Russia Growth Diagnostics (6): Taxation and Laws

< Part 5: Uncertainty

Taxation and law enforcement are a bunch of different factors, whose impact on growth could be described best as “it depends”. So my goal here will be modest. For each issue, I briefly outline the references on topic, discuss the magnitude of a possible impact on growth, and check if this issue is a candidate for a growth constraint.

Inflation

Despite inflation being an important topic in macro, economic growth theory barely touches inflation at all. For rare examples, see Barro (1995), Bruno and Easterly (1998), IMF (2014). Scarce evidences suggest that problems with growth may start after inflation shoots above 4–15%. But this connection is not traced back to monetary policy. A typical confounding issue: high inflation may be a consequence of other factors (incompetent state, currency crises), so GDPPC won’t grow if monetary authorities simply target low inflation. It’s a desirable, but not sufficient condition.

The CPI in Russia remains within the 4–15% interval for the last ten years. It’s above the world average, but the values converge. More interestingly, the price indices of GDP components:

infln_gdc

Government had been increasing wages in the public sector, so prices in government consumption, which includes services, grew faster. The second possible explanation of this acceleration is more speculative: government procurement overheats some markets.

Taxes

The traditional metrics of tax burden (government revenue to GDP ratio) isn’t informative in our case. Tax burden positively correlates with GDPPC, but its components aren’t born equal. The desirable approach is twofold. First, investigating welfare implications of the taxes as it’s done in public economics and, in particular, optimal taxation theory. Second, measuring the market value of government spending. Since the Russian government is a price setter in many markets, the deviation of the price from marginal social value may be large. So not all rubles the Russian government spends are equally useful.

The Russian tax system has its own peculiarities: heavy fossil fuel subsidies, flat income tax rate at 13%, dependence on commodity prices, and revenues concentrated in the central government. These practices are at odds with what developed countries do. There’re common problems as well. One worth mentioning is the tax incentives related to accumulation of human versus physical capital (see this post).

Regulations and Costs of Doing Business

The Russian government improves important regulations (tax administration) and worsens others (oversight of the mass media). It also retains excessive control in areas where control makes little sense (import–export operations and internal migration, even before 2014).

Business does complain about these regulations, but it’s supposed to in any country. Less so in Sweden, more in the United States and Russia. How can we understand it it’s real? Two popular tools — surveys and composite indices — don’t suit well. Surveys for their usual problems. Composite indices, like Doing Business, for the limited range of issues and excessive formalism (see Pritchett, 2010).

Perhaps the best approach is to identify the most harmful regulations, rather than trying to find an aggregate variable which says that Russia would gain y% of GDP if it reduced regulations by x%.

Corruption

Olken and Pande (2012, Table 1) summarize things we know about corruption. Dreher and Herzfeld (2005) explain why it’s important. Rothstein and Holmberg (2011) show correlates of corruption.

Russia demonstrates high indicators of corruption (Transparency International, World Bank). Russian business considers corruption a real obstacle to operations, even when these concerns are compared among the sample of Eastern European and the former Soviet Union countries (BEEPS 2013).

How to measure the magnitude of the problem? Gorodnichenko and Sabirianova Peter (2007) measure the market of bribes in Ukraine at 1% of GDP, using plausible assumptions and additional controls. Their estimate is a lower bound of corruption because it’s calculated as the difference in incomes between public and private employees, excluding likely risk premia for corrupt officials.

Russia must have a smaller, but somewhat comparable market. A market that large reflects two things. One is an informal tax on citizens. Another is misallocation of resources when public officials rank projects by their corruption potential, not economic value. Misallocation of resources hurts economic development more than the tax does. But in the Russian case, both channels are important.

Law Enforcement

Xu (2011, p. 458) makes a comprehensive literature survey. Four papers in this survey study the direct relationships between law and GDP: three by Ross Levine (1998, 2000, 2002) and one by Daron Acemoglu and Simon Johnson (2005). A key summary of the latter (watch Panel A and C):

Source
Source

So-called contractual institutions lose significance when instrumented (Panel A, model 3). Private property institutions don’t, and their coefficients imply a big impact (Panel C). It’s a very rough indicator of what we should pay attention to.

