From Informal Exchange to Formal Guarantees

Tax policy in Russia for most of the 1990s can best be described as a classic collective action problem⁷

in which the two most powerful actors concerned—the Russian government and the Russian oil companies (hereafter ROCs)—followed individually rational strategies that were collectively suboptimal.⁸ Owing to mutual suspicion and weak enforcement, the Russian government opted to maximize its revenue in the short term through setting arbitrarily high tax rates by decree and the ROCs opted to minimize their tax burden in the short term by developing increasingly elaborate schemes to evade these exorbitant tax rates. As a result, the government was able to collect approximately half of its projected tax revenues and the ROCs could keep a substantial portion of their profits. Both sides, however, incurred heavy costs over the long term in the form of unreliable revenue streams, insecure property rights, and asymmetrical information that had a negative effect on the Russian economy as a whole and could have been reduced or eliminated through cooperation.

From the Russian government's perspective, particularly the Ministry of Finance, maintaining high tax rates was the best way to replenish the budget despite low compliance rates (see, e.g., RPI, March 1996 and Samoylenko 1998).⁹

The official tax rates for industry and revenue sharing for regions that existed on paper were rarely, if ever, observed in practice, and tax collection rates were abysmally low as a result (Gustafson 1999, chap. 9; Shleifer and Treisman 2000, chap. 6). According to the IMF (2000, 69, 71), even as of January 1, 2000, the value of unpaid taxes at the consolidated level (federal and local governments) was 8.3% of the GDP. Instead, economic elites presiding over the country's industrial enterprises as well as regional leaders engaged in ongoing negotiations with the government to determine their respective tax burdens (see, e.g., Easter, 2002). Not surprisingly, the government purposefully targeted the highly lucrative and concentrated industries in the energy sector for revenue extraction and its budget was highly dependent on this sector as a result. In 1998, for example, the oil sector accounted for approximately one-fourth of all tax revenues (Russian Economic Trends 1998, 6). The Russian government was able to collect at least a portion of the revenue it sought from this particular sector by raising tax rates arbitrarily and threatening to employ different coercive means, such as blocking access to pipelines and export markets, if companies did not comply. Moreover, responsibility for determining tax rates in the energy sector was often shared by the Ministry of Fuel and Energy and the Ministry of Finance, which resulted in constant fluctuations in the tax rates, especially pertaining to excise taxes. Despite the high transaction costs involved in revenue extraction, the Russian government, nevertheless, managed to collect between 33 and 35% of the ROCs' revenues based on a statutory tax rate of 53%.¹⁰ At the same time, the government could guarantee itself a source of fuel by arbitrarily granting tax arrears to companies in exchange for providing energy to delinquent customers, which often included domestic industries as well as households (Jones Luong 2000).

Yet this strategy only exacerbated the problem of noncompliance, particularly among the ROCs, by creating a strong incentive for economic actors to hide their profits. It also failed to take into account that the ROCs' tax burden was much higher than even the government projected because of the regional and local governments' tendency to levy informal taxes on the oil companies operating in their regions by forcing them to provide social services and infrastructure investments (Gustafson 1999, 207). The ROCs responded to this untenable situation by developing a series of legal and semilegal schemes to hide their profits through which they effectively evaded heavy taxation.¹¹

Transfer pricing was the most common form. Because the corporate income tax (or profits tax) was based on trade rather than production, parent companies could reduce their official income by creating trading subsidiaries (often located in a low tax zone within Russia) from which they purchased oil at below-market prices and then resold this oil at equally low prices to offshore Russian intermediaries (often located in a free-trade zone). By some estimates, the ROCs have been able to hide at least 25% of their export proceeds through transfer pricing.¹² As a result, the government only received 22% of the approximately $30 billion in windfall rent from natural resources sales in 2000, while 78% remained in the hands of oil and gas exporters.¹³ Actual (versus statutory) tax rates on oil not only were lower than they should be, but also differed markedly from company to company (see, e.g., Novaiia gazeta, August 7, 2000). Another form of tax evasion that detracted from profit-making activities included the development of intricate schemes to avoid payroll taxes. Here, parent companies would create offshore subsidiaries to pay their employees, arrange for insurance companies to pay their employees under the guise of large monthly payouts from life insurance policies, or pay higher corporate banking fees so that employees would earn higher interest rates than the market rate on their checking accounts.¹⁴

