The Selected Issues paper and Statistical Appendix analyzes output developments in the Russian Federation since the 1998 crisis. It outlines near-term growth prospects for the economy. The paper highlights that output growth accelerated in 1999 and the first half of 2000, but has slowed since then. The initial output recovery was led by import substitution as a result of the large exchange rate depreciation in 1998. One finding in the context of an overall policy package is that the real exchange rate and oil prices were the main determinants of growth after the 1998 crisis.

Abstract

The Selected Issues paper and Statistical Appendix analyzes output developments in the Russian Federation since the 1998 crisis. It outlines near-term growth prospects for the economy. The paper highlights that output growth accelerated in 1999 and the first half of 2000, but has slowed since then. The initial output recovery was led by import substitution as a result of the large exchange rate depreciation in 1998. One finding in the context of an overall policy package is that the real exchange rate and oil prices were the main determinants of growth after the 1998 crisis.

IV. Tax Reform in Russia Since 1999 1

A. Overview

1. The Russian authorities have, since 1999, been pursuing tax reform as a pillar of the transition to a market economy.2 These reforms have required changes in both administrative arrangements and tax policy so as to secure adequate revenue to achieve macroeconomic stability, foster the development of a market-oriented economy by minimizing distortions, and support fiscal decentralization. The specific changes aim to ensure that the tax system has as neutral an impact as possible on the allocation of resources, distributes the tax burden fairly, is relatively simple to administer, and relies on broad-based and elastic revenue sources.

2. The tax reform shifts revenue from subnational governments to the federal budget and exploits high oil prices to partly offset the overall cost of reforms. At constant 2001 oil prices ($20.4 a barrel of Urals oil, f.o.b.), the reforms cost 2.1 percent of GDP (Table 1).3 These costs largely reflect the reductions in turnover taxes in 2001 and in profits tax in 2002.

Table 1.

Impact of Tax Reform at Constant 2001 Oil Price

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Sources: Ministry of Finance; and Fund staff estimates.

3. The federal government actually gains over ½ percent of GDP in 2001, with no net loss in 2002. These federal gains reflect both the complete shift of domestic VAT to the federal level and changes in hydrocarbon taxation that also shift revenues from the subnational to the federal level, while largely insulating subnational budgets from further oil price changes. In contrast, subnational budgets lose over 2 percent of GDP in 2001, reflecting both the VAT centralization and the loss of turnover taxes, and a further ½ percent of GDP in 2002, owing to their diminished share of natural resources taxation.

4. These findings highlight the importance of improving tax administration and compliance, especially at the subnational level.4 They also suggest that the authorities’ review of fiscal federalism arrangements will need to focus on appropriate tax bases to devolve to subnational governments.

5. Regarding Laffer effects, the evidence is still unclear, but tax performance in the second and third quarter of 2001 does appear better than expected. The strong performance could reflect higher income rather than a Laffer effect. Evaluating the precise causes requires micro-level data that will only be available in April/June 2002. Meanwhile, in view of the interest in the issue, the authorities may want to encourage some data sampling to obtain a preliminary picture.

B. Reforms from 1999 to Date

Context

6. Through the period until 1998, the Russian tax system performed poorly. Taxes as a ratio of GDP fell almost continually from 39 percent in 1992 to 33.5 percent in 1998. Many taxpayers withheld payments in expectation of explicit amnesties or offset operations that would allow them to supply goods and services. Large taxpayers routinely negotiated their tax payments. Measures to address these shortcomings were ineffective. As a result, the public was left with an impression of an arbitrary tax system where the government was unable to enforce statutory tax obligations.

7. The rudimentary tax administration and the low levels of taxpayer compliance were reflected in large tax arrears. Although the stock of arrears was reduced by high inflation, this stock remained high compared to OECD countries. For example, as a ratio to tax collections over the prior 12-month period, these arrears reached 34 percent on August 1, 1997, compared with tax arrears to collection ratios of 4–6 percent for Canada, the United States, and Australia.5

8. These negative developments were the backdrop to continued reform to make tax rules stable and predictable, while relieving the tax burden on law-abiding taxpayers and increasing pressure on non-filers and tax evaders. President Putin, building on efforts initiated under President Yeltsin, made tax reform a cornerstone of the government’s Comprehensive Program of Economic Reform. The “Strategies and Measures to Improve the Tax System” submitted to the Duma proposed phased reforms with the goal of eventually establishing a fair and consistent tax system.

Objectives

9. The specific objectives of the authorities’ program are to make the tax system:

  • fairer, by: ensuring that all taxpayers are treated the same (without any discrimination); abolishing inefficient and harmful taxes; excluding procedural requirements that distort the substance of taxes, e.g., negotiating over rates and accepting non-cash payments or offsets; easing tax pressure on law-abiding taxpayers by ensuring a more equitable distribution of the tax burden (tax incidence), while gradually reducing rates across the spectrum of major federal taxes;6 and lowering payroll taxes;

  • simpler, by: establishing an exhaustive list of taxes, duties and fees to be levied while reducing their total number; minimizing targeted taxes and duties; and adopting uniform computation methods and payment procedures across all the various taxes;

  • more stable and predictable, thus increasing the level of certainty for taxpayers as to their future tax liabilities on a long-term basis; and

  • more efficient, by significantly improving tax collection.

