By tinkering with the tax system, Ministry of Finance (MinFin) has remade Russia’s budget dynamics and successfully created enough cash to pay for the war in Ukraine.

The whole point of the extreme sanctions imposed on Russia in the first week of the start of the war in Ukraine was to strip Russia of its ability to make money and pay for the war. It didn’t work.

The government’s income has been on a rollercoaster ride over the last two years, but its finances are improving now. MinFin has been forced to rebuild the tax system but that is up and running increasingly well.

As bne IntelliNews reported, one year on from the disastrous results at the start of 2023, MinFin has just posted a solid set of numbers for the first three months of this year. The federal budget is still in deficit thanks to the $100bn a year the Kremlin is spending on defence, but that is a modest 0.4% of GDP and easily financed with existing resources.

Moreover, after MinFin totally changed the way taxes are calculated, to take into account the impact of oil sanctions, Russian Finance Minister Anton Siluanov said that he is expecting tax revenues to stay above forecast levels this year, and MinFin should easily keep to its 0.8% deficit for the full year – significantly down from the 1.9% of GDP (RUB3.4 trillion) deficit Russia ended 2023 with.

Discounting Urals blend prices

In the first year of the war Russia’s oil and gas were not sanctioned, although exports fell thanks to self-sanctioning. It was when the twin sanctions on oil and then oil products were introduced, on December 5 2022 and February 5 2023 respectively, that European traders were forced to stop buying from Russia.

Russia responded by re-routing its oil trade to Asia, but the change had an immediate impact on the budget. Revenues collapsed and the deficit blew out to all-time highs. To sell oil, Russian companies had to offer large discounts to Brent prices; pre-war Urals typically sold at a $2 discount to the Brent price, but in the first months of the war that discount mushroomed to $35 at its peak. The discount fell to only $5 at the end of last year, but more recently has increased again to $16, according to the Kyiv School of Economics (KSE), after Office of Foreign Assets Control (OFAC) began to introduce smart sanctions and has imposed secondary sanctions on over 40 tankers and dozens of shipping companies.

The key was MinFin calculates taxes on the price of its Ural’s blend that was also the blend named in the $60 oil price cap sanctions. MinFin immediately put in place changes to abandon the Urals blend benchmark and by the middle of 2023 oil revenues began to quickly recover.

Russia has implemented a revised method for calculating the mineral extraction tax (MET), that includes oil, this year, aimed at stabilizing revenues affected by fluctuating market prices and sanctions.

Under the new system, if the price gap between Urals oil and Brent crude becomes substantial, the Finance Ministry will cap the discount at $20 per barrel for tax purposes.

For instance, if Brent is trading at $100 and Urals at $50, the tax will be calculated on an adjusted price of $80 per barrel, not the actual $50. "This manoeuvre has proven effective," stated analyst Kirill Rodionov, noting that the average price used for tax assessments has risen from $51 last year to about $70 per barrel this year, Meduza reports.

Alongside MET adjustments, Russia has reported an increase in revenues from the quarterly profit-based tax (NDM), which unlike MET, is levied on the profits from sales, allowing companies to defer their tax liabilities until profitable phases. This structure encourages ongoing investment in resource development and prevents premature project closures, Meduza reports.

As companies transition to the NDM regime, they continue to pay MET but at a significantly reduced rate. This approach has substantially grown its contribution to the federal budget from 9% to 52% over five years, with revenue from NDM jumping from RUB211bn ($2.3bn) in the first quarter 2023 to RUB587bn ($6.3bn) in the first quarter 2024.

A one-time MET rate increase was also implemented in January 2024 following a reduction in damper payments—subsidies for domestic oil sales—which had led to a spike in Russian gas prices. This policy adjustment is intended to recoup the shortfall caused by the previous cut in subsidies. Although specific figures were not disclosed, sources from Interfax estimated the revenue gain at around RUB190bn ($2bn).

The depreciation of the has also played a role in fiscal dynamics. With the weakening from RUB70 to RUB90 against the US dollar, the conversion of dollar-denominated oil revenues has resulted in higher figures, bolstering the budget.

Non-oil revenue gains

Non-oil and gas revenues have also seen a marked increase as Russia’s economy grew far more strongly in 2023 than anyone expected. Russia ended 2023 with a 3.6% expansion and rising real incomes, driven by the extreme tight labour market and salary inflation, as companies hunt for labour. The upshot has been a military Keynesianism economic bump and increased consumption that has translated into a higher non-oil tax take, rising 43% to RUB5.8 trillion ($62bn) in the first quarter. Turnover taxes like VAT contributed RUB3.4 trillion ($36.3bn) to the tax take by itself. The downside of the military Keynesianism boost has been persistently rising inflation, which has forced the Central Bank of Russia (CBR) to increase the growth-killing prime rate to 16% with little prospect for rate cuts anytime soon.

The Finance Ministry anticipates continued revenue growth from non-tax sources this year as the economy is still running hot, although the rate of growth is expected to slow to around 2.2% this year.

In parallel, MinFin continues its hunt for fresh sources of non-oil revenue and has restarted a limited privatisation drive as well as going over the existing tax code to weed out inefficiencies, waste and institutionalized corruption. One of the ironies of the war has been to force the government to make long-overdue deep structural reforms.

As the Russian government increases spending—evident from a 20% hike in budgetary expenses from the first quarter of 2023—the fiscal outlook remains cautiously optimistic.

“In the first two months of 2024 alone, expenditures amounted to RUB6.5 trillion ($69.4bn) while revenues totalled only RUB5 trillion ($53.4bn), resulting in the Finance Ministry nearly exhausting the deficit limit for the entire year. Last year, the same trend raised concerns; in the end, however, the deficit didn’t stray too far from the target,” Meduza reported.

Analysts from Raiffeisen Bank do not view early-year spending surges as a risk, predicting the budget deficit will be halved this year to RUB1.6 trillion against last year’s RUB3.2 trillion.

Additional fiscal pressures are expected as the government rolls out five new national projects and welfare initiatives announced by President Vladimir Putin as part of his strategy to placate voters in a time of war, likely leading to further tax adjustments to balance the increased spending. Economists estimated the cost of the new national projects implementation at RUB1.2 trillion ($12.9bn) per year. This will be likely offset by tax increases, which, just a month ago, was raising concerns among economists.

However, MinFin has had a bit of luck as oil prices are surging thanks to OPEC’s voluntary production cuts and now fears of a region-wide war in the Middle East after Iran attacked Israel on April 13. Currently, the increase in oil prices will more than offset the increase in spending.

FX woes

Apart from inflation, Russia’s other vulnerability is a sinking ruble. As Russia ramps up government spending to support its economy, pressures on the national currency are intensifying. The Finance Ministry, in its effort to boost local production, is channeling funds into businesses, particularly those that import components and equipment, necessitating increased purchases of foreign currencies that is also softening the ruble. The Economic Development Ministry projects an average exchange rate this year of RUB90 to the dollar. SberCIB Investment Research is more pessimistic, anticipating the ruble will decline further to RUB95 against the dollar and a few others say it will go to RUB100 again by the end of this year.

Russian export dynamics will play an important role in setting the exchange rate as exports, particularly of raw materials, are on a downward trend. That reduces the inflow of foreign currency and thereby contributing to a burgeoning deficit.

Additionally, there is a noticeable increase in domestic demand for dollars and euros among the Russian populace. In February alone, Russians exchanged approximately RUB100bn ($1bn) for these currencies, with the amount escalating to RUB155 billion ($1.66bn) in March.