The Façade of Fiscal Federalism in Russia

By Michelangelo Freyrie

Since the early days of privatization, political conflicts between Moscow and Russia’s other regions have helped determine the contours of the country’s political space. Tax revenue centralization is one such outcome of this constant tension. For instance, the percentage of levied funds which are allocated directly to federal subjects fell from 65% in 1999 to 30% today. With these resources gone, unstructured transfers from the capital to the regions have become an important component of regional budgets, as well as a powerful instrument to reward loyalty.  

Imperfect federalism, or the centralized financing of decentralized expenditure, is usually the result of a rather fair bargain: regional elites are insured against local economic downturn, while the center can easily punish unruly subnational units.

Transferring federal funds to subnational entities is commonplace, and it is usually regulated through mathematical formulas, as to minimize an arbitrary use of these funds by the center. Countries such as Germany use a strong federal senate to ensure regional control over these arrangements. However, the same cannot be said for Russia’s Federation Council, a body with limited competences whose weakness has recently been displayed by the surprising arrest of senator Arashukov in the middle of a session.  

From a purely economic perspective, the division of labor between the federal center and regional units could be determined by which layer of government is best suited to provide a public good by exploiting economies of scale and scope. However, a stable federal structure requires credible risk-sharing (or insurance against regional shocks) and redistributive arrangements to smooth income inequalities among regions. In Russia, transfers contribute to closing the gap on social spending between rich and poor subjects. In 2017, federal transfers amounted to 1.63 trillion rubles or 10% of the country’s GDP. Importantly, while half of the overall funds are distributed through formula-based subsidies and subventions, non-earmarked grants account for the rest of the allowances and give  Moscow leeway on how to manage the funds.

For some entities, these allocations are true financial lifelines. In Chechnya, Moscow has effectively bought a fragile, repressive peace by contributing up to 80% of the regional budget, mostly to the benefit of Kadyrov’s allies. Rating agency Fitch points out that the arbitrary nature of these revenues contributes to subjects’ uncertain budgetary planning.  Moreover, these transfers do little to encourage cross-regional, private-led growth and are hardly successful when it comes to ensuring against regional shocks. Even worse, there’s a tendency for federal transfers to follow a procyclical policy: since both GRPs (gross regional products) and the GDP largely depend on the global demand for natural resources, it is often the case that a local shock will be coupled with lower federal revenues, consequently hitting regions with high social expenditure the hardest.

Notwithstanding the Chechen case, transfers serve more as financial camouflage to hide the government’s unwillingness to conduct infrastructural investments. Along with being granted nominal constitutions or charters, federal subjects are fiscally and politically responsible for the domains of health, education, and infrastructure – all areas in which lack of budgetary certainty in the medium period is highly detrimental. This is perfectly illustrated by the objectives posed by Putin during his last mandate. The “May Decrees” of 2012 put significant pressure on regional budgets, especially in terms of recruiting new civil servants. Even in the best of times, administrative friction complicates the allocation of federal investments, and when the financial crisis of 2014 struck, many regions had to substitute the sudden reduction in federal funds with loans. So, a restructuring program was implemented in 2018 to counter the proliferation of debt. Notably, federal transfers reached a record of 1 trillion rubles ($15bn), half of which is dedicated to filling the void left by the imposed lending caps.   

Yet, the regions will still be among the prime enforcers of Putin’s newest “May Decrees.” Of the estimated 25.7 trillion rubles ($393bn) needed for implementation, 4.9 trillion ($75bn) will come from local government. Reassurances have been given that an overwhelming share of this expenditure will be covered by federal transfers. Yet, many regional administrations have preferred fiscal prudence and saved resources, leading to a relative slowdown in investments in 2018. The presidential decrees were meant to find an alternative to the waning “Crimea Consensus,” that justified Putin’s grip with a newly found “great power status.” But because of the financial fragility caused by Russia’s political posture, the Kremlin also needs to maintain reasonable emergency reserves. The result is a policy of passing the buck to the regions to hide the government’s impotence in pursuing both agendas at once.

The ineffective fiscal federalism can be considered as one of the major culprits of Russia’s social hardships. For example, in 2014, as inflation and consumption fell, social security funds increased less than 3%, while heavy cuts to federal transfers slashed the ability of regions to finance social programs. Relatively impoverished federal subjects were hit particularly hard due to plummeting spending on housing, education, and healthcare. Although entities such as the Moscow Oblast are rich enough to shoulder such weights, one wonders how other subjects will fare. The decision to introduce key performance indicators (KPIs) to judge regional governments will do little to counter these structural phenomena. A lack of economic equity will prove to be an even greater danger for the federation’s cohesion especially considering the weakening of local political machines. Russian federalism aims at ensuring territorial control, not the welfare of its citizens. But as history has shown numerous times, the lack of a coherent economic perspective, coupled with an uncaring central government, seldom encourages loyalty and order.

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