10. This tax reform agenda, delivering lower rates, fewer exemptions, less discretion, fewer taxes, and better compliance is being gradually implemented. The initial focus has been on improving tax administration and lowering the overall tax burden on the economy.

11. Part I of the new Tax Code was enacted into law in July 1998. It includes the procedural law and significant substantive provisions, including revenue relations among the different levels of government, and “definitions” (for example, determining in which instances the reported price at which a transaction is carried out would not be used for tax purposes). The Code builds in safeguards aimed at protecting taxpayers’ interest by establishing an exhaustive list of rights and responsibilities of both taxpayers and revenue authorities, clearly defines the Revenue Administration’s supervisory role, and requires that penalties be enforced only by courts coupled with a drastic reduction in penalties.

12. Reform of tax legislation will be completed as the Duma adopts in steps all of Part II of the Tax Code covering the “substantive taxes.” Part II sets out procedures for computation and payment of federal taxes, guiding principles for regional and local taxation systems, and describes special tax treatments.

13. In summary, tax reform rests on phased adoption of an integrated and coherent Tax Code covering the entire tax system at federal and subnational levels and on a modernization of the administrative processes for tax collection.

Part I of the Tax Code and tax administration

14. The adoption of Part I of the Tax Code in 1998 represented a major step forward in clarifying the obligations and rights of taxpayers and tax officials. However, major improvements were required in order to facilitate tax administration. Amendments to Part I of the Tax Code were therefore developed, including: limiting deferral of payment to exceptional circumstances; attempting to better balance the rights of the tax authorities with those of taxpayers; improving means of collection; eliminating caps on interest; and providing adequate authority to issue regulations. These amendments were presented to the Duma in 2001.7 Once they are adopted, Part I of the Tax Code will help support the required improvements in tax administration.

15. Reforming tax administration has proved to be a slow and lengthy process because of resistance from those benefiting from the status quo. A major deficiency has been an organizational structure that is open to abuse because it matches tax officials to firms rather than assigning them on functional lines. Moreover, the tax administration has provided low priority to taxpayer education and has resisted reliance on self-assessment of tax obligations by taxpayers. In view of the difficulties with overall reform, in 1999 the authorities launched a pilot Tax Administration Modernization project in Nizhny Novgorod, Volgograd, and Moscow (Box 1).

16. To emphasize the importance of tax administration, the authorities created a Ministry of Taxes and Fees in 1999.8 They also reorganized the debt collection/arrears management process. This resulted in some Rub 257 billion of extra tax payments during 1999, or about 25 percent of all taxes collected by the Ministry.

17. The level of voluntary compliance by taxpayers (i.e., payment by the statutory due date) remained under 70 percent during 1999.9 Thus, efforts in 2000 focused on encouraging voluntary compliance, with timely follow-up action where nonpayment is detected. This involves telephone action within 3–4 days of a nonpayment by large taxpayers and computer-generated payment demands within 7–14 days of a statutory due date for other taxpayers. Tax officials initiated further follow-up action within a relatively short time based on the size of debt involved.

18. Notwithstanding these efforts, tax arrears remain high (over 5 percent of GDP as of mid-2001), partly reflecting the absence of administrative action to write off uncollectible debts (i.e., because the taxpayer no longer exists, cannot be located, or has no assets). This issue is the subject of current discussion, including consideration of a possible tax amnesty.

Part II of the Tax Code

19. Four chapters of Part II were passed by the Duma in July 2000 and have been in force since January 1, 2001: the Personal Income Tax (PIT), the VAT, Excises, and Social Taxes. Overall, this legislation represented a major improvement. The legislation also reduced the turnover taxes (e.g., those earmarked for the Road Fund), but did not eliminate them as originally planned. Legislation on the profits tax and the taxation of natural resources, as well as sections dealing with the (very) numerous smaller taxes were adopted in 2001 and will take effect with the 2002 budget. The various measures adopted move Russia toward a fairer, simpler and more efficient tax system.

Tax Administration Modernization Project in Nizhny Novgorod, Volgograd and Moscow

This project aimed at improving efficiency and effectiveness of tax administration in the pilot regions. It also focused on related areas such as improved service to taxpayers and reductions in taxpayers’ compliance costs. By June 2000, the project had set up data processing centers, trained staff in use of new software and focused efforts on large taxpayer operations. More importantly, it introduced self-assessment with a system of audits and a switch to a functional organization to replace relations between tax collectors and taxpayers. The pilots achieved the immediate objectives, but they did not produce the benefits anticipated. Inter alia, this was due to: lack of clarity in the overall goals of the modernization project; a strong tendency to simply automate existing, and at times poorly-designed, manual processes, rather than undertake a fundamental and holistic redesign effort; failure to challenge existing business practices; artificial limitations imposed by provisions of the tax and other laws governing the work of the tax authority; and selection of inadequately skilled staff for the redesign effort. Many of the difficulties reflect the tax administration’s lack of experience.

