (consisting, essentially, of the residual transfer of profits to the state, after deductions for various enterprise funds) was not compatible with the efficient functioning of a market economy. Because economic agents did not function as reasonably autonomous decision-making entities, taxes did not have the effects on individual economic behavior generally observed in market economies (for example, payroll taxes and the effects on individual labor supply behavior). So many features distinguished a given Soviet tax from its market-economy counterpart that it may actually be somewhat misleading to think of them as being the same tax. One example was the enterprise profit tax (it accounted for nearly one-third of total budgetary revenues in the Soviet Union by 1990), which expropriated rather than taxed the profits of state-owned enterprises and arbitrarily defined allowable expenses, exemptions, and deductions (for example, to various funds for social development, and for research and development). Moreover, the tax often differed by branch of industry or by enterprise to even out profitability and, in the context of the soft budget constraints characteristic of that era, was frequently waived altogether for enterprises that demonstrated financial need. Because the state played the role of both taxpayer and tax collector, profit taxes were often subject to a great deal of bargaining at the enterprise level and were usually fully determined only ex post.

A number of considerations can be identified in Russia as having driven the authorities in the direction of tax reform. Key among them were the need to eliminate the most glaring distortions and to restructure the tax system in a way that enhanced the transparency and efficiency of existing taxes and that brought the system closer to internationally accepted norms; the need to provide an adequate level of revenue to support Russia’s macroeconomic stabilization efforts as other traditional sources of revenue dried up (for example, profit taxes, following the large-scale transfer of enterprises to the private sector and the associated difficulties in monitoring their activities); and the need to have tax reform support other aspects of economic reform (for example, the system of incentives and signals in the economy at large). These reforms have included the introduction of value-added and excise taxes (1992); the movement away from the multiplicity of turnover taxes levied at a broad range of product-specific rates; the introduction of schedular personal income taxes; the adoption of a profit tax to replace conflscatory profit taking from the enterprise sector; and the conversion of nontariff trade barriers to ad valorem duties. In addition, privatization receipts have emerged as another source of revenue.

At present, Russia’s tax system suffers from a number of deficiencies that have contributed to the emergence of a somewhat incongruous situation: rapidly declining revenues and simultaneous complaints from taxpayers about high tax burdens and arbitrary administration of existing tax legislation. The basic legal tax provisions remain embodied in a large collection of legislative acts and presidential decrees that have been put together with no attempt at consistency or administrative simplicity. Some of this reflects Russia’s special circumstances during the early part of the transition period: radical transformations in the structure of the economy and the perceived interests of various social groups, and changes in the political environment, which often revealed the lack of consensus on the aims and means of economic reform and which frequently resulted in the emergence of sectoral pressures for tax relief and privileges. Thus, rather than being based on a few clear, coherent, and easy-to-understand tax laws, Russia’s existing tax legislation is based on a number of laws, resolutions, and decrees, each reflecting a balance of prevailing interests and compromises. In addition, tax laws have been subject to unpredictable and frequent changes; both the VAT and the profit tax law, for instance, were amended 12 times each during 1992–95.17 These changes have resulted in the emergence of a number of undesirable features in particular taxes; some of the most important are identified below.

Value-Added Tax

Two VAT rates (10 percent and 28 percent) emerged in 1992 with nontransparent rules as to what was taxable at what rate; a large number of exemptions also created the usual complexities for taxpayers engaged in both taxable and exempt activities. (For instance, food products are assessed a lower—10 percent—rate, but the definition of food has sometimes been interpreted broadly and, until 1995, included all raw materials used in the agricultural sector.) The experiences of many other countries have shown that maintaining a VAT with several rates and generous exemptions leads to high administrative and compliance costs and encourages tax evasion. If the intention of the authorities was to offset the regressive impact of the VAT on low-income groups, a better mechanism would have been targeted transfer payments through some income-support system, which they could have financed from the resources they generated by taxing foodstuffs at the standard rate and limiting exemptions to a few items, such as bread and milk.

Some of the original deficiencies in the definition of the VAT base have gradually been corrected. For instance, imports were included in the base in early 1993; food imports, which had been exempted, began to be taxed in mid-1995. Deductions for the VAT invoiced on purchases of capital equipment, which were not allowed initially, began to be permitted. The deductions could be spread in equal installments over a 24-month period as of 1993, and the period was further reduced to six months beginning in mid-1995. As of April 1, 1996, such tax credits were allowed on a full and immediate basis, thus eliminating an important distortion that, for a time, had discouraged productive investment, although it also induced some short-term adverse effects on revenues. More important, in July 1995 the practice whereby an enterprise could claim VAT credits at the time of production rather than at the time of payment was formally abandoned.