Thus, by the end of the 1990s the Russian government and the ROCs were locked in a vicious cycle in which exorbitant tax rates encouraged evasion and evasion encouraged even higher tax rates and threats of expropriation, leading to more elaborate and time-consuming schemes to hide profits. The results were disastrous for the Russian economy on the whole, which did not record positive investment rates or economic growth for most of the decade (IMF, 2000). Although the government had attempted to introduce new tax legislation since 1995, it was continuously stalled in the Duma due to the opposition of the “Left” (i.e., the Communists and Yabloko) and of the oil and gas lobby, which the Yeltsin administration attempted to circumvent by issuing new decrees. Even as late as April 1998, the Duma and the government could not reach an agreement concerning tax reform. Rather, the former continued to impede reform by adopting numerous amendments, while the latter refused to compromise by addressing procedural issues related to taxpayers' rights or lowering the tax burden (see, e.g., Samoylenko 1998). Similarly, in addition to blocking tax reform in the Duma, the ROCs continued to hide their income, to exaggerate their losses in order to obtain tax breaks (RPI, April 1998, 10) and to pressure the government to reduce the energy sector's tax burden (RFE/RL, July 23, 1998).

This situation, however, changed dramatically by the end of 1998. Despite nearly a decade of failed tax reform, from 1998 to 2002 the Russian government and the ROCs were able to achieve mutual gains from cooperation in the form of a new tax code. In sum, this new tax code is designed to increase the reliability of revenue streams for both sides by creating incentives for broad-based tax compliance without a significant improvement in the government's administrative capacity and pegging the ROCs' tax payments to fluctuations in the global price of oil. It also reduces information asymmetries by eliminating transfer pricing and encouraging the ROCs to disclose their actual profits. By setting fixed tax rates and reducing incentives for the government to resort to coercive tactics to meet its revenue needs, moreover, the new tax code has the potential to secure property rights for the ROCs and thereby enable them to both increase their investments at home and attract foreign partners to expand their operations abroad.

Furthermore, it puts Russia decisively on the path toward market reform. By most accounts, Russia's new tax code exceeds Western standards not only because it sets lower tax rates than the OECD recommends but also because it is much simpler and clearer than the previous one. For example, it has introduced a 13% flat tax on personal income, capped corporate contributions to the social insurance fund, reduced the profits tax (a.k.a. corporate income tax) rate from 35 to 24%, abolished turnover taxes (as of 2003), tied export tariffs directly to the price of oil, and established new accounting procedures that are on par with international accounting standards. In addition, a new mineral extraction tax was introduced in January 2002 (Chap. 26, Part II) as a flat rate pegged to the price of oil. It has also won the praise of foreign and domestic financial and political analysts for the inclusive nature of tax benefits and, thus, its potentially positive impact on the Russian economy as a whole (see, e.g., Andersen 2002 and Rabushka 2002).¹⁵

These assessments were confirmed by the initial results, which indicate that tax collection rates have increased since the new code was put into effect (see, e.g., Kommersant, October 19, 2001; Pravda, October 18, 2001; and Russia Journal, July 18, 2002). For example, the fact that income tax revenues jumped by 70% following the introduction of the flat tax on personal income has been directly attributed to the abandonment of costly tax-evasion schemes (Aslund 2001, 22).

The Failure of Existing Accounts: Coercion, State Capture, and the “Resource Curse”

How did the Russian government and the ROCs manage to overcome their collective action problem and cooperate with one another to their mutual advantage? This outcome is especially puzzling because none of the existing accounts provide a satisfactory explanation. Neither the general predictions nor the particular assessments of Russia that stem from the predominant view of institutions as coercion can explain the emergence of this new tax code as a product of intense negotiation and compromise. Indeed, both the literature on institutional emergence generally and that on economic reform in postcommunist states specifically predict that Russia should fail to establish a viable tax code—either through contracting or at all. Nor were the mechanisms often cited in contractarian explanations of institutional emergence through cooperation present in this case.

