18.02.2004
Politics vs Economics
№1 2004 January/February
Vladimir Mau

Vladimir Mau is Rector of the Russian Presidential Academy of National Economy and Public Administration.

Vladimir Mau, Doctor of Science (Economics), Professor,
is Director of the Academy of the National Economy under the
Government of the Russian Federation.

Vladimir Mau

If we were to make a brief summary of the year 2003 for Russia,
here is what it would entail: an overall favorable economic
situation; general economic growth; changes in the political
atmosphere which were manifest in the campaign against the YUKOS
oil company and parliamentary election results; preparations for
the presidential election and debates over what political and
economic policies Vladimir Putin may pursue during his second
presidency. Last year’s results are worthy of an in-depth analysis,
as many of those events will clearly mark out a course for the
coming years.

The economic policies were influenced by three main factors.
First, the economic growth rate was up for the first time since
2000, accompanied by the growth of investment. Second, the market
situation remained favorable, with energy prices remaining high,
despite political ups and downs around the globe. Developments in
the forex market were also positive: while the U.S. dollar rate
substantially weakened against the ruble (both in its real and
nominal value), the ruble’s real exchange rate only slightly
strengthened against the euro – the main currency for Russian
importers – thus moderating pressure on Russian producers which in
turn allowed them to keep competitive prices. This situation gives
the impression of high stability, but actually it is fraught with
additional risks. The feeling that economic threats have been
averted can provoke eccentric economic and populist budgetary
solutions, and decisions of property redistribution. Such moves
will inevitably lead to political destabilization.

Third, political rivalries escalated against the backdrop of a
favorable economic situation. The main political clashes, rather
than being associated with the electoral cycle, were in line with
the logic of post-revolutionary stabilization that occurs in a
split society which has begun moving toward accord on basic values
and priorities.

Finally, no technological or monetary catastrophe was
registered, even though they had been predicted for 2003 throughout
the preceding decade. An evolutionary approach was chosen to deal
with technological obsolescence, which resulted in high investment
levels. The government had resolved the debt problem due to proper
debt management policies pursued during the preceding three
years.

Russia’s Socio-Economic Development in 2000 through
2003

(% change on previous year, unless otherwise
stated)

 

  2000    2001  2002    2003
GDP   10.0  5.1  4.7 

 6.7 (11 months)

Industrial production    11.9   4.9   3.7  6.8 (11 months)
Engineering and metal-working    20.7   7.2   2.0  8.5(11 months)
Share  of machinery, equipment and means of transport
in exports
 8.8    10.5   9.5  8.4  (11 months)
Share  of machinery, equipment  and means of
transport in imports
 31.4   34.0   36.2   38.4  (11 months)
Capital investment   17.4   10.0   2.6   12.2
Consumer price index        20.2   18.8   15.1   12.0
Net outflow of private capital, $ billion   -24.8   -14.9   -8.2   N/A
Gold and forex reserves, year-end,  USD, million  27.951  36.622    47.703   76.938
Oil price, Brent, average annual, USD per barrel
(IMF)
 28.3   24.4   25.0   28.7 (7 months)
Ruble real effective exchange rate  (REER), 1999=1
(IMF)
 1.21   1.33   1.33   N/A
Ruble real  exchange rate against dollar, 1999=1  1.11   1.20   1.29   1.54
Ruble real exchange rate against euro, 1999=1  1.22   1.40   1.26   1.24
Birth rate, per 1,000 persons   8.7   9.1   9.8   10.5 (11 months)
 Natural population growth,   -6.7   -6.5   -6.5   -6.0 (11 months)
 Suicidal  death rate,  per 100,000
persons 
 39.3   39.7   38.6   N/A

    

PRE-ELECTION YEAR

The approaching parliamentary and presidential elections were an
important background factor for last year’s economic policies. But
the influence of the election campaigns was essentially different
from what one could expect while relying on traditional ideas about
political and business cycles.1
There were no clear signs on budgetary populist policies, let alone
the loosening of monetary policies. Populism, if it emerged at all,
was of a political, rather than fiscal nature.

Last year, some events arose owing to the pre-election year.
Most importantly, there was a slowdown of economic reform and an
increase of political infighting over the results of the past
decade. There were also disagreements over the righteousness of the
ownership and power systems that had formed in Russia. Strictly
speaking, those issues are only partially associated with the
elections – to the effect that election campaigns bring certain
problems to the foreground, while overshadowing other problems,
even though those problems as such are not created by the elections
(unlike standard variations in monetary and budgetary policies that
are pegged to the electoral cycle).

The government moved ahead in certain important spheres toward
making the Russian economy more efficient. It launched major
reforms of Russia’s Unified Energy Systems and railways, the
pension system, local government, and adopted liberal forex
legislation. A search was initiated for new approaches to
administrative reform, reform in the sectors on the government’s
payroll (primarily education and public health), the creation of a
mortgage system and modern migration legislation.

Most probably, the main obstacles to progression in the
aforementioned spheres stemmed from the government’s inner
problems, rather than from the approaching elections. A certain
amount of fatigue began to show, along with a burden of commitments
and compromises. Furthermore, there was an obvious scarcity of
practical suggestions. Since a pro-government majority has emerged
in the State Duma, bills will be able to pass through parliament
much faster; the executive’s analytical resources, together with
its ability to elaborate legislation, have now become the only
bottleneck in the process.

