Russian Federation Country Study. A Public Finance Perspective

Russian Federation Country Study. A Public Finance Perspective

RUSSIAN FEDERATION COUNTRY STUDY

A PUBLIC FINANCE PERSPECTIVE

Ryan Grace rgrace@indiana.edu
Dmitri Maslitchenko dmitri@mailroom.com
David Lamp dlamp@indinana.edu

Political Background

The separation of powers which existed under the Soviet constitution was essentially a myth. A Russian accurately characterized the relationships that existed between party, state and society as, ...The state absorbed the society, the Party absorbed the state, and the Party appartchiks, the nomenclature under the totalitarian leadership of the Secretary-General absorbed the Party." Both legislative and judicial branches served as rubber stamps" to the Presidium of the Supreme Soviet which unlike the Supreme Soviet itself was constantly in session. The development of political reform in the late 1980s weakened the party's control over the reigns of power. The devolution of power from the Presidium occurred through the creation of the office of the President which received the executive powers while the legislative powers were assigned to Congress of Peoples Deputies. The judicial branch also achieved higher visibility during the late Soviet period through the creation of the Committee on Constitutional Supervision. The Soviet Union's collapse in 1992 introduced radical changes into all aspects of Russian society. Russia has little experience with democracy in any form. Without a strong democratic tradition, it should not be unexpected that instability would develop in all aspects of Russian life. The role of governmental finance in post-Soviet society is no exception. Competing explanations exist for Russia's travails but a shared trait of many them is the distribution of power at the federal level and the relationship between the federal and sub-national levels of government.

Political problems did not take long to develop in the Russian Federation after the USSR's dissolution. At the federal level, the creation of the present constitution is one cause of the instability which plagues Russia today. After winning a national referendum on August 15, 1993 in which the electorate was asked to endorse the Yeltsin's reform policy, he convened a constitutional assembly to ratify his version of the new constitution. Three drafts were in contention to replace the constitution under which the Soviet Union was nominally ruled. Other than Yeltsin's constitution which became the one implemented, the two other variants were the communist draft which advocated a strong Presidium of the Supreme Soviet with a chairman who had similar powers to the position of General Secretary during the Soviet period and the Rumyanstev draft which contained plans to restrict executive power and grant the legislative body wide powers. Yeltsin's draft advocated the exact opposite of the aforementioned plans with wide powers to the executive and minimal power delegated to the legislative. After the Duma rejected Yeltsin's order to dissolve, he ordered military troops to forcefully evacuate the building--which they did by shelling it. Briefly, the president is the protector of the constitution, human rights, and civil liberty. In order to protect the constitution and the aforementioned rights, the constitution grants the president wide injunctive and declarative powers. The former powers consist of the president's ability to use "conciliation procedures to resolve disputes between the federal government and the governments of the constituent subjects and disputes between the various subjects of the federation." A three stage procedure exists for the adjudication of disputes but his ability to suspend legislation after it is submitted to the appropriate court" which he deems to be in violation of the constitution is considered by many as inappropriate for a fledgling democracy. The President also has the power to issue decrees and orders which are superior to the laws of the government as long as the decree or order does not violate the constitution. Further, the president has the ability to appoint important member of his government without consent for the Duma and has sole power to appoint and remove the command structure of the Armed Forces. In regards to the legislature, the president has the ability to dissolve the Duma if it passes two no-confidence vote in the Russian government within three months of each other and if it rejects three presidential nominee for Chairman of the Russian government. Although there are limitations of the president's ability to dissolve the Duma, it remains a potential weapon against a contentious parliament that affects every aspect of public finance.

The power of the legislative and judicial branch are limited in relation to the executive. Russia's judicial system consists of a several court systems that have different spheres of federal/national jurisdiction." The most visible court is the Constitutional Court which has the right to review the constitutionally of all federal laws, presidential orders and degrees, legislation of government, and unratified treaties. Challenges to the aforementioned areas must be brought by individuals with standing. Although the Constitutional Court's power seems vast, the president's expansive powers and lack of civil relations between the different branches makes the Court's utilization of this power suspect. Federal law and federal constitution laws are the two types of laws which exist in the Russian Federation. The latter is considered superior to federal laws. The procedure for enactment differ in each case. Once a bill is passed it must presented to the president within five days of the passage by the parliament. The president then has fourteen days to reject the law. In order to veto the federal law, a two-thirds majority must be gained in both parts of the legislative assembly. In the case of federal constitutional law, three quarters of the Federation Council and two thirds of the Duma must approve it for enactment. The constitution does not describe any right for the president to veto federal constitutional laws. According to Article 106 of the Russian Constitution, laws in regard to the following area must be voted upon by the Federation Council: The federal budget, federal taxes and levies, foreign currencies, custom regulation, and currency issuance.

