The Flat Tax Reform
By Jon Hellevig
Something Bush and Putin both have in common - tax cuts
Jon Hellevig, a Finnish citizen currently practicing business law in Moscow, sends us this article about the tremendous success of the supply side tax reforms implemented in Russia since 2002. In addition to a better climate for investors and businesses, these changes have given millions of Russians the freedom to travel, to communicate instantly via email and cellphones, and greater access to Western media networks. The social and political consequences of all of this for Russia are now being vigorously debated, but no one can deny that Russia's economy has surged forward in the last six years.
Putin's efforts to pull Russia out of political and social anarchy and strengthen statehood are starting to pay off transforming Russia into one of the best investment climates in the world while rewarding the nation with unprecedented increases in living standards. At the same time there have been big advances in the judiciary and the legal culture at large; relaxation in the bureaucratic press and reduction in corruption. In all of this, tax reform has played a crucial role in bringing stability and predictability back to Russian society.
After the anarchy of 1990s, the Russian government set out in the year 2000 to implement transparent and predictable tax laws. Gradually over the years from 2001 to 2005 this goal has been achieved through enacting the new Russian Tax Code. And today Putin's tax reforms stand out as the prime example of success achieved during the years of his presidency.
Another win for The Gipper - the former "Evil Empire" adopts his supply side ideas
At the heart of the reforms lies the classical liberal tax theory according to which lower taxes translates into increased tax revenues. The best known theorist behind this idea was the late Arthur Laffer, but the person whose name is most associated with them is President Ronald Reagan. Therefore, it is an interesting historic irony that Russia, a country where the socialist creed reigned strong still very recently, has now been converted into the international showcase of economic liberalism. In America, President Reagan and his supporters were known for campaigning for such tax policies, but it is Putin's Russia that has actually implemented them. Reagan could never have dreamed of pushing such measures as Putin's 13% flat income tax rate through Congress. It would be fair to say that never before has there been such a dramatic and speedy shift from socialist tax policies to classical liberalism, and the results could hardly have been more impressive.
The tax reform as a model for far-sighted and well-thought out legislation also had the side-effect of helping to improve the overall lawmaking process and stabilizing the task of state administration. It has also improved the judiciary, which is showing encouraging signs of moving towards a system where court precedents are awarded a significant role that would more closely resemble the Anglo-American system than the more rigid Continental European practices.
Having consolidated these achievements in tax administration, the government has concentrated its recent efforts on reigning-in notorious abuses in the fields of customs. The effects of this crack down on customs corruption and gray import schemes began to be felt last year among the foreign suppliers that have relied on such scoundreling for their profits. By now there is something resembling a panic among Russian importers as many declare that they no longer can continue import operations as before with the government's demand for transparent sales domestically in Russia. Customs values on imported goods are also catching up with market values, a sign of increased risk and stiffer penalties for cheating.
My prediction is that the government's efforts in streamlining customs will during the next two years deliver similar results as those achieved in taxation. Most would argue that the success of the tax reforms has been pivotal in ushering in the economic upsurge, a boom that we can now start calling an economic miracle.
The Russian Economic Miracle
In dollar terms, Russian GDP has increased fivefold from 2000 to 2006. According to our source, Deutsche Bank, the total growth will be six fold by end of 2007. At end of 1999, per capita Russian GDP was just $1,334 (the dollar to ruble exchange rate being 27.0). By the end of 2005 per capita GDP had risen to $5,346 annually, for the year 2006 it was $6,879 and by the end of 2007 it is expected to reach $8,350. This is more than 600% growth in 7 years.
It is difficult to understand why economists question whether the government's goal of doubling Russian GDP within 10 years is achievable,Â considering that it already has already grown more than fivefold between 2000-2007 in real, inflation-adjusted dollar terms! These numbers can be verified by looking at any macro economic charts that carry Russian GDP figures. The problem is that an element of confusion is often introduced by trying to adjust the figures to "real growth", which supposedly would clear the performance of emerging markets from inflation, asset value hikes etc. But GDP figures for Western economies are not calculated this way, and therefore the comparison is not apples to apples. Nothing can be more real than comparing the dollar denominated Russian GDP of 1999 with the GDP of 2006. And these figures speak for themselves.