Only in certain cases were delays in taking the required
measures caused by the pre-election situation. The reform of
Gazprom, the last natural monopoly still unchanged since its
inception not long before the Soviet Union’s collapse, seems to be
such a case. The government commission worked out a concept for the
monopoly’s reform and put the proposals on the cabinet’s agenda
twice, however, both times they were canceled.

The situation was similar to migration legislation. The adopted
populist version cannot effectively regulate migration flows – it
greatly complicates the inflow of citizens of the CIS member states
into Russia, while it does not correspond to the state’s ability to
combat illegal immigration. True, soon after the law was adopted,
the Russian president proposed a list of amendments to it. There is
little doubt that the amendments will be approved, but that has
been delayed until after the elections.

So, it was not the government’s policy that was particularly
influenced by the election campaigns. The election year’s biggest
effect was a steep rise in the authorities’ populist rhetoric and
populist political actions. Such moves will have direct and, most
likely, long-term effects on the activities of economic agents and,
therefore, on the country’s economic developmental prospects. In
this connection, it is worth singling out new and important
phenomena.

POWERS THAT BE AND BUSINESS IN 2003

The situation around YUKOS was the brightest event of the
election campaign period. Its president Mikhail Khodorkovsky had
openly stated his political ambitions, giving the authorities an
excuse for intensifying their attempts to forcibly separate
business and politics and show business its proper place – out of
politics and under the authorities’ control.

The event will have a long-term mixed effect on economic
processes.

In particular, the direct effect of the YUKOS case has been the
escalation of capital flight from Russia. This figure reached $8.6
billion in the third quarter of 2003.2 However, this cannot be unequivocally
interpreted as a negative development. Under the current
macroeconomic conditions, the outflow of portfolio capital is a
positive factor, as it slows down any further strengthening of the
ruble. But the reaction from the business world associated with
direct foreign investment will be predictably different. Presently,
it is hard to draw unequivocal conclusions. On the one hand,
foreign investors who are putting their money into new markets are
used to working with strong-arm (authoritarian) regimes; actually,
they often give them preference over weak democracies. On the other
hand, the situation in Russia is still uncertain and it is
difficult to say with any level of certainty if it tends toward
authoritarianism or democracy – it is uncertainty that strategic
investors find particularly unpleasant.

Some of the reports on foreign investment in Russia are quite
worrying. First, on the whole, capital flight in 2003 substantially
declined (from $8.3 billion in 2002 to $2.7 billion) due to loans
to the banking sector. This seems to be a rather natural
development considering the current energy prices and the weakening
dollar. But in the corporate sector capital flight grew from $10.8
billion to $12.3 billion – $5 billion worth occurred in the fourth
quarter. Second, foreign direct investment went down to $2.5
billion – the lowest amount since 1994 when it was first estimated.
The reasons behind that reversal have yet to be identified more
accurately, though. Perhaps, this was only partially caused by
political factors, as the amount of foreign direct investment in
Russia is so small that even changes in the course of action of one
or two investors can lead to dramatic changes in the overall
situation.

The Russian business community’s reaction has been a nervous
one. The main problem is that it has lost its bearings about the
‘rules of the game’ in terms of its relationships with the state.
The hitch is that virtually any assurances by the authorities will
at best go unheard or, at worst, put businesses on the alert. It is
the practical steps that matter most in the world of business, and
it has to understand them and get used to them. And business will
now closely watch – watch and wait – for practical steps on the
part of the authorities.

Procedural considerations will be quite important in this
respect, not to mention the threat of being kept in custody
during  an investigation. The personal immunity of an
individual is a key problem, and earlier stages of economic growth
provide enough evidence of that.3

Reaction on the part of the Russian business community is also
critical for economic development since foreign capital only
arrives if domestic businesses are actively investing as well. This
is particularly important in Russia where a substantial amount of
capital has been taken abroad and, as a rule, returns in the form
of foreign capital.

The business community’s future structure is yet another
problem. The current political campaign may have a two-pronged
effect. On the one hand, the escalation of anti-oligarch rhetoric
and moves by the law-enforcement agencies weaken (politically as
well as economically) the biggest corporations and strengthen the
positions of small and mid-sized businesses. On the other hand, the
campaign may be perceived as a signal for fighting local (regional)
businesses, which would incur grave consequences for
entrepreneurial activities at all levels. Both trends were obvious
at the end of last year; which one will prevail is hard to predict
at the moment.

Finally, the recent developments surrounding the YUKOS oil
company have given a new turn to theoretical debates in Western
economic publications, which discuss institutional problems related
to the development of the Russian economy.  I mean the so
called ‘state capture,’ which refers to actions by certain
businesses to influence the state’s decisions to their own
advantage.4 It is now clear that
the gravity of the problem was strongly overstated and the
‘business capture’ problem is no less important.5

POPULISM ON THE RISE

Populist rhetoric has intensified and populist parties have
become much stronger. This can be witnessed in the bitter disputes
in Russian society over the results and prospects of the economic
policy, as well as in the list of parties represented in the State
Duma. The clearly populist parties are the Communists of the
Russian Federation, the Motherland bloc and the Liberal Democratic
Party of Russia (LDPR). These either do not have any economic
program or they have a program that is definitely aimed at property
redistribution. In fact, United Russia members have also engaged in
populist rhetoric, although to a much lesser extent. As for the
anti-populist Union of Right Forces (SPS), it has failed to surpass
the 5-percent threshold of the vote in order to secure seats in the
Duma.