Budgeting

Recently, the Duma rejected the government's first draft of the budget. Deputies were divided over the size of the projected federal budget deficit, which was set at 95.4 trillion rubles or 3.5 percent of GNP. When the budget is rejected by the Duma, the government has 20 days to revise and re-submit the budget. If differences exist between the government's proposed budget and the Duma's, an option exists to create a committee to reconcile their disagreements. The Duma rejected the government's proposed 1997 budget in October 1996 and did not opt initially for such a commission. If no budget agreement is reached, parliament would be forced to pass monthly or quarterly budgets which would cause confusion throughout the economy. Since the initial rejection however, a reconciliation commission (in which both houses of parliament and the government are represented), has been working on a new version. The reconciliation commission is due to have a final meeting on Wednesday, with the Duma giving the budget a new first reading on November 20 or 21. There is no legal framework to cover the failure to pass the budget, but parliament has faced the problem every year of Russia's independence except 1996 and has in the past approved temporary budgets.

The work of the reconciliation commission is being drawn out because neither the communist majority in parliament nor the government wants to take responsibility for making a decision on the budget. Russia is trying to keep to a small deficit in 1997 under pressure from the International Monetary Fund, but the Duma is eager to increase budget spending to a starved economy. Reform minded deputies want a lower budget deficit to achieve lower credit rates--which they say are vital for economic growth but which are kept high through heavy government borrowing. The dilemma is that the communists in the parliament want to increase spending and as a majority they can block implementation of any budget bill.

Taxation

Russia's tax system is an exercise in frustration for both Russians and foreigners. The problem arises because it seems that many taxes spring out of the blue and carry heavy retroactive penalties" which are often three times the tax amount due. Russian tax reform is difficult now because the government desperately needs money and has little room to maneuver since revenues are static and low. The budget take, both federal and regional, came in at just 27.3 percent of GDP, compared to 50 percent in the Czech Republic and 47.7% in Poland Russia's budget deficit has been narrowed in recent years, but this only been achieved by cutting back on expenditures in real terms, almost 50 percent from 1993 to 1995.

Like the United States, Russia has a three-tiered system of taxation. Federal taxes are enforced by Parliament, regional taxes enforced by the regional councils, and local taxes enforced by the local authorities. Under the existing system, very little coordination can be found between the three levels of government which causes serious tax policy problems. In a 1993 decree, regional and local authorities were given the power to decide on types and sizes of taxes for their jurisdictions. The hope was that authorities at each level, being responsible to its citizens, would act within reasonable limits. Local authorities, seeing a way to increase revenue, devised more complicated and exotic taxes. There are 150 locally imposed taxes within the Federation . They were competing who would invent the more interesting taxes at their respective levels--for example a tax on grazing cattle.

Tax Code

The Russian tax system is very complicated. The first two sections of the new code have 416 articles which are contained in more that 100 pages--and this is just an the overview of general principles. In an effort to improve tax law, a new draft of tax code was presented to the Russian parliament in February 1996. Apart from laws, the tax regime is regulated by many other documents. The list of these tax documents includes 900 items. It is understandable that the taxpayer can be confused by so many documents. Even a good taxpayer can make mistakes. The code is not expected to be enacted this year but it is a good step toward improving the clarity of the tax system. The current system, plagued by an excessive tax burden and rampant tax evasion, has seriously impeded tax collection efforts. The proposed draft code seeks to implement a number of the reforms prevalent in Western economies during the 1980s, including a broadening of the tax base, lowering of tax rates, and the reduction of incentives, exemptions, and deductions.

