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Sales tax to speed up inflation and slow down economy

Implementing a sales tax will not help the regional budgets. The excessive tax burden will drive business into the ‘shadows’ and raise the price of goods and services. In addition, retailers will see turnover fall, reducing profits and investment activity. This forecast was included in ‘Macroeconomic Analysis of the Impact of Changes in the Tax Rate on the State Budget and Market Participants’ by the Director of HSE’s Centre of Development Institute Natalia Akindinova

Falling revenues on the one hand and rising costs on the other have led to an imbalance in the budget system. Oil and gas revenues, which constitute half of federal revenues, are not growing, economic growth is slowing, and non-oil and gas revenues are also on the decline. With this, defence spending, pension obligations and liabilities stemming from decrees signed on May 7, 2012, are increasing. As a result, a budget deficit is arising, and this is even worse in the regions. The regional budget deficit was 1% of GDP in 2013, while it is estimated at 1-1.2% of GDP in 2014-2017.

To balance the budget, the government is considering increasing the tax burden on the economy, in particular, by introducing a sales tax and increasing value-added tax (VAT) and the personal income tax.

In the current environment of economic stagnation on top of the high risk of slipping into a recession, any potential increase in the tax burden will further reduce investment activity and adversely impact GDP growth, Natalia Akindinova posits in her report ‘Macroeconomic Analysis of the Impact of Changes in the Tax Rate on the State Budget and Market Participants.’ Further, additional losses from introducing a sales tax will amount to 0.2% of GDP in 2015 and 0.4% of GDP in 2016.

Too many taxes

Compared with other countries, the overall tax burden on the economy is not high in Russia – about 35% of GDP. This figure is comparable to the fiscal burden of most of the BRICS, as well as EU countries with a similar level of development as Russia.

Figure 1. Overall tax burden in the EU, U.S., and BRICS in 2013, % of GDP

 

Note: Data for Russia excludes oil and gas revenues (35% of GDP including such revenues).
Source: The Heritage Foundation (‘2014 Index of Economic Freedom’)

At the same time, the tax burden on business is close to its maximum values, the author of the study notes. Honest companies give up 50% of commercial profits in the form of taxes, which is significantly higher than the average value for the EU (42%) and the U.S. (46%). As a result, more than a quarter of Russian companies prefer to stay in the ‘shadows,’ guaranteeing themselves with certain relief in terms of taxes. An increase in the tax burden will result in an even greater rise in the shadow economy, the expert predicts.

‘In most regions, the introduction of a sales tax will not solve the problem of the budget deficit, and tax revenues might grow solely in Moscow, St. Petersburg and the Moscow region, as was the case during the previous sales tax experiment of 2003,’ Akindinova emphasizes.

Figure 2. Proceeds from the sales tax, as % of tax and non-tax revenues of the regional budget in 2003

 

A new tax will speed up inflation

In addition, inflation has been rising recently, and the introduction of additional taxes on consumption – which includes a sales tax – will further accelerate inflation.

The introduction of the sales tax will add at least 0.5% to inflation in 2015, the economist estimates. As a result, real disposable incomes will lose 0.8% next year. A 1% rise in VAT could yield similar results.

Against this background, the economist believes consumption will fall and retailers will see profits decline, which will drive down investment activity as a result. In addition, the deterioration of the business climate in retail trade will have an impact on the general economic downturn.

Growth of personal income tax in lieu of taxes on consumption

Given the worsening macroeconomic situation, it would be advisable to postpone a tax increase at least until inflation has stabilized and the economy returns to a path of growth, Akindinova notes. The author suggests considering other ways of achieving a balanced budget, for example, by using previously accumulated reserves and limiting an increase in spending obligations.

‘Stable growth in revenues needed to ensure the budget system’s long-term balance, given the relative decline in oil and gas revenues and the growth in spending obligations, is guaranteed primarily by measures that contribute to increased business activity and an improvement in the business environment, as well as by measures that lead to a reduction in the informal sector of the economy and an increase in tax collection,’ Akindinova writes.

If increasing the tax burden is unavoidable, then preference should be given to increasing existing tax rates before introducing new taxes. It is also necessary to take into account that the main unresolved imbalances occur at the regional budget level. From this point of view, the best option is to increase personal income tax since this, among other things, is not yet contributing to an acceleration of inflation.

 

September 18, 2014