A number of other problems, however, remain. Chief among these one can point to the following:

  • The invoice credit method for VAT determination has not been extended to the retail and service sectors, which means that, since the introduction of the VAT, Russia has been operating under a dual system of rules, one for manufacturers and one for distributors.18 This creates serious complications for control, because it requires that a clear distinction be drawn between a taxpayer that is a manufacturer (wholesaler) and one that is a retailer19 and it imposes compliance costs on retailers—which can be high in periods of high inflation—associated with the holding of inventories and the need to reestimate the markup on a monthly basis. Moreover, because this dual system of rules facilitates evasion, it has a negative impact on revenues.

  • A hybrid system exists for VAT on foreign trade, namely, on an origin basis for trade within the Commonwealth of Independent States (CIS) and on a destination basis for trade outside the CIS, creating problems for transshipment and trade rerouting, especially through customs union countries (for example, Belarus).

  • There is an occasional separate surcharge (3 percent in 1994, 1.5 percent in 1995) that uses the same base as the VAT and for which an independent return must be filed and a separate payment order prepared, thereby considerably increasing the administrative burden on the tax authorities and the enterprise sector.20

  • At present, there is no requirement for mandatory issuing of VAT invoices, which severely undermines tax auditing.

  • The discretionary use of exemptions continues; the VAT on imports at the full rate is estimated to have been paid on only some 30–40 percent of recorded imports during 1995–96.

These as well as other features have severely undermined the simplicity of the VAT and contributed to a shrinking of the tax base that might otherwise have been avoided.

Profit Tax

Perhaps the key issue affecting the yield of the profit tax during the transition period is low effective tax rates resulting from the existence of various special allowances and concessions. Together with losses carried forward from earlier years, total deductions can reach up to 50 percent of pretax profits. Allowable deductions (in addition to depreciation) are identified in Article 6 of the profit tax law (the longest article in the law) and exist for “capital investments intended for the purpose of production, for housing construction and also for paying off bank credits obtained and used for these purposes, including the interest on such credits” (section la of the article); “enterprises’ expenditures on the maintenance of health, educational, cultural and sports facilities and institutions, child care centers, summer camps” (section lb); enterprise outlays for “conducting scientific research and research and development activities” (section lg); plus a number of other sector-specific allowances for a broad range of activities. In addition, section 4 of the same article contains special provisions for the exemption of the profit tax during a four-year period (the first two years at 100 percent, declining to 50 percent in the third year and 25 percent in the fourth year) for newly created “small enterprises engaged in the production and processing of agricultural products, in the manufacture of consumer goods, construction materials, medical equipment, medicines, housing construction, housing repair,” among others.

The sections of the profit tax law that regulate the implementation of these concessions is general enough to permit any enterprise to carry out the bulk of its investment program under one of the above provisions. At a time when much of the country’s industrial base is undergoing modernization and/or conversion, most enterprises have found it quite easy in practice to view the creation of new assets as contributing to these processes and, therefore, as being eligible for the relevant deductions. Thus, during much of 1992–96, the taxable base was reduced by such investments, significantly cutting into the revenues generated by the most important Russian tax. Beyond the revenue impact, it is clear that the existence of such concessions requires higher tax rates for a given level of profits and creates enormous complications in tax administration. Given the general language used in the legislation, a potential area of conflict between the tax authorities and the enterprise sector immediately emerges, creating a ripe environment for corruption, arbitrariness, and resource misallocation.

Until January 1, 1996, when it was finally eliminated, the profit tax base included wages paid in excess of the equivalent of six times the minimum wage.21 This provision of the profit tax legislation had been seen as a mechanism for moderating wage increases and for preserving a certain level of profit transfers to the budget that might otherwise have simply been distributed in the form of higher wages. The excess wage provision was extended to privately owned enterprises but exempted foreign-owned businesses. While in practice nearly 25 percent of the total profit tax collected originated with the tax on excess wages, the tax itself is thought to have introduced a number of distortions and inefficiencies. It may have discouraged the growth of the entrepreneurial sector in domestic enterprises at a time when such managerial capacities were very much in need of being developed. Because the tax on excess wages did not become effective until total enterprise profits were positive, it did not affect excess wage payments in profitable and unprofitable enterprises equally. As in other cases with such nontransparent mechanisms, additional problems for tax administration were created. These problems were associated with the interpretation of the regulatory provisions and the opportunities for abuse.

