Learning from Russia's supply-side flat tax reforms

Between 1998 and 2000, the Russian economy was down to its knees. The government was severely underfunded with an inefficient tax system marked by high tax rates and rampant tax evasion. The central bank of Russia was forced to finance government spending by printing rubles, leading to hyperinflation, debt default and the devaluation of the currency.

The newly appointed Russian President Vladimir Putin embarked on a pro-growth agenda; so good that it made the anti-growth IMF sick to its stomach. Keeping the IMF at bay, Putin implemented a tax reform policy taken page after page from the supply-side playbook, creating a structure of incentives that fuelled production and investment. His tax reform hit the entire spectrum of producers from individuals to large corporations to small entrepreneurial ventures.

Putin firmly committed himself to his aggressive agenda, reducing fears that tax reforms would be temporary. He made tax evasion less profitable and integrated an underground economy that thrived for years with an above-ground market economy.

Russia's recovery, effective January 1, 2001, started with a flat 13% personal income tax applicable to worldwide income received by Russian tax residents. The flat rate replaced a progressive tax structure that ranged from 12-35%. Applicable income included earnings, bonuses and other forms of compensation. There was no capital gains tax and gains from the disposal of assets were taxed at a flat 13% rate. Gains from real estate held for more than five years and other assets held for more than three years were exempted from income tax.

Effective January 1, 2001, under payroll taxes, the Unified Social Tax replaced payments by corporate taxpayers to four separate off-budget funds: the pension fund, social insurance fund, medical insurance fund and employment fund. The combined tax burden used to be 38.5% of annual gross salaries paid by employers, and in addition, employees paid 1% of their salaries to the pension fund.

Later, these taxes were combined and collected as one single tax payable by employers and were regressive in nature. The tax had been levied on the following scale: 35.6% on the first RUB 100,000 ($3,200) of income; 20% on earnings from RUB 100,000 ($3,200) to RUB 300,000 ($9,600); 10% on earnings from RUB 300,000 ($9,600) to RUB 600,000 ($19,000) and 5% on all earnings above RUB 600,000 ($19,000) (reduced to 2% in 2002). The employee contribution was eliminated.

Effective January 1, 2002, Russia implemented a new corporate profit tax of 24%, reduced from 35%. Dividend income received by Russian organisations from domestic organisations was taxed at 6%, lowered from 15%. The new lower tax rate came at a cost of some former tax benefits, including the capital investment allowance that allowed corporations to reduce their effective tax burden significantly, but also included improved depreciation rules.

VAT (value-added tax) was still levied at a standard rate of 20% with a few exceptions taxed at 10%. Sales tax was levied by regional officials but in most cases set at a maximum of 5%.

Effective January 1, 2003, a new tax system was implemented for small businesses that have less than 20 employees and earn less than RUB 10 million ($320,000) in annual sales. Such qualifying companies were able to choose between paying 8% of annual gross revenues or 20% of annual net profits. They were also able to write off 100% of capital expenditure immediately. This new tax system was in lieu of tax payments for the Unified Social Tax, VAT, sales tax, property tax and corporate profit tax for these companies. Under the existing tax law for small businesses, up to 50% of operating capital was estimated to be lost to taxes and regulatory fees.

Effective July 1, 2001, the mandatory surrender of export earnings was reduced from 75% to 50%. This liberalisation of currency controls meant that Russian companies must now only sell 50% of foreign currency earnings in exchange for rubles.

Turnover taxes, considered very detrimental to investment climate, since even unprofitable companies can suffer substantial taxation, were completely wiped out of the Russian tax code. Under land reform, a new land code had been adopted, confirming the right to private property for both foreign and Russian citizens by legalising the ownership of urban land.

The aim was to enhance property rights and encourage private ownership as well as encourage the use of property as collateral in transactions. Transparency in real estate transactions was a key component for attracting foreign investment in Russia.

Putin knew that his No 1 priority was economic growth. Despite sharply lowering tax rates across the broad, tax revenue as a share of GDP expanded robustly under the new tax regime. Tax revenue increased 51% in 2001 over collections in 2000, expanding from 11% to 16% of GDP.

The Russian economy continued to grow robustly, which led to budget surpluses and the government's fiscal balance sheet in a very positive position. Annual growth went up from 2% to an average of 7% and the budget deficit from 2% to a surplus of 3% of GDP.

Another key area of concern regarding Russia's future was its foreign debt burden. The following three years of prosperity, starting in 2001, allowed the government to accelerate its external debt repayments, in such a way that the external debt, which was at 130% of GDP in 1999, went down to 50%.

Putin's most significant accomplishments had been the achievement of political stability. Such stability served as a catalyst for a revised risk analysis concerning foreign and domestic investment in Russia, integrating the country into the modern industrial global economy by transitioning from a centrally controlled command economy to a market-based economy.

The positive economic development in Russia led to a consistent upgrading of its sovereign credit rating from CCC- (1998) to B+ (2002) and an outlook upgrade from stable to positive, with reform momentum and the commitment to timely debt service cited as key factors for the change in the outlook.

Russia's renaissance is proof that supply-side economic reforms and the flat tax works. The odds of Russian recovery, according to the IMF, were slim to none. The players, however, who bet on Russian red would have broken the bank. Russia had risen from ashes to establish herself as one of the global economy's bright spots.

Even in 2001 with weaker oil markets, Russian equities significantly outperformed, the ruble remained stable and the economy continued to expand. Now, if only we in Pakistan could import these supply-side flat tax reforms, keeping the IMF at bay, to our shores!

The writer is a philanthropist and an economist based in Belgium