That the view of institutions as coercion has dominated scholarly assessments of Russia's transition is clearly demonstrated in the overwhelming pessimism concerning its prospects for economic reform in the absence of either a strong leader within or external pressures from outside the country. Many have attributed market failure in Russia throughout most of the 1990s to the weakness of either President Boris Yeltsin or central state institutions vis-à-vis powerful economic interests (see, e.g., Hellman 1998, McFaul 1995, Reddaway and Glinski 2001, and Robert and Sherlock 1999). Thus, not surprisingly, Russia's hope for establishing the political order necessary to achieve market reform has often been placed in its newly elected president, and seemingly more authoritarian leader, Vladimir Putin, who succeeded Yeltsin in March 2000 (see, e.g., Nicholson 2001 and Shevtsova 2003).¹⁶

Because he not only enjoyed a popular mandate but also faced a Duma that was less polarized, and therefore more pliable, after the 1999 elections Putin seemed poised to unilaterally redefine Russia's political climate and single-handedly push through his economic agenda (see, e.g., Remington 2001). Putin's position as former head of the Soviet Union's internal security service (i.e., the KGB) bolstered the presumption that he would be a strong leader, capable of using force to impose his will.

According to this perspective, the new tax code is best understood as yet another example of Putin's unrivaled authority since his election. Almost immediately after ascending to the presidency, for example, Putin launched sweeping administrative changes aimed at reducing the power of the regions to influence national policy-making, including tax reform. The most significant of these was the reorganization of the Federation Council, through which the regional leaders had previously obstructed the government's attempts at tax reform and weakened the federal budget by demanding complex revenue-sharing arrangements (see, e.g., Treisman 1999). Putin also demonstrated to the ROCs that he was willing to use force through his decisive treatment of the notorious oligarchs Boris Berezovsky and Vladimir Gusinsky in the first few months of his presidency (see Lloyd 2000 for details). Yet, if this is what brought the ROCs to the bargaining table, it fails to explain why negotiations over a new tax regime began in late 1998 under Yeltsin.

It also fails to explain why Putin did not simply impose a new tax regime that solely reflected the government's preferences. With the elimination of the two biggest obstacles to tax reform in the 1990s—the polarized Duma and recalcitrant regional leaders—perhaps Putin could have passed the new tax code without even the tacit approval of the ROCs. He also could have continued Yeltsin's arbitrary practice of changing tax rates by decree. Yet Putin chose to forfeit this particular advantage vis-à-vis the ROCs and, instead, to continue the negotiations and make the necessary compromises so that a comprehensive tax code could be passed through the Duma as a law that was endorsed by the country's most important taxpayers—the ROCs.¹⁷

As will be described in more detail below, to reassure the ROCs that their assets would not be expropriated after the 1998 crisis, he also publicly recognized the property rights of the oil industry and pledged his commitment not to renationalize. Thus, he seemed to be interested in making a truce with the remaining oligarchs rather than alienating them. Moreover, despite signs of economic growth and increased tax revenues in 1999, agreeing to formalize a tax code with lower fixed rates was not costless for Putin. If the ROCs chose to renege on their commitment to comply with the lower tax rates, the Russian government risked a budget deficit because it could no longer arbitrarily raise tax rates.

Others have looked to the international community to provide either the financial incentive or direct pressure to propel market reform in Russia and other postcommunist states (see, e.g., Aslund 2002, Sachs 1994, and Stone 2002). Indeed, the undeniable importance of international competitiveness and the increasingly direct role of transnational actors in domestic affairs in the context of globalization (Rodrik 1997) and a post-Cold War world (Weinthal 2002) lend support to this argument. Thus, an obvious alternative explanation for the new tax code is that the government pushed through this new tax regime in order to attract foreign investment or appease its foreign creditors. Yet it has been clear since independence that, particularly in the energy sector, Russia has very little interest in bringing in direct foreign investment (Jones Luong and Weinthal 2001). In fact, until very recently, both the executive branch and the Duma have stalled the adoption of PSAs, which are universally viewed as the key to further foreign investment in the energy sector.¹⁸