The Tax System

Five main taxes (VAT, corporate profits, personal income, excises, and customs duties) account for the bulk of total tax revenue. In practice, however, a presidential decree issued in December 1993 clarifying various aspects of the relationship between the federal budget and the budgets of the members of the federation allows the regional and local authorities to introduce new taxes not envisaged in the tax legislation.22 Understandably, this decree led to a proliferation of new taxes and to a pervasive sense in broad segments of the enterprise sector that if all taxes due were actually paid, most economic activity would be rendered unprofitable.23 In the absence of appropriate coordination between the tax demands of the center and those of the regions, it is perhaps not surprising that tax evasion has become pervasive, tax arrears have grown, the government itself has had to take initiatives to allow enterprises to defer payment of various taxes (and, subsequently, to agree to their rescheduling), and, in the process, tax enforcement and administration have become arbitrary and unpredictable.

A climate characterized by the absence of legality and due acceptance of and respect for the law has emerged. This element of unpredictability in the tax system—linked to the large and highly variable number of taxes and the nominal levels of taxation that they imply in the aggregate—has introduced considerable uncertainty in the investment climate. It is increasingly difficult to know whether activities that are profitable today will remain so tomorrow, given the operation of the tax system; this uncertainty in turn has discouraged the long-range planning and investment that are essential for the recovery and modernization of the Russian economy. There is thus an overwhelming need to simplify the tax system, to eliminate a number of taxes with small yields, and to carefully circumscribe the jurisdiction of local and regional authorities in the area of tax legislation. The disorderly conditions have also undermined the credibility of the system underlying intergovernmental fiscal relations—there is evidence of a growing number of regions entering into “special” fiscal regimes with the federal government, involving, among other things, the remittance to the federal budget of a smaller VAT share from the region than called for in the law, or “single-channel” agreements whereby established revenue-sharing formulas are bypassed altogether and the regional government makes a single payment to the federal budget.

The authorities took an important step to address some of these deficiencies in the first half of 1997, presenting to the Duma a draft tax code whose chief purposes are to (1) bring into a single document all the disparate pieces of “legislation” presently regulating Russia’s tax environment while establishing a common terminology and laying out clearly defined procedures for the payment of taxes; (2) reduce the number of taxes collected at all levels of government from some 75–80 at present (as far as is known) to no more than 25–30; and (3) define the rights and obligations of taxpayers and the tax authorities and the avenues of legal redress available to both. While the draft tax code was approved on first reading, eventual promulgation is unlikely before mid-1998.

Another feature of Russia’s tax system is its revenue structure, which differs from that prevailing in other countries, say, those belonging to the OECD. As shown in Table 6, while the share of personal income taxes, corporate profit taxes, and taxes on goods and services in total tax revenues in the OECD account, on average, for some 37 percent, 11 percent, and 43 percent, respectively, the corresponding shares in Russia are closer to 10 percent, 29 percent, and 40 percent, respectively. The reasons for this distribution stem from the state’s traditional role in the Russian economy of main intermediary and distributor of resources through the budget. Given the large share of public services that were financed through the budget, wage levels were necessarily understated. With wages being “monetized” and with wage determination increasingly becoming a market-determined process, however, there has been a sharp increase in the level of wages and a distinct rise in their variance across the labor market. At the same time, it remains a medium-term priority of the government to gradually reduce the many hidden subsidies provided to employers in the public sector, with wages being adjusted upward. By establishing a closer link between productivity and benefit levels, wage policy should encourage the development of the private sector and contribute to the creation of a broader base for the income tax. Furthermore, the recent elimination of the allowable wage deduction for the calculation of enterprises’ taxable profits (equivalent to six minimum wages) should also contribute to a redistribution of taxes away from profits and in favor of the personal income tax.

Table 6.

Selected Countries: General Government Tax Revenue, 19951

(In percent of GDP)

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Source: Organization for Economic Cooperation and Development, Revenue Statistics, 1997.

Excluding social security.

Unweighted average.

