The economic consequences of the recent senior government appointments

President Putin has transferred his chief-of-staff Dmitri Medvedev to the government, introducing the office of first deputy prime minister especially for him. Defense Minister Ivanov was promoted to deputy prime minister. The economic consequences of these appointments will have an impact on ordinary citizens.

President Vladimir Putin’s decision to appoint Dmitri Medvedev, formerly head of the presidential administration, as first deputy prime minister and Defense Minister Sergei Ivanov as deputy prime minister would seem to have a purely political significance. Indeed, Putin made it part of Medvedev’s duties to chair the presidential council on implementing the national projects, and the government will have to implement the projects. Thus, transferring Medvedev to the government is a logical move: he is the most appropriate person to take charge of the process. But observers concluded immediately that the national projects weren’t the main issue here, and that the appointments were linked to the problem of the succession after 2008, as well as the future of Prime Minister Mikhail Fradkov, whose fate many regard as uncertain.

Political reshuffles at such a high level are bound to influence both economic policy and the daily lives of ordinary citizens. The most obvious consequences concern the national projects themselves. Regardless of any hidden political significance in Medvedev’s transfer from the presidential administration to the government, he will have to behave in such a way that all this has the outward appearance of intensifying work on the national projects. Thus, the basic ideas involved in the projects proposed by Putin will be implemented, one way or another, especially since this won’t all that difficult: thanks to the exceptionally favorable exports situation, the federal budget has more than enough petrodollars. The total volume of federal budget expenditure on items other than interest payments, adjusted for inflation, should rise by at least 15% in 2006 and 27% by 2008. Budget spending will go up by 348 billion rubles in 2006, and a total of 1.028 trillion rubles in 2006-08. Funding for the national projects has already been allocated. The draft budget for 2006 includes 21.9 billion rubles for the affordable housing project, 22 billion rubles for the education project, 57.9 billion rubles for the health-care project, and 14.2 billion rubles for the agriculture project. What’s more, the government and the United Russia party have already reached agreement on allocating an additional 18.6 billion rubles for all these aims. Funding for the national projects will almost double by 2008.

Medvedev will focus on the health-care project first – that is, raising the salaries of state-sector doctors and nurses. This ought to make a big impression on ordinary citizens: everyone comes into contact with doctors, one way or another, and many people have friends or relatives who are health workers. So this will be a case of the economy influencing politics, rather than politics influencing the economy: the federal funding spent in this manner will boost the authority of the president, the government, and First Deputy Prime Minister Medvedev personally.

Officially, Medvedev is only responsible for the national projects, not for the overall prosperity of Russian citizens. But the difference between the national projects and overall prosperity is so variable that it wouldn’t be hard for Medvedev to see himself as a fighter for constant wage rises for all citizens – especially state-sector workers. As at 2005, the average wage in the state sector is 6,360 rubles a month; the plan at this stage is to raise this to 7,599 rubles in 2006, 8,601 rubles in 2007, and 9,875 rubles in 2008.

Meanwhile, Deputy Prime Minister Sergei Ivanov now has an opportunity to show all citizens, military and non-military alike, that he is fighting for increased state spending on defense and security. This expenditure will rise by at least 129 billion rubles in 2008, and by a total of 410 billion rubles in 2006-08. And Deputy Prime Minister will certainly do all he can to make this growth even more substantial.

Naturally, a great deal depends on how Medvedev and Ivanov get along with Finance Minister Alexei Kudrin and Deputy Prime Minister Alexander Zhukov, who can always say that they have a better understanding of the fine points of budget finances. And here we turn to some other consequences of these political appointments: the less-obvious economic consequences.

This concerns the ongoing debate about cutting the VAT rate from the current 18% to 13%. That’s exactly what Prime Minister Fradkov proposes to do. The most comprehensive argument for this proposal has been set out by Mikhail Kopeikin, deputy Cabinet chief-of-staff, in a memorandum entitled “Supplementary measures aimed at accelerating economic growth,” which Fradkov signed in early October together with a list of specific instructions addressed to the Economic Development Ministry and the Finance Ministry. According to Kopeikin’s calculations, cutting VAT ought to add 1.5% to GDP growth by 2008. What’s more, Fradkov demanded at Cabinet meetings that Economic Development Minister Herman Gref take account of his taxation proposals in writing the government’s mid-range economic program. But Gref did not include cutting VAT to 13% in this program. He maintains that while a VAT cut would be acceptable in theory, it should go no lower than 16%.