As will become clear in the following section, the Russian government also did not adopt a new tax regime to attract foreign direct investment but, rather, because the ROCs sought an additional guarantee for their property rights at home by attracting Western partners for joint ventures abroad. Nor is the new tax code simply a product of direct pressure from foreign financial consultants or the IMF compelling the Russian government to design a more suitable (i.e., Western-style) tax regime. In fact, since 1997 the IMF has been encouraging the Ministry of Finance to raise, not lower, Russia's tax rates.¹⁹

The contractarian approach has also been rejected in the form of two prominent and closely related approaches to understanding the failure of economic reform in postcommunist states. The first is the “winner take all” view, according to which a narrow set of actors captured the gains from early market reforms by virtue of their position and then effectively prevented subsequent reforms that might threaten these early gains (Hellman 1998).

For Russia, in particular, this perspective is directly related to what many have deemed the evils of “insider privatization” (or privatization policies that deliberately favor those closest to the regime), because it either enriches a few agents who prefer to maintain insecure property rights so that they can exploit their privileged access to social assets (Sonin 1999) or creates “early winners” who block subsequent reforms that would threaten their ability to continue to reap the benefits of their ill-gotten gains (Alexeev 1999; Black, Kraakman, and Tarasova 2000). The most notorious “early winners” are the ROCs because of the way in which these well-positioned private actors acquired ownership of the energy sector—first, through a pure “asset grab” and, then, through a suspicious “loans for shares” deal (see Johnson 1997 and McFaul 1995 for details). By agreeing to the new Russian tax code, however, the ROCs do not “take all” but, rather, incur substantial economic losses. Despite reduced tax rates, the new tax code actually increases their tax burden because it eliminates the tax benefits of transfer pricing and capital expenditure deductions.²⁰

Even when oil prices began to recover, moreover, the ROCs chose to continue negotiations with the Russian government and to bring their profits onshore rather then reverting back to tax evasion.

More specifically, according to this perspective Russia's inability to develop a viable tax regime thus far has also been attributed directly to this elite “redistribution of power resources” following the Soviet collapse (Easter 2002). The new Russian tax code, however, demonstrates not only that the ability of economic elites to derail the economic reform process is more limited than these pessimistic accounts suggest but also that, under certain conditions, these “insiders” or “early winners” can in fact serve as the engine of further reform.

The second is the view of the Russian state as fully “captured” by key economic interests. The tax code, then, is merely the result of “state capture”—that is, the ROCs have used their excessive political influence to impose lower tax rates for their own benefit. Yet this is an unsatisfactory portrayal of the emergence of the new tax code for several reasons. First, if the ROCs were capable of simply dictating their preferred policies to government officials, it is not clear why they would prefer to establish a formal tax regime rather than continuing to benefit from the status quo in which they relied on informal networks and influence both to negotiate favorable tax rates and to evade unfavorable taxes. It also does not explain why the ROCs endorsed a tax code that inflicted short- and long-term costs on them by forcing them to fully disclose their profits, adopt accounting procedures, and accept an overall increase in their tax burden. Second, the literature on “state capture” predicts that those who benefit from a “capture economy” will reject institutions that disperse rents (Hellman, Jones, and Kaufman 2000) or improve the protection of property rights (Sonin 1999). Yet by protecting tax payers rights vis-à-vis state agencies, lowering rates for all taxpayers, and endeavoring to increase compliance across sectors and broaden the tax base, the new Russian tax code does both. It thus provides tax benefits that are inclusive in nature and is already having a positive impact on the Russian economy as a whole.

Beyond the literature on institutional emergence and the politics of economic reform, the long held conventional wisdom on resource-rich states also predicts that Russia will fail to develop the necessary institutions to promote economic growth, particularly a stable and comprehensive tax regime. In the vast literature on the “resource curse,” a weak (or nonexistent) tax regime is viewed as perhaps the most prevalent negative outcome of resource wealth due to state leaders' myopic thinking and heavy reliance on external (i.e., rather than internal) sources of revenue (see, e.g., Karl 1997, Mitra 1994, and Shafer 1994). The emergence of a viable tax code in energy-rich Russia, therefore, is a striking anomaly.

