The Federation Council Approves Putin's Tax Reform Package The More Significant Question: Will It Make Any Difference? by Kent F. Moors

In a remarkably easy victory, the Federation Council, Russia's national legislative upper house, on July 26, passed the government's tax reform measures in a 115 to 23 vote. The lower house, the Duma, had previously passed the package, which now will be phased into operation next year. The new approach has been widely touted by Russian President Vladimir Putin and his administration as an essential part of structural economic reform. The Council is comprised of the governor and legislative leader (the regional legislative speaker) from each of Russia's 89 regions. The Council had been expected to stall the tax reform package in a show of opposition to changes in house makeup. A political tug of war has been going on between the Council and Mr. Putin since he proposed legislation to curb the powers of the governors and replace them with directly elected representatives in the upper house.

The Tax Reforms

Under the plan, taxes are to be simplified. Personal incomes taxes will be collected at a flat 13 percent rate. Currently tax rates range from 12 percent to as high as 30 percent but are widely evaded. The new rate will also apply to a wider number of individuals, meaning it is effectively a tax increase on most of the population. At present, about 90 percent of the national workforce pay taxes at the lower 12 percent level. Corporate taxes, following a last minute series of revisions prior to the vote, will actually increase. The existing 30 percent tax on corporate profits remains and will be joined by a new five percent rate to subsidize regional government budgets. The five percent tax will be levied on profits. It is intended to replace most of the "social services" tax that local governments currently collect on four percent of corporate revenues. The proceeds from this tax are used to pay for everything from road repairs to community programs. The turnover tax (has been) the source of continuous disagreements between companies and local tax authorities with companies often claiming it serves primarily to retard business development. Taxing elements other than profits has also combined with other payroll taxes used to subsidize workers' benefits to create the "gray" payment system in force at most Russian corporations. Salaries are significantly under-reported, while creative inter-company bartering and credit exchanges are used to minimize revenue lines in order to lower "official" tax liability. In a compromise reached late in the process, however, one percent of the present turnover tax will be retained, although scheduled for elimination by 2003. That makes the total overall company tax exposure 36 percent versus the current 34 percent, with the present squabbles over distinguishing actual profits from revenues likely to continue. The payroll tax system is to be simplified and the rates reduced. But since the salary levels reported are not accurate under the current system, reflecting actual income would push tax payments up even at lower rates. Additional changes provided in the reform package include new excise taxes on beer (30 percent), wine and liquor (5 percent) and cigarettes (50 percent), a three-fold increase in gasoline taxes, but a reduction by half in taxes on natural gas sold within the CIS (from 30 to 15 percent), and certain food and children's products (from 20 to 10 percent). The value-added tax (VAT) on other consumer products, would remain unchanged at the 20 percent level.

Invest(or) Reaction Subdued

"Revenue collections are regarded as an adversarial process in the Russian economy, with politically-connected companies able to gain concessions others cannot," says Vadim Mitroshin, an analyst at CS First Boston's Moscow office. Initial response from foreign investors is also muted. "Tax reform, while symbolically significant, has little impact on outside direct investment decisions," suggests Luca Parmeggiani, manager of Eastern European funds at Vontobel Asset Management in Zurich. Jim Belashek, Deputy Director of Deloitte & Touche Russian operations. . .in Moscow, agrees. "The reforms are certainly not going to stimulate foreign investment," Belashek concludes bluntly. "Taxes alone do not address all of the structural problems in the [Russian] economy." And Samuel Watterson, London-based analysis director for General Bank Managed Fund Flemings-Guta, adds: "Until there are some widespread legal guarantees to protect property interests, especially against the shortsighted and politically motivated decisions of regional court systems, tax reform alone will not mean much."

Concerns Mount for Next Budget

"All of the problems resulting in low revenue collections will remain," concludes Peter Houlder, director of research at Moscow's CentreInvest brokerage house. "This is a cosmetic move, but it will not result in significantly more money for the central budget." If this estimate is accurate, the 2001 budget may be in trouble already. First Deputy Finance Minister Sergei Shatalov told a Moscow newspaper on July 24 that the reforms would bring in an additional 100 billion rubles ($3.6 billion). But Shatalov also admitted the 2001 budget is already based on the expectation that the additional funds will be coming in before the end of next year. That expectation is not shared. To make the reforms more palatable to regional leaders, the Kremlin has agreed to move major social programs such as welfare from the local to the central budget. The problem is that the government has no real idea about the true cost of social relief programs if they were genuinely funded.

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