A new mechanism for tax refunds in the case of overpayment is also provided in the code. If a taxpayer paid too much tax at his own initiative, the taxpayer may request the overpayment amount be credited towards his next payment or be refunded within a specified time limit. If the time limit was exceeded, the amount would be refunded with interest at a interest rate tied to the prime rate of the Central Bank. In January 1996, new rules came into effect concerning the refund of VAT if the taxpayer is involved in exports operations. It was a major problem since VAT refunds were the responsibility of local budgets. The 1996 budget, which was submitted in mid-August, provided such VAT refunds from special funds of the federal budget.

Overview of Major Taxes

Income tax

Russia's individuals income tax has several bands which range from 30 to 60 percent. The 60 percent rate is essentially the only rate in effect for Westerners. In 1993, the tax law was changed. Earlier, individuals could only pay taxes in rubles. Now, taxes on income earned in hard currency may be paid in rubles or in hard currency. Proposals to increase the Russian personal income tax rates were rejected by Russia's upper house, so the 1995 personal income tax rates remain in effect as of January 1, 1996 (see appendix). Three tax brackets now exist in the Russian Federation: 12 percent on income up to Rubles. 10 million, 20 percent up to Rubles. 50 million, and 30 percent over Rubles. 50 million. The current exchange rate is one dollar to approximately 4,700 rubles. While many individuals may complain that the higher income tax rates will cripple them, Russia would still have the lowest personal income tax rate in Europe at 35 percent.

Excise tax

The excise tax in Russia explicitly covers imported luxury goods, including tobacco products, beer wine and spirits, cars and light truck, tires, jewelry, gemstones, rugs, crystal, fur, and leather products. The rate of excise tax ranges from 10 percent for crystal to 90 percent for grain alcohol personal. A new principle was applied, in accordance with a recent decree, to the calculations of excise taxes on alcohol and tobacco imports. In contrast to the previous practice where excise taxes were calculated in proportion to the customs value of the imported goods, under the new procedure, the taxes (on August 1, 1996) will be imposed in ECU per one unit of commodity item. In some ways, excise taxes and single-stage retail taxes would seem to be prime candidates for regional taxation in the Russia just as they are in market economies, especially if the taxing locality is large enough to avoid revenue loss from consumers crossing the border to regions with lower tax rates Such taxes thus seem more suitable for larger intermediate governments than for small local governments.

Profit tax

The profit tax calls for a 32 percent tax on all profits, with an exception for profits generated by retailers. Profits by retailers are taxed at a 45 percent rate. The tax discriminates against Russian workers because the tax is not applied to the wages of foreign workers. The profit tax keeps intact the profit reinvestment concept of prior Soviet tax legislation. Essentially, no tax is imposed on profits reinvested in the business venture. Also, the government has not changed the 15 percent withholding rate for interest, dividends, and other passive income. A 20 percent withholding rate applies to royalties on copyrights and licenses.

VAT

A VAT of 28 percent passed into a law on December 6, 1991 and became effective on January 1, 1992. The VAT was not initially imposed on imports or exports. However, the government changed the policy very soon afterwards. For instance Russian neighbor, Ukraine will be happy to realize that Russia imposed a VAT on imported goods originating from Ukraine (Decree No 1216 of August 18, 1996). The reason for the decree is to preserve stability of the Russian commodity market. The decree also takes into account that Ukraine is not a part to an agreement signed by the member states of the Commonwealth of Independent states on the coordination of tax policy. The general VAT rate as of January 12, 1996, remains at 20 percent. A rate of 10 percent applies to certain food items and children's goods. Payment of the profits tax and VAT of state owned enterprises is centralized at the level of their ministries administrative departments (Decision No 629 of May 22, 1996).

Corporate income tax

The corporate income tax has three tax rates and the application is based on the type of income earned. Manufacturing income is taxed at 18 percent, service income at 25 percent, and income earned by retailers at 45 percent. One of the most interesting things is that the revenue is not intended to go to the central government. Moreover, the law is written that regional authorities can tax corporate profits up to 18 percent, 25 percent, and 45 percent.

Sales tax

The sales tax was first introduced on December 29, 1990 by USSR Cabinet of Ministers. It was decided to approve a list of goods and services whose sale on USSR territory will not incur the 5 percent sales tax. The local and regional authorities may make additions to list of goods in everyday demand and services to the population which are exempt from the sales tax (see the appendix). population.

