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WSJ: Opinion Journal

November 26, 2002

Editorial Page

The Putin Curve

We don't usually tout Russia as a model of economic enlightenment. But with the tax-cutting debate in full cry here in Amerika, it's a good time to review Russia's recent tax revolution. We hope President Putin's "very frank" discussions with President Bush last Friday included talk of tax reform.

The Russian reforms began in earnest at the start of 2001, when Mr. Putin introduced a 13% flat tax on individual income, replacing a convoluted system that had a marginal rate of 30%. Then came a cut in the tax on corporate profits by nearly one-third to 24%, the closing of a large number of tax loopholes for companies, and the simplification and reduction in social security levies.

What happened next is illustrated in the nearby chart. Tax revenues immediately began heading north, as citizens decided it was easier to pay taxes than go to the trouble of avoiding them. This was a classic Laffer Curve result -- an enlarged tax base and a surge in tax revenues.

Before Mr. Putin's reforms, the post-Soviet tax system had been marked by fluctuating tax rates -- all high -- and a Byzantine tax code, the interpretation of which was left to poorly paid bureaucrats who relied on "gifts" for favorable rulings to supplement their incomes.

The International Monetary Fund didn't help matters by opposing lower tax rates and counseling tougher enforcement. Enforcement being something Russian officials do instinctively, armed tax troops set out raiding corporate offices and tearing through files. Most individuals who earned above-average wages (roughly more than $200 a month) asked for and received the bulk of their income under the table.

Shorn of revenues, the government cut "offset" deals with Russia's corporations, writing off taxes in exchange for fuel, electricity and other commodities. The system and its enforcement led to spiraling evasion and gray market activity.

After the 1998 crash, the IMF hightailed it out of Moscow and thereafter remained mercifully on the sidelines. With the loss of outside help, sheer economic necessity forced Moscow to take a revolutionary approach to taxation. At the stroke of a pen, Mr. Putin decriminalized practically an entire society of tax cheats. He made complying with the law an affordable alternative to cheating.

Russia's corporate tax cuts have not had as dramatic an effect on revenue as the flat tax, in part because the closing of numerous tax allowances has meant a steep increase in the effective tax rate for many companies. While the changes make corporate taxation fairer, there is a clear need to reduce rates further, something the government has been talking about.

Rising tax revenues also reflect the recent growth of the Russian economy, which is attributable in part to a run-up in world oil prices. But that isn't the whole story. The tax reforms have provided a solid basis for economic growth and investment. As important, they have signaled to Russian individuals and businesses that the government is serious about creating incentives to productive work and risk-taking.

As flat-tax advocate Steve Forbes likes to say, taxes are a fee charged on productive endeavor, particularly successful endeavor. Tax cuts lower the cost of labor and risk-taking. In the nature of things, corporations pass on taxes to consumers or, failing that, reduce investment or the rewards to shareholders and employees. Whether or not tax cuts boost revenues, they always free up the productive resources of the economy.

So far, Mr. Putin has demonstrated a better understanding of this relationship than many in Washington. Another tax going on the Russian scrap heap is the "road user" tax. At about 1% of corporate revenues (not profits), the tax was highly regressive, a disincentive to investment that pushed a lot of business into the black market. Economic Development and Trade Minister German Gref sounded like a supply-sider when he said that the elimination of the road user tax is "the first step to stimulating economic growth."

Russia's tax reform remains a work in progress. A new transportation tax and increases in the gasoline excise tax and the land tax next year are a return to the IMF playbook. Russia's overall tax burden remains far too high, especially for a poor country. It is one piece of a need for further broad economic reforms.

Still, Russia's government is on much sounder footing now than it has been at any time since the fall of the Soviet Union. The economy grew 9% in 2000 and 5% in 2001 and is expected to expand by more than 4% this year. The Moscow stock exchange has been galloping while other exchanges have groaned.

The Russian example shows that this is precisely the right time for tax reforms to spur economic growth in the U.S. Opponents complain, as always, that tax rate cuts will shatter governmental budgets. What's the Russian word for baloney?
 

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