Russia is near the world median in terms of Panel C (the important one): private property rights are a potentially big and significant negative factor. But unlike tax rates, the policy implications of these indices are very obscure.

Summary

In terms of these five domains (inflation, taxation, regulations, corruption, and legal enforcement), Russia performs worse than developed countries. And this constraint has two interesting details.

First, corruption and poor legal enforcement ease the problems caused by excessive regulations and taxation. It means that fighting corruption before easing regulations may lead to worse outcomes. However, this idea is often manipulated to justify corruption as a consequence of regulations. But corruption also stimulates regulations because the public official without regulations would have no power to sell. The connection is, of course, twofold, and that’s how one should treat it.

Secondly, weak performance in these domains pushes businesses into the informal sector. In the short term, businesses save on costs and become more competitive. Over time, however, everyone loses because the informal sector involves more risk, less legal protection, and less access to credit.

A Brief History of Russian Debt

Paul Krugman draws attention to the role of exchange rates in the Russian debt. I’d add a few notes on this in addition to yesterday’s overview.

External Debt Was Cheap

For two reasons:

  1. QEs and zero interest rates made the dollar and the euro very attractive currencies for borrowing.
  2. The ruble appreciated in nominal terms, while its PPP conversion factor (how much rubles you need to buy the stuff worth $1 in the US) grew steadily (Paul Krugman’s point). Here’s the movement between 2000 and 2008:
WDI 2013
WDI 2013

The ruble becomes de-facto weaker (red line), but the exchange rate (green line) moves in the opposite direction. Russian businesses thought that borrowing abroad at low interest rates was a great idea. A corporation borrows a dollar at 1% per year, exchanges it for rubles in 2004, holds rubles for one year while the exchange rate going down, and returns the principal and the interest to the lender in 2005. Okay, corporations did something else to this money and paid a higher interest, but ruble-denominated debt was still more expensive.

The Russian Private Sector Accumulated $650 bn. of External Debts

About 90% of Russia’s external debt is corporate, though the state owns many of these borrowers:

World Bank's Russia Report, 2014
World Bank’s Russian Report, 2014

It Was Time to Pay the Debts

Russian corporations had to pay about $100 bn. of debts by the second half of 2014, when the States and EU lifted the sanctions:

wb14_debt_payments
World Bank’s Russian Report, 2014

Meanwhile, the oil prices fell to $60 and the currency inflow halted. This led to the shortage of dollars in Russia, so several big borrowers could break the thin market when they started lurking for dollars inside Russia:

Bloomberg
Bloomberg

The Central Bank of Russia held about $500 bn. in reserves but it didn’t support the ruble much over the year:

The Economist
The Economist

It didn’t matter than Russia had a current account surplus of about 5% of GDP throughout the 2000s. These $700–900 bn. were export revenues. Exporters converted them into rubles to pay taxes, wages, and other expenses. So, $500 bn. ended in the central bank.

External Debt Became Expensive

The corporate borrowers panicked in December 2014. The Central Bank didn’t offer enough dollars when the market was running out of them. The exchange rate hiked on December 16. This 10% daily hike meant really large annual returns (try to calculate 1.1^365). The dollar became an attractive investment. Not only corporate borrowers, but the entire population wanted dollars for now. Companies and families bought dollars with their savings or newly borrowed rubles.

People also reasonably expected import to become more expensive and started shopping before retailers adjusted their prices for the new exchange rates. It ended with a daily inflation peak because retailers did react to the new demand.

After the government intervention, the ruble stabilized around 60 RUR/USD. But $720 bn. of external debt remained. Corporations now have to pay about 100% of real interest, adjusted for the exchange rate shift. Though many of them are exporters and sell for dollars, Russian banks naturally earn their revenues mostly in rubles, which makes it difficult to pay forex debts. (Banks can buy the dollars back after the hike, but the financial sector has many other problems now.)