Every now and then we hear the misleading claim that the Russia's GNP is roughly equal to that of the Netherlands, or of Sweden. Even with the formal, PPP adjusted figures, the Russian economy is still the 9th or 10th biggest economy in the world. There is good reason to believe that Russia in a not so distant future will surpass Brazil, Italy, France and even Great Britain to become one of the six largest economies in the world.
Often the GDP numbers for various countries are made comparable by adjusting them using so-called purchasing power parity (PPP). This is done in order to attempt to take into account the differences in the relative price level in various countries e.g. the price for a hair-cut in France versus in China (or the fact that there are places where the hair cuts are done at home for no pay). In that regard Russian GDP would on a PPP measure be $12,000. which is already more than one third of the average for Western Europe. It also more than half of the year 2000 level of GDP in Finland, to take the European showcase of my homeland as an example. This should show how deceptive it is to try to read in too much structural difference to these statistics.
According to some estimates the ruble is very much undervalued, and therefore the correct purchasing parity figure could be as high as $18,000 per capita. If we were to consider the huge differences in general price levels across this biggest country in the world (with housing and food being much cheaper in the regions than in Moscow and St. Petersburg), then this adjusted figure could,in fact, be closer to the truth.
From Rags to Riches During Putin's Presidency
When Putin took over the presidency in year 2000 the country was on the brink of ruin Â For many Russians and Western observers it seemed that the fall was inevitable and final. GDP per capita was at the level of third world countries; the external debt was $150 billion or more than 100% of the country's GDP; Russia had recently gone through a devastating devaluation and received an emergency loan of $10 billion from the International Monetary Fund (many claim that even this money did not reach the state coffers, but was stolen by corrupt officials in the Yeltsin Administration). By contrast, in June 2006 Russia's external debt had dropped to $60 billion or less than 6% of GDP, which makes Russia practically debtless compared to the world's leading economies. The debt rates in European countries are significantly higher e.g. in the same year in Germany the total was 67,7%, in France 66,8%, in Finland 41,1% and in Italy 106.4% (2006 figures from the European Central Bank). Â The problem for Russia's creditors in recent years has not been to extract payments from Moscow on its outstanding debt, but to keep Russia from paying them off ahead of schedule. The Paris Club, an elite group of Western creditor nations, was shocked to experience Russian prepayment last year.
The currency and gold reserves of the Russian Central Bank were a mere $36,6 billion in 2001, but today they have ballooned to a staggering $315 billion (Source: www.minfin.ru). Russia's cash reserves today are the third largest in the world, trailing only China and Japan. On top of this the Finance Ministry has created a Stabilization Fund where surplus proceeds from oil revenues are saved; by January 1, 2007 the fund had accumulated $88,7 billion (source: www.minfin.ru).
The officially calculated average monthly salary in Russia was $81 at the time when Putin took the helm of a very shaky country. But at the beginning of 2006 the average salary was $371 and by December 2006 it had already reached $550. This is the highest level of salaries paid in all of the CIS countries. Still these absolute figures should not be compared with Western salaries; the differences in purchasing power and the economic structure hide a different reality more favorable for Russia.
In 2001 the World Bank estimated that 27.3% of Russians or 40 million people lived below the poverty line; by the end of 2005 the number of people living in such dire poverty had been halved down to 15.8% of the population or 22,6 millions. According to recent EU statistics this figure corresponds with the EU average which is the same unfortunate 16% (Business Week, February 2007).
The Russian Economic Miracle is the Result of Sound Polices, Not Just Higher Oil Prices
Russia's critics dismiss all of this by arguing that the economic upsurge is exclusively "oil-driven", that Russia simply enjoys "windfall revenues" from export of oil, gas and raw materials buoyed by surging world market prices.
Just a few sponsors of a recent investment forum in Moscow
These critics of Putin's reforms forget that the raw materials have been under Russian soil for ever, but it is only now, under Putin's leadership, that they have brought unprecedented growth and prosperity to the country. Putin did not create the raw materials; he created the conditions for a democratic market economy that can leverage natural resources to diversify the economy. It is through consistent and well-planned economic and social reforms, along with the rule of law that the economy has taken off. Therefore, when we put aside all of the exiled oligarch-funded propaganda designed to paint Russia in black, we will be reminded that during Putin's presidency Russia has been placed on a solid foundation for a competitive democratic market economy.