An additional feature of Russia’s tax system is the energy sector’s relatively low contribution to tax revenues. While the oil and gas sectors in 1995 accounted for some 18 percent of GDP, their combined contribution to the budget amounted to about 3½-4 percent of GDP. The relative tax burden for this sector in 1995, defined as the ratio of oil and gas revenues to total revenues, divided by the share of the sector in GDP, was one-third to one-half that in most other energy-producing countries.24

Exemptions

By far the most challenging issue in the area of tax reform in the period ahead is tax exemptions. Tax revenues during the transition have been severely undermined by the general and specific exemptions granted at various times to various sectors and enterprises, across a broad range of taxes. While frequently motivated by the perceived need to support key sectors of the economy or, more generally, boost economic activity, these exemptions have often reflected the lobbying efforts of key constituencies representing various vested interests. Furthermore, these exemptions have often been taken by various agencies within the government on their initiative, with no attempt to examine the macroeconomic or budgetary impact of the exemptions. Indeed, no attempt has been made thus far to identify the budgetary cost of these exemptions, for instance, in the preparation of the draft budget, partly because no single agency has a comprehensive listing of all exemptions in place. A situation emerged, therefore, where there was virtually no tax for which there was not some form of exemption and there was no sector that did not enjoy or seek some form of tax relief. In time, this state of affairs led to the emergence of a culture where tax privileges were the rule rather than the exception and, given the inequities that were inevitably created, pressures for new and broader exemptions multiplied.

While the direct revenue impact of many of these exemptions was often not large, some did have an appreciably heavy effect on the budget. Among these, one can single out exemptions to the payment of oil export duties that, during 1994, became nearly universal and exemptions given to the National Sports Foundation and other organizations deemed charitable (for example, Afghan War Veterans’ Union), which applied to import duties, excises, and the VAT. In the context of an otherwise tight budgetary situation, these exemptions made fiscal adjustment more difficult than was necessary and, by reinforcing a growing culture of nonpayment, may have contributed to the large growth of tax arrears seen during and after 1995. Monitoring and supervising these exemptions also placed heavy demands on the administrative abilities of the authorities and led to perceptions of unfairness in the tax system, which have not contributed to creating a culture of tax compliance.25

Tax Administration

In Russia, as in other countries in transition, tax administration has evolved in a way that does not put enough emphasis on voluntary compliance, that is, the responsibility of taxpayers to determine their own tax liabilities as well as to report and pay their taxes on time. No doubt because the tax administration system until recently was largely geared to collecting taxes mainly from the enterprise sector, large-scale involvement by tax officials is seen as a necessary ingredient of effective tax administration. This approach contrasts with the principles of self-assessment and voluntary compliance on which modern tax systems in market economies are based. Because of the large increase in the number of taxpayers in recent years (reflecting, for instance, the emerging private sector and such developments as the introduction of broadly based consumption taxes such as the VAT), the bulk of the tax administration resources are being allocated to routine functions associated with tax reporting by taxpayers, with little attention being given to audit and control.

A key priority for tax administration in Russia therefore is to move to a system based on the principles that prevail in market economies, which will allow officials to focus their attention on those taxpayers who fail to comply with existing tax legislation and regulations. As part of this, it will be necessary to introduce more specialization in the functions of the staff at the State Tax Service so as to support a system based on self-assessment (for example, processing returns, collecting tax arrears, and carrying out audits). Efficiency gains obtained through specialization would free State Tax Service staff who could be released from routine undertakings and redirected to enforcement activities. The need for such gains is underscored by the significant deficiencies that exist in other areas. Among these may be cited: (1) an inadequate level of coordination between the center and the regions in terms of the work of various organizations performing a number of tax administration and collection functions such as customs offices, branches of the central bank, and currency control bodies;26 (2) the need to monitor more closely the evolution of tax exemptions (which in Russia emanate from a broad range of different sources, including the office of the President, the Prime Minister, the Ministry of Finance, and various government dependencies); (3) the absence of an effective system of computerization that will provide a master file of registered taxpayers, which would facilitate the identification of delinquent taxpayers and allow tax inspectors to distinguish appropriate cases for audit and control; (4) the unavailability of detailed statistical information on the size and the structure of the tax base and the tax burden for certain categories of taxpayers, including detailed sectoral identification of each, which would allow analysis of the implications of changes proposed to existing tax legislation; (5) the need to create a streamlined accounting framework, with forms and procedures considerably simplified so as not to discourage taxpayers from completing them and fulfilling their tax obligations in a timely manner; and (6) the need for greater attention on the collection of tax arrears, which have grown rapidly in recent years.