Meanwhile, starting in the second half of2000, the Ministry of Taxes began planning for a “Concept of Operations” (CONOPS) that would incorporate lessons from the pilot program. The CONOPS envisages:

  • improving the link between electronic service delivery and data capture (e.g., co-coordinating electronic data services to taxpayers, data collection and information on taxpayer transactions);

  • changing methods of paying taxes to reduce the burden on taxpayers while achieving quicker crediting of payments to Treasury accounts (e.g., use of pre-identified payment vouchers/orders, systems of electronic funds transfer and direct debit, internet banking); and

  • creating Data Processing Centers (DPCs) in coordination with a review of the size of the network of local inspectorates and their internal organizational design—the bulk of staff is located in over 2600 local inspectorates, many of which may not be economically viable.

20. These reforms also embody a revised concept of fiscal federalism regulating tax-sharing mechanisms in the Russian Federation’s three-tier government system. Thus, the adoption of the chapters relating to the above advances the process of codifying tax laws under a single source of law—the Tax Code of the Russian Federation. The general approach adopted has been to split each tax between the three levels of government, thus unifying in one tax the revenue needs of federal, regional, and local budgets. Accordingly, the same tax base will apply to the three levels. The new system makes it possible to take into account specific features inherent to each region by allowing each subnational government some leeway in setting rates for its share of the base. This is particularly important in such a vast country as Russia where economic conditions vary significantly from region to region.

21. Some key changes in the Tax Code are shown in Table 2. Effective with the 2001 budget,

Table 2.

Tax Code Changes, Including Measures Effective Only in 2002

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Sources: Ministry of Finance, Fund staff, and FAD TA reports.
  • the taxation of individuals was modified, with the introduction of a flat 13 percent rate and a series of social tax deductions to replace the three-band progressive tax rates of 12, 20, and 30 percent. In counterpart, the number of deductions was reduced. Before reform, the average effective tax rate was 14 percent, and in practice the tax was more flat than progressive, owing to the extensive use of deductions;

  • a unified social tax was introduced, lowering the highest tax rate on payroll by several percentage points, while applying a regressive rate for contributions to the State extrabudgetary funds. The pension, social, and medical fund contributions were consolidated at a maximum rate of 35.5 percent and the 3 percent unemployment fund contribution was eliminated. The new law enacted a regressive contribution scale (with, for example, a 5 percent band applying to wages in excess of about $21,000 for a given employee);

  • provisions were adopted to enhance excise-tax collection and to counteract avoidance/evasion schemes. These provisions included the introduction of bonded warehouses for alcohol products; setting up tax posts to check books and records, monitor disposal of goods, control access to goods, manage the warehouse, and keep track of payments made; shifting the tax burden from alcohol distilleries to wholesalers by making them liable for as much as 50 percent of the statutory rate;10 and introducing special regional stamps;

  • the tax base was broadened by subjecting diesel fuel and lubricants to excises and increasing rates of excise tax on other oil products (by three times) and alcohol-containing products by Rub 2–5 per deciliter;

  • a major VAT overhaul was implemented, including, among other things, changes to the place-of-supply rules; application of the tax to individual entrepreneurs; elimination of the three-payments-per-month system; crediting of VAT on construction inputs rather than capitalization; elimination of some exemptions; and the introduction of small business exemption thresholds as a measure to reduce compliance burden;

  • the “road-user’s” turnover tax rate was reduced from 2.5 percent to 1 percent of gross sales, and a series of taxes were eliminated including those on: the sale of fuel and lubricants; maintenance of housing stock and social objects; individual types of transportation vehicles; and acquisition of motorcars; and

  • effective July 1, 2001, the destination principle was adopted for VAT on non-energy trade with CIS countries,11 with analogous changes in excise taxes.

22. Additional changes which became effective in 2002 include:

  • reducing the overall profit-tax rate from 35 percent to 24 percent, while canceling (mainly local level) tax incentives and tax holidays;

  • merging the tax on recovery of mineral resources, the mineral excises, and the subsurface mineral tax into one ad valorem charge (“natural resource tax”), and simplifying the methods of adjustment for geological conditions; and

  • increasing the excise rate for alcohol by 12 percent and raising the specific rates for oil products (see Table 2).

Impact of reforms

23. We estimate the adoption to date of Part II of the Code to result in a loss of revenue (at constant oil prices) equivalent to 2.1 percent of GDP, assuming no change in compliance (Table 1).12 Losses from the turnover tax (1.7 percent of GDP), domestic VAT13 (0.6 percent of GDP), profit tax (0.5 percent of GDP), and personal income tax (0.2 percent of GDP) are partially offset by gains from import VAT (0.6 percent of GDP), and oil and gas export taxes14 (0.2 percent of GDP). Changes in natural resource taxation were roughly revenue-neutral.