Further Drawbacks of the Russian Tax System

Attorneys and tax specialists in Russia say the greatest problem facing enterprises is the lack of a satisfactory tax code. It is necessary that tax policy should be circumscribed and that more power should be given to the legislature. The nature of the tax structure allows some people to be heroes by breaking the rules. For example, a pharmaceutical company chief who had his security guard expel tax inspectors from his head quarters and vowed to shoot them if they returned, was elected to a seat in Parliament instead of going to jail. The penalties for non-payment of taxes is a defiency of the tax system that drives people from the tax system because they are so afraid of making a mistake that they prefer not to pay. For example, a standard 100 percent fine exists for understating income. The interest rate on late payments alone amounts to 0.7 percent a day, or 255 percent per annum, a penalty that can dwarf the actual liability. The penalty amount is presently reduced and is tied to the refinancing rate of the Bank of Russia. The penalty for each day of delinquent payments would equal 1/300 of the prime rate of the Central Russian Bank.

Russia also does not have a specialized tax court. To seek justice in tax issues, taxpayers have to find a people's court which is willing to accept the case. The courts do not have expertise in the area of tax law which is why most of the courts are reluctant to accept tax cases. The lack of legal recourse leads to corruption within the tax collection system. Russia does not have a law like the Freedom of Information Act (FOIA) or the Privacy Act which hinders the accountability of the tax service.

Aside from ample monetary reasons to evade and avoid taxes, taxes (in the Western sense) did not exist in Russia during the Soviet period and therefore the idea of a Western style taxation is unpalatable to many Russians. Taxes began to appear in the USSR only in 1991 which means that the current population has only had to deal with the issue of taxation over a short period of time. The result of this historical experience is that only between 60 and 75 percent of projected tax revenues have been collected this year.

Recent attempts to Improve Revenue

Decree No 1212 of August 18, 1996 is designed to improve tax collection by preventing tax evasion and streamlining cash and non cash turnover. Among other measures, the decree orders enterprises in arrears of payments to the government to open settlement accounts in banks or credit institution within the Russian Federation. Those accounts are referred to as accounts of enterprise in arrears. When requested by the appropriate tax authorities, banks and other credit organizations are required to provide data about the transaction of enterprises holding these accounts. Taxation organ may refuse to register the account of an enterprise in arrears in case there are no funds available on the correspondent account of the bank or other credit organizations. An interesting aspect of this decree is that the government finally began to crack down on misrepresentation "in case of noncompliance with this requirement or intentional provision of false information in the notice submitted to taxation organ enterprise in arrears that had performed the transactions in question will be fined by the taxation organ in the amount of the transaction value". It has proposed to improve the tax system by scrutinizing financial transactions through banks. If an enterprise opens a bank account, the bank or other type of credit institution must immediately inform the tax organs about the accounts for tax purposes. Such tax policy will let the tax agencies observe tax payments more efficiently as everything will be recorded.

Presidential Decree No 1212 of August 18, 1996 also introduced policies concerning cases containing the circumstances stipulated in the Law of the Russian Federation on Insolvency (Bankruptcy) of Enterprises, the Federal Department on Insolvency (Bankruptcy) at the State Property Management Committee of the Russia Federation shall file with arbitration court request to institute proceedings on insolvency (bankruptcy) against enterprises that have repeatedly violated this Decree during one calendar year. As it was with collective farms and state farms, enterprises can just change their names and continue to evade taxes. An important issue related to insolvency is loss of massive amounts of jobs and what will workers and one enterprise" towns do for a living and revenue.

On the bases of the decree, the government has widened its crackdown on tax evaders--adding several leading oil companies to a list of tax delinquents that might be forced into bankruptcy court unless they pay their arrears. The move was the latest in a series of desperate measures the government is taking to boost tax collection and mend its thread bare budget. The government hopes that by threatening major tax evaders with bankruptcy, they will scare the country's errant tax payers into filling empty coffers. Major companies targeted for bankruptcy can avoid insolvency proceedings, if their accounts showed the government owes them an amounts equal to their tax debts for fuel supplied to state organizations.