There are clear signs of the strengthening of economic and
political populism, together with nationalist rhetoric, and of the
glorification of poverty. There have been calls for imprisoning
certain politicians and business people, as well as demands that
the results of privatization be revised, and taxes and government
expenditures increased. These claims were pronounced in the heat of
the election campaign, but one cannot fail to notice that the
electorate has clearly shifted toward leftist and “restoration”
ideologies.

Restoration here means the sweeping victory of those forces
appealing to the Soviet Union’s past record and success as a
superpower able to wage a war against the whole world. All parties
that have won seats in the Duma have energetically capitalized on
this sort of nostalgia. As for leftist economic ideology, there are
grounds for speaking about this idea in connection with two
important issues in the election polemics.

First, a revision of the privatization results was clearly put
on the agenda. Even though a large-scale revision is unlikely, the
voters have shown a large interest in this issue – including
Muscovites. It looks like this possibility has made the Moscow city
authorities greatly worried; it made Moscow’s Mayor Yuri Luzhkov
publicly regret that the SPS and Yabloko have not made it into the
Duma, even though the Mayor’s relations with the SPS leaders are
rather complicated. Actually, the results of Russia’s controversial
privatization equally concern the business tycoons and
politician-tycoons, Mayor Luzhkov being an illustrative example of
the latter – any revision of privatization in Moscow would be
fraught with grave consequences.

Second, the forces favoring higher taxes enthusiastically
expressed their views for the first time. Whenever the Communists
insisted on increasing government expenditures, they failed to
mention the particular mechanisms for attaining such a goal. The
Motherland bloc has openly called for an alteration of the tax
system, together with higher taxation. If successfully enacted,
this would waive an important achievement of President Vladimir
Putin’s first term as president – the flat income tax rate. Time
will tell how serious these demands are, but the very fact that
they have been forwarded says quite a lot.

In a way, the success of populist rhetoric was a reaction to the
crises and hardships of the last decade. In the past, when the
threat of an economic catastrophe was great, the bulk of voters
backed the more prudent political forces. But now that the economy
has been growing for five years running, it is easy to get the
illusion that it is possible to relax and play populism by
supporting those who promise “a lot and quickly.”6

With respect to Russia it would be premature to say that this
course has been chosen. Even though populist parties were
successful in the parliamentary election, United Russia has won a
majority in the State Duma, while it claims to be in the
right-center of the political spectrum. Presently, there is not
enough evidence to draw the conclusion that it will be a
right-center party, but its very intention to be guided by rightist
values gives the country a chance to avoid Latin American-style ups
and downs.

NEW POLITICAL SYSTEM

For the first time in Russian history, one party enjoys an
absolute majority in parliament, while not being the only party
there. No matter what is said about this party and the reasons
behind its electoral success, it cannot be denied that a
fundamentally new situation has emerged, unprecedented in Russian
politics. This factor requires a thorough analysis since it may
have an ambiguous effect on the country’s economic and political
development.

Above all, the constitutional history of modern Russia has made
a new turn. The main responsibility for decision-making and
drafting legislation now moves to the executive (the president and
the cabinet). The Duma majority will automatically stamp submitted
bills, without analyzing them in detail – the latter is only
possible in political debates, when a coalition majority has to be
formed for the adoption of each draft law. The adoption of the 2004
budget clearly showed new mechanisms for passing bills through
parliament: even before the draft budget was submitted to the Duma,
a ‘zero reading’ had been held by those factions that jointly
formed parliamentary majority. Following this, the Duma approved
the draft budget with hardly any amendments.

The emerging constitutional situation may develop according to
either of three possible scenarios, as follows from the history of
parliamentarianism.

First, Russia may establish a one-and-a-half party system
similar to those installed in Japan and Italy after World War II.
After a period of acute parliamentary struggle in those countries
there emerged much larger parties which were ideologically
inconsistent and were comprised of incoherent hostile factions.
Yet, they were united by two main goals: that of retaining power,
and preventing leftist forces from coming to power. Ideological
principles are of secondary importance in this case. This model has
a certain internal dynamic which may ensure successful economic
development, as well as a relatively sustainable political
development. Political crises may occur, but they are usually
isolated events within the party and are resolved through the
redistribution of posts amongst the various factions. However, the
model has a serious drawback: it instigates corruption. This is a
rather natural occurrence when a party stays in power for a long
time and cannot be replaced by an alternative political force.

Another option is based on the British parliamentary model. As a
parliamentary majority is formed, the executive power concentrates
virtually all decision-making levers, automatically having its
initiatives approved by parliament. The prime minister has
extensive real powers and can take virtually any decision
(including the dissolution of parliament). True, in today’s Russia
that power is mostly vested in the president, but the prime
minister can also play an important role. Naturally, this course of
events is only potentially possible for the time being. For the
model to be realized there should be an alternative political force
which the electorate can vest with authority during a general
election. Unless there is an alternative, it is the same
one-and-a-half party system.7

Finally, it cannot be ruled out that unfavorable developments
may lead to authoritarianism with the existing Constitution
remaining in effect.

In general, the attitude to the Constitution will be one of the
main criteria for estimating the nature and prospects of the
political and economic models in Russia. Making sure that the
Constitution remains unchanged is a most important condition for
the gradual formation of a stable democracy. Really, the process
rests not so much on the letter of the Constitution as on the
inviolability of the ‘rules of the game’ (naturally, if they are
democratic in principle). The strengthening of democracy in Russia
requires that it develop corresponding traditions. The present
Constitution provides such a foundation for this.

