Beyond the frontiers of Moscow: Fiscal adjustment of Russian regions during the crisis

Living in Russia for almost a year now, and having visited several regions, one thing is clear—there are many Russias! A vast country, with swathes of territory extending into remote and frontier regions, Russia’s territorial endowment and economic geography is mesmerizing. Contrary to some perceptions of “Moscow” running the country, Russia is actually quite decentralized. The degree of fiscal decentralization in Russia is similar to that of other middle-to-high-income federal countries. For example, Figure 1 shows that when looking at the size of subnational government spending as a share of GDP, Russia is not unusual.

Figure 1: More similar than you think: Fiscal decentralization is Russia compared to others (subnational spending as a percent of total government spending)

global_20170710_decentralizationSource: World Bank, Russia Economic Report #37, 2017

Though much has been written and discussed about how Russia fared during the crisis years of 2014-2016, little is known about how the subnationals (“regions”) managed during these years. This is the gap that our latest Russia Economic Report attempts to fill, and some findings are surprising.

 Let’s get fiscal

What do subnational governments spend on? Mostly on social sectors—education, social protection, and health—which together accounted for over half of total subnational expenditures in 2016. How do they earn their revenues? While there are variations (sparsely populated oil/gas/gold-producing regions of the far north and east of the country have the highest per capita revenues), most of the subnational revenues came from a combination of sources, with shared taxes (personal income tax and corporate income tax) accounting for over half of all revenues.

So how did the regions fare during the crisis? We find that the regions weathered the slowdown well, showcasing low deficits and broadly moderate debt levels. Indeed, it is after a decade that they registered a modest fiscal surplus (revenues less expenditures).

However, years of deficits have resulted in growing levels of subnational debt, which reached 35 percent of subnational discretionary revenues and 2.7 percent of national GDP in 2016. By global standards, this is not large (most OECD countries impose a ceiling on subnational debt ranging from 60 percent to 100 percent of annual revenues). The cost of servicing debt is not a significant burden to subnational governments either: interest payments consume only 1.6 percent of budgetary expenditure.

So, if neither volume nor cost of debt is a significant concern, what then is the issue?

The first is that there is significant variation across regions: over half of the regions have debt-to-revenue ratios of more than 50 percent, and five have debt-to-revenue ratios more than 100 percent. The second relates to the structure of debt: A significant part of subnational debt (almost 40 percent) takes the form of short-term loans from commercial banks. The short-term nature of such debt means that subnational governments face a rollover risk. As Figure 2 shows, in response, the federal government has begun to step in. Federal loans now account for one-third of subnational debt, and it is not clear how long this can continue.

Figure 2: Subnational Debt: Commercial loans are high and federal loans are on the rise

global_20170710_subnational_debtSource: World Bank, Russia Economic Report #37, 2017

The taxing journey to sustainability

While subnational governments have, so far, adjusted successfully to the recent economic downturn, it is unclear how sustainable this adjustment will be. Moreover, it is unclear how long the latter can continue relying on expenditure cuts at the subnational level before the social and political consequences force it to step in further. Better debt management and unlocking the growth potential of regions is the way forward.

We caution against blunt expenditure cuts. This is because the fiscal impact of cutting capital spending is unlikely to be large as capital spending represents only a small proportion of total subnational spending (10 percent in 2015). In contrast, cutting the wage bill (by freezing nominal wages and/or reducing staff numbers) is likely to have a much larger effect due to the large proportion of subnational spending devoted to salaries. But these cuts have to be nuanced and need to be accompanied by pay and grading reforms, even allowing some subnationals to increase salaries in occupations that have been difficult to fill.

There is more hope on the revenue side. Even though all personal income tax (PIT) revenues accrue to the subnational governments, the PIT rate is fixed in the federal tax code (a 13 percent flat tax rate). Barring changes to that, a better strategy might be for regional governments to raise the corporate income tax (CIT) to the maximum 17 percent and refrain from granting exemptions and tax reductions to individual firms (for example, Moscow reduces the CIT by 4.5 percent if you want to build a ski resort). Given the importance of the CIT, this could have a significant impact on revenues, particularly in industrialized and urbanized regions. Moreover, regional governments can also accelerate the shift from book value to market value as the basis for assessing the corporate asset tax, land tax, and building tax; only 56 of the over 80+ regions used market value for property taxation of businesses.

The future interface: shifting fiscal responsibilities in Russia

However, in the longer run, fiscal sustainability may require fundamental changes aimed at improving the public-sector efficiency of subnational governments. There may have to be a fundamental rebalancing of the division of revenues and functional responsibilities between the federal government and subnational governments. The former could either shift more functional responsibilities to the federal level or increase the revenues of subnational governments. Nonetheless, sustainably moving the needle on productivity and efficiency across Russia’s vast and disparate regions was never going to be easy.