Furthermore, it is necessary to complement reforms in the above areas with a credible system of penalties that are both severe enough and credible enough to discourage noncompliance. Taxpayers must believe, from experience, that if they fail to comply with tax regulations or, in general, if they understate their tax liabilities, there is a high risk that they will be caught and that the associated interest charges and penalties will more than offset any potential benefit of evasion. These conditions are not in place in Russia as yet; during the first half of 1995, criminal legal proceedings for tax evasion were initiated against 1,658 individuals and enterprises. Only 216 were ultimately submitted to the courts, resulting in 107 convictions. At the same time, penalties should be imposed within the margins of the law and be balanced by an appeals process designed to protect taxpayers’ rights.

It may also be desirable to introduce incentives for taxpayers to act within the framework of the law. The more they come to see the advantages of compliance (other than the fear of penalties), the more successful tax collection is likely to be. Many have pointed out the potential benefits of education campaigns designed to highlight, for instance, the utility of VAT receipts as essential components of consumer protection, legal redress, and so on. In countries with high social security contribution rates, powerful incentives for evasion exist, leading sometimes to informal arrangements between employers and employees. But if the majority of benefits are linked to these contributions (as opposed to being available across the board), then employees will have strong incentives to register. Finally, the state must win the confidence of the population that it will use these resources well and that its policies will be guided by the desire to protect the interests of the population rather than to preserve the benefits and privileges of lobby groups. As noted by Etzioni (1988), “studies have found a relatively close association between the sense that taxes are fairly imposed, the sense of the legitimacy of the government and the purposes for which revenues are used, and the extent of tax evasion.”

Penalties and Fines

One area in which reforms are needed is the system of penalties and fines. The present system of fines is not based on sound principles, is at times unduly harsh (and for that reason ineffective), and contains elements of arbitrariness, which must be corrected. Some examples will illustrate this general principle.

(1) When an enterprise wrongly includes some item as a cost of production in calculating profit tax liabilities, the penalty is equal to eight times the amount included. The corresponding penalty in the case of the VAT is the amount of the cost included. The reasons for the sharply differential treatment are not clear. It is thus necessary to move to a system that links penalties not to the tax base but to the amounts not actually paid to the budget. There are in place numerous other penalties associated with, for example, inaccurate keeping of accounting books, inhospitable treatment of tax inspectors, and so on, which have made the system at times vulnerable to abuse and corruption.

(2) The authorities also need to address a provision in the existing tax legislation that deals with cases of enterprises that conclude sales contracts at fictitious prices so as to reduce their profit tax liabilities. As presently enforced, this provision states that the tax authorities have the right to value the goods at market prices in such cases where there is a presumption of underreporting. Enterprises have argued that in Russia’s present financial situation, characterized by a large outstanding stock of interenterprise arrears, they are often forced to sell at cut-rate prices. Then they are visited by a tax inspector who arbitrarily passes judgment on the market price and punishes the enterprise for alleged underreporting. There would thus appear to be a need to make antievasion regulations more transparent.

(3) Under established practice, enterprises make three advance payments of the profit tax during the quarter on the basis of estimated profits. Because they are allowed to make their own estimates, they have, in the past, tended to underestimate expected profits. In the highly inflationary environment characteristic of the early part of the transition, underestimating profits was tantamount to receiving a zero-interest loan from the budget. In late 1993, this anomaly was corrected, and enterprises that underestimated profits were required to pay interest on the difference between the actual tax due and the total amount paid in advance, with the rate assessed at the central bank refinance rate. In those cases where the enterprise was due a refund, the Ministry of Finance would also pay the refinance rate on the overpayment. Subsequently proposals were put forward to make the system asymmetric; that is, the enterprise would continue to be punished when actual profits exceeded estimated profits, but the ministry would refund the difference without interest when the reverse was true. Predictably, this led to complaints of arbitrariness and unfairness in the implementation of penalty provisions.

The ultimate objective should be to have a system of penalties that is simple, predictable, and consistent with the constitution and other tax legislation. Taxpayers often make the case that most violations are due not to deliberate tax evasion but rather to the inability of enterprises to keep up with the morass of rapidly changing and difficult-to-interpret tax regulations.