ECONOMIC POLICY AND ECONOMIC GROWTH

Economic growth was the focus of economic and political debates
in the country throughout last year. In his address to the Federal
Assembly, the president set the objective of doubling the country’s
GDP over 10 years, provoking debates on whether that goal can and
needs to be attained.

Alteration of the growth model. The main news was a reverted
trend in economic growth. Throughout 2000-2002, the growth rate had
been declining, as well as the investment rate, instigating the
sharp criticism that the policies of the government were
inefficient. The government was accused of being unable to take
advantage of a favorable situation in foreign trade.8

Last year’s results allow us to cautiously suggest that a shift
has begun toward a new economic growth model. The GDP growth rate
was up to 6.7 percent in 2003 from 4 percent in 2002, while the
investment volume grew by 12 percent; this number stood at a mere
2.5 percent in 2002. The machine-building sector’s output was up
8.5 percent, the second highest figure after the fuel industry.
Imports of machinery substantially increased, contributing to the
technological renovation of the economy. But it is still premature
to draw the conclusion that a new growth model has been formed.

First, the structural effects of the investment boom are not
obvious or, in other words, it is not absolutely clear whether this
boom reflects the growth potential of all sectors of the national
economy, or is mostly the result of a favorable situation in
foreign trade. Last year the fuel industry continued to dominate in
the overall investment volume – its share was 21-22 percent, as in
2001 and 2002. It was followed by investment in transport (17
percent), public utilities (15 percent), power engineering (5
percent), the food industry and communications (4 percent each),
ferrous metallurgy and machine-building (more than 3 percent each).
The fuel and energy sector’s dominance cannot be described simply
as a negative factor, however, as it can become a driving force for
other sectors.

Second, the stability of any new trend that may lead to
investment growth depends on many factors, most importantly on the
authorities’ ability to create favorable conditions for domestic
and foreign investors. This factor is still open to question, and
the political events in the second half of 2003 certainly did very
little to clear up the situation. Presently, it suffices to say
that Russia is at the initial stage of transition to a new phase of
economic growth that is based on attracting new investment.

This transition is very vulnerable in political terms, due to
two trends. On the one hand, the consolidation of power is
underway, and the government direly needs economic growth from
which it needs – and is in position – to derive maximum dividends.
On the other hand, deep-rooted political stability is lacking, and
there is a high degree of distrust among the main parties of the
economic and political establishments – the state, owners and
employees (they are all lacking the necessary ‘credit history,’
both in economic and political terms). On the surface, it seems
that stabilization is in place and the political situation is
favorable for business activities. But there is a conflict between
the authorities, who are looking to secure immediate economic
dividends, and the business community. The authorities start
looking for a guilty party in the business or political community,
thus further aggravating the situation by creating obstacles to
economic growth.9

Under modern conditions, general attitudes of discontent with
politics are supplemented by the situation on the global markets,
which adds to the illusion of stability. Yet, external economic
factors under these conditions are not so much a source of
stability as additional threats to a positive shift in growth. On
the one hand, the situation with export prices adds uncertainty, as
price dynamics are unpredictable for the time required for making
economic and political decisions. On the other hand, a favorable
price situation tempts the government to shift from cautious
economic (primarily budgetary) policies to populist solutions. It
is not surprising that populist rhetoric steadily intensified
throughout last year.

Debates on growth policies. Against this backdrop, heated
debates were opened on the nature and prospects of economic growth.
Since the issue of economic growth is an opportunity for various
political forces to lay their claims to power, last year’s increase
in the growth rate from 2002 certainly did little to dampen the
enthusiasm of the parties involved.

The debate focused around growth rates, structural changes, the
prevalence of raw materials in exports, and the development of new
sectors. The objective of doubling the GDP in ten years encouraged
debates on the various ways for attaining this goal. The question
was asked if such a jump was compatible with economic
restructuring, and what was the role of particular instruments in
ensuring this accelerated growth. Moreover, a concept for
accelerated growth was on last year’s agenda as one of the most
pressing issues.

The government proposed its view of the problem which was in
line with the logic it had adhered to during the past three years.
In fact, it outlined a set of macroeconomic, institutional and
sector-specific measures constituting an extensive plan of
action.

In the macroeconomic sphere, it proposed pursuing a cautious
policy aimed at ensuring monetary and financial stability,
including a balanced budget and a floating exchange rate. Actually,
the government’s budgetary policy has been sharply criticized by
those favoring populist solutions and demanding that budgetary
funds (and even the Central Bank’s reserves) be implemented to
speed up growth and achieve economic restructuring. But even when
high growth rates are successfully fulfilled, government leaders
are accused of impeding the growth of a country’s economic
might.10  It is true that
every government that pursues a conservative policy inevitably
faces this type of criticism.

Institutional policy last year was in line with the course of
the previous years. Certain progress was made in the reform of the
natural monopolies (with the exception of Gazprom) and pensions.
There was a general improvement in budgetary legislation (first and
foremost, with the formation of a stabilization fund), as the
formation of a guaranteed system for bank deposits of private
individuals, the liberalization of currency legislation, the
adoption of laws regulating foreign economic activities, etc., went
into effect. In other spheres involving administrative and
budgetary reform, the reform of social welfare, and military
reform, the preparation of basic concepts and the required
legislative foundation were intensified. In general, much of the
necessary groundwork for progress has been laid, but several more
years will be required to realize the plans in their entirety.

