To plug Russia’s fiscal gap, something has to give
The Kremlin is targeting the lowest hanging fruit
The Russian government is working on a plan to introduce a progressive taxation system in order to plug the growing budget gap.
Ahead of presidential elections last weekend, Vladimir Putin said in an interview with state media that he believed both ordinary Russians and Russian businesses viewed the move with a degree of understanding.
Having secured a fifth term on Sunday, Putin hopes the measure will help boost budget revenue, finance key social and military endeavors, and avoid further bloating of Russia’s external debt.
Russia’s Economic Reality
The Russian economy will face a number of challenges during Putin’s next term as president. Chief among them will be the Russian regions’ struggle to cope with unrelenting sanctions pressure and guaranteeing that the economy can attract enough foreign exchange to cover the country’s budgetary needs. The Kremlin has limited the number of economic changes it’s willing to make in order to avoid destabilizing the economy any further, but it can’t allow the country’s external and internal debt and budget deficit to swell uncontrolled. Something has to give.
In 2023, Russia’s federal budget saw a deficit of 3.24 trillion rubles ($35.4 billion), or 1.9 percent of gross domestic product, in part due to rising spending. In the first two months of 2024, federal budget expenditures amounted to 6.5 billion rubles, a 17.2 percent increase from the same period in the previous year. But the problem isn’t limited to the federal government; individual Russian regions are also experiencing soaring debt.
According to Russia’s Ministry of Finance, 73 of Russia’s federal subjects have seen increases in public debt, which totaled 3.2 trillion rubles for all regions in January, a 15 percent increase over January 2023. Traditionally, loans provided from the federal government account for the majority of regional debt – nearly 77.4 percent so far in 2024 – though they’re often not paid back. In a recent address to the Federal Assembly, Putin announced that the government would write off two-thirds of the regions’ outstanding debt on budget loans.
However, the state still plans to increase its provision of infrastructure loans (issued at 3 percent interest per year for up to 15 years) to the regions by no less than 250 billion rubles annually starting next year, meaning that their public debt will only grow. (These loans are crucial to maintaining and improving infrastructure, so forgoing the money isn’t really an option for the regions.)
The Kremlin needs to address the situation, but it’s options are limited. It’s grappling with a slowing economy as foreign companies continue to hesitate to do business with Russia. The Russian economy is starting to overheat, with growth rates expected to decline after sharp increases last year as the economy recovered from the initial fallout of the Ukraine invasion in 2022.
Gross domestic product increased by 3.6 percent in 2023, but some economic forecasters predict just 2 percent growth for this year. In addition, the demand for labor decreased substantially this month for the first time since spring 2022. As falling labor demand is often a result of declining industrial output, this could indicate the beginnings of a recession.
The Kremlin can’t allow the income levels of the poor and middle classes to fall. In addition to growing inflation, which now exceeds 7 percent, Russian society is characterized by a high degree of inequality. In 2023, Russia’s Gini coefficient, which measures a country’s level of income inequality, jumped to 0.403 from 0.395 a year earlier.
Considering that at least a third of the population lives on state benefits and that many others work in state institutions, supporting social projects and income growth may require much more financing than the Kremlin is willing to allocate. Russia still has a safety net in the form of the National Welfare Fund, which holds about 12 trillion rubles.
But its ability to replenish this fund is constrained, in part due to Western sanctions, which are limiting its revenue
from oil and gas, and in part due to the lack of infrastructure connecting Russia’s energy sector to potential new markets. Thus, Russia’s only way to offset its growing budget spending is to introduce progressive taxation.
Sharing the Burden?
The government believes this system won’t result in mass unrest or social destabilization, or at least not as much as doing nothing to address the problem would. Roughly 76.4 percent of Russia’s federal budget revenues come from taxes. Most of this is collected through fees and payments for the extraction of natural resources – which account for almost 50 percent of all tax revenue.
However, due to an OPEC+ deal to cut output, Russia’s lack of new technologies and export limits, Moscow has been forced to reduce oil production, limiting government revenue derived from energy sector taxation and fees. The government’s second-largest source of tax revenue – duties paid on imports – is also not a reliable source of income considering the West’s increasingly tight sanctions regime and new trade routes being developed that allow countries to conduct trade without accessing Russian territory.
Value-added tax accounts for 20 percent of all tax income, but given the rising inflation rate, the Kremlin can raise the VAT only in very targeted ways without provoking public backlash. For example, the VAT on hamburgers increased from 10 percent to 20 percent last October. This forced the former McDonald’s restaurant chain, now called “Vkusno i Tochka,” to raise prices for its burgers, but it did not result in any serious social unrest.
The government’s only reliable option to increase tax revenue is to introduce higher personal income tax rates – under the pretext of sharing the tax burden more equitably. Personal income taxes currently account for 10 percent of budget revenue, but this can increase significantly under a progressive taxation system.
Initial indications of a transition to just such a system appeared in 2021, when it was announced, at the initiative of the president, that income over 5 million rubles per year would be taxed at 15 percent, while those earning less than this amount would continue to pay the flat rate of 13 percent.
The government is now talking openly about introducing a full progressive taxation system.
While the majority of the population won’t see significant changes to their tax payments, wealthier segments of the population will be expected to pay more, according to the proposals for implementation that the government is considering.
One of the plans under consideration would tax those earning less than 360,000 rubles at a rate of 0 percent, up to 5 million rubles at 13 percent, between 5 million and 10 million rubles at 15 percent, 10 million to 50 million rubles at 25 percent, between 50 million and 100 million rubles at 30 percent, and more than 100 million rubles at 35 percent.
The scheme would affect less than 10 percent of the entire Russian population, which has an average monthly income of 100,000 rubles.
It’s difficult to say how much revenue a progressive taxation system generate. Considering that the biggest burden will fall on a small, though wealthy, segment of the population, it seems that the Kremlin isn’t willing to take the risk of angering the middle class or scaring off businesses and potential investors by imposing broader tax hikes. It’s a limited measure that can partially offset losses, but it’s no panacea, and it certainly won’t replace tax revenue from the largest source: the oil industry. It also comes with a number of risks.
It’s possible that tax evasion will spike, the gray market will grow, and more people will transition to selfemployment to try to avoid paying higher tax rates.
But higher rates for the wealthiest individuals are now seen as inevitable. It’s possible, then, that Putin was correct in asserting that Russian individuals and businesses understand why the changes to the tax system are being imposed, knowing that they can’t do much to stop them anyway.
But their support will continue only as long as they see some benefits, either to market conditions or to their own pocketbooks, in exchange.
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