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.

Economics of Poor Governance

Ideas about “structural reforms” get copy-pasted from one development report to another, and for a good reason. These recommendations—basically about improving the economy’s fundamentals—indeed matters. But guess who’s supposed to implement them? Governments! And the quality of reforms depend on the quality of governments that implement them. What’s happening to government?

QoG Dataset
QoG Dataset (which aggregates other sources)

So, why is that?

The rule of law, which government is supposed to provide, is crucial for economic development:

QoG Dataset
QoG Dataset

But the rule of law implies incorruptible public officials:

QoG Dataset
QoG Dataset

Which is not the case when a country lacks specific institutions:

QoG Dataset
QoG Dataset

However, these institutions undermine narrow political power and, therefore, unlikely to emerge:

QoG Dataset
QoG Dataset

In brief, we ask corrupted officials to stop being corrupted and limit their power. Actually, it does make sense because development economists also address honest officials, who are more numerous and try to change things. It may work. Ruling parties in non-democracies attempt to improve governance without giving much power away to the press or opposition. They initiate genuine openness reforms, let citizens request information, complain, sue the government—unless it becomes political.

Still, the quality of government stagnates around the world. Partly, it happens because dark forces hiding in ruling parties defend their interests. Hey, that’s the problem we’ve started from! Not surprisingly. The literature says about the benefits of good governance, but its recommendations follow from the relationships found in developed countries, which already have uncorrupted governments to enforce the rule of law and the rest. Demanding Switzerland-style governance from corrupted governments looks like a hopeless idea. Not only the dark force resists, we also have few reliable solutions in mind—solutions that would be feasible given all peculiarities of political institutions in developing countries.

What sort of knowledge is to look for? Perhaps, of two types:

  1. How to improve governance when the dark force resists? Honest judiciary, transparent elections, and able police create conditions for economic development. Well done. Now we want to know more about paths to these conditions. Much work has been done before in law and political studies. But as an ignorant economist, I see much space for improvements. Economists got their invisible hands on these subjects just recently and noticed the scarcity of (a) formal models, (b) suitable data. These are nice things to have. Theories escaping these two pieces leave us in the Middle Ages, which is not nice.
  2. How to run an economy with dark forces? Given its history, economic theory paid more attention to well-governed nations, not to those with problems. For one example, corruption creates information asymmetries of the type that economists haven’t paid much attention to. Take a firm that has political connections and can generate profits above the market average. Can it gain access to capital? No. For this, it must credibly disclose its superiority to banks, which is impossible because the advantage comes from informal political connections. One way or another, capital finds these opportunities, but imperfections remain, so the equilibrium level of investments is lower than the economy and technology allow. So, the problem has implications that have not been studied as deeply as the economics of good governance.

These issues arise in development economics; it’s impossible to ignore them. But the field is small compared to the rest of econ-worlds:

Screen Shot 2014-11-25 at 8.55.44 PM

Economics of poor governance awaits intellectual reinforcement from other fields. Wellbeing of 6 bn people is at stake.