Sector-specific problems are the most complex issues of modern
economic policy. While the government is proceeding with the course
outlined in its Strategic Program adopted in 2000, it decided not
to define priorities for particular sectors with the purpose of
translating them into budgetary subsidies. This policy is in line
with the specifics at this stage of technological development, when
it is virtually impossible to a priori define promising sectors and
allocate financial resources to them in a centralized manner.
Therefore, traditional measures of industrial policy that were
typical of the first half of the 20th century – such as
‘handpicking the winners’ and fixing sectors that would receive
priority financing from the budget – look unacceptable.11

Meanwhile, the diversification of production and exports,
together with the accelerated development of ‘new economy’ sectors,
tend to become the key issues. In this connection, it has been
proposed that sector-specific measures, different from the general
(macroeconomic and political) instruments used to ensure an
investor-friendly climate, be applied. This does not mean special
support for particular sectors and enterprises. An example of this
approach would be the creation of special economic zones where
businesses are offered particularly favorable terms for investment
and production (a simplified administrative regime, tax breaks). It
is a specific feature of this approach that priority enterprises
are not defined, and incentives are offered to any enterprise
meeting a set of certain criteria.

The application of special mechanisms for encouraging growth and
diversification is a hot issue inside the government. Clearly, the
fiscal and tax agencies are skeptical about such ideas, fearing
that they could lead to numerous financial offenses typical of
Russia in the 1990s. Naturally, the possibility for such offenses
should not be overlooked when related decisions are made. But it
should also be taken into account that during the past several
years, the state’s administrative resources have grown, thereby
increasing its abilities for promoting economic growth. It is
necessary at this point to discard the practice of ‘handpicking the
winners’ in advance.

So the government’s economic policy concept has focused on
creating the required institutional preconditions and ensuring
macroeconomic stability as a foundation for economic growth. This
approach is expected to ensure sustained long-term growth targeted
at real, rather than artificial (imposed by state officials or
lobbyists from particular sectors) priorities. But the model is
politically vulnerable. It is not devised to impress the public.
Rather, it calls for lengthy, painstaking and the rather tedious
job of ‘cultivating’ institutions. Furthermore, the model depends
on a relatively stable situation in the external markets. High oil
prices, for example, will significantly slow down positive
structural changes.

An alternative view of mechanisms for instigating economic
growth and restructuring – an approach upheld by the leftist forces
– has been expressed most consistently by the Motherland bloc. The
bloc’s program includes a range of standard macroeconomic steps
that are typical of left-leaning populist parties and governments
in Latin America in the 1930-1950s. Its main provisions are:

  • redistribution of property and revenues (to “ensure
    justice”);
  • higher taxes (the Motherland bloc has focused on the need to
    return to progressive taxation for the income tax and royalties
    first and foremost);
  • an energetic industrial policy, the defining of priorities
    (sectors of “national pride”), and their support from the budget
    and tax breaks;
  • the withdrawal of extravagant profits from the “compradora
    bourgeoisie,” in fact, from all of the export sectors, and using
    them in the priority sectors. Levying of natural resource rent
    (particularly in the fuel and energy sector) and using it for
    “national interests;”
  • macroeconomic destabilization, which would include waiving the
    federal budget surplus and allowing a deficit of up to 3 percent of
    the GDP with funds allocated for increasing the state’s demand; it
    has also been proposed that the Central Bank’s reserves be used for
    economic enhancement purposes; 
  • a partial revival of the state-supervised regulation of
    prices.

Latin America’s past record shows that this policy is extremely
dangerous, even at the industrial development phase. Nations that
have followed such a formula failed to even partially close the gap
and catch up with the economically developed nations, while several
fell behind even more than was previously the case (e.g.,
Argentina). A brief period of economic growth (which was registered
in only some countries) was followed by grave economic and
political crises. Solving crises that were initiated by populist
policies was always painful, and in most cases was accomplished
only through a military coup.12

Such arguments give me serious reservations that this sort of
policy can be efficient in modern Russia.

In the event that this course is pursued, the choice of
priorities will inevitably be a result of interaction of corrupt
government officials and lobbyists from traditional sectors which
are the wealthiest ones and have the resources for imposing their
will on the state. But even if a totally transparent system for
choosing priorities was in place, picking priority sectors would be
impossible for the primary reasons mentioned
above.    

The rejection of the flat tax rate would mean a radical review
of the tax policy consistently pursued during the past several
years, that is, a policy aimed at streamlining the tax system,
shifting from progressive to flat tax rates, and annulling tax
breaks. The reasons for following this course of action was not so
much due to the government’s liberal ideological guidelines, as to
its intention to bring its economic (including tax) policy into
line with the state’s ability to ensure the observance of law.
Above all, this inability to use intricate tax instruments – in
particular, to collect progressive taxes – prompted the government
to adopt flat tax rates. The positive effects that this move has
had on the budget surpassed all expectations. A rejection of those
principles would mean a return to the situation when the state’s
demands failed to correspond to its ability to collect taxes, with
fiscal efficiency sacrificed to leftist ideas of ‘social
justice.’

