Sent: Thursday, October 08, 1998 9:49 PM
Subject: Finally...the comparison I've promised
Comparing the Russian and American systems of fiscal federalism and taxation is an overwhelming task, and I do not pretend that I'll do it justice in what lies below. Therefore, the best place to start is by lowering expectations. In the sections below, I'll share what I learned as I learned it and will add additional commentary and observations as necessary to clarify my journal entries. By the bottom, you'll have a sense for how and where we differ. You'll lack a lot of details, and you'll probably be frustrated about what's missing. But you'll know what I do, and you'll have a vastly improved understanding of where the challenges lie.
My first observation about the Russian system came early on in my visit. The following is based on a journal entry I made on Sept. 7th, after my first day of work (morning at the Union of Russian Cities, afternoon at the federal Ministry of Regions and Nationalities): Our first stop was the Union of Russian Cities, where a relatively brief (and utterly nonsubstantive) meeting with the Director was followed by an incredible (far too short) meeting with a bunch of former mayors-the Chief Deputy Director of the Union (former mayor of Kaliningrad), two other Union employees (both former mayors of smaller cities), and Vitaly (also a former mayor). Translation was performed by a guy who graduated from Moscow's premier translator's institute, and he was awesome. Best translator I've ever had by a power of ten. We mostly talked about revenues and expenditures at the City level - basic State Controller's report stuff, embellished by my explaining California's sales tax and excise tax systems and talking about what types of taxes are imposed by which levels of government in the U.S. I took the opportunity to ask about Russia's system and actually got great answers. We compared and contrasted systems a lot, but the lesson I learned was that the 89 state-like regions (krais, oblasts, etc.) make all the decisions about how much revenue cities get. Cities collect taxes and pass them on to the regions, but the regions are extremely arbitrary in their return of revenue to cities. This not only creates year-to-year planning problems, it creates a very unfair allocation of responsibilities. Cities in Russia provide everything our cities do, plus health and welfare. So…cities collect money, pass it on to an arbitrary higher level of government, and fail to receive enough money to carry out their responsibilities. On one hand, it's proper that taxes not be directly related to levels of service provision (taxes vs. fees, after all), but on the other hand, Russian cities' failure to impose fees and subsequent heavier reliance on taxes creates a system that's broken. They did laugh, however, because they came to understand how confusing and multi-layered our system of taxation is in California (sales taxes on top of excise taxes, state taxes on top of federal taxes), and my explanation of property tax allocation was enough like their city/oblast relationship that they understood it immediately. I left feeling they'd learned a lot about our system, and I know I learned a lot about theirs. A very enjoyable and enlightening session for us all. Later in that day's journal entry, I observed: "The most interesting question of the day (which came at the federal Ministry of Regions and Nationalities) was a request for the book that has all the formulas used to calculate the amount of money given to state and local governments in the U.S. by our federal government (for all types of programs - welfare, education, transportation, etc.) I explained how impossible that request was to fulfill, how it would entail poring through thousands of pages of laws and regulations and how even programmatic experts would take a very long time to compile all the relevant formulas for their particular policy area in one place, let alone how impossible it would be someone to compile all formulas for all policy areas in one place. But, I probed the questioner regarding her reasons for asking, and it turns out that she sits on the federal committee charged with figuring out how much money each region should get from the federal government for each expenditure area. Currently the money is allocated in very arbitrary ways, which leaves all 89 oblasts/krais and Lord knows how many cities all climbing over each other at once, trying to convince the federal government why each is more worthy of money than another. I gave her a very detailed response by walking through all of the analytical steps one would take to calculate such sums fairly, and she was blown away and VERY appreciative. Never had anyone explained any of this to her (her exact words, though in Russian, of course). Of course, the examples I gave were very simple. Clearly I had neither the time nor the expertise to advise her on specific formulas for specific program areas in her country. But simply walking her through a few simple examples (I did primary and secondary education, prisons, and welfare payments) provided what she claimed was immensely valuable insight. Simple analytical reasoning, but it was new to her and the others. Wow." Observations after my first day of lectures at Kaluga City Hall on Sept. 8th:: "Once again, I was struck by the reversal in systems of budgeting between Russia and the U.S. In Russia, each local government is on its own when it comes to lobbying higher levels of government for rubles for programs. In the U.S., the federal and state governments devise formulas based on collective information they receive from local governments, with supplementation by federal/state department employees who go into the field to verify what they're being told by the locals. I've stressed in these conversations the analytical nature in which formulas are developed in the U.S., and I think I've made the point well (or hope so, at least). However, these discussions have also allowed me to comment on some of the problems inherent in systems that are less top-down than the Russian system. For example (as I cited), the relative autonomy of lower levels of government in the U.S. leads to variability from one place to the next. So, one state might have a completely different set of criteria for funding education or welfare or prisons than another. Thus, I stressed that I wasn't advocating a system lacking federal control. This they understood. Thankfully, all of my repeated reminders about my role here (I'm here to share theory and practice, not to tell you what to do nor to critique your system) seem to have sunk in well. I haven't gotten questions asking, 'What should we do?' Just lots and lots and lots of questions asking, 'How do you deal with this situation?'"
