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10 explanations for Russia's coming fiscal squeeze

- February 13, 2014

A general view shows the construction site of the Olympic athletes’ village in front of the Olympic Park in the Adler district of Sochi on Feb. 18, 2013. (Kai Pfaffenbach / Reuters)
Joshua Tucker: As the Sochi Olympics continue, so does our companion Monkey Cage series of Russian politics-related posts. Today we bring you Emory University political scientist Thomas Remington  on why the future economic prognosis for Russia is not as rosy as might seem for a country that had the wherewithal  to spend more on these Olympic Games than all other Winter Olympics combined.  Previous posts from this series can be found at the end of this post.
According to Russian deputy prime minister Dmitrii Kozak, every ruble spent on preparations for the Sochi Olympics has been justified.  The massive cost overruns that led the final spending figure to reach 1.5 trillion rubles–almost $50 billion–from the initial estimate of 314 billion, or $10 billion–had to do with various unanticipated but legitimate expenses.  According to Kozak, audits by the Audit Chamber and the State Financial Inspectorate of Olympic spending have revealed nothing improper.
Regardless of how much the extraordinary cost of the Sochi Olympics results from innocent underestimates, corruption, or pervasive inefficiency, the financial burden the games pose for Russia is just one of a number of severe pressures facing Russia’s state budget.  Russia’s press has been documenting these problems in depth. Although there are many sources of Russia’s fiscal plight, I would single out 10 in particular.
I.  Russia is experiencing a long-term economic slowdown.  Recently prime minister Dmitrii Medvedev said that Russia is suffering from the Dutch disease syndrome, which occurs in countries dependent on natural resource exports where sales of natural resources drive up the value of the currency, raising prices and incomes but not competitiveness outside the resource sector. The diagnosis is flawed (for example, Russia’s currency is not appreciating, and its lack of competitiveness is a long-standing problem) but it is certainly true that Russia’s reliance on natural resource exports to meet its fiscal needs has risen under President Vladimir Putin as the share of non-resource goods and services in its export mix has declined.  Currently the oil, gas, and related industries provide about 70 percent of budget revenues and about 40 percent of GDP, while manufacturing output is stagnant.  The steady growth rates from 2000-2008 masked the deep weaknesses in Russia’s economy, but one indication of its vulnerability to global downturns was the depth of its recession in 2009.  In that year, output shrank by about 8 percent, the greatest decline of any G-20 economy.  Putin’s government poured money into maintaining liquidity for banks, industry, and households, but missed an opportunity to undertake structural reform.  Recovery since the recession has been tepid: the growth rate for 2013 was not much over 1 percent.  The government’s forecasts for growth rates of 2.5 percent in the coming years appear over-optimistic.  Inflation continues to pose a stubborn threat to growth as the authorities appear unable to bring it down below 5 percent.
Meantime, Russia’s workforce is shrinking but rising wages and benefits mean that labor costs take a steadily growing share of the economy.  In short, Russia cannot move forward without a significant increase in labor productivity and modernization of its economy.  As Medvedev put it a few days ago, Russia’s economy is “stuck.”

Data: Mikhail Tovkailo, "Ekonomika zavisla iz-za 10 let uspekha," Vedomosti, January 16, 2014.  Based on calculations of Center of Development, HSE; Rosstat.  Figure: Thomas Remington/The Monkey Cage

Data: Mikhail Tovkailo, “Ekonomika zavisla iz-za 10 let uspekha,” Vedomosti, January 16, 2014. Based on calculations of Center of Development, HSE; Rosstat. Figure: Thomas Remington/The Monkey Cage

II.  A second source of pressure is demographic.  Life expectancy is slowly rising and birthrates are very low.  The workforce has begun shrinking as more people retire from the labor force and fewer people enter it (the inflow of migrant labor is slowing and does not offset the decline in working age adults).  The workforce will shrink by several million people in the next few years.
One consequence of the aging population is that the demographic burden–the number of nonworking people for each person in the workforce–is rising rapidly.  The Russian state statistical agency calculates that by 2020 there will be about eight non-working people for every 10 who are employed.  About 60 percent of these dependents are older than working age.
Data: Rosstat . Figure: Thomas Remington

Data: Rosstat <http://www.gks.ru/free_doc/new_site/population/demo/progn4.htm >. Figure: Thomas Remington