Appendix. Major Tax Exemptions in Force, 1992–96

This appendix lists some of the most important formal tax exemptions in force in Russia during 1992–96. No attempt is made at comprehensiveness; rather, the aim is to identify those exemptions with the largest impact in terms of forgone revenue or those that are more likely to be abused.

Profit Tax

(1) Enterprises’ contributions to “special extrabudgetary funds,” from which they are able to finance certain capital intensive projects (for example, plant modernization and reconstruction of pipelines in the oil sector), are included as a cost of production and deducted from taxable profits. The rates (as a percentage of the cost of production) vary from sector to sector but can be as high as 3 percent. Decree No. 1004 of May 23, 1994 (section 4) called for the elimination of these funds as of July 1 of that year and suggested that they be consolidated into the federal budget. But the decree was largely ignored on this point and these funds existed throughout 1995, further eroding the profit tax base. The funds were phased out in early 1996.

(2) All enterprise expenditures for capital investments “intended for the purpose of production” as well as investment in construction, including housing construction, are exempt from the taxable base. Repayment of bank credits obtained in connection with the above activities is also deductible. This latter exemption also includes purchases of transportation equipment used in construction and certain types of machinery.

(3) Expenditures by enterprises that provide social services to workers, including those for the maintenance of health, educational, cultural, and other facilities, are exempt from the profit tax.

(4) Newly created small enterprises engaged in the production and processing of agricultural products and in the manufacture of consumer goods, construction materials, medical equipment, medicines, housing construction, and housing repair are exempt from paying the profit tax for two years following registration. The tax is set at 25 percent and 50 percent of the prevailing rate during the third and fourth year, respectively. Enterprises are expected to repay the taxes only if they cease operations after the end of the fifth year following registration.

(5) Enterprises’ contributions to charitable organizations, typically up to 3 percent of the taxable base, are exempt from the profit tax.

The cumulative deductions listed above (in items 1–5) may not exceed more than 50 percent of the taxable base.

(6) Enterprises’ contributions to reserve funds, up to 15 percent of the taxable base (10 percent in 1995), are also exempt.

(7) Voluntary donations to campaign funds for the election of officials to federal, regional, or local bodies may be deducted from the tax base, up to the equivalent of 10,000 minimum wages in the case of federal bodies.

(8) Other exemptions are granted to certain specialized enterprises (for example, television and radio broadcasting companies and consumer cooperatives situated in the territories of the far north) and to religious and invalids’ organizations.

(9) Since 1994, the republic of Ingushetia has enjoyed special “offshore” tax status within the Russian Federation. Any enterprise registered in Ingushetia is exempt from paying regional or local taxes (profit taxes, property taxes, and certain social taxes) and is refunded, through funds provided by the federal government to the republic, the federal share of the profit tax and 50 percent of the VAT. The original idea was to provide incentives to enterprises to move operations to the poorest oblast in the Federation; in practice, however, because the profit tax law is ambiguous on the issue of registration and location of the physical plant, many enterprises have reregistered in Ingushetia and have thus benefited from the tax exemption, but have not actually moved operations to the republic.

(10) The 30/70 rule allows enterprises to set aside 30 percent of their revenues for wage payments, even if in so doing they fail to fulfill all their tax obligations. The rule was introduced in the last quarter of 1994 for a fairly narrow set of enterprises that met a number of strict conditions, but was considerably broadened in scope in early 1995, when the eligibility provisions were extended to all enterprises in the productive sphere. The mechanism was phased out on March 1, 1996, but reintroduced again in August 1996.

Value-Added Tax

(1) A comprehensive VAT exemption on housing construction (building materials and labor services) was introduced on January 1, 1993 and remained in force until May 1, 1995. While in force, the exemption applied to all forms of construction by the enterprise sector, including for residential and/or social purposes, and also affected repairs, maintenance, and renovations.

(2) State Customs Committee Directive No. 248 of April 13, 1995 exempted all entities importing technological equipment from paying the VAT and the special (VAT) tax. According to the directive, any merchandise “used to manufacture goods or means of production shall be regarded as technological equipment.” The list of equipment, given in an attachment, was eight pages long. Goods not specified in that attachment may also, in any event, be exempted at the discretion of the State Customs Committee. Certain types of transport equipment are also exempted, including cruise boats and “other analogous” ships, civilian helicopters, and other civilian aircraft. The exemption was made retroactive to December 10, 1994. All taxes already collected between that date and April 13, 1995 were to be refunded to the importers. Attempts were made in late 1995 to revoke this exemption, but these failed.