24. The reforms could cost less than estimated here. This is because the tax reform is designed to improve compliance, while the above estimates assume unchanged compliance. Some optimism that compliance could improve is in fact justified, since there is still scope for important tax administration measures (see Section III). Moreover, our analysis of the personal income tax is consistent with the hypothesis of some improvement in compliance (see Section IV). Further, some improvement in performance could arise from collection of tax arrears, which in July 2001 were estimated at 11 percent of GDP (including penalties of 5 percent of GDP).

Changing split between Federal and Subnational budgets

25. As discussed above, the tax reform is shifting resources to the federal from subnational budgets. The reform broadly completes implementation of the revenue side of the Concept of Reform of Intergovernmental Relations for 1999–2001, approved in 1998. With the package of measures already adopted, and holding world oil prices constant at their 2001 level, federal revenue increased from just over one-third of total consolidated government revenue in 1998 to almost one-half in 2001 (Table 3).15

Table 3.

Changing Split of Revenue between Federal and Subnational Authorities at Constant 2001 Oil Price, 1998–2002

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Sources: Ministry of Finance; and Fund staff estimates.

26. Subnational revenue, which fell below 13½ percent of GDP in 2000, is set to decline sharply in 2001, to 11½ percent of GDP, or less than one-third of total consolidated revenue. Extrabudgetary revenue is projected to decline slightly, from about 8 percent of GDP through 2000 to 7½ percent of GDP in 2001. This reflects the unification of the various payroll taxes into the Unified Social Tax (UST), which was associated with an overall rate reduction of about 4 percentage points. For 2002, the above projections assume some increase in compliance, which will help stabilize subnational revenues and reverse the decline in extrabudgetary revenues (although the extrabudgetary balance is still likely to worsen).

27. The sharp reduction in subnational revenue after 2000 may create fiscal imbalances. Subnational governments may not cut expenditures in line with lower revenue, and they lack sufficient tax handles to generate the additional resources needed to maintain spending. Moreover, spending pressures are increasing with the large wage increases in December 2001 for staff paid under the Unified Tariff Schedule (UTS) and with the expected burden from reform of housing services (see Chapter VI, “Structural Reforms”). The transfer of responsibility for welfare payments may also add to fiscal pressures, in the absence of adequate federal transfers and/or cuts in benefits.

C. The Remaining Agenda

Tax administration

28. As explained above, despite the measures to date, compliance rates remain low and the tax administration still needs fundamental restructuring. The Ministry of Taxes and Fees is, therefore, incorporating the lessons from the pilot (Box 1) into a strategic plan for modernization of the tax administration being prepared with Fund and U.S. Treasury assistance. To facilitate implementation, it is discussing with the World Bank a second Tax Administration Modernization Project (TAMP II). This program includes, among other things, measures to:

  • increase the level of tax compliance;

  • promote efficiency by streamlining the network of offices, generalizing the functional structure adopted in the pilots, and improving links between departments based on computerization;

  • create a small network of regional data processing centers to undertake the bulk of information processing tasks together with a new information systems infrastructure and associated applications systems;

  • encourage professional ethics by establishing a code of ethics, increasing professionalization of staff, and establishing a strong internal audit function to monitor integrity;

  • refine the system of self-assessment;

  • improve the fairness of the tax system by improving dialogue with taxpayers and adopting transparent dispute resolution procedures;

  • reduce the taxpayer compliance burden by improving service delivery and simplifying procedures; and

  • enhance staff development programs.

Tax policy

29. The key tax policy reforms are now in place or about to be enacted (Section II). The remaining agenda consists of fine-tuning various measures based on implementation results and anomalies that slipped into the legislation, particularly the corporate profits tax. Other areas where the authorities plan to move include:

  • VAT. The authorities have indicated their intention to adopt the accrual method of accounting, but have moved slowly. The authorities aim to facilitate compliance by significantly simplifying the current rules for the timing of liabilities and credits. The Ministry of Taxes and Fees will need to develop implementation and education programs and decide on transition rules. In the medium-term, the authorities are considering adopting a single VAT rate of about 16–17 percent. As for VAT on intra-CIS trade in energy products, it is still applied on the origin principle, but in the medium term consideration may be given to adopting the destination principle.

  • Export taxes. These taxes were introduced as temporary emergency measures in the context of the recent Fund arrangements. The authorities plan to phase out non-energy export taxes over 2002–03. They are also committed, in principle, to phasing out energy-related export taxes once appropriate arrangements for taxing minerals are in place. However, there is no clear timeframe for this as of now.

  • Personal income tax, profit tax and unified social tax. The different rates applying to income of various types create incentives to shift income from one category to another. In particular, the large differential that will arise once the profit tax rate is cut may induce employers to shift some compensation to profits. This could have a negative impact on unified social tax receipts. The authorities are currently exploring proposals to move to a flat rate for all income and social taxes. Unification of the profit tax rate and personal income tax rate is also being contemplated, but no firm decisions have been made.