Finally, Russia's ability to achieve mutual gains from trade in the form of a new tax code is also puzzling because the causal mechanisms that are commonly invoked in the literature to explain cooperation—such as a precommitment strategy²¹

or social norms (e.g., focal points)²²—were clearly absent in this case.

Neither the Russian government nor the ROCs were unilaterally willing to make an extreme strategic move to signal their commitment to cooperation. Rather, each party continued to pursue independently rational strategies. For example, even when oil prices were declining in early 1998, rather than easing the tax burden on the ROCs, the government sought to squeeze the ROCs for additional taxes to cover the gaps in the government budget (RPI, June/July 1998). Likewise, the ROCs' strategy to exaggerate their losses to obtain tax breaks only added to the level of mutual distrust between the ROCs and the Russian government (RPI, April 1998).²³

Moreover, the persistence of the behavioral norms and informal networks that guided elite behavior in the Soviet period actually contributed to their incentive not to cooperate rather than serving as a focal point to overcome the collective action problem they faced. As noted earlier, the ROCs benefited from arbitrarily high tax rates under Yeltsin because they had privileged access to both formal and informal policy-making channels. Throughout the 1990s, they exerted political influence through two main forms of lobbying. The first and most common form was to influence deputies in the Duma to oppose or support proposed government legislation. The ROCs achieved this by either simply bribing deputies or supporting their own candidates (often former employees) for election to the single-mandate seats.²⁴

The second form of lobbying took place through direct, personalized contact with members of the executive branch—most importantly, the Ministry of Fuel and Energy.²⁵ Many oil companies used their close relations with key government ministries to block what they considered to be unfavorable legislation, including previous versions of the tax code.²⁶ Regardless of the method, however, the oil and gas lobby was highly effective and thus widely considered to be “one of the strongest and most effective lobbies” in Russia.²⁷ For the latter part of the 1990s, this lobby convinced a sufficient number of deputies and government officials to block tax reform and even to reverse unfavorable changes made by executive decree. In March 1997, for example, the ROCs persuaded both the Duma and the government to reverse a R15,000 increase in the oil excise tax (from R70,000 to R55,000 per ton of crude) that the Ministry of Finance and the State Tax Service pushed through several months before (RPI, March 1997).

Mutual Vulnerability and Interdependence

Although its root causes were much deeper, the Russian government's decision to devalue the ruble and place a moratorium on external debt payments triggered the August 1998 financial crisis that sent shockwaves throughout the Russian economy: Real GDP plummeted, inflation and unemployment soared, and commercial banks went bankrupt (see, e.g., OECD 2000, 33–45). This crisis, of course, was also precipitated by the recession that spread across Asia in 1997 (or the “Asian flu”) and the steep decline in world oil prices in 1998. The immediate effects on Russia's economy were devastating, yet the political effects (and the potential they offer for long-term economic growth) are even more striking. This exogenous shock enabled the Russian government and the ROCs to escape the vicious cycle of exorbitant tax rates and widespread evasion that characterized Russia's tax regime in the 1990s. In short, both sets of actors emerged from the August 1998 financial crisis with the realization that the costs of their past failure to cooperate were too high.

Two conditions facilitated this change in perceptions: the mutual vulnerability and interdependence of the Russian government and the ROCs.²⁹

Mutual vulnerability provides both actors with an incentive to come to the bargaining table because their own survival is threatened. While interdependence often gives rise to collective action problems, it also serves as the basis for cooperation when it creates a situation in which each side needs the other in order to recover from an economic crisis. Thus, our argument contrasts with the widespread depiction of institutional creation as bargains struck between kings and capitalists (or rulers and key economic actors) found in the contractarian literature in which it is sufficient for one side to feel threatened by the potential actions of the other (see, e.g., Levi 1988, North and Weingast 1989, and Tilly 1990). It also diverges from the view that a crisis can induce economic reform by weakening the bargaining power of one set of actors—usually organized interests, such as labor, or the losers of reform—and strengthening another's—usually the state or incumbents (see, e.g., Remmer 1998) or when the state is sufficiently strong vis-à-vis societal actors to utilize the crisis as a window of opportunity to push through unpopular reforms (see, e.g., Krueger 1993). Likewise, it differs from the literature that argues economic reform can only come about after bargaining power shifts in a “war of attrition” such that one of the vulnerable socioeconomic groups concedes and bears most of the distributional costs of the reform process (see, e.g., Alesina and Drazen 1991). Rather, both mutual vulnerability and interdependence are contingent upon the existence of socioeconomic actors who are powerful enough to challenge the state. Although the existence of such actors is taken for granted in standard contractarian models, this is more often the exception rather than the rule in developing countries where the norm since the 1950s has been state-led development (see, e.g., Chaudhry 1993).³⁰ In Russia, this is the case only because the oil sector was privatized to domestic actors in the mid-1990s (for details, see Jones Luong and Weinthal 2001).