More observations, these culled from a very full three days of lectures/give-and-take with seminar participants at Kaluga City Hall, supplemented by the day I spent at Kirov City Hall and conversations I had with two book accountants (one in the west, one in the east): There is no such thing as a state income tax in Russia. Only the federal government imposes income taxes. There is no such thing as an autonomous state or local tax collection agency in Russia. Local tax collection agencies answer to the krai/oblast tax collection agencies, which answer to the federal tax collection agency. Whether taxation or budgeting, Russia is top-down. Cities do the bidding of their parent krai/oblast and the federal government and are almost completely at the arbitrary will of these higher levels of government for revenue. Krais and oblasts do the bidding of the federal government and are almost completely at the arbitrary will of the feds for revenue. Cities are allowed to keep some (relatively small) percentage of the tax revenue they raise and are required to relinquish the rest to higher levels of government. Same with krais and oblasts. Complicating all of this is the inability of any level of government to raise enough revenue. So, budgeting and fiscal federalism in Russia is a complicated series of finger pointing. Cities blame the krai/oblast and the federal government for lack of revenue. Krais and oblasts blame the federal government for lack of revenue. The federal government blames taxpayers for not remitting what they owe. Taxpayers claim an unfair and burdensome tax system. And so it goes. Which is an excellent segue to Russian taxes. Is the Russian tax system burdensome? I'll let you decide. However, I will observe that the current tax system is very highly reliant on taxes paid by corporations. Thus another difference between our two countries. Both our federal and state government are approximately four times more reliant on personal income taxes than on corporate income taxes. The situation in Russia is reversed (though I can't give you any percentages, because they're not public information). A new Russian tax system is supposed to be put in place on January 1, 1999, but the current economic turmoil will likely delay that date and may dramatically change the system that is eventually implemented. Thus, rather than speculate as to the new system based on what's already been published, I'll describe the existing one. Under the existing Russian tax system, individuals pay two types of taxes - a personal income tax of between 12% and 50% (theirs is progressive, just as our is, but they don't allow for differences in filing status) and a pension tax that used to be 1% but was increased to 3% sometime during 1998. Both income and pension taxes are deducted from employees' paychecks each pay period (just as in the U.S.), and end-of-year tax returns are due from each individual (just as in the U.S.). There is no such thing as capital gains taxation in Russia. Businesses must pay a large number of different taxes, including a value added tax (I was quoted rates between 12% and 28% and told by one group that the rate depends on the type of good sold but by another individual that the rate depends on the type of business buying the good); a profits tax between 35% and 43% (this is a flat tax, and the rate is dependent on the type of business; commercial businesses pay 43%); a 28% pension tax (I'm not sure if this is a tax on income earned or on wages paid); a 5.4% social insurance tax (much like our Social Security tax in that it's paid on total wages paid); 3.6% medical insurance tax; 1.5% unemployment tax; plus additional (variable rate) land, utility, and assorted local taxes. Tax expenditures are common, but they're doled out (arbitrarily) to individual companies rather than allowed to all companies who qualify based on criteria contained in law. The system for paying corporate taxes is astounding in its user-unfriendliness. Each business must be represented by a "book accountant." This book accountant is responsible for preparing monthly or quarterly tax returns (payment frequency depends on the size of the business) and physically taking the monthly or quarterly return and money owed to the tax agency each reporting period. The book accountant is required to sit in a room with a tax agency employee while the tax agency employee reviews the tax return. If the tax agency employee has questions, he/she will first ask the book accountant. If unsatisfied with the book accountant's answer, the tax agency employee will visit the business for additional information (no mail solicitations; no phone calls; everything in person). Book accountants are liable for the validity of the information contained on the returns they prepare. This together with the fact that businesses have tremendous incentives to underreport income leads to a great deal of care among accountants in choosing the businesses they represent. Annually, the tax police is supposed to visit each business to review the onsite bookkeeping practices. However, even a top heavy organization like the tax police (which truly has a TON of employees) lacks sufficient personnel to visit each