The immediate options in a situation where revenues fall and expenditures rise would be to increase the budget deficit or taxes. Both options will impair Russia’s economic growth and would drain the resources for development, thus reducing stimuli for private investment. The government made a strategic decision to avoid both solutions.
For the next few years, Russia’s fiscal policy will be largely determined by several important factors.
Firstly, it is high time Russia finally overcame the repercussions of the 2009 economic downturn. When the global financial crisis hit, the Russian government dramatically increased spending while at the same time cutting revenues, for example, by reducing the profit tax. Given the emergency situation, they removed all restrictions on spending commitments. Moreover, some of their additional expenditures were not one-off payments, as is usually the case with anti-crisis programs – they were fully fledged long-term programs. Consequently, aggregate spending was increased by more than 3 percentage points of the GDP. In 2011-2012, Russia’s budget policy shed most of the irregularities that were added during the recession. This process needs to be carried through, which means streamlining the procedure for taking on spending commitments – something that became rather chaotic after 2008.
At the same time, we should bear in mind the danger of another wave of the crisis. Many economists believe that Greece is likely to withdraw from the eurozone within a year, which would seriously affect the European and global economies, as well as the global financial system.
The next important factor which needs to be taken into consideration is an impending reduction of government revenues in terms of percentage of the GDP, starting next year. This will be a long-term trend now that the physical volume of Russia’s crude production has stabilized and will remain at the same level according to the government’s estimates. In previous years, this effect was offset by growing oil prices. However, once the oil price falls, or at least stabilizes (which is predicted by the new budget forecast), the oil industry begins to account for a lesser share of the economy, which automatically sends government revenues down, because the tax burden in the oil industry is 150% higher than elsewhere.
Finally, in the next three years, military spending will grow due to a major government armaments program. The plans to raise the salaries of teachers, doctors and other public sector workers, in compliance with President Vladimir Putin’s directives in May 2012, will also burden the federal budget with additional spending. On the other hand, these social obligations are mainly to be financed by regional and municipal governments.
The immediate options in a situation where revenues fall and expenditures rise would be to increase the budget deficit or taxes. Yet, both options will impair Russia’s economic growth, because both would drain the resources for development, thus reducing stimuli for private investment. With this in mind, the government made a strategic decision to avoid both solutions. Vladimir Putin cited this decision in his pre-election articles and later in his state-of-the-nation address. Moreover, next year, we will return to strict budget rules. Government spending from then on will be based on the average oil price over a long period of time, rather than on its expected value. This approach will significantly reduce the dependence of the budget and of the economy on oil market fluctuations, because government spending will no longer be linked to the current oil price. Any surplus earned in a favorable market will be saved in the Reserve Fund, providing a safety cushion for a potential decline of that market.
It will not be easy for the government to follow tight rules while at the same time fulfilling its social obligations. The next two years are bound to be the most difficult, because effective spending will remain flat and will only grow by the same margin as inflation. These will be the transitional years. Starting from 2015, the government will be able to comply fully with its budget rules, and the federal budget is expected to be balanced by that time.
One effective cost-cutting measure is more efficient spending. There is obvious room for this, and some possibilities have already been discussed. One obvious issue is state procurement, where the government incurs annual losses of up to 1 trillion rubles due to inefficient spending. Large-scale change is planned in the state procurement system. The Russian government’s spending on road construction and other government investment is especially inefficient, compared with similar projects in other countries. The government has introduced a policy aimed at improving this practice, which involves new incentives for the recipients of government money. One of the cornerstones of this policy is “program budgeting” which implies that all expenditures will be held up against the effect they were meant to achieve. As a result, the entire public sector, as well as specific companies and agencies entitled to government financing, should become more effective.
Regional governments will also face the task of cutting inefficient spending. The only difference from the situation with the federal government is that their need to optimize their budgets will stem from higher expenditures rather than from smaller revenues.
Critics of the new federal budget law focus mainly on two issues. One is lower spending on long-term development programs. This criticism sounds reasonable only at first glance, and it becomes less so after considering it in more detail. Federal budget spending on the national economy, including government investment, will indeed be cut in terms of percentage of the GDP. On the other hand, this will be merely a downward adjustment after a sharp increase during the crisis. This spending will return to its 2007 level in 2015 (in terms of percentage of the GDP), but will still be higher than in 2001-2006. While the government will cut spending on education and healthcare at the federal level, the main funding of these sectors will come from the regional budgets and extra-budgetary funds. If we look at the entire system of the federal, regional and local budgets, we will see that spending on the development of human capital will actually grow, although not as fast as the GDP. This reflects some new priorities in the government’s fiscal policy. Whereas in 2009-2010 the emphasis was on pension spending, now it is obviously being shifted to national defense. This change certainly weakens the prospects for Russia’s economic growth, because we have in fact abandoned “productive” spending, which promotes long-term development – a top priority during the pre-crisis period – in favor of boosting social and military spending, which do not contribute to Russia being more competitive internationally. However, these decisions were made a long time ago, and then Finance Minister Alexei Kudrin was the only official who tried to oppose them. Those who are not happy with the result should criticize the cause, not the effect of the shift in fiscal priorities.
The other issue targeted by the critics of the draft is the plan to save part of the revenues in the Reserve Fund, while at the same time keeping internal borrowing at a high level. Some economists criticize this decision for purely financial reasons –because the Reserve Fund profitability is lower than the cost of borrowing. Others offer a macroeconomic rationale, saying that internal borrowing drains potential private investment resources. I agree with these criticisms only in part. Given the persistent high probability of a new crisis in the eurozone, we need to acquire a large safety margin to support the budget as well as to preserve investor confidence. A production slump in the European Union, which is Russia’s largest trade partner, accompanied by a fall in internal demand, plummeting commodity prices and capital flight from emerging markets, would inevitably cause a painful crisis in the Russian economy if the government has no reserves to mitigate external shocks. Under the new budget law, the government plans to accumulate 6.5% of the GDP in the Reserve Fund, which is a very modest target compared with 10% of the GDP in late 2008 when the crisis hit, or with the rainy-day reserves of other oil producing countries.
As for the possibility that internal borrowing may affect investment, this does not appear to be the main obstacle for investment at this stage: the massive outflow of capital for over two years suggests that businesses do not see any profitable projects here.
Therefore, the macroeconomic parameters of the federal budget, along with the decision to restore the budget rules, are important steps toward a healthy fiscal policy. Our key goal is to offset the lopsided structure of government spending with greater efficiency of each program. This is not an easy task, but it can be accomplished nonetheless, especially if it truly becomes a government priority as it should be.