The August 1998 financial crisis, which resulted in enormous losses in profits and tax revenue to the ROCs and Russian government, respectively, revealed the extent to which these equally powerful actors were both vulnerable to global markets and, thus, the costliness of their previous failure to cooperate. The crisis was “sobering” for the ROCs because it “forced [them] to acknowledge the cumulative negative effects of their previous behavior.”³¹

Following the crash in August 1998, many ROCs (e.g., YUKOS, Sibneft, and TNK) faced bankruptcy and lacked a cash flow to service their short-term secured bank debt (Tanguy 2002).³² Because many of them acquired substantial foreign debt, the Russian government's decision to devalue the ruble made it even more expensive for the ROCs to repay these loans (RPI, September 1998, 7). Over the first nine months of 1999, for example, the indebtedness of 5 major ROCs went up 54% (Kommersant, November 23, 1999). As a result, they were unable to pay salaries and some of them (e.g., Sibneft) were forced either to shut down their operations for several months or to radically downsize their operations and decrease expenditures (RPI, October 1998, 17).³³ Moreover, due to their reduced cash flow, combined with the lack of prior strategic planning and domestic investment to boost productive capacity, they could not immediately reap the benefits of the ruble's devaluation by increasing production.³⁴

Similarly, the 1998 financial crisis exposed the government's susceptibility to fluctuations in the global marketplace because of its dependence on the oil sector for budgetary revenue. Almost immediately, federal government revenues and expenditures plunged in response to the 1998 crisis. According to the IMF (2000, 60, 63), cash revenues dropped in the third quarter of 1998 to just 7% of the GDP, from 10.5% of the GDP in the first half of 1998, and cash spending fell in the third quarter to 11% of the GDP, from 16% of the GDP in the first half of 1998. As a result, according to Sergei Shatalov, First Deputy Minister of Finance, who had been a strong (but lonely) advocate of tax reform since the mid-1990s, “The 1998 financial crisis created the collective realization that we needed to change the [current] system of securing revenue.”³⁵

The August 1998 financial crisis also made it painstakingly clear that they were dependent on one another not only for their economic recovery but also to insulate themselves from the effects of future crises, which required stable rules. For the ROCs, at a minimum “recovery” required investing in modernization, for which they also needed both greater predictability and more secure property rights. Prior to the 1998 crisis, the ROCs' property rights were threatened by frequent tax inspections that resulted in profit losses through indiscriminate taxes and fees.³⁶

The 1998 crisis, furthermore, exacerbated the fear among the ROCs that the government might renationalize their assets because many of them accumulated huge tax arrears and faced bankruptcy.³⁷

At a maximum, the ROCs' “recovery” required attracting Western partners in order to improve their assets at home and expand their operations abroad, which in turn required increasing transparency (e.g., disclosing information about profits and providing accurate information about profitability to shareholders) and establishing corporate governance. Specifically, the ROCs recognized that strategic partnerships with Western companies would give them access to foreign capital and technology, thereby enabling them to engage in the long-term strategic planning and domestic investment that were clearly so vital after the August 1998 crisis.³⁸

At both ends of the spectrum, then, the ROCs could not recover without obtaining formal guarantees from the government that it would not arbitrarily expropriate their assets or the proceeds from these assets through indiscriminate taxation.³⁹ Tax legislation, moreover, would both enhance predictability and require increased transparency, thus providing them with the stability to invest in their assets at home and the credibility to attract Western partners to expand their operations abroad.