(3) Until mid-1995, imported food was exempt from the VAT. In addition, all food products and certain children’s items were assessed at the lower rate of 10 percent, but the definition of food products was applied liberally and included, for instance, virtually all raw materials used in the agricultural sector. Proposals were put forward in late 1994 to drastically reduce the list of food items that were assessed at the lower rate (basically, it was proposed to include only those items that were part of the minimum consumption basket at that time) and to include all imported food at the same rate as the one corresponding to the domestically produced item. After some delay, this measure was approved in mid-1995, with the list of products assessed at the lower rate consisting of 16 products deemed to be essential.

(4) In late 1995, and effective January 1, 1996, enterprises in the mass media received a full exemption on the payment of VAT (as well as on the payment of import duties) on purchases of an extensive list of goods needed for the production process.

(5) All “scientific research and experimental and design work financed from the state budget,” as well as independent research paid for by educational institutions—encompassing such areas as agriculture, mining, and research in various fields, including purchases of equipment and services required to carry out such scientific work—are also exempt from the VAT.

(6) City transit services and commuter passenger services by sea, river, rail, and road are exempt from the VAT.

(7) Housing rents are exempt from the VAT.

(8) Goods and services manufactured by enterprises in which at least 50 percent of the workforce is disabled are exempt from the VAT.

(9) New VAT exemptions were introduced in 1995 for the economic activities of prisons, labor camps (for instance, those attached to the timber and mining industry), and other security-related institutions.

Excises

(1) The list of excisable goods was reduced in late 1994 with the exclusion of automobile tires, trucks, fine wines, furs, genuine leather clothes, yachts, motor boats, hunting guns, and carpets, among other items. The list was reduced further in 1995 and, as of end-1996, included only alcoholic beverages, cigarettes, gasoline, precious metals, and oil and gas.

(2) Beginning in mid-1993, the National Sports Foundation was exempted from paying excise duties on all its imports. By the time this exemption was withdrawn, on October 1, 1995 for alcohol, and on December 1, 1995 for tobacco, the National Sports Foundation had become Russia’s largest importer of vodka, other spirits, and cigarettes, with an annual turnover estimated to amount to $3–4 billion.

(3) Excise tax exemptions on sales of domestically produced cars were also granted to various enterprises selectively throughout the period under review, often in the form of temporary reductions in rates.

Customs Duties

(1) Exemptions on the payment of duties on oil exports began to be granted in early 1994 and were made nearly universal by the end of the year, but were eliminated in the 1995 budget.

(2) Beginning in mid-1993, the National Sports Foundation was exempted from paying customs duties on its imports. This exemption was terminated on October 1, 1995 for alcohol and on December 1 for tobacco, although the foundation received compensation from the budget (amounting to some $200 million) through the end of the year. Through satellite organizations affiliated to the foundation, virtually all cars and alcohol and tobacco products imported in the two years to mid-1995 were exempted from the payment of import duties. The revenue impact of the elimination of these exemptions, however, was minimal because a similar exemption was granted in Belarus shortly thereafter. Since Belarus and Russia have free trade, imports of these goods continued to enter Russian territory tax free. Other specialized organizations, also created in 1993–94, such as the Afghan War Veterans’ Union, continue to enjoy tax-exempt status. In 1995, the government established the Humanitarian Aid Commission, a body that may grant customs duty exemptions to organizations importing goods for humanitarian purposes. The scope of activities of the commission has expanded rapidly; in particular it has approved in a number of instances the importation of alcoholic beverages by religious and other organizations under the understanding that the proceeds of the sale of these beverages would be used for humanitarian ends. Once the tax-exempt status has been granted, however, there is no mechanism in place to check that the exemption is being used for the purposes originally intended. It is estimated that tax-exempt imports through the commission amount to several hundred million dollars a month.

Personal Income

(1) Excluded from the definition of taxable income are, among others, all types of pensions; all forms of severance pay; other benefits provided by the state; all interest income on bank deposits or other such instruments as well as interest earned on state bonds of the U.S.S.R.; income earned in gold prospecting, sand washing, casting, processing, and other activities related to gold production; income earned through the sale of apartments, houses, country houses, garden houses, land plots, and land shares (up to 5,000 minimum wages); income earned through the sale of animals (live or otherwise) as well as “products of plant and flower cultivation grown in natural or processed form” ; amounts paid by enterprises to compensate employers for the cost of passes for children to establishments “for the leisure of parents with children” ; income earned through the sale of willow bark, wild berries, nuts and other fruits, mushrooms, and medicinal herbs.