The most recent step in fighting tax evaders was Russian presidential decree No 1428, (dated (October 11, 1996, which created a Processional Emergency Commission (the Commission) on strengthening fiscal discipline. The major principals and objectives are:

. Control over the timely and full payment of taxes and customs and other compulsory payments; . The elaboration of measures to secure a full-scale collection of taxes and other compulsory payments; . Securing the legality and efficiency of the work of tax and customs, as well as tax police agencies; . Control over the timely and special-purpose use of the resources of the federal budget and state extra budgetary funds. . Take decisions to carry out checks of the financial and economic activity of legal entities and compliance by individuals and entities with the tax, customs and banking legislation of the Russian Federation; . Check the operations of tax and customs bodies;

. Organize check of the timely and special-purpose use of the resources of the federal budget and state extra budgetary funds.

In addition, the President granted broad powers to the Commission to meet the objectives of the decree and secure its accountability.

Monetary Policy

Interest rates, much to the chagrin of reformers, in the past barely reacted to currency stabilization and the ensuing drop in inflation. Little confidence existed in the sustainability of reforms while inflation expectations remained high. In 1996, interest rates finally started to come down--albeit slowly. Real interest rates, however, are still very high. As recently agreed by the Russian government and the IMF, the ruble is due to become convertible by 1997. Better access to the ruble market could thus lead to a rapid increase in international interest in the currency. Nevertheless, the ruble is trying to join the club of respectable currencies. Due to the establishment of a crawling peg, the currency's downslide is almost under control. A generally more stable economic environment and high interest rates could make the ruble more attractive. The ruble's recent past has been eventful to say the least. Between January 1992--effectively the start of economic reform under Yeltsin--and March 1995,the currency depreciated by a massive 2,130 percent. In the second quarter of 1995, an over-restrictive monetary policy led to a severe shortage of the currency which then duly appreciated by 15 percent within three months. As concerns rose that too rapid currency appreciation would further destabilize the economy, the free-floating ruble program was abandoned and a 'ruble corridor', which envisaged further depreciation but within predetermined limits, was introduced. The ruble corridor program has proven to be quite successful. The Central Bank, which has been intervening repeatedly in the market, has managed to keep its foreign exchange reserves at a satisfactory level, and the business community has been able to rely on a more predictable exchange rate trend. In July 1996, the 'fixed' ruble corridor (the upper and lower limits of which only had to be redefined every few months) was transformed into a 'variable' ruble corridor, with the band shifting on a daily basis. Under this program, monthly depreciation now stands at around 1.5 percent. By the end of December 1996, the exchange rate against the dollar should have reached Rb 5,700/US $.

Russia's monetary environment started showing promising signs of stabilizing in 1996. During 1995, inflation reached 200 percent by December. 1996 is drawing to a close and the inflation rate seems set to fall to 19 percent. The central bank has been pursuing a very consistent policy lately, so its goal of maintaining monetary stability looks credible. Moreover, low inflation is one of the conditions imposed by the IMF in return for its monthly credit and it is therefore hardly in the government's interest to start emission based means of financing the budget deficit. The main risk for inflation could come from a high budget deficit due to low tax revenues. Financing the deficit has become easier than in the past due to good international credit ratings--for example, IBCA: BB+, Moody's: Ba2.--are making it cheaper for Russia to borrow on the foreign capital markets.

A key element of Russia's macroeconomic stabilization program has been a tight monetary policy to soak up excess rubles floating around the Russian economy and fueling inflation. That policy's success is among the factors that drove T-bill yields up by 26.6 percent Monday to an annualized 121.4 percent on the secondary market. Just a month ago, yields stood at 53.33 percent, according to Skate-to Press Consulting Agency.

The reason for the jump, analysts say, is simple supply and demand - little ruble supply in the market at a time when government spending demands revenue. The banks do not have the money to invest in GKO (treasury bills) at 3 percent per month--but they will find the money to invest for 10 percent per month. Russia's monetary expansion under the IMF agreement is not to exceed 3 percent, compared with 9 percent in December. Combined with promises by Yeltsin to repay wage arrears and ease the impact of reforms on the social sphere, that tight policy has forced the government to raise yields as a lure to banks to loan the government money.