  • Production sharing arrangements. In view of its complexity, this topic was separated from the reform of natural resources. Consultations are under way with current and potential investors in the minerals sector (including gas and oil). The objective is a transparent regime that protects the interests of the state while providing appropriate incentives to investors.

  • Property taxes, inheritance taxes, state duties, sales taxes, and small business taxes. Reform of these taxes may be considered as part of the new fiscal federalism arrangements that are being developed. The authorities are considering phasing out the sales tax, given its distortionary nature. The other taxes offer bases that could be devolved to subnational governments to better match tax and expenditure assignments.

D. Performance of Personal Income Taxes After the Reform: Is There a Russian Laffer Curve?

Introduction and overview

30. As mentioned above, in 2001 Russia implemented an income tax reform that introduced a single 13 percent rate to replace a progressive schedule with three rates of 12, 20, and 30 percent.16 In the face of this reduction in rates, PIT revenues in Russia have performed better than expected. During January-September 2001, collections reached 2.7 percent of GDP, compared with 2.3 percent of GDP in the corresponding period of 2000. However, tax performance has exceeded expectations across the board, and even more so for taxes other than the PIT.

31. The strong performance of income tax collections has led to a widespread perception in Russia that lower rates have resulted in increased revenue (the Laffer curve effect).17 This Laffer effect might arise because of a high elasticity of aggregate labor supply, or (likely more relevant to Russia) because tax cuts provide an incentive for labor to move from the underground to the official economy, discouraging tax avoidance and reducing tax evasion. In this section, we first review some of the international evidence (see Box 2) and then analyze the Russian experience to date.18

32. We conclude that the positive revenue performance in the first quarter of 2001 can be explained without appealing to Laffer effects, while the second and third quarters present somewhat of a puzzle. However, we have insufficient data to distinguish between Laffer effects and other explanations. For instance, the positive revenue performance could plausibly reflect an underestimation of nominal GDP and the wage bill (which in turn may only partly reflect Laffer effects), and/or errors in estimating the quarterly profile for effective tax rates and estimated taxes. The paper, therefore, suggests areas for further work that would help pinpoint the impact on tax revenues of a reduction in tax rates.19

Review of International Evidence of the Laffer Curve

Ebrill (1987) fails to identify a Laffer effect in Sweden, Korea, Jamaica, or India.

He reviews Stuart’s work on Sweden and Kwon’s work on Korea and fails to find evidence of a Laffer effect in India and Jamaica despite positive performance of taxes following rate reductions.

Evidence from the United States and Canada also fails to support the argument that cutting top marginal rates results in increased revenue. The Reagan tax cuts failed to generate revenue and a recovery in revenue is associated with the Bush/Clinton tax increases of the early nineties. Moreover, Goolsbee (1999) points out that extensive literature finds very little impact of changes in tax rates on labor supply in the U.S., thus refuting the central Laffer curve tenet.

Goolsbee (1999) also summarizes much of the criticism of the New Tax Responsiveness work and points out that correcting for the methodological flaws results in significantly lower elasticity estimates. More importantly, he finds that the high elasticity reported for the eighties tax cuts is atypical. Making the simplifying assumption that there was only one rate in the tax code, his estimates suggest that the Laffer peak for high income taxpayers ranges between 42 percent (1985–89 data) and 100 percent (1934–38 data).1 Excluding the eighties, the lowest peak would have been 63 percent (1922-26 data). However, the “optimal” tax rate is likely to be well below the Laffer peak.

Richupan (1987) finds evidence that a progressive structure yields less revenue than a proportional tax structure in the presence of significant tax evasion. Sahyal etal. (2000) point out that intensified tax efforts may have the same impact as higher tax rates in encouraging tax evasion.

Lindsey (1987) and Feldstein (1995), among others, emphasize the major efficiency costs of high marginal rates and hypothesize that high rates fail to raise revenue at the top of the income distribution. Even if labor supply elasticity were zero, the Laffer curve effects would hold if high taxes result in a shift of income out of taxable form. This approach, labeled by Goolsbee (1999) as the New Tax Responsiveness (NTR) literature, focuses on estimating the elasticity of taxable income with respect to the tax rate. This literature suggests that high income individuals may face a Laffer curve (high income Laffer curve). Goolsbee finds no empirical support, however.

Notwithstanding lack of empirical support for a Laffer curve, Tyler Cowen (1980) points out that cutting taxes has a positive effect on private-sector productivity. This in turn may generate enough economic activity to produce, on the same base, enough additional revenue to pay for the cuts. Dalamagas (1998) confirms this effect for G-7 countries where governments crowd out the private sector (U.S., U.K., and Italy) while the opposite is true for Japan, Germany, and Canada where public sector activity complements private capital in the production of private goods.

Hall (1999) points out that the NTR methodology does not allow a direct answer to the question of whether an increase in tax rates raises or lowers revenue. Moreover, he suggests that the variability of the elasticity estimates across episodes and the high elasticity observed in the eighties imply that institutional factors may be critical in the observed response.