business this frequently. Typically, annual visits are only made to businesses suspected of trying to evade taxes. One question I received repeatedly (until I simply anticipated it and incorporated it into my lectures) had to do with how our tax agencies deal with taxpayers who can't afford to pay their entire tax liability at once. I discussed the ways in which our systems are designed to accommodate taxpayers who may have fallen on hard times but who still want to fulfill their tax responsibilities rather than filing for bankruptcy. Which led me to explain that our tax agencies understand that pushing taxpayers into bankruptcy is often self-defeating - that they're often better off being patient, agreeing to installment payments or making settlements, and waiting 'til taxpayers' financial situations improve than asking for everything all at once. Russia hasn't quite figured out that you can't get blood from a stone. In Russia, no installment payments are allowed. If you owe tax, you owe tax. Period. Even if you have no money. Even if you haven't received wages or a pension from the federal government for several months. Tax owed is tax owed. And, in Russia, tax owed is often tax left unpaid. I'll conclude by offering some commentary. Clearly, Russia's tax system requires significant change. I found a great paragraph in a recent report co-written by the National League of Cities, National Conference of State Legislatures, and National Governors' Association ("Is the New Global Economy Leaving State-Local Tax Structures Behind?"). To quote: "Consider this worst case scenario: the tax structure gradually taxes a smaller and smaller percentage of all economic activity (for example, that which is easy to identify and collect); over time, rates on this smaller base are forced higher to generate sufficient revenue; this pattern heightens the public's conviction that the tax structure is inherently unfair; voluntary compliance declines; tax agencies are forced to spend more to collect and enforce inefficient taxes; and ultimately the integrity of the tax structure and the credibility of these governments are tarnished." That quote was not written with Russia in mind, but it describes the current Russian tax situation perfectly. However, to my mind, the challenge is not rewriting Russia's tax system. Get 20 smart people in a room (some tax wonks, some economists, some lawyers, a few business people, a few politically astute individuals) and you could probably craft a system that (on paper) would work in Russia. The challenge would be implementing it. At the simplest level, a new tax system would require a set of transition rules. For example, how do you shift more of the tax burden to individuals when most people haven't received their wages for several months? However, even if you could design a set of functional transition rules, more (greater) challenges would remain. For example, how do you restore peoples' confidence in the tax system when their government has repeatedly been highly arbitrary in its use of tax revenue?. Thus, a huge challenge lies in reforming Russia's system of fiscal federalism to ensure that the responsibilities of various levels of government are clear, decisions about spending are based on analytically-based law rather than made arbitrarily, and revenues provided are commensurate with service responsibilities. However, even if a wonderful (theoretically functional) system of fiscal federalism could be designed, enormous challenges would still remain. It's hard to understand the amazingly high levels of distrust among Russian people toward their governments and among Russian governments toward each other unless you've seen it for yourself. Yet, having seen it convinces me that designing a new tax system (complete with transition rules) and a new system of fiscal federalism that is fair and accountable to both people and governments is just the beginning. Having designed those systems, the fundamental challenge becomes gaining agreement among all relevant parties to comply with the new systems. This may seem obvious, but it is not in Russia. People there have been trained their whole lives to adopt a survivalist mentality - to look out for themselves at all costs and to distrust those who haven't proven themselves through action. You cannot simply put a new system in place, say a few words about how well it's designed and how everyone should rally behind it, and walk away. People and governments need to be won over and convinced that the new systems will work, and this somehow needs to be done early enough that the momentum of those early believers is sufficient to generate momentum throughout the rest of the country. Given those incredible (some would say insurmountable) challenges, where does one start? My (thankfully simple) answer is would be, "Where we have. At the simplest level. With information sharing between Russians and Americans." Rome wasn't built in a day. Restoring functionality to Russia's systems of taxation and fiscal federalism won't be done in one either. Understanding is the first key, patience is the next. Determination, bravery, willingness to take chances…there'll be plenty of time for those, too.