Intergovernmental Finance

The decentralization of the Russian Federation's intergovernmental financial relationships began with a series of successive tax sharing arrangements along with the regions expenditure responsibilities increasing. This sharing and reassignment strategy continued up to and on through the adoption of a new constitution in December 1993. In Russia, the tax formula sharing rates vary by region and are often negotiated by each locality with the center. This makes any assessment about the equity impact of transfers or their effects on local revenue effort difficult. A general disadvantage of tax sharing is that it does little to enhance local accountability or efficiency. Localities receive revenue regardless of their tax effort and have no discretion to set the tax rate or base. If they view these revenues as costless, their incentive to spend efficiently is lessened. The result may be undue expansion of subnational spending. In Russia shared taxes are retained by (or accrue to) the jurisdiction in which they are collected. This differs from most market industrial and developing economies where shared taxes (like the VAT in Germany) may be shared through a formula based on factors such as population, per capita income, urbanization or other factors. Derivation-based sharing as a rule channels resources to high income areas where the tax base and, therefore, revenue collections are largest. It is thus inherently counter-equalizing. This may be a problem in countries where regional inequities are serious and where the intergovernmental system lacks other instruments (such as transfers) to address such imbalances.

The intergovernmental fiscal relations of the Russian Federation continues to be highly opaque due to the bargain-based system which presently is being utilized. The bargain-based system is making accountability in fiscal policy even worse than is necessary--therefore further reducing the transparency. The size and structure of the Russian Federation contributes to the problems occurring in its fiscal relationships. It is made up of 89 regions consisting of 29 republics, 50 oblasts, 6 krais, and 10 autonomous okrugs, plus 2 metropolitan cities (Moscow and St. Petersburg) which are referred to as the 89 "subjects of the federation" in the constitution. The regions are even further subdivided into more than 2000 districts, where all the local governments within a region report to the regional governments and are subject to regional regulations, although each local government has independent" (emphasis added) budgetary and administrative status.

Effects of Decentralization

Economic decentralization has led to the transfer of a number of services with major benefit spillovers (education, health, and social welfare) to the regional and local levels. While the administration of these programs by local governments may be appropriate because they are closer to the people, the many small local governments that have been created as a result of the strong political push for decentralization cannot likely provide these services at an adequate level from their own resources. In some regions, enterprises' "public" spending exceeds budgetary social spending and, in a few "one-company towns" there is no public spending by the budget at all on non-administrative functions. Enterprises did not provide these services once privatized, and responsibility fell onto regional and local governments to finance them. But local governments will need revenue sources to finance the additional burden.

Decentralization, which led to ownership assignment and financial responsibility, has caused the regions to become more involved in the commercial sector through producer subsidies, capital transfers, and privatization. It has also led to the budgetary expenditures by the regional governments to increase from 13 percent of the GDP in 1992 to around 18 percent in 1994. Recent policy changes have suggested that this trend of more subnational spending is likely to continue.

The Federal government has approved legislation which led to the previously discussed changes in expenditure assignment and also gave local governments the power to formulate budgets and raise revenues without worrying that their surpluses were going to be extracted by the central government. These new assignments of expenditures are not efficient, in part because the federal government has passed down" many of the expenditure assignments which were formerly the responsibility of the Soviet state. Revenue autonomy has not been reached partially due to the yearly changes in tax sharing rates. Disparities between the rich and poor regions has also contributed to a problem budgetary concern. Along with these disparities, the high rate of inflation has significantly contributed to revenue unpredictability of the rayons and oblasts. Revenue predictability and the subnational area's economic state due is of the utmost importance when one is considering expenditure assignment of the federation.

Social Welfare and Russia

The significance and necessity of an efficient social safety net in the Russian Federation can only be understood within the context of the Soviet experience of social security and how today the ideological inclination toward a welfare state is affecting Russian society. The state's pervasive role in Soviet society affected both economic and social conditions. Economically, a state-caused inverse relationship existed between GDP and the state's commitment to social safety during the Brezhnev regime. Economic and political stagnation characterized the latter years of the Brezhnev era. Economically, GNP growth declined precipitously between 1961 and 1985 (see A1 and A2). Prior to 1960, the USSR utilized extensive rather than intensive factors of production--specifically labor, capital (stock), and natural resources. In essence, Soviet authorities were able to take advantage of Imperial Russia's lack of a strong industrial base by transferring much of the population from agriculture to industrial production during Stalin rapid industrialization drive of the 1930s and 1940s. The emphasis placed on heavy industry produced a correspondingly high rate of consumer saving which allowed for increased capital growth, that when combined with the natural resource abundance and intensive use of existing capital helped sustain economic growth The USSR's ability to sustain economic growth in the 1970s was fostered by its large reserve of oil that helped finance imports of western technology.