Another consequence for Russia, as for other societies with a growing median age and a growing demographic burden, is rising expenditures on pensions and health care.  Former finance minister Aleksei Kudrin and economist Evseii Gurvich argue that the current share of GDP spend on pensions and health care, about 12.5 percent, will double by 2050 if the savings and insurance systems funding these programs are not reformed and made sustainable.
The government has responded with a significant reform of the pension insurance system, but has eliminated the mandatory individual retirement savings scheme that had operated for 10 years (it will now be optional).  This move simply postpones the day when pension liabilities will pose an insuperable burden for the economy.  Meantime, Putin has consistently refused to raise the retirement age, which Stalin set in 1932. He fears the social unrest that could develop if people feel that their pension rights are abrogated, and he has no way of building a broad consensus around a new and sustainable system where people pay into a system they trust and the government makes pension entitlements secure.  My belief is that in order to build a new the social contract–a shared set of norms about how the opportunities and costs of economic growth are shared–Russia needs a different set of political institutions.  At present, however, many people refuse to pay their fair share of taxes and social contributions, thus contributing to a growing deficit in the state budget and the social insurance funds.
III.  Third, Putin has made a number of ambitious financial commitments.  One set has to do with large-scale infrastructure and showcase projects, such as the Sochi Olympics in February 2014 and the Asian-Pacific Economic Cooperation summit meeting in September 2012.  He also has pressed to use much of the National Welfare Fund–a reserve fund created to stabilize the economy in the face of rising mineral export prices–to finance transportation and development projects in Siberia and the Far East.  He has created a Ministry for Far Eastern Development to oversee these plans, and it has proposed projects that would cost trillions of rubles.
IV. Putin has also substantially raised spending on the military, law enforcement, and state security sectors.  These items are now taking up at least a third of the federal budget, although the total is probably more.  Military spending is growing at the expense of spending on health care and education.  The sharp increase in military spending was one of the precipitating factors in former finance minister Aleksei Kudrin’s abrupt departure from the government in 2011.
V. Fifth, Putin has significantly increased pay for senior government officials and public sector employees more generally.
Some senior government officials saw a doubling and more of pay from 2012 to 2013.  For example, the pay of the chairman of the board of Russia’s social insurance funds tripled in 2013 and will quintuple in 2014, compared with 2012. This brought his total compensation (base salary plus the numerous bonuses that constitute half and more of many officials’ pay) from about $24,000 per year in 2012 to about $120,000 in 2014.
Many other officials in the military, state security bodies, presidential administration, Federal Assembly, and government have received increases similar in scale.
VI.  Sixth, Russia is straining to meet the targets set out in Putin’s May 2012 decrees, issued within hours of his taking office for the third time as president.  These decrees are the subject of a great deal of attention in the Russian press. (The texts of presidential decrees may be found at: http://kremlin.ru/acts)
The May decrees addressed a wide range of issues: demographic policy; foreign policy; armed forces; military service; inter-ethnic relations; state administration; affordable housing; education and science; health care; social policy; and long-term economic policy. The decrees all specified ambitious goals for the government, including concrete target dates for the accomplishment of particular tasks.  For example, the decree on demographic policy ordered the government to raise overall life expectancy at birth to 74 by 2018 (from the current 69.8 in 2011).  The decree on health care demanded that the government cut mortality from cardiovascular disease to 649.4 per 100,000 population by 2018.  The decree on economic policy instructed the government to raise Russia’s ranking in the World Bank’s rating of “doing business” from 120st place to 20th place by 2018 and to create 25 million high-productivity jobs by 2020.  Many more similarly bold target dates and performance goals highlighted the eleven decrees.  Estimates over what the decrees would add in costs to the budget of the federal and regional governments varied wildly, from half a percent of GDP per year to 3-4 percent of GDP.
The decrees set a number of targets requiring costly spending increases at both federal and regional levels.  Regional governments are responsible for the pay of public sector workers such as teachers and doctors, and Putin decreed that their pay should be set to at least at the level of the average wage in each region.  These decrees created what in the United States are called “unfunded mandates.”  Regional governments have been struggling to comply.  Coupled with the slowdown in economic growth, which brings shortfalls in tax revenues, the fiscal strain posed by the May decrees is leading a number of regional governments to the verge of fiscal collapse.  The total indebtedness of regions rose 50 percent over the 2010-2013 period, and is projected to double again over the next two years.
Likewise the federal budget is also straining to meet the social welfare obligations set out by Putin.  Putin has significantly increased the base rates for pensions but most increases have failed to keep up with rising prices and the steady growth in wages.  As a result, because wages are increasing faster than labor productivity, and because contributions to the Pension Fund suffer from serious problems of evasion, the pension fund is running a rising deficit.  Indexing pensions to wages therefore contributes to inflation.
Data: Rosstat, Regiony Rossii; Figure: Thomas Remington/The Monkey Cage