Any proposals that the natural resource rent be withdrawn and
redistributed are also quite dubious. It is not that the idea of
the government receiving higher revenues from those sectors
producing and exporting natural resources is wrong – under the
current prices in the global markets, this is quite possible. But
there are certain questions that demand answers. Unless they are
adequately answered, it is impossible to prudently discuss higher
taxes in these sectors.

First, revenues from natural resource rent depend on whether
world prices are high. But how the state is supposed to receive the
necessary funds after global resource prices drop is open to
question. This would prove to be particularly important should the
price situation worsen after a certain time period during which the
Russian economy had become strongly dependent on oil revenues –
much more dependent than it is today. Actually, that is why the
Soviet Union collapsed – in the 1970s, the leaders believed that
the prices of natural resources would indefinitely remain at very
high levels, and they adjusted the economy to that price level. But
when the prices suddenly dropped, that system collapsed.

Second, it is particularly important to consider how those extra
revenues are used. Should higher taxes on the export sectors be
accompanied by a reduction of the overall tax burden? Or is the
move only aimed at increasing state revenues?

Third, there should be clarity about the mechanisms used for the
withdrawal of windfall revenues from sectors producing natural
resources. In this case, windfall tax differentiation is required
to accommodate the terms for businesses which should get a tax
return that corresponds to the costs of extracting natural
resources. Such an approach would mean the return to the days when
a bureaucrat decides what tax rate is fair in each particular case,
i.e. it can instigate corruptive practices of state policy with
respect to natural resource producing sectors. This would be one of
the most obvious and dangerous effects of the rejection of the
unified mineral production tax in its current form.

The above considerations are not absolute arguments against
applying higher taxes to the producers of natural resources. When a
selling price is favorable, this can be an expedient move, but it
should be carried out in a manner that would not aggravate
corruption nor make the state budget more dependent on fluctuations
of energy prices. It is quite possible to get higher revenues from
the fuel and energy sector, while at the same time adhering to a
common approach: by marking up the unified mineral production tax
rate and export tariff rates, together with an institutional reform
of Gazprom.

Finally, the debate on windfall earnings from natural resources
has mostly been a political debate and has had little to do with
real actions by the politicians. This became evident last June when
the State Duma voted on the government’s proposal to mark up the
rate of the unified mineral production tax, which would have
leveled off the profitability for the producers of mineral
resources and other sectors. Both left and center factions voted
against the proposal, including those whose political campaigning
is based on calls for taxing windfalls.

Administrative reform. Improving the efficiency of
decision-making by the authorities is a priority for making their
economic policy more efficient. The state’s inability to attain its
goals and ensure the observance of the law has seriously limited
its choice of economic policy instruments. Last year the government
attempted to focus on this problem.

Administrative reform is among its top priorities. The potential
for ensuring sustainable growth through economic levers proper has
been virtually exhausted. The efficiency of economic legislation
has been declining in a sense that each new improvement of the
legislative base regulating economic life will have increasingly
less effect under the current system of political institutions. One
can endlessly perfect banking legislation, engage in deregulation
or fine-tune labor legislation, but this will be senseless unless
the situation improves in spheres like public administration, the
judicial and law-enforcement systems, not to mention military
reform.

This entire issue has been pressing for some time already. There
was a provision devoted to the different ways for improving the
performance of the government agencies in the strategic program
that was adopted in 2000, but it was decided instead that the
government’s program should focus on economic issues. In late 2002,
the government started paying more attention to administrative
reform, and in the second half of last year a commission headed by
deputy prime minister Boris Alyoshin was formed. His group began
analyzing in detail the functions of various government agencies
with the purpose of streamlining and optimizing them.

The progress of administrative reform has been significantly
complicated by two specific features. First, this reform will take
a lot of time. It will produce effects, but gradually, as the
‘rules of the game’ change in the state machine, together with all
of its traditions, customs and even generations of employees, which
is by far more important than just an alteration of a legislative
base. Unlike tax reform, administrative reform cannot quickly yield
visible results, and a government implementing such reform has to
be able to see far and wide.

Second, administrative reform is being carried out by government
officials, i.e. by those it concerns most of all. This is at odds
with the general principle of any reform: players should not
establish and enforce the rules, nor should they be the arbiters
when assessing their own performance. Clearly, army generals should
not carry out military reform, but it would be wrong to draw an
analogy and say that administrative reform has to be performed by
other public servants; in this situation, there really is no other
choice. But this puts a serious brake on reform, and the country’s
top leadership has to clearly express its political will for
administrative reform to be accomplished.

It would be wrong to reduce administrative reform to simply
reforming the structure of the executive and the number of
ministries and agencies. This reform is a complex problem with a
whole range of serious objectives, including the following main
ones:

  • reform of public service sector with the goal of increasing the
    efficiency and responsibility of public officers;
  • refining, streamlining and elaborating the functions of the
    different ministries and agencies. This would include a separation
    of political and control functions, and services;
  • reform of budgetary spending as a structural (not fiscal)
    reform, with the purpose of increasing its efficiency by modifying
    the allocation rules and procedures, as well as restructuring the
    budgetary expenditure pattern;
  • job cuts in the public sectors; despite market reform, the
    number of public employees has been steadily growing.

Last year, the commission for administrative reform mostly
focused on the analysis of those functions performed by government
bodies. During the past two or three years, reform of state service
and public spending has also been conducted.

