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:

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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):

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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.

Amazon Monopoly Is Better than Free Market

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Amazon’s monopoly in online retail got some attention recently. For years, Amazon restrains other online retailers with predatory pricing and covers its own losses with debt. The debt is cheap because the company enjoys a low-risk monopoly and can fix its profit margin anytime. But there’s no need to do so until lenders see this huge advantage.

That’s a bad thing about Amazon. A good thing about Amazon is that the company invests in new technologies and better service. Customers don’t have to stay 20 minutes on the line or worry about out-of-stock goods. Scale and scope of Amazon operations made this possible.

Online retail in Russia shows how the world without this kind of a monopolist looks like. Thousands of firms sell about the same stuff. Independent price search engines (of the kind Google tried to be) ensure competitive prices, hence, profit margins remain low. Low profit margins kill any chances for these small retailers to invest in service and inventories. Sellers economize on everything. In the end, customers buy stuff across dozens of shops with equally poor service and red tape, like entering all your personal information again and again.

An Amazon-type retailer isn’t emerging in Russia because the entry cost is already high and VC firms dislike investing in highly competitive markets. In turn, online retailers have no sources of capital to reach Amazon’s benefits of scale. “What about Walmart?” you may ask. It had emerged out of a competitive industry and became the largest company in the country.

It seems that Walmart appeared at the right moment. When Sam Walton opened his first shop, the United States invested heavily in new highways and railroads. Import of goods and interstate trade intensified. You need efficient logistics to keep prices down in this game. Walmart had it and became a monopolist in its segment. It entered international markets too late, as with Germany, and failed there.

Such technological revolutions rarely happen. But when they do—as with Walmart, Amazon, or Russian retailers—they shape the market for years. The sequence is important. You do want an Amazon-type monopolist to explore efficient practices in the beginning. Thousands of small firms don’t innovate like this, so low quality reigns the free market for years, which is a real loss. But after you have the monopolist that sets high standards, governments need to understand how to regulate it to revive competition.

Nobel for the Evident

Jean Tirole got this year’s Nobel for showing how to regulate big firms better. His work may be confusing to non-technical audience, but it makes millions of customers happier. When you pay your phone bills or mortgage, recall Tirole. Without him, these bills would be more expensive.

The Nobel committee published a summary, which also explains how economics relates to the real world. This point is not evident even to graduate students in economics, because professors pay attention to techniques of, not motivation for, economic analysis. Like education in general.

A relevant example from the summary. The 2008 crisis was triggered by the shift in the quality of financial assets. Assets that seemed safe were not so. But market participants were unsure which ones. Sellers knew their assets better than potential buyers. Buyers expected sellers to put toxic assets on market first, and no one wanted to buy suspicious property. The market would be still when sellers needed cash and other things in exchange for their (perhaps) good assets.

The government had to intervene to prevent the negative impact on the economy. What should it do? Whose assets to save first? In less fortunate countries, the answer was evident: the assets of public officials’ friends. That’s not the best choice, unless the friends had the worst assets, which Jean Tirole recommends to buy first. Then the government should provide financing to the owners of mediocre assets, without buying the assets themselves. In the end, according to Tirole, only high-quality stuff remains on the market, so normal buyers are no longer afraid to act.

Sure, “it’s evident.” But on the way to the evident you need to reject hundreds of other evident hypotheses. Second, you need to prove it. Not just few facts leading to a desirable conclusion, but a coherent model that prevents tricks like 2+2=5 in reasoning (happens more often than many think). It matters for those billions of people who suffer from very confident policymakers who know everything without proofs.

In other words, the committee awards the Prize for the path, not the result. And even a great path needs some explanatory background to appreciate it fully and demand something similar from those who make key decisions.