Data: Rosstat, Regiony Rossii; Figure: Thomas Remington/The Monkey Cage

VII. A seventh problem is declining investor confidence.  Capital flight is accelerating.  Last year Russia lost close to $60 billion in capital, the equivalent of the entire defense budget or the Moscow city budget.  Closely tied to capital flight is the outmigration of talent and declining consumer confidence.  This contributes to the lagging competitiveness of Russian industry in world markets, slowing growth, and rising dependence on natural resource exports.
VIII. The eighth problem is the inefficiency of the tax system.  The bulk of federal tax revenues derive from the energy sector in the form of the minerals extraction tax, export duties, profits taxes on energy companies, and excise taxes.  This means that fluctuations in world oil prices have a direct impact on government revenues.  Revenues from the income tax (a flat 13 percent rate) go to the regions rather than the federal government, and Putin in any case has refused to raise it or make it progressive.
In advanced industrial economies, the progressive income tax is the major source of revenue for the central government, but its adoption and effective administration require a level of social consensus that Russia lacks and for which authoritarian rule cannot compensate.
The tax system is inefficient in many ways: tax collection is poor and fraught with evasion and corruption, and the structure of taxes is flawed.  The system relies heavily on more easily-monitored sources of revenue, such as large legacy enterprises, but at the same time it offers countless special deals and exemptions that are intended to generate incentives for investment but that end up having little effect.  There are some 128 different categories of tax exemptions on the books, many of which are hardly used.  Altogether they cost the budget about 1.8 trillion rubles (about $60 billion).  For example, 300 tax-exempt special economic zones are registered, but fewer than half are being used.
IX.  A ninth source of pressure on the budget is the utilities sector.  Largely unreformed since the Soviet era, it is  highly inefficient and corrupt.  Utilities companies are monopolies and are formally subject to federal and regional regulation, but regulation has been unable to force them to modernize the aging infra-structure.  As costs steadily rise, the companies raise rates, but never by enough to finance a major overhaul.  Rapid rate increases in the past few years have created major social discontent, so the government has frozen rates, which in turn only contributes to the financial hole of the utilities companies and requires the government to make up the deficit from the state budget.  A Catch-22 situation is the result.
X.   The tenth problem has to do with the growth of the army of state employees as a share of the total workforce.  Overall, the number of employed people in the economy is flat and is beginning to decline.  However, the share of employed people who are state employees has risen rapidly, although it has declined very modestly in the last few years.  Almost all of this growth has occurred at the regional and municipal level, as Figure 4 indicates; for many poor regions, public sector employment is a form of social welfare, but it requires growing subsidies from the federal government to finance. Altogether, the public sector–both state employees (uniform and civilian) and public sector employees (doctors, teachers, and so on) now represents about 25 percent of the total workforce.  At a time of growing fiscal stringency, economic stagnation, and rising resource dependency, the growing state sector is a further drag on the budget.
Data: Rosstat . Figure: Thomas Remington/The Monkey Cage

Data: Rosstat <http://www.gks.ru/wps/wcm/connect/rosstat_main/rosstat/ru/statistics/wages/labour_force/#>. Figure: Thomas Remington/The Monkey Cage

How has the Russian government responded to these fiscal stresses?  It has taken some difficult fiscal steps, for example reducing the rate at which the budget is growing to below the inflation rate.  One result is that many public sector employees will suffer from falling real incomes this year.
Another is a short-term maneuver by which all 2014 contributions to the personal retirement savings accounts (which have been 6 percent of wages since 2002 for workers born after 1967) will be diverted into the current pension insurance system.  However, this only frees up 244 billion rubles and is only being used to make up a part of the Pension Fund’s current deficit.
The government has also turned to non-fiscal measures.  One is stepped up political control over the mass media (for example, reorganizing the relatively free-thinking RIA Novosti press agency and placing it under the direction of a fierce conservative, expulsion of the Radio Liberty correspondent David Satter from the country, and the new legislation allowing the government to block websites for extremist content without judicial review).  Another is Putin’s recent embrace of  a conservative social agenda.  Russia’s fiscal squeeze helps explain the pandering to the Russian Orthodox Church (for example, the harsh sentences given to the Pussy Riot participants in the “punk mass” at the Cathedral of Christ the Savior), the anti-gay legislation, the Dima Yakovlev law banning adoptions of orphans by Americans, and the efforts to impose a single, nationalistic interpretation of Russian history in the school curriculum.  These measures in the ideological sphere, along with the substantial pay hikes for the military, the police, top government officials, and public sector employees, can all be regarded as efforts to shore up political support for Putin in the face of the deepening strain Russia faces to meet its fiscal obligations.
But these are all short-term measures.  Some in fact exacerbate the deeper problems.  A long-term solution to Russia’s fiscal problems would require not only a comprehensive structural reform of the economy, but also an overhaul of the political institutions through which a new social contract can be constructed.  Rebuilding the social contract will be far harder than preparing for the Sochi Olympics.
Previous posts from our Sochi-companion Russian politics series:
What you need to know about Putin’s popularity
How to understand Russia’s Arctic strategy