Having focused on functions, Alyoshin’s commission has declined
to deal with the formation of a new, ‘optimal’ structure of
ministries and agencies. Really, this would have been rather
senseless, even if for the reason that in a democratic society, an
optimal number of agencies and interrelation of their functions is
not a problem13– there should be
as many as required to ensure stable support for a cabinet in
parliament. In an extreme case, a special agency can be created to
perform each particular function or, on the contrary, all functions
can be concentrated in one agency (a super ministry). A practical
solution actually lies somewhere in between.

What must be achieved now is agreeing on a concept for an
efficient state administration system, together with an
understanding of its functions. An important step at the conceptual
level agreed that one body should not combine such functions as the
drafting of a policy, the implementation of rules and norms, and
control and inspection. This is the right approach, otherwise a
conflict of interests arises that works along a well-known scheme:
first an agency adopts particular rules that are impossible to be
observed, and then it fines (or takes bribes from) the offenders.
The private sector should be assigned the functions it can perform.
For instance, it has been decided that the inventory of real estate
can be performed as a service in the market (that function has been
performed by the notorious BTI state-controlled inventory bureaus).
Similar proposals have been made about vehicle inspection – the
Interior Ministry has monopolized this market with quite grave
consequences. In principle, it would be important to strip control
agencies of the right to suspend the functioning of businesses
without a court verdict.

The following steps in the administrative reform framework would
be important. They would limit – and increase –- the efficiency of
the state’s interference in the economy:

  • the drawing up and introduction of a system of budgeting based
    on past results, i.e. appropriation of funds from the budget for
    clearly defined goals;
  • ensuring open access to information on the activities of state
    government bodies;
  • the introduction of a system requiring that government agencies
    proposing new forms of state interference in the economy should
    publicly substantiate the need for it;
  • the introduction of procedures for periodic efficiency
    assessments of state regulatory measures. This would include the
    rejection of certain measures of regulation on the results of those
    audits;
  • increasing the efficiency of state property management;
  • total rejection of the overlapping of functions between
    government agencies and business entities;
  • the drawing of a legislative base for the activities of
    self-regulating organizations which should take over part of the
    functions now performed by the state.

Finally, an analysis of the state-performed functions will have
to be followed by huge efforts aimed at updating a vast number of
legislative measures now regulating the state machinery’s
functioning. There are many such documents – from federal laws to
endless departmental instructions. One of the main purposes of
these myriad documents was, in fact, to provide certain grandeur to
a particular agency (or its head).

Administrative reform has just started and a lot more has to be
done. One thing is certain: it will be a laborious effort, both in
technical terms (a vast amount of documents will have to be
analyzed) and political terms (too many interests are
involved).

PRIORITIES FOR THE UPCOMING PERIOD

The summing up of last year’s results requires that priorities
should be defined for this year and into the future, that is, for
the whole of the next political cycle.

Those issues have been actively debated in the presidential
administration, the cabinet, and among economists close to the
cabinet since last summer. In particular, the following panels were
involved in debates:

the cabinet proper and its experts who drafted law-making
priorities for 2004 and beyond; the Commission for Administrative
Reform has played a special role;

a working group led by the president’s deputy chief of staff
Igor Shuvalov; initially it was comprised of representatives of the
various political forces and social groups in order to identify and
elaborate on the most important socio-economic development issues
which could enjoy wide public support and, therefore, be put on the
list of priorities for the next four years. Five priorities were
laid out during the preliminary discussions – reform of education,
public health, developing a mortgage market and private housing
construction, military reform (primarily in terms of resolving
social problems of the military), and resolving the Kaliningrad
region’s problems. Leading analysts and government officials have
started their intense elaboration.

Russia’s Ministry for Economic Development and the Center for
Strategic Research (CSR) which are closely associated. As in 2000,
the CSR has become one of the main organizations for initiating
broad public debate on economic policy issues. Work has been
started there on a number of important regulatory documents that
may be submitted to the Duma after the presidential election.

Importantly, the above groups have close interaction and they
cannot be regarded as alternative groups. They rather supplement
each other.

The following issues are among the top priorities for advancing
economic reform in the mid-term run:

1. Administrative reform as a precondition for increasing the
efficiency of state administration, including the realization of
the economic policy proper.

2. Completing the elaboration of a sound economic plan and
launching a large-scale reform in the budget sphere.
Decision-making procedures should be revised in that sphere. It is
necessary to develop budgeting based on results, modify allocation
procedures and the expenditure pattern (the list and status of
organizations and their functioning principles). It would be
essential to gradually shift to mid-term budget planning. Reform of
public spending was supposed to follow tax reform, yet no progress
has been registered during the past two years.

3. Elaboration of a concept for overcoming the Russian economy’s
dependence on natural resources and its transformation into a
package plan.

4. In pursuance of the above two points (reform of budget
spending and diversification), work should start on making the
public health sector more efficient. That sector, along with the
humanitarian effects, can generate a significant boost and promote
the development of other sectors of the Russian economy: it would
create a demand chain in many other sectors and industries, and
that demand would be real. A shift to personal insurance plans is a
key direction here.

5. Substantial progress has to be made in military reform,
primarily in terms of recruitment to the armed forces. This is
important from the political and military standpoint, but also in
economic terms: accomplishing a post-industrial breakthrough is
hardly compatible with diverting young people from energetic
creative activities for a long period. Discussions conducted in
2002, combined with more openness concerning defense spending in
the 2003 budget, provide a basis for more resolute steps toward a
professional army.