Jackson (2000) cites evidence from the United States and Canada that tax levels are neutral in efficiency terms. He argues there is no trade-off between equity and efficiency. Taxes to finance productive expenditure may result in higher growth than tax cuts with spending cuts. Mackenzie (1987) finds “the impact of marginal income tax rate reductions depends on the value of many parameters and that the elasticity of savings, somewhat surprisingly, may be relatively unimportant.”

In summary, the evidence seems to suggest that there is no direct Laffer effect of an automatic base expansion to compensate for lower rates.

1 These are average rates that are well above those facing high income people.

Review of evidence from Russia to date

Context

33. In the case of Russia, given poor compliance and significant unrecorded activity, the reduction of rates with stronger enforcement may result in an increase in the tax base. Indeed, this is the objective of the authorities. The international experience (see above) suggests that the Russian package of lower rates and stronger enforcement could have indeterminate results in terms of compliance. Nevertheless, if there were a positive effect from reducing rates in Russia, it would probably arise through a reduction in tax evasion. At the macro level, the rapid increase in reported wages, which far exceeds the growth of recorded expenditures (a proxy for growth of actual wages and income), is consistent with such a hypothesis.

34. Until the micro-data can be collected, an analysis of available macro-data can help test for the presence of Laffer effects; however, the test will not be conclusive. Specifically, we use parameters from previous years, information from the Ministry of Finance, and macro-data for January-September 2001 (in particular, the estimated wage bill, estimated exemptions, and the estimated average effective tax rate) to construct PIT revenue projections, based on the assumption of no Laffer effects. If these projections fall short of actual collections, then this suggests that there may be a Laffer effect. However, the discrepancy may also reflect errors in estimating the wage bill and/or exemptions.20

Personal income tax reform: impact by quarter

35. We estimate personal income tax reform to result in a modest revenue loss of about Rub 21 billion (0.2 percent of GDP) in 2001. This revenue loss occurs in the second half of the year, and particularly in the last quarter. In contrast, for the first quarter we project a small gain of Rub 3 billion, owing to an effective increase in the tax rate, offset by an equivalent loss in the second quarter.

36. This pattern of increased revenue in the first quarter, with losses concentrated in the second half, arises because of the tax assessment rules. Under the old tax code, taxpayers paid at the lowest marginal tax rate (12 percent) until their cumulative annual income exceeded the upper bound for the lowest income-tax band. Any further income was then taxed at the next higher marginal rate, until the cumulative annual income exceeded the upper bound for that band too, and so on. This system implied that effective rates increased through the year, from about 12 percent in the first quarter of 2000, to an estimated 13½ percent in the second quarter, and about 15 percent in the second half of the year; the average for the year as a whole was 14 percent. Thus, the move to a uniform tax rate of 13 percent implies an increase in effective tax rates in the first quarter of the year and a reduction in the second half.

Projected versus actual revenue

37. We should avoid reading too much into the small deviations observed between projected and actual revenue (Table 4). There are three reasons for this. First, a small reduction in the effective rate, from 14 percent to 13 percent, would not be expected a priori to generate large gains and losses. Second, in the circumstances of Russia, our estimates are affected by large data uncertainties. In particular, the small deviation between actuals and projections is very sensitive to two assumptions. We assume that the split of the annual wage bill across quarters is correctly reported by Goskomstat, even though it estimates a total wage bill for the year as a whole that is significantly different from that reported to the Ministry of Finance. Further, we assume that the ratio of deductions to the total wage bill remains in each quarter at the level observed by the Ministry of Finance in the 2000 outcomes. Finally, GDP estimates are subject to uncertainty and have in the past been subject to significant revisions.

Table 4.

Actual and Projected Personal Income Tax Collections in 2001

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Sources: Ministry of Finance; and Fund staff estimates.

38. Subject to these caveats, tax revenue in the first quarter was virtually equal to the projected level of Rub 49 billion (2.6 percent of GDP). In contrast, in both the second and the third quarters, income tax receipts exceeded projections by about Rub 5 billion (0.2 percent of GDP). Put differently, during the first three quarters, actual collections exceeded projections by an amount equal to the projected revenue loss from reforms. Prima facie, this does not rule out the possibility that the reforms were, if not revenue-enhancing, at least revenue-neutral.

39. Without detailed information on the source of this increase in collections, we cannot verify if it reflects a widening of the base, higher compliance, higher nominal wage growth, or other possibly one-off factors. We can, however, investigate to what extent plausible changes in the above factors can explain the difference between projected and actual revenue in Q2 and Q3. In turn, this can help set plausible bounds to the size of any Laffer effects.