Finally, Weather Forecast

Asian countries had a pretty severe recession after the 1997 currency devaluation:

asia_forex_gdp

As Paul Krugman noted, broken balance sheets created troubles for these countries. When you borrow the currency that is different from the currency of your operations, well, you must hedge. Did Russian corporations know the Asian lesson and hedge? We’ll see, soon.

Picking the winners is still up to the government. The Central Bank has plenty of options here. It can use the remaining reserves to bring exchange rates down. It can keep the interest rate high (but not for long because businesses need credit). Or it can pick winners one-by-one.

More notes on the consequences are coming.

The Ruble, Russia, and the History of Twelve Devaluations

Bloomberg made the ruble’s collapse look like the end of the world yesterday. It’s not the first collapse of this kind, so let’s put some history together.

Russia

The last time the ruble collapsed in 1998, when the Russian government defaulted on its ruble-denominated debt. Economic recovery came immediately. That situation is only tangentially reminds what’s happening now. Right now, it’s the the private sector who is heavily indebted, not the Russian government. Secondly, Russia had several years of recession before 1998, and much physical capital dropped out of production to be available later. As for 2014, physical capital is fully employed and investments are now a huge concern.

rus_forex_vs_indicators

In its best years, Russia accumulated forex reserves by running a trade surplus:

rus_forex_vs_bop

The reserves remain in the range from $200 bn. (informal estimates adjusted for “availability”) to $360 bn. (official). The Central Bank provides this liquidity to banks that have to pay their foreign credits and avoids dumping dollars directly into the market. Huge reserves leave an opportunity to wipe out speculators playing against the ruble, but it’d eradicate reserves, which may be needed later to save the Russian financial sector from bankruptcies and their consequences for the economy at large.

That is, the Central Bank ensures forex liquidity for the economy and allows the exchange rates to go up and down. Also, contrary to some media stories, Monday’s interest rate hike addresses inflation, not exchange rates. That’s according to the Head of the Bank.

Other Countries

Twelve countries that had episodes of rapid (and not so rapid) devaluation. The interesting part is (a) what’s happening to output after devaluation, (b) under what conditions the local suggency recovers (hint: low inflation).

Exchange Rate vs GDP

South-East Asia, 1997

asia_forex_gdp

Latin America

latam_forex_gdp

Exchange Rate vs Inflation

South-East Asia, 1997

asia_forex_infl

Latin America

latam_forex_infl

Inflation-Hunt

The inflation fear appears here and there, but mostly around government initiatives. One problem with this fear is: regardless of how you measure it, there’s no inflation in government initiatives. Economists spend a lot of time in the media repeating this.

But “inflation” is not even a public concern. You won’t find it in polls or, for instance, Google Search trends:

Source
Source

In fact, “inflation” is a problem in just one place:

Source
Source

Ok, in two places. Wall Street made traffic for NYC. Meanwhile, elsewhere:

Source
Source

Employment does remain a top problem in public polls for long. You might expect the media to keep the public updated on this, but:

NYT Chronicle
NYT Chronicle

The New York Times devotes about the same attention to inflation as to unemployment, despite unemployment being a much bigger concern.

What comes after ignoring both public and experts? Correlation in the tail of the plot is suggestive:

Source
Source

And anyone who disagrees is a witch!

Congress-speak

The New York Times evolved over time in words and topics (onetwo). And so did the US Congress.

To track topics in the congressional agenda, I compared the word frequency in bill titles over the last 40 years (see Appendix for details):

Education surges in the recent years, while health care does not

Health care takes about 18% of US GDP, but the US Congress mentions it only 400 times a year in its bill titles.

Security happens to be more important than freedom

About ten times more important. But the two correlate, so one serves another in certain contexts.

China replaces the Soviet Union

The Soviet Union appears in US Congress documents after 1991, when it ceased to exist. But China became popular around that time. The EU is less so, mainly because it’s still treated as two dozens of independent states, not a single union.