6. Continuation of reform of the natural monopolies.

7. The completion of negotiations on WTO accession and adopting
the required legislation. Delaying the negotiations threatens an
indefinite delay in joining the organization in connection with
plans to reform the WTO.

8. Perfecting the legislative and regulatory base, and making
the functioning of financial institutions more efficient. The
banking sector’s reform with the goal of making it more reliable.
However, the issue can only be resolved in full measure as the bulk
of economic players (companies, banks, citizens, and the state)
gradually receive a credit history.

9. Refining Russia’s policy vis-?-vis the EU as its main trading
partner. Last year it became clear that in the foreseeable future
the EU will be bogged down in its own problems (expansion, common
currency) and will be unlikely to be able to actively deal with
Common Economic Space issues. This makes it even more important for
Russia to decide what European legislation is acceptable and
proceed with its law-making accordingly.

Finally, protecting what has already been achieved and formed
has grown increasingly relevant. This concerns both the general
principles for the country’s functioning and within its
institutions. In the political sphere, preserving a democratic
system and the 1993 Constitution are top priorities. In the
economic sphere, keeping the tax system that emerged in 2000-2003 –
with low flat tax rates and minimal exemptions – ranks as one of
the most critical problems.


1 See: Alesina A. Political
Models of Macroeconomic Policy and Fiscal Reform. Washington D.C.:
The World Bank, 1992.

2 Compared with a net inflow of
$3.6 billion in the second quarter.

3  The adoption of the
Habeus Corpus Act in England at the end of the 17th century, which
guaranteed immunity to an individual, is often mentioned among the
main factors behind the start of modern economic growth – even
though political rights remained a minority’s privilege for another
two ages. A similar case has been cited about the New Economic
Policy period in Soviet Russia: A lawyer asked an entrepreneur if
business people would take their money to banks after the adoption
of a decree guaranteeing the protection of money in bank accounts.
The answer was negative, because no one guaranteed “the account
owner’s immunity.” (Mau V. Reforms and Dogmas. Moscow: Delo, 1993,
p. 120 – Russ. Ed.)

4 Hellman J., Janes G.,
Kaufmann D. Seize the State, Size the Day: State Capture,
Corruption, and Influence in Transition. The World Bank. Policy
research working paper – 2444. Washington D.C.: IBRD and EBRD,
2000.

5 In many respects, the debate
reminds discussions of a virtual economy concept, which was
extremely popular in Western literature between 1997-1999. It
looked like a universal theory was discovered, explaining all
problems of the Russian economy for a long period. But after the
1998 crisis it turned out that those conjectures were not based on
reality – the ruble’s devaluation alone smashed the theory to
pieces.

6 This reaction is well known
in Latin America. When people are sick and tired of political
forces that have stabilized the economy and ensured economic
growth, they elect left populists. The latter bring the country to
an economic crisis and new problems make people bring right
liberals back to power.

7 For comparison of
constitutional systems of modern Russia and Britain see: Mau V. The
1993 Constitution and Economic Reforms in Russia // Constitutional
Law: Vostochnoyevropeiskoye obozrenie, No. 3, 2003 – Russ. Ed.

8 There was another explanation
for the declining dynamics. It was based on the analysis of the
so-called recovery growth. (The Russian Economy in 2002: Tendencies
and Prospects. Moscow: IEPP, 2003, pp. 10-13 – Russ. Ed.) In line
with that logic, after a deep slump and lengthy recession, the
first growth phase is related exclusively with political
stabilization, recovery in demand and the commissioning of idle
capacities. Naturally, as available resources are used up, the
growth rate inevitably declines. A new rate increase occurs later
and is based on intensified investment activities, that is, when a
transition takes place from growth based on available capacities to
growth based on new investment. No one can predict when this
transition can be accomplished, as it depends on a whole range of
factors determining a country’s investment climate.

9 This was the course of events
at the end of the 1920s. The Soviet political leadership was
displeased at a slowdown of economic growth rates. It charged
private businesses with intrigues and accused many prominent
economists and government officials of sabotage. This meant an end
to the New Economic Policy and a shift to coercive
industrialization, which resulted in huge casualties.

110 A typical example in
Russian history was a policy pursued by the then Minister of
Finance and later Prime Minister Vladimir Kokovtsov between
1909-1913 – he was accused of having focused too much on financial
and monetary stability to the detriment of economic growth, whose
rate was around 6 percent a year at the time. (See: Kahan A.
Government Policies and Industrialization of Russia // Kahan A.
Russian Economic History. The Nineteenth Century. Chicago and
London: The University of Chicago Press, 1989).

11 For more detail on the
issue see: Mau V. Post-Communist Russia in the Post-Industrial
World. Voprosy Ekonomiki, No. 7, 2002 – Russ. Ed.; Breach A.
Broadening Horizons: Russia’s Road to Prosperity in the
Post-Industrial World. Brunswick UBS Warburg. Global Equity
Research. January 31, 2003.

12 Classical criticism of
populist economic policies can be found in: Dornbusch R., Edwards
S. (eds). The Macroeconomics of Populism in Latin America. Chicago
and London: The University of Chicago Press, 1991.

13 An ‘optimal’ number of
ministries can only exist in a totalitarian system. It was not
accidental that the Soviet Constitution of 1936 contained a special
article with a whole list of people’s commissariats (ministries).
As soon as the first gleam of democratization emerged, the article
was dropped.