40. We are interested in which factors could lead us to increase our estimate of the tax base, which is essentially the wage bill. Higher nominal GDP per se would not directly change our projections. However, it would be an indication that we may have under-estimated the wage bill. Table 5 summarizes what nominal GDP levels, and wage shares in GDP, would be required in 2001 Q2 and Q3 to explain the observed tax collections, assuming unchanged compliance. At one extreme, if the estimated nominal GDP were roughly correct, then the true wage share in GDP would have to be up to 2 percentage points higher than estimated. Such wage underestimation would hardly be unprecedented, nor implausible.21,22 Alternatively, if the wage share in GDP were correctly estimated, then the true nominal GDP would have to be about 10 percent higher than estimated. Such a difference is significantly larger than the typical ex post revision in nominal GDP, but not unrealistic. Overall, plausible combinations of higher nominal GDP and higher wage ratios could comfortably account for the revenue overperformance. If neither nominal GDP nor the wage share are underestimated, then unexplained revenues amount to 0.2 percent of GDP, which could be interpreted as an upper bound to any potential Laffer effect on personal income taxes.

Table 5.

Potential Laffer Effect for Different Nominal GDP in 2001 Q2 and Q3

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Sources: Ministry of Finance; and Fund staff estimates.

41. To explore this effect further, and to determine whether it could simply reflect sampling variability, we undertake a simple econometric analysis, running a regression of personal income tax collections on (estimated) assessed taxes. We use quarterly data for the period 2000 Q1-2001 Q3, and normalize both the independent and the explanatory variables by nominal GDP so as to induce stationarity.23 We run the regression in logarithmic form and allow for a constant, but the results are not sensitive to the particular specification.

42. The regression model performs very well, with an R2 of 0.88 for the period as a whole (Figure 1). The elasticity of tax collections with respect to assessed taxes is insignificantly different from unity, which is in line with our prior expectations. However, the fit clearly worsens in the last two quarters, where the difference between actual and fitted collections becomes economically important (the average discrepancy is about 0.15 percent of GDP, or about 6 percent of total income tax collections), with some indications of statistical significance (the average residual equals 1.5 times the standard error of the equation). 24 The residual would be somewhat larger if we adopted the alternative approach of recursive estimation, that is, if we estimated the coefficients using only data through 2001 Q1, and used these to predict the outcomes in 2001 Q2 and Q3.

Figure 1.
Figure 1.

Personal Income Tax Collection: Actual versus Predicted

Citation: IMF Staff Country Reports 2002, 075; 10.5089/9781451833034.002.A004

43. One final crucial issue concerns the interpretation of any change in the wage bill. So far, we have assumed that, to the extent that high personal income tax collections reflect high economy-wide wages, there is no puzzle to explain and no need to invoke any Laffer effect. An alternative view is that the Laffer effect would operate not through an increase in compliance as conventionally defined, but rather by inducing a shift from the underground to the official economy, and in particular by encouraging employers to report payroll figures more truthfully, with an implied increase in both nominal GDP and the wage share. In principle, the Goskomstat quarterly wage bill estimates on which we rely (unlike the Ministry of Finance figures) do embody adjustments for the size of the gray economy; while such adjustments may be imperfect, any error should be random. In practice, estimates of the relative size of the gray economy are only revised infrequently. As a result, when the gray economy is shrinking, the reported wage bill growth may exceed its true value for extended periods. Our methodology would then underestimate the size of any Laffer effect. In the absence of a well-specified wage determination model, there is no simple way to gauge the magnitude of this error, but we are confident that it does not fundamentally invalidate our analysis. One reason is that, while the wage share in GDP for the first three quarters of this year is indeed 2 to 3 percentage points above the corresponding values for 1999 and 2000, it is even further below the corresponding values for 1996–98, when compliance is generally estimated to have been lower, and the gray economy significantly larger, than is currently the case. That is, changes in the relative size of the gray economy appear to be only one, relatively minor factor behind observed variations in the wage share.

44. Overall, we conclude that the positive revenue performance in 2001 Q2 and Q3 is unlikely to reflect mere sampling error. It could plausibly reflect an underestimation of both nominal GDP and the wage share, as well as errors in estimating the quarterly profile for effective tax rates and estimated taxes. Alternatively, the apparent buoyancy in personal income tax revenues might reflect Laffer-style effects, sufficient to fully offset the projected Q2 and Q3 revenue loss from reform (amounting to Rub 9 billion). In any case, most of the revenue loss from reform is not projected to occur until 2001 Q4. Hence, clear conclusions will be impossible until, at the very least, figures are released for whole year nominal GDP and tax collections.

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1

Prepared by Ali Mansoor (FAD), and Nikola Spatafora (EU2).

2

The current system of taxation was only introduced in 1991. Officials were initially unfamiliar with key issues in tax policy, and particularly in tax administration. Moreover, they lacked the time needed to plan and set up a reasonably effective tax system.

3

Since the reforms alter the sensitivity of federal, local, and consolidated revenues to oil prices, the precise reform cost does depend on which ‘constant oil price’ is assumed. Roughly, for every $1 a barrel reduction in the assumed Urals oil price, the reform cost increases by 0.13 percent of GDP at the federal level, decreases by 0.07 percent of GDP at the local level, and increases by 0.06 percent of GDP at the consolidated level. These calculations of reform costs should not be directly compared with the calculations presented in Chapter V, “Fiscal Sustainability”, which assumes a different, non-constant oil price.