Fradkov’s proposal is also resisted by Kudrin, who argues that VAT must not be reduced before 2008, because doing so would cost the state vast amounts of tax revenue. Actually, Kopeikin also admits that the revenue loss in the initial phase could be around 300 billion rubles. Kudrin maintains that it would be much higher – around 500 billion rubles. Oddly enough, the private sector isn’t all that keen on the VAT cut idea either. Alexander Shokhin, head of the Russian Union of Industrialists and Entrepreneurs, has stated that the main problem for private companies is tax administration, and a VAT rate cut could always be “compensated by tougher tax administration and increased fines and penalties.”

The side Medvedev takes in this dispute will determine his relationship with Kudrin (and consequently, whether the Finance Ministry cooperates with Medvedev’s proposals for uninterrupted national projects funding), as well as the taxation regime in Russia. Clearly, 18% VAT is very different from 13% VAT. Medvedev is likely to choose the same solution that was proposed by the presidential administration when he headed it. Arkady Dvorkovich, head of the presidential administration’s analysis directorate, argued that the state could cut the VAT rate to 15-16% from 2007, while simultaneously abolishing the concessional rate of 10%. He also noted that the government should take measures to avert price increases for essential goods when this is done, since the concessional rate applies to them. Dvorkovich said: “Various organizational measures could be used with regard to medications, and economic measures with regard to food products.” Dvorkovich noted that if VAT rates are unified in this manner, some price increases would be almost inevitable in the first three months; in his view, however, prices would then come down again, since there are no economic reasons for them to stay high, and there is a sufficient level of market competition for the goods in question.

The sufficient level of competition is an arguable point. Prior to Medvedev’s transfer, citizens were increasingly concerned about the government’s inability to come up with an effective way of fighting inflation, which is over 10% a year – an incredibly high figure by world standards. As soon as Medvedev’s new appointment was announced, the Economic Development Ministry submitted the package of anti-inflationary measures which the Cabinet had ordered in late October. Officially, this package was developed jointly by the Central Bank, the Finance Ministry, and the Economic Development Ministry; in practice, however, it contains some mutually exclusive methods of fighting inflation. The Economic Development Ministry states that the Finance Ministry is largely to blame for inflation, because its level of social spending is too high: “Due to increased social spending in the federal budget, the extra rise in real incomes has led to the inflation target being exceeded by 1.4-1.8%.” According to the Economic Development Ministry, inflation in Russia is caused by an imbalance between supply and demand. Real incomes rose by 8-9% in the first ten months of 2005, while the supply of goods in the economy increased by only 6%. Thus, every effort should be made to accelerate economic growth; then there will be more goods available, and prices will stop rising so fast. Economic growth should be accelerated by means of budget spending – investment spending rather than social spending. That’s because increasing social spending by 1% of GDP produces an inflation rise of 0.7% and GDP growth of only 0.15%; but increasing investment spending by 1% of GDP produces an inflation rise of 0.4% and GDP growth of 0.3%.

Meanwhile, in the very same anti-inflationary package, the Finance Ministry argues that investment spending must not be increased; on the contrary, state revenues should be increased – and they should go into the Stabilization Fund, not the federal budget. The Finance Ministry proposes to direct export tax revenue from petroleum products and natural gas, as well as crude oil, into the Stabilization Fund from January 1, 2007.

Medvedev is unlikely to support the Economic Development Ministry in this dispute, because he’ll have to increase social spending anyway. He seems to be more in favor of the Finance Ministry’s stance: after all, President Putin is constantly praising the growth of the Stabilization Fund. At any rate, it’s clear that regardless of which position Medvedev chooses, this will have no impact at all on reducing inflation. That’s because consumer prices have been rising rapidly all along – whether GDP growth is high or low, whether the ruble is appreciating or depreciating, before and after the Stabilization Fund came into existence.