“Recovery” for the Russian government required, at a minimum, budgetary stability. In order to regain their budgetary losses in the short term and to stabilize the flow of tax revenue from the oil sector, the Russian government needed to give the ROCs a greater incentive to pay their taxes voluntarily. As aforementioned, throughout the 1990s, the Russian government relied heavily on taxing the oil sector to fill its coffers. In addition to exorbitant corporate income tax rates, oil producers were subject to a fixed excise tax rate and stiff export tariffs. Yet, by August 1998, it became clear that this strategy was leading to the ROCs' insolvency and creating an unreliable revenue stream. The fixed excise tax rate, for example, meant that oil producers paid approximately 55 rubles per ton (or about $9.00) regardless of the price of oil. Thus, when oil prices plummeted in 1998, “many of the companies [were driven] to the verge of bankruptcy” (Samoylenko 1998, 3) At the same time, cumbersome bankruptcy procedures hampered the Russian government's ability to seize private assets to induce tax compliance.⁴⁰

The government's “recovery” at a maximum required expanding the tax base and increasing compliance overall so as to reduce the budget's dependence on the oil sector for revenue. Structural reform aimed at promoting real growth across sectors thus became a top priority for the government, and establishing a stable tax regime was a central component of this strategy (see, e.g., Vasiliev, February 2000).⁴¹

In particular, Prime Minister Yevgeni Primakov sought to reduce the overall tax burden (e.g., lower the profit tax and VAT) and to introduce a package of basic laws in the Duma concerning fiscal reform (see, e.g., RFE/RL, October 14, 1998, and Vasiliev 2000). His efforts were supported by the Ministry of Energy and Fuel in late 1998 and later the Ministry of Economic Development and Trade in 2000, both of which viewed lowering the tax rate and tying export tariffs directly to the price of oil as promoting long-term recovery and growth in the oil sector while also serving to stabilize the government's revenue stream, broaden the tax base, and improve the rate of compliance (RPI, September 1998).⁴²

Incremental Strategic Moves, Common Knowledge, and Institutional Change

Although the shock of the August financial crisis generated widely shared perceptions among both the Russian government and the ROCs concerning the benefits of cooperation and the need for formal guarantees, this was not sufficient to produce institutional change. To achieve a formal agreement, both sets of actors needed to demonstrate convincingly to one another that this mutual realization had actually occurred and would be sustained—that is, they needed to have common knowledge that all the relevant actors now preferred cooperation. In contrast to the standard approach in international relations in which institutional bargains are struck after one side makes a single unilateral or preemptive strategic move (see, e.g., Jervis 1978 and Maoz and Felsenthal 1987), we argue that this was achieved through a series of incremental strategic moves—both private and public—whereby each side assured the other that they were committed to tax reform.

In sum, the ROCs' strategic moves included bringing their business activities back onshore through increasing domestic investment, adopting new international accounting standards, and embracing corporate governmance, while the government's included pledging to honor private ownership of the oil sector and continuing to work with the Duma to pass an acceptable tax code as a law rather than to change the tax system by decree. These assurances were effective not only because they were reciprocated but also because they were consistent—they continued even as the price of oil rebounded in late 1999⁴³

and the economy began to recover, resulting in an increase in both the government's tax revenues (see, e.g., OECD 2000, 61) and the ROCs' profits (see, e.g., RFE/RL, September 10, 1999).

Shortly after the August 1998 crisis, the ROCs initiated an informal dialogue with the Russian government to convince it to “soften” the tax system—that is, to become “less aggressive vis-à-vis the oil companies”—in order to aid their recovery by making investment in modernization possible.⁴⁴

Specifically, the ROCs lobbied for several features that are embodied in the new tax code—including the flat rate for corporate profits tax,⁴⁵ the cap on contributions to the social fund, and export duties based on profits rather than production—because these changes were conducive to their newfound desire to invest more capital in domestic production and expansion.⁴⁶ In addition, the new tax code includes their demands for increased exemptions for investment in infrastructure, new technology, and new fields exploration, and compensates companies drilling in older fields. The ROCs also pressured the government to introduce a flat rate for the mineral tax, which would be tied directly to the world price of oil so that when the price is low, the companies will be assured of a guaranteed amount of cash available for investing and long-term planning.⁴⁷