4

Although compliance varies between federal and subnational governments, a single organization (formerly the State Tax Service, and now the Ministry of Taxes and Fees) collects all taxes (other than trade-related ones), operating from local and regional offices throughout the country. Until recently, however, the local offices were generally more sensitive to local than to national interests. As a result, they exerted more effort in collecting taxes for local governments than for the national government, e.g., collecting first those taxes where the local take was highest; did not remit to the Federal Government all that it was owed; and provided more favorable tax treatment to locally based enterprises.

5

The accumulation of tax arrears and offsets cannot be blamed entirely on inadequate administration. It also reflects a circle of non-payment between the government and its suppliers, with the tax authority caught in the middle.

6

The term ‘federal taxes’ is used as shorthand for ‘taxes accruing to the federal budget’.

7

These amendments to Part I of the Code have been introduced repeatedly by the government, but were not passed earlier.

8

While this ministry is the only organization responsible for federal budget and subnational tax collection, there is also a separate Tax Police, which complicates tax administration.

9

This compares with compliance rates of about 80 percent in the U.S., 85 percent in the EU, and 95 percent in the Nordic countries. However, in Russia compliance rates relate only to payments of assessed taxes, and not to whether or to what extent such assessments cover the real taxes that are legally owed under the statutes. Thus, the 70 percent is not directly comparable to the 80–85 percent figure for developed countries, which covers a much higher proportion of truly owed tax.

10

Shifting the tax liability from producers (distilleries) to wholesalers was a negative development that complicates tax administration.

11

VAT on all trade with non-CTS countries was already on the destination principle.

12

Some tax reform measures have been (or are close to being) adopted by the Duma but would only take effect in 2002 (e.g., the profits tax and natural resource taxation). We include the impact of such measures in our overall estimation but distinguish between measures already in place and those adopted but yet to be implemented. We do not estimate the impact of measures that are still under discussion (e.g., removal of export taxes and possible unification of the VAT rate with fewer exemptions). The impact is estimated using the 2001 tax base.

13

More accurately, VAT on exports, which are now zero-rated following the partial move to destination basis for VAT. These losses are almost exactly offset by the increased VAT on previously exempt imports.

14

In particular, the gas tariff for non-CIS exports is doubled to 10 percent.

15

This analysis explicitly estimates and controls for the significant impact on the federal/local split of changes in oil prices. Future work might usefully examine the impact of other, less important but nevertheless significant factors, such as changes in the real exchange rate.

16

The effective rate was little changed, from 14 percent to 13 percent. Perhaps more significantly, the progressive rate structure was replaced by a flat tax, which may facilitate tax administration and improve compliance.

17

For example, see the interview of Tax Minister Gennady Bukaev with Izvestia on March 12, 2001.

18

Since the Laffer curve is concerned with increases in labor supply, we should ideally consider marginal rather than average rates. We would like to focus on high income earners, benefiting from a marginal rate reduction from 30 percent to 13 percent. Unfortunately, we do not have the micro-level data needed to verify the importance of the high income group in generating personal income tax revenue.

19

As noted earlier, the overperformance of the PIT is relatively unimportant from a macroeconomic perspective compared to that of other taxes. It would, therefore, be desirable to extend any micro-level analysis based on tax returns to the major taxes that have shown strong performance, and in particular the VAT, profits tax, and excises. It will also be crucial to examine the performance of the profit tax after the rate cuts that came into effect in 20O2

20

In addition, strong PIT collections could also reflect the positive impact on compliance coming from the reduction in social taxes following their consolidation into the UST. While this could also be seen as a Laffer effect, it implies that any analysis of PIT revenues should examine their performance not in isolation, but jointly with that of the UST. Given lags in information collection, we do not attempt such an exercise.

21

To obtain a sense of the underlying volatility, note that the percentage wage share in GDP for the first quarter of each year during 1997–2001 is estimated, respectively, at 30.6, 35.3, 27.4, 24.8, and 28.8. Admittedly, such estimates are themselves likely to be affected by compliance effects, and may therefore overestimate volatility in the ‘true’ wage share. Parenthetically, these wage ratios are as reported by Goskomstat, and cannot be directly compared to the values shown in Table 5, which have been scaled down to match the much lower annual totals reported by the Ministry of Finance.

22

The labor market is clearly tightening, in response to both cyclical and demographic factors, although it is hard to quantify the precise impact of these changes.

23

We exclude earlier periods, for reasons that are both principled (the outcomes were heavily distorted by the effects of the crisis) and practical (we lack reliable data on the tax base). Given the limited sample, all results should be treated with great caution.

24

The predicted values from this exercise, based on a formal econometric methodology, need not equal the projected values discussed earlier, based on a deterministic methodology with add-factor adjustments. However, the two sets of values turn out to be extremely close. In any case, a deterministic approach cannot be used to discuss statistical significance.