Unemployment periodically becomes an issue

Unemployment gets moderate attention (about 1/20th of “security”). Congresspersons ignore inflation, while the NYT devotes lot of attention to both and clearly prefer talking more about inflation:

Appendix: Data and replication

The US Congress bill titles are available from two sources:

Bitcoin and virtual currencies

Angel.co reports about half a thousand companies dealing with virtual currencies. CruchBase mentions 17 startups related to Bitcoin alone. Bitcoin was around for five years and attracted attention of the IT community, less of brick-and-mortar sellers and no attention of the finance industry. So, why not?

Critics’ key point about the bitcoin is: it’s not a currency. The plots by David Yermak:

The bitcoin’s value increases over time. Great. You become richer while not spending bitcoins. Hence, very few intend to pay for things in bitcoins. Meanwhile, everyone is glad to accept bitcoins over dollars. And that’s why some sellers integrated bitcoin transactions. They welcome payments in the asset whose value grows effortlessly. Especially if buyers make no adjustments for the deflation and overpay in bitcoins.

Volatility reflects risks, and the bitcoin happens to be a volatility champion among assets. Real prices nominated in fixed bitcoins fluctuate much over very short periods of time. When you have large margins or small number of transactions in bitcoins, it may not hurt. But most retailers are sensible to price changes and have to hedge the risks of even not-so-volatile currencies. Can they hedge bitcoins? Apparently, no:

Well, you don’t even know what asset you should buy to protect your bitcoin holding from sudden movements.

The bitcoin may have something like the Federal Open Market Committee to maintain the exchange rate against the basket of traditional currencies. But the supply of bitcoins is restricted by design, so you can’t treat it like normal money and create inflation of about 1-2% a year. At best, such a committee could avoid excessive volatility if it had sufficient volume of bitcoins under control. Then market participants would form correct expectations about the rate of deflation and would discount prices accordingly. This hypothetical central committee goes against the ideology behind the bitcoin, though.

Is it possible to design a decentralized currency that can smooth its own exchange rate movements? That’s an interesting exercise about managing the monetary base in a particular way. Injecting more money doesn’t move the consumer price level (or exchange rates) by itself. For example, the Fed’s quantitative easing after 2008 didn’t create inflation for non-financial assets also because other financial institutions preferred keeping money to spending it. You’ll need helicopter money drops for deflation, at least.

That’s just a hypothetical solution. Being centralized in terms of both capacities and responsibilities, any central bank is a major stakeholder for its own currency. Along with a national government, the bank is responsible for making its currency suitable for transactions and economic stability, insofar as monetary policies work. The bitcoin is an asset without a central bank. You have no stakeholder who cares about deflation and volatility. People outside the bitcoin community care little because, unlike the dollar, the bitcoin has no impact on the rest of the economy. And current holders of bitcoins must like the idea of ever-increasing value of their assets. All this hurts the bitcoin and similar virtual currencies at large.

NYT-speak continued

The New York Times’ choice of words tells much about history and the media. As seen before, their Chronicle shows great snapshots of the newspaper’s wording evolution.

Here, a few more cases.

Information sourcing

As Robert Fisk once noted, the media now rely more on what officials said, rather than sourcing news by themselves. That’s a confirmation:

Money and knowledge in crises

Though in general money and knowledge move in the same directions, money moves in greater magnitudes. Also, notice that in the Great Depression, as well as in the Great Recession, the NYT mentioned money less frequently. And the opposite happened during stagflation in the 70s.

Inflation and unemployment

Mentions of unemployment and inflation went in different directions before the 70s: right until the economy happened to have both. But it was a short period and right now there’re no mutual relations (at least, in wording).

In- and equality

Inequality never was an issue for the NYT. Even in the late 20s, when inequality was extremely high. So, it’s a new topic. Meanwhile, previous mentions of equality are generally associated with civil rights movements, as in the 60s.

“Make war, not love”

At its peak, war themes took up to 30% of the newspaper materials. But local wars, like Iraq and Afghanistan, never draw so much attention.

Referring to minorities

A similar graph was in the previous post, but here changes in wording are clearer. Especially right after the Civil War, when politicians no longer needed support from the black population, and one hundred years later, when politicians and media had to update their vocabulary.

Sports becoming more popular