How Putin's Tax Reforms Are Fueling the Economy
The great tax reform undertaken in Russia under the Putin presidency in years 2000 through 2005 has been the decisive contribution to the reforms and by far the most remarkable achievement in building a democratic state of free individuals. These reforms have given Russia Europe's most liberal system of taxation. Today in Russia there are transparent tax laws and internationally low tax rates, which provide good incentives for hard work. The corporate profit tax rate is 24 % and Russians enjoy a European-low 13% flat tax rate for all income brackets. With this low rate, Russia is near the top of world rankings for individual tax freedom as shown by Avenir's World Individual Tax Freedom Survey (see chart below). Thanks to the low flat tax rate, Russia avoids the European trap of punishing hard work with big taxes. The employer's social contributions are paid in form of a social tax charged on a regressive scale from 26% to 2%, meaning that the more salary the employer pays to an employee the smaller the tax. Thus the employer is also stimulated to increase salaries. This is in line with the overall business friendly approach inherent in Russian tax laws.
The legislative initiatives are supported by a general improvement in tax officers' professional skills, spearheading a breakthrough in administrative transparency. This progress has been possible thanks to major advances in the judiciary with enhanced predictability and court precedents increasingly shaping a Russian legal framework.
Legislation, administration and the judiciary aside, perhaps the biggest change has occurred in the taxpayers themselves who are busy shaking off the burdens of the old "kryshe" black market economy and memories of the chaotic 1990s, and are now "going white", as they say in Russia. In spite of some infrequent and spectacular crimes by the people who formerly benefitted from the anarchy of the Nineties, most companies and individuals are increasingly valuing the benefits of operating within the legal system of the country. Russian businessmen realize that one both earns more and sleeps better at night by staying within the official legal system. There is an increased awareness of the primacy of creating shareholder value and that this is exclusively the product of legally sound business practices within a transparent economy.
The Kremlin made a major impact by targeting the most flagrant examples of tax evasion schemes (e.g. Yukos). The resulting public discussion, administrative guidelines and ensuing court practice have all contributed to create a more transparent and professional business climate. The outcome is a tremendous growth of tax revenues as corporations have repatriated capital from offshore tax havens and eliminating illegal money laundering schemes.
Behind all of these achievements there is the determination to establish the rule of law necessary to sustain a democratic legal order, market principles, competitive plurality, and a window of of political stability giving time to enact major reforms. Some of these reforms, of course, by strengthening the state, have produced criticism from around the world. But many of these critics did not seem to mind when Russia was weak and could not enforce the rule of law or control access to its natural resources.
Lower Taxes Contribute to Individual Freedom in Russia
The tax reform is also a strong statement about the liberal orientation of Russian reforms, for there can hardly be any more significant issue affecting individual freedom than levels of taxation, which leaves the individual with a real choice about how to spend his resources and live his life. By this measure, Russia is becoming a showcase for the growth that record low tax rates can stimulate. To a great extent this is evidence of a political system that encourages individual freedom, not only in speech, but more importantly in action. In the early to mid 20th century, Europe and the United States successfully created a large middle class, and this is the road now being taken in today's Russia.
Even the favorite hack topic of Russia critics, freedom of speech, comes out in new light when considered against this measure of the tax freedom ranking. After all the human freedom to keep one's own income and decide how to use it must be regarded as fundamental.
Shoppers at Moscow's Stockmann Department store
Clearly when the tax burden is less, then there is more personal discretion as to how to use one's income. Today Russians have a wide choice in this respect. When tired of Russian television they can e.g. choose from international satellite channels, from CNN to Sky Channel, all serving Russia with the best truth that money can buy. There is a wide choice of domestic newspapers, but the Russian reader may also pick up his copy of the Financial Times or, for the sake of more objective coverage, the International Herald Tribune. Half of Russia's college students are enrolled in paid tuition programs, thus parents and students may chose from the market those schools and programs that best suit their own world-view. The mobile phone networks cover practically all the country encompassing all the economically and politically active population. Russians were not more free to access the outside world through the Internet in the 1990s when it did not exist, nor to post their views online uncensored by their government (unlike say, citizens of America's leading trading partner China or of its Arab allies).