(2) The legislation also provides a number of additional exemptions, up to a predetermined level, typically set as a multiple of the minimum wage. For instance, war veterans may deduct from their monthly income the equivalent of five minimum wages.

(3) In addition, all military personnel and personnel attached to the security ministries and to other organs of state security, including the State Customs Committee, are exempt from paying any income tax at all.

9

However, over 3 percentage points of revenue in 1996 was collected in various forms other than cash.

10

Consumer subsidies in Russia were embodied in the prices of hundreds of commodities, including basic foodstuffs, energy and fuel, children’s clothing, and Pharmaceuticals.

11

Oil exports from Russia to countries outside the former So-viet Union fell from $27 billion in 1990 to $12 billion in 1992, a drop that largely reflects a contraction of volumes.

12

Public investment fell from an estimated 11 percent of GDP in 1991 to 3 percent in 1992.

13

The 30/70 rule allows enterprises to set aside 30 percent of their revenues for wage payments, even if in so doing they fail to fulfill all their tax obligations. The rule was introduced in the last quarter of 1994 for a fairly narrow set of enterprises fulfilling a number of strict conditions, but was considerably broadened in scope in early 1995, when the eligibility provisions were extended to all enterprises in the “productive” sector. The mechanism was phased out on March 1, 1996, but reintroduced again in August 1996.

14

See Decree of the President of the Russian Federation, No. 1006, May 23, 1994, “On Implementing a Complex of Measures to Achieve Timely and Complete Payment of Taxes and Other Obligatory Charges to the Budget,” and Decree of the President of the Russian Federation, No. 291, March 21, 1995, “On Invalidating Clause 2 of Decree of the President of the Russian Federation No. 1006, dated May 23, 1994.”

15

A case in point is the tax exemptions granted to the National Sports Foundation in 1993 that were intended to support athletes’ preparation for the Atlanta Olympic Games, and that in the end were used to allow the importation of a broad array of commodities free of customs duties, VAT, and excises. In time, this organization became the main importer of tobacco, distilled spirits, and cars in Russia, with a yearly turnover variously estimated to have reached $3–4 billion.

16

For a listing of some of the tax exemptions in force during 1992–96, see the Appendix.

17

For instance, new versions of the VAT law were issued on May 22, July 16, and December 22, 1992; February 25 and March 6, 1993; November 11 and December 6, 1994; and April 25, June 23, August 7, August 22, and November 30, 1995.

18

Manufacturers’ liability is determined as the difference between the VAT charged on sales and the VAT paid on purchases, whereas wholesalers, retailers, and caterers are taxed on gross margins, or the difference between selling and buying prices.

19

This distinction is sometimes difficult to make; for instance, is an enterprise engaged in assembling or repairing part of the manufacturing or the retail sector?

20

Although the surcharge was eliminated in 1996, the possibility of its reintroduction reemerges every year as discussions on the budget get under way in parliament and last-minute efforts are made to find additional revenues.

21

During 1992–93, the threshold was set at the equivalent of four minimum wages.

22

Decree of the President of the Russian Federation No. 2268 of December 22, 1993 states that “in the republics within the Russian Federation, its territories, regions and autonomous formations, and the cities of Moscow and St. Petersburg, additional taxes and dues not provided for by the legislation of the Russian Federation may be introduced by decisions of the organs of state power of the subjects of the Russian Federation and of the local organs of state power.”

23

A draft law approved by the Duma (parliament) in late 1995 “On the Fundamentals of the Tax System of the Russian Federation” actually identified no fewer than 75–80 known taxes and fees in existence at the federal, regional, and local levels.

24

Gray (forthcoming) estimates that for the oil and gas sector in Russia, actual revenues were about 54 percent of notional liability, defined as tax revenues assuming full compliance with the law and without exemptions.

25

The draft tax code presently under consideration envisages a substantial reduction in the number of exemptions.

26

Less than 1 percent of the entire staff of the State Tax Service (about 160,000 employees) works at headquarters; this number may have to be significantly increased if some of the coordinating functions are to be enhanced.

Cited By

Issues During the Transition in Russia
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