The Russian government needs to find RUB2 trillion ($31bn) from somewhere to plug the gaping hole in the federal budget, as the country runs its first deficits since President Vladimir Putin came to power. It hopes to find most of it in the millions of pay envelopes passed under the desks of workers at the end of each month. 

And it is not proving easy. Russia is on course to end this year with a federal budget deficit of about 4% of GDP or at least RUB1.5 trillion. With oil revenues cut off at the knees since the price of oil collapsed in December 2014 and expected to stay lower for longer, there is going to be no short-term relief from that quarter, despite the fact that Russian oil companies are pumping record amounts of crude.

Exports of other types of products could provide some relief, but none of the other sectors are anywhere near to being able to come up with the missing RUB2 trillion a year. Following the collapse of the ruble, several car companies based in Russia have begun talking about exporting to the rest of Europe but none have started yet. Agriculture is more promising; Russia became the world’s largest exporter of wheat this year and will earn some $5bn as a result, which is a useful but insufficient amount. The government expects that grain exports will rise steadily and earn as much as $100bn a year, but it will take at least 30 years to get there.

The alternative is to cut spending from the RUB15.8 trillion earmarked in the budget. But here too there is little wiggle room: Finance Minister Anton Siluanov has already slashed 10% off spending across the board, but with social and military spending put off limits by Putin there is little fat left to trim from the state budget and this measure will save a few hundred billion rubles at best – again a useful but insufficient amount.

The Kremlin could also raise taxes, but it really, really doesn't want to go there. When Putin came to power the first thing he did was slash taxes to the flat 13% income tax and 24% corporate profit tax – amongst the lowest in Europe – and over the years he has consistently promised not to monkey with these rates, which are a big contributor to his sky high popularity.

However, taxes should go up as they are clearly too low now. The only way that Russia could afford such low taxes is if the budget was supplemented by excess oil revenues that were heavily taxed with the state taking some 80 cents of every dollar earned over the $27 oil price. The federal government is now on the wrong side of the Laffer curve, an economic concept that argues there is an ideal tax rate that maximises revenues for a government. If taxes are too high, people and companies cheat so you get less tax; if they are too low, you simply collect less. While no one is sure where the ideal level is (academics are split between a 70% rate and about 35%) it is clear Russian taxes are well below the maximising level for tax collection and could be raised. However, with Duma elections this September and presidential elections in 2018, no one is expecting any tax hikes before then.

The one exception might be a small hike from 18% to 21% in VAT, which is already the biggest contributor to the budget, accounting for about a third of the tax take. But any bigger increases would drive up inflation, which the CBR is very keen to avoid.

 

However, there is one giant pool of dark money the government can tap: the shadow economy. The state has launched a dual attack to capture more of this shady money: tightening regulations to bring more wages into the white economy, and a wide ranging anti-corruption drive that has affected everyone in government except the people at the very top.

The campaign to improve the efficiency of tax collection kicked off at a mundane level by simply modernising the tax administration services and increasing the focus on tax compliance. Tax revenues have gone up as a result, while the June deficit was a fairly small RUB121bn, both due to the seasonally modest spending, but also reflecting an improved tax take that is running ahead of the plan.

The government has also recently launched a big offensive to reduce the size of the shadow economy and reduce grey payments of wages that could make a significant difference if effective.

The issue has been on the agenda at least since May when the Presidential Economic Council was set to brainstorming how to restart economic growth in Russia in the current recessionary environment. "On this topic [the president] got actively involved in the discussion and urged us to understand what makes people hide in the shadow economy and work out how to legalise their labour," RBC business portal quoted one unnamed participant of the talks in May.

Kommersant daily reported that as of May 2016, 30mn people in Russia, 40.3% of the economically active population, had either permanent or occasional income from seasonal or shadow activities, while for another 8.7mn or 11.7% the shadow economy was the only source of employment.

“Last year saw a significant improvement in VAT on imported goods and excise collection, and the turn has come for the labour market. Siluanov indicated that the legalisation of under-the-table wages might contribute, in total, an additional RUB1.5-RUB2.0 trillion to all levels of the budgetary system,” VTB Capital said in a recent research note, which estimates 12% of all wages in Russia might go unrecorded and untaxed.

The pension fund is one of the biggest burdens on the budget. The state has already slashed expenditure on pensions by reducing the indexation of pension payments to 4% - well below the current 7.1% inflation rate and leading Prime Minister Dmitry Medvedev to make his now infamous comment to a pensioner in Crimea: “We have no money.” Since then an online petition calling for Medvedev’s sacking has garnered 180,000 names. Contributions to the state pension fund grew by 4.5% y/y in 2015, while expenditures doubled by 9.0% YoY, with the federal budget having to transfer RUB3.1 trillion to cover the revenue shortfall.

So what is the current state of the fiscal debate? There is a Gordian knot to untie in state spending, where the government has to maintain a delicate balance between ‘socially acceptable’, ‘politically possible’ and ‘fiscally responsible’. Optimising spending on line items in the budget is made more difficult by the institutional confusion that exists between how different sectors are defined and the different ministries responsible for spending on them, which is in some cases a throwback to central planning definitions. This means the government tends to opt for an inferior second best: top line proportional cuts, which ministries themselves have to spread out to the best of their judgement.

 

While the growing anti corruption drive lead to a big reshuffle of the regional administration in July (and had the additional benefit of shoring up the Kremlin’s election machine ahead of the September poll), the pedestrian review of tax rules has probably produced more money for the state coffers.

The ministry of finance and the federal tax and customs services implemented a new unified IT platform this year that makes fraudulent rebates of unpaid VAT (a popular scheme in the past for imported goods) considerably more challenging, and was behind the much improved VAT collection numbers. The same IT system can also tracks bottles of vodka from the brewery to the point of sale and led to a crack-down on illegal alcohol manufacturing, which is visible in data on vodka output.

But the biggest win is expected from a crackdown on wage payments. Siluanov recently called grey wages “the biggest loss to the budget system”. Increasing personal income tax revenues would kill two birds with one stone, as unlike almost all the other taxes these ones accrue directly to regional and not federal budgets. While the macroeconomic indicators at a federal level are fairly solid, as bne IntelliNews has reported many of Russia’s regions are teetering on the edge of collapse.

At a meeting with Putin, the head of the Accounts Chamber Tatyana Golikova stated that 14.8mn people are employed in the ‘shadow’ economy, but VTB points out that this is an estimate of the informal economy, which is not the same as a shadow economy and where many people pay income and minimum social taxes. Rosstat doesn't have a formal estimate for the size of the illegal employment in the grey economy, which is the bit of the economy the ministry of finance wants to target.

However, VTB estimates 12% of Russia's total wage bill is in the shadows, equivalent to a total of RUB3.4 trillion. That would produce a maximum additional RUB1.5 trillion of income taxes if all these payments became legitimate.

The bottom line is that the ministry of finance's drive will have some success and will increase the tax take, but like the other measures it will be useful, but insufficient. The government’s hope is all these measures taken together will keep the deficit lower and buy enough time for the economy to get back on its feet and simply grow its way out of all these difficulties.