Russia Needs Reform, Not Higher Taxes

Friday, October 30, 1998

By defaulting on its debts and devaluing the ruble simultaneously on one day in August, the Russian government wiped away the only two achievements of economic reform since the collapse of communism—a stable currency and controlled inflation. Since then, Russia’s economy has been in a free fall as the ruble falls, prices soar, goods in stores disappear, banks close, and people begin to wonder how they will survive the winter.

The Russian government and the IMF had a plan to avert this short-term financial crisis—a plan that attempted to redress Russia’s financial imbalance primarily by raising taxes. Had the Russian government proved capable of implementing the program, the August financial collapse might have been avoided. In the long run, however, even the IMF-backed plan for macroeconomic stabilization would not have produced real economic reform in Russia without accompanying progress regarding microeconomic reforms.

The problem with the IMF-inspired prescription for raising revenues is that the Russian economy produces little to tax. Russia does need a more rationalized tax code, which might help collect revenue from the handful of oil and gas companies that do generate profits. But the vast majority of Russian companies are bankrupt and have been operating at a loss for several years. Neither the $22.6 billion IMF bailout nor the Yeltsin government’s so-called anticrisis program of July 1998 addressed this deeper cause of Russia’s economic problems: poorly defined property rights and the consequent dearth of profit-making companies.

In 1992, the Russian government began an ambitious effort to privatize most of the economy. Two years later, Russia (and its Western advisers) trumpeted the program’s success as more than 100,000 enterprises were declared to be in private hands. Although speedy, this privatization program did not produce effective owners or profitable enterprises. Instead, insiders—that is, Soviet-era enterprise directors in cahoots with trade union officials loyal to them—gained controlling shares at three-quarters of all large enterprises. These insider owners were interested first and foremost in securing control of their companies and thereby maintaining their jobs. Attracting investment or expanding market share were distant, secondary concerns.


The underlying causes of Russia’s current economic problems are poorly defined property rights and the consequent dearth of profit-making companies.


Because these directors do not report to outside shareholders interested in profits, they have avoided pressure to become more efficient, to downsize, and to improve their products. Through complex arbitrage schemes, delays in paying workers, and stripping assets, these directors can amass individual wealth while their companies continue to operate in the red. Under market conditions, the companies would be forced into bankruptcy; their assets would be reorganized and auctioned off, and either new owners interested in making profits would assume control or the enterprises would be shut down. In Russia, however, bankruptcies rarely occur. Instead, the state continues to subsidize ailing companies, initially through direct state transfers and now by allowing those companies’ taxes or bills owed to other enterprises to go unpaid.

Given these conditions at the grass roots, the Russian government’s plan to raise revenue will not have any sustainable effect. No matter what the tax rate, you cannot generate revenue by taxing bankrupt businesses. Collecting taxes from the handful of companies that do generate profits is a necessary but short-term solution. After all, most of these profit-making companies are owed huge sums from the same government-supported, bankrupt enterprises.

At some point, the Russian state must break this vicious cycle by enforcing bankruptcy procedures as the first step toward restructuring enterprises, establishing real property rights, and ultimately finding new, more responsible owners for the country’s industries. The new owners, it must be remembered, will invest only under the right conditions, which include lower interest rates, state protection of their property, and lower—not higher—taxes.

Those with a stake in the status quo are quick to warn that embracing a true free market risks creating more pain for the people and igniting social unrest. When companies are allowed to go bankrupt, workers lose their jobs. But, in contrast to Russia’s first attempt at privatization, this next attempt should not be undertaken at all enterprises simultaneously. By moving more methodically, the government can build a case that bankruptcy is necessary to clear away growth-stifling debt and to make companies more productive.

Here is where Western assistance can be most useful. Instead of allowing the government to keep bankrupt companies afloat, Western money can help construct a social safety net so that Russian companies can get out of the welfare business. Without this fundamental shift, enterprise directors will continue to blackmail the state by threatening mass layoffs of workers and the workers will continue at their jobs even if they are paid sporadically. And investors will keep their money elsewhere.

A social safety net in Russia would be expensive but surely not any more expensive than the current IMF bailout. Twenty-two billion dollars would pay for a lot of unemployment checks and job retraining programs. Carrying out these reforms would take years, if not decades. And they can occur only if the IMF remains engaged in Russia for the long haul. But Western assistance should continue only if the Russian government is committed to allowing true private control of its industries. The consequence of continuing to subsidize bankrupt enterprises will be even more expensive bailouts down the road—no matter how high the tax rate climbs.