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.

The French Connection

One month ago the French police arrested two Uber executives for running an illegal cab company (yes, Uber) — the sort of accusations supported by the French court. I hope the CEO of Uber won’t end like Al Capone, but I would say a couple of good things about the company in advance.

Uber found an ironclad source of value: a heavily taxed and regulated industry with unsophisticated laws. A few changes in the business model totally confused regulators, and Uber currently enjoys a tax advantage across North America and Western Europe. The company surely shares the profits from this advantage with its drivers and clients, but at the expense of other cab services.

These traditional cab services operate in a boring market where no one makes big profits. High prices usually just include all the payments to the city, like expensive licenses and employee-related taxes. Are these payments a waste? In cities like Paris tourists enjoy clean streets and good roads because they pay this high price for personal transport. And so do locals: a taxi means more jams, more pollution, and more roads. On the contrary, when cities keep transport-related taxes low, the mayor gets reelected but the entire city spend each morning in jams.

What about the better drivers that Uber has? Actually, they are paid higher wages:

Source
Source

How’s that? The part-time employment that implies lower taxes (and cost hiding). Which brings us back to the argument above.

Yep, Uber has all those driver ratings and such, but even small traditional taxi companies learned how to get feedback on their drivers. But better employees want wages that are — taxes included — incompatible with the industry.

The second success factor of Uber-like multinational taxi services is the McDonald’s signal. Wherever you happen to be, there’s a company with the known standards of quality. As for taxis, at least you won’t end up in the wrong part of the city with the driver having his first week in a new country. But that’s for folks who travel a lot across cities, so not the biggest deal.

It’s possible, of course, that Uber creates value in other ways, like managing its cab fleet better. They don’t reveal this information. They did reveal the interest in replacing humans with self-driving cars after their raid on Carnegie Mellon, but that’s for the future.

This sounds less revolutionary and disruptive than the “sharing economy” evangelism, but startup founders waste time on ideological companies that fail because sharing by itself creates little value. It’s really better to spend less time in development and more time in looking for real sources of value here.