Sanctions on Russia are barking up the wrong tree. The Kremlin’s Achilles’ heel is not its dependence on oil export revenue. Russian President Vladimir Putin has a far more powerful tool to fund his war in Ukraine: VAT.

Oil and gas export revenues are very important to the budget and account for about a third of the total tax take. But by far the largest contributor to the government’s income is the domestic economy. Non-oil taxes account for two thirds of the government’s income, more or less equally divided between VAT and personal income tax. 

And in a virtuous circle, the more the Kremlin spends on the military – a third of which goes on wages alone – the more Russian go  out and shop, allowing the government to recover much of its spending from the VAT it earns on all retail sales. 

For now, Russia’s strong economic growth is not being driven by investments into tanks and bombs, but by spending on services and shops. 

It took a year, but the keystone of the sanctions regime was to cap the Kremlin’s income by slapping oil price cap sanctions on Russian exports and limiting the price to $60 a barrel. Twin oil embargoes on selling to Europe were also imposed at the end of 2022 and start of 2023. These sanctions spectacularly failed as the oil companies rapidly switched markets and sent their product to an eager Asia in a matter of four months – the time it takes a tanker to sail to India or China and back. Not a single barrel of Russian crude oil has been sold below the oil price cap of $60, the Financial Times reported.

Cutting the Kremlin off from its oil revenue would hurt the budget badly, but increasingly the Kremlin’s biggest source of income is the domestic economy. VAT receipts have always been the biggest source of tax revenue, and the value added tax is becoming increasingly important.

The Ministry of Finance (MinFin) plans to reduce the share of oil and gas revenues in total revenues to around 25% in the next few years. The Russian Ministry of Finance has outlined several strategies to reduce the federal budget's dependence on oil and gas revenues:

1. Diversification of Revenue Sources: The government aims to increase the share of non-oil and gas revenues in the budget. Finance Minister Anton Siluanov stated that the contribution from oil and gas is expected to decrease to 27% in 2025 and further to 23% by 2027.
2. Tax Policy Adjustments: Plans include easing the tax burden on major energy producers, such as Gazprom. A draft budget indicates that the mineral extraction tax on gas production will be reduced, leading to a projected decline in oil and gas revenues from RUB11.3 trillion in 2024 to RUB9.77 trillion by 2027.
3. Economic Diversification: The government is focusing on strengthening other sectors of the economy to compensate for the anticipated reduction in oil and gas income. This includes investing in industries like technology, agriculture, and manufacturing to create alternative revenue streams.
4. Fiscal Policy Reforms: Implementing fiscal policies that promote sustainable economic growth and reduce reliance on volatile commodity markets is a key component of the strategy. This involves prudent budgeting and the development of financial instruments to support non-energy sectors.

Salaries, not oil, driving economic growth

Russia’s military spending has soared and now makes up just over 6% of GDP. Just military salaries are currently running at about RUB3 trillion a year ($32bn) – equivalent to this year’s entire projected budget deficit, or 1.7% of GDP. The military payroll makes just under a third of the total RUB10.8 trillion of planned defence spending this year.

This high spending is widely seen as a weakness, but it appears it is actually a strength. Some have predicted that there will be a wave of bankruptcies in 2025 thanks to the record high central bank prime interest rates, but according to a recent paper by leading economists Russia’s economy is a lot more robust than it first appears. As reported by bne IntelliNews, soldiers’ salaries have been soaring and sign-up bonuses have risen to $30,000 this autumn – an enormous amount of money in a country where the average salary is just under $1,000 a month.

However, the point most are missing is that the Kremlin can recoup much of his money back from VAT receipts. Times are good for most Russians. The war in Ukraine barely has an impact on their daily life. Jobs are plentiful and increasingly well paid, which has created a new War middle class. The shop shelves are full again as the 1990-era trade routes are re-established. Serving on Ukraine’s front lines remains optional.

Another unintended side-effect of the war is that Russia's poorest regions have been the biggest winners from the militarisation of the Russian economy. A study of retail bank deposits also showed most of the military wages are going to the most backward regions, which is further fuelling consumption where it counts most. That has gone a long way to undoing Russia’s legendary income inequality, leading to a broader-based and more equitable growth across the whole country, not just the leading cities.

The CBR forecasts that while household consumption grew by a whopping 6.5% in 2023 and is expected to end this year at 4-5%, consumption could fall off a cliff in 2025 with no growth at all, or at best 1% growth, the ultra-conservative regulator warned.

The economy is booming and civilian production and the service sector are on a roll. Car sales have completely recovered after they came to a screeching halt in 2022. The bars and restaurants are full. And shoppers are upgrading to buy more expensive goods as the share of essentials in shopping baskets falls from its peak of over 50% at the start of the war. All this shopping is taxed at a 20% VAT rate. The Kremlin increased the rate by 2% in the midst of the Russian World Cup in 2019 – one of the few significant tax hikes on consumers Putin has made in 23 years in office. (The reduced 10% rate remains on essential goods.)

And next year the contribution to the tax take by the population will increase again as the Kremlin has very cautiously launched a progressive tax regime – the first major rise in income taxes during Putin’s entire presidential career. Putin promised the planned tax overhaul would increase inflows to the state budget, benefit low-income families and provide a more equitable tax regime that will affect a very small share of the population to begin with.

Corporates also saw a tax hike. The increase in revenues from the corporate profit tax increase is estimated at RUB1.6 trillion, while the effect of the change in the personal income tax is estimated at RUB0.5 trillion.