The exhaustion of labor surplus, declining birth rates, inefficient use of natural resources and other factors of production, the growing expenditures needed to maintain military parity with the United States, and the sudden drop in oil prices, and the mis-development of the economy all were factors that contributed to the USSR's economic stagnation in the late 1970s and early 1980s. While economic efficiency decreased during the Brezhnev period, the USSR's leadership demonstrated increased commitment to the Soviet version of the social safety net. The party-state's pervasive role in society had the effect of slowing economic growth through poor re-allocation of resources and the social effect of retarding the development of a civic society. As a result, Soviet society developed an enduring attachment to the idea of an omnipotent state which provided for their basic needs regardless of the economic costs.

From a Western perspective, the Soviet Union was ideologically a hyper" welfare state in the sense that prior to the Gorbachev era, the state attempted to provide a high level of social security for every citizen, often to the point of harming economic efficiency. Additionally, it heavily restricted the development of private sector in order to prevent wide wage disparity. As mentioned above, the CPSU's monopoly on power extended to every aspect of society and in exchange for party dominance the working population received implicit social guarantees in the form of a social contract." Linda J. Cook succinctly identifies each sides' basic commitments and responsibilities:

Basically, the regime provided broad guarantees of full and secure employment, state controlled and heavily subsidized prices for essential goods, fully socialized human services, and egalitarian wage policies. In exchange for such comprehensive state provision of economic and social security, Soviet workers consented to the party's extensive and monopolistic power, accepted state domination of the economy, and compiled with authoritarian political norms. Maintenance of labor peace in this political system thus required relatively little use of overt coercion.

The weakening of the party and other unintended consequences of glasnost and perestroika such as the emergence of the Russian Republic, the decision to release Eastern Europe from Soviet domination, and the attempt to make state owned enterprises more efficient all had a direct impact on lowering the standard living for the USSR's population. Gorbachev tried and failed to cut the guarantees of the social contract. In contrast to earlier in the Soviet period, the perestroika reforms had the effect of giving significance to money" in the sense that inputs had developed value through the economic decisions which constituted perestroika. From the center's perspective, the problems caused by the inability to cut expenditures through revision of the social guarantees were compounded by revenue loss in three key areas: vodka sales, turnover tax, and republic contribution to the center--especially from the Russian Republic.

Gorbachev began perestroika with an attack on worker efficiency. One measure adopted to combat this perceived evil was restriction on the sale of alcohol. The consequence was a loss in revenue which was further compounded by expenditures related to the Chernoybl disaster and the massive Armernian earthquake in 1987. In 1990, the center granted state owned enterprise (SOEs) greater leeway in the setting of prices--between 50 percent and 100 percent of state mandated prices. Since retail prices were unaltered, the state lost a huge amount of revenue from the turnover tax. In addition, Russia offered to lower the profit tax for those enterprises willing to pledge" allegiance to the Russian Republic. Finally, the dissolution of the Soviet Union was hastened by the rise of Russian nationalism and populism both of which had economic implications. The Russian Republic provided 80 percent of the revenue to the USSR's budget. Yeltsin, using his powerful position within the Russian parliament, declared in October of 1989 that the Republic would halt all payment to Union institutions. He followed this devastating maneuver by nationalizing" the USSR Ministry of Finance and seizing its mints. In October of that year, Russia seized her share of the USSR'S precious metals. Faced with such tremendous loss of revenue which created a budget deficit that equaled 10 percent of GNP, the Soviet government elected to increase the amount of money in circulation without a corresponding increase in the production of consumer goods and services. The decision to increase money circulation, through wage increases, had a jarring effect on Soviet society. The first impact, characterized by the indelible image of long bread lines and the stereotype that a large profit could be made on a pair of Levis familiar to many Westerner was the result of the disruption of goods and services to the general population.

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