Today Russian citizens can, for the first time in history, freely communicate with each other from one part of Russia to another, spreading real-time information through eleven time-zones from east to west. Russians can also travel abroad - and return home, like never before. And they are making use of this newfound liberty. In year 2005 (Rosstat) Russians made 15 million trips abroad to Western countries. That number equals about 10% of the population. (There is some overlap because the statistics register the number of trips and not individuals traveling, but on the other hand these figures do not register travel to neighboring CIS countries, such as Ukraine and Kazakhstan).
Heading out - a Russian traveller (Photo by: St. Petersburg Times)
On their trips abroad the Russians have a good chance to verify whether they have truly been victimized by restrictions on freedom of speech or brainwashed by state television into supporting Putin, as is claimed in the West. But for some reason Russians return home without experiencing the sensation of having become privy to previously hidden facts of life back home in Russia. With enough patience and a sense of humor they could, however, read about ex-FSB agent Litvinenko being lifted to the ranks of Andrei Sakharov and declared a "Russian dissident", about "friends of Litvinenko" on Boris Berezovsky's payroll serving for the British press as the most reliable sources possible on all things Russian; about Russia allegedly using energy to intimidate its neighbors, the fragile democracies of Georgia, Estonia and (a the latest "victim") Belarus; or the investigative journalist Anna Politkovskaya having discovered that there was a brutal guerilla war going on in Chechnya; and that only the super rich have benefited from economic reforms, which puts all those 15 million that traveled abroad in the category of Russia's new "super rich".
Avenir Corporate's Survey of World Individual Tax Freedom
For this survey Russian personal tax rate was compared with a sample of other developed countries (data from Finnish Taxpayers Center and Avenir Corporate, Russia). Of all the countries surveyed, the tax rates were by far the lowest in Russia according to Avenir's ÂWorld Individual Tax Freedom Survey. In Russia the individual is left with a record 87% of his income, to be used as that person wishes. Also taking into consideration the low cost of utilities in Russia; free education; and the comparatively low level of other living costs outside Moscow and St. Petersburg, we may conclude that in Russia a middle class person in reality Âis free to decide on his own discretion how to dispose of his income and how to live.
Annual Income Level 31,400 euros
1. Russia 13,0%
2. Ukraine 15,0%
3. Slovakia 19,0%
4. Switzerland 14,6%
5. Japan 18,6%
6. USA 22,1%
7. Estonia 22,4%
8. UK 23,4%
9. Australia 24,3%
10. Spain 24,4%
11. Norway 24,9%
12. Austria 25,1%
13. Canada 26,1%
14. Sweden 30,1%
15. France 30,7%
16. Finland 30,8%
17. Holland 31.2%
18. Italy 33,8%
19. Denmark 36,8%
20. Germany 39,6%
21. Belgium 39,8%
Annual Income level 102,500 euros
1. Russia 13,0%
2. Ukraine 15,0%
3. Slovakia 19,0%
4. Estonia 23,2%
5. Switzerland 25,4%
6. Japan 29,0%
7. USA 35,2%
8. UK 33,4%
9. Spain 36,7%
10. Canada 36,8%
11. Norway 37,4%
12. Australia 39,4%
13. Austria 39,6%
14. France 40,1%
15. Italy 43,6%
16. Holland 43,9%
17. Germany 46,3%
18. Finland 46,8%
19. Sweden 47,0%
20. Denmark 52,5%
21. Belgium 53,0%
(Sources: Finnish Taxpayers Center and Avenir Corporate)
The writer is a Finnish lawyer active in Russia. He is the co-author of Avenir Guide to Russian Taxes, with recent launches of updated editions in both English and Russian. He has written the book Expressions and Interpretations discussing Russia's social development from the viewpoint of philosophy and philosophy of law. He is also the author of several books on the Russian tax and labor law.