Budget performance

In the most recent reported results, Russia's federal budget posted a surplus of RUB500bn ($5.2bn) in September, despite a sharp rise in spending, according to data released by the Ministry of Finance on October 10.

Revenues grew by 19% year on year to reach RUB3.3 trillion ($34bn), with a cumulative 33% gain in the first nine months of 2024. This growth was driven by a 4% rise in oil and gas revenues, which jumped 49% over the same period, while non-oil and gas revenues surged 24%.

At the same time, government expenditures surged 34% y/y in September, reaching RUB2.8 trillion, bringing total spending for the first nine months of 2024 to RUB26.6 trillion ($277bn), up 23% compared to the same period in 2023.

The September surplus helped lift the year-to-date budget balance to a modest RUB200bn, equivalent to 0.1% of GDP. However, the Ministry of Finance still anticipates a year-end deficit of RUB3.3 trillion, or 1.7% of GDP, due to a substantial increase in spending during the final quarter, says Renaissance Capital.

While oil and gas revenues surged in September by a lot more than the non-oil and gas revenues, they already play a much smaller role than the domestic economy non-oil taxes, which already account for two thirds of all the government’s income:

• For the full year, MinFin is expecting budget revenues to amount to RUB36.1 trillion ($360bn), or 18.4% of GDP.
• Oil and gas revenues in 2024 are expected to be RUB11.3 trillion ($113bn), or 5.8% of GDP, and their share in total revenues is estimated at 31.3%.
• But non-oil and gas revenues are expected to be twice as much at RUB24.801 trillion ($250bn), or 12.7% of GDP, and their share in the total 68.7%, Interfax reports.
• From the non-oil tax revenue VAT and personal income tax account for about half of the tax take each. The more the government spends on military personnel the more both of these taxes will increase.

Crashing oil prices to $50

Gossiping with contacts in the oil industry, there is a growing feeling that the new Trump administration has a much more concrete plan for countering Russia than has been reported and that includes crashing oil prices to $50 a barrel.

In September, the government earned RUB11.3 trillion from oil exports at a time when the average price for oil was still $74 per barrel, but the price is falling slowly and was down to $71 for the first weeks of November. If oil prices crashed to $50 a barrel the oil and gas revenues could fall to RUB7.5 trillion, according to bne IntelliNews estimates, doubling the budget deficit. Such an extra RUB4 trillion shortfall to the budget deficit would be a major, but not entirely insurmountable, problem for the MinFin. However, this would be offset to some degree by a dramatic weakening of the ruble, which increases the amount of rubles the government gets from oil taxes, as they are denominated in dollars but collected in rubles. 

A fall to $50 prices would put pressure on the Russian and Iranian budget, but also the Kingdom of Saudi Arabia (KSA) with whom US relations have become increasingly strained after the latter went from being a net importer of oil to net exporter following the shale revolution in 2016.

Indeed, KSA is already feeling the pinch and has begun to cancel large investment projects into its Neom City programme that was designed to diversify the Saudi economy away from oil and gas. Experts estimate that the KSA budget needs at least $80 a barrel to break even, but prices have been sliding and are currently hovering at around $65, as the global economy cools.

The MinFin has anticipated this fall in oil prices and is actively getting ready for it. The Central Bank of Russia (CBR) issued a pessimistic medium-term macroeconomic outlook at the start of August that forecasts lower oil prices next year. The CBR says that oil prices are an average of $85 per barrel this year but will fall to $80 in 2025, $75 (2026) and $70 (2027). But those forecasts are already looking very optimistic.

A drop in the oil price to $50 will hurt the current account surplus, which was $51bn in 2023 but is now on track to come in at over $50bn this year. It will decline to $34bn and $29bn in 2026 and 2027 respectively on current estimates, but will fall much further if oil prices do drop to $50 a barrel.

These falls will also affect consumer activity, which was higher than expected in the first half of this year, driving growth in both savings and retail turnover.

But the Kremlin has plenty of cash in reserve to keep the pump primed. The Ministry of Finance plans to borrow RUB4 trillion this year (about twice its pre-war borrowing) which is enough to more than cover the planned budget deficit and there is another RUB19 trillion of liquidity in the banking sector. On top of that is the population’s high saving ratio, boosted by the sky-high interest rates, which will continue to fuel consumption growth albeit at a slower rate.

Rather than cutting military spending in the new three-year budget plan, MinFin plans to increase it. The high spending will support consumption, and the ministry can recycle the VAT receipts it recoups back into spending and keep the wheels of this perpetual motion machine turning for longer.

In the meantime, the CBR is working hard to solve Russia’s other big macroeconomic problem: persistently high inflation that peaked at 9% in August. The prime rate has been hiked to a crushing 21% and economists widely expect the regulator to hike rates again to 22% before the end of the year. However, the CBR has teamed up with the government to use non-monetary policy methods to cool the economy, the first of which was to end a generous mortgage subsidy programme on July 1.

More recently, the regulator is about to launch new corporate deposit rules to discourage companies from squirrelling away their cash to make a return on the same high rates and keep their money in circulation. Retail borrowing has already been reduced by new macro-prudential restrictions. All this will slow growth but will allow the CBR to start easing interest rates maybe in 2025 to boost growth again. In the meantime, the Kremlin can continue to fund the war effort and use that spending to drive the economy, but the CBR needs to solve these basic problems in the next few years before the Kremlin runs out of money. All these pressures are contributing to the growing willingness to halt the war in Ukraine and go back to business.