Several other more demonstrative strategic moves followed that served to reassure the Russian government that the ROCs were committed to reform. First, in June 1999 they showed good faith by agreeing to pay all their taxes in cash by December 1999 despite having recently downsized their operations (Moscow Times, June 23, 1999). This was a sharp departure from their behavior prior to the August 1998 crisis, when the ROCs would often run up huge tax arrears on their exports and then settle their tax liabilities in kind (e.g., barter deals), which made it extremely difficult for the Russian government to estimate how much revenue the oil sector would actually contribute to the budget on an annual basis (Aitken 2001). Second, at the end of 1999, the ROCs took an even bolder step by beginning to increase their level of domestic investment and increasing their transparency. To ensure their immediate recovery, the ROCs began to invest heavily in increasing production either through fixing old wells (e.g., Yukos's strategy) or through drilling new wells (e.g., Sibneft's strategy). This trend continued unabated, such that the following year (2000) the ROCs' total investment jumped by 95% (see Figure 1) and shareholder confidence was actively being restored.⁴⁸

In March 2001 at the Second Annual Russian Energy Summit, Lukoil's chief executive Vagit Alekperov emphasized the need for oil companies to enhance the transparency of their operations and adhere to other standards of corporate management and declared his own company's intention to continue to reinvest in its domestic projects. Finally, the ROCs agreed to reveal their profits through their implementation of international accounting methods (i.e., GAAP standards) and corporate governance codes (RPI, October 2001). Overall, these incremental strategic moves assured the Russian government that the ROCs were serious about bringing their profits onshore and no longer hiding them by investing offshore.

The ROCs' overtures did not go unrequited. Several key actors within the Russian government simultaneously made incremental strategic moves that were intended to convey its own commitment to reform. First, the Ministry of Energy and Fuel introduced several tax proposals in late 1998 to eliminate the oil excise tax and to introduce instead a variable tax on incremental revenue in order to reduce the tax burden on the ROCs and provide incentives for the ROCs to adopt Western technologies and to establish alliances with foreign partners (RPI, September 1998, 27). Although there were a few officials in the Ministry of Finance receptive to tax reform in the early to mid-1990s, such as Shatalov, this ministry was generally opposed to such cuts after the crisis for fear that it would lead to further losses to the federal budget (see, e.g., RPI, March 1998, 39).⁴⁹

Second, Yeltsin's dismissal of Prime Minister Kiriyenko, who had initiated accelerated bankruptcy proceedings against the ROCs in mid-1998, and his replacement by Yevgeni Primakov in September conveyed to the ROCs that the Russian government had abandoned its attempts at coercion and was willing to negotiate. Although initially he advocated a reversal of Russia's neoliberal reforms, shortly after his appointment Primakov met with representatives of the largest ROCs to begin seeking a compromise (Kommersant, September 30, 1998, 4). Primakov's appointment also conveyed to the ROCs that the Yeltsin administration was committed to pursuing the formalization of the tax code by working with the Duma on tax reform rather than reverting to setting arbitrary tax rates by executive decree. While Kiriyenko and “the reformers” lacked a majority coalition in the Duma, Primakov was considered to be acceptable to the large faction of Communists in the Duma (Shleifer and Treisman 2000, 177). This was reassuring to the ROCs, both because it signaled the government's willingness to compromise and because they universally considered a formal tax code, which required the approval of the Duma, to offer more stability than tax reform by decree.⁵⁰ This commitment was reinforced in December 1998, when the Russian government proposed a package of eight laws to the Duma, which linked tax rates to the profitability of oil wells, and then again in January 1999, when Part I of the Russian Tax Code officially went into effect (Vasiliev 2000). To further demonstrate its commitment to fiscal reform and its willingness to compromise with both the ROCs and the Duma, the Primakov government introduced a reduction in the profits tax from 35% to 30% (RFE/RL, November 17, 1998; Vasiliev 2000). Although the Duma had approved a similar reduction in July 1998 (RFE/RL, July 16, 1998), President Yeltsin vetoed the law (RFE/RL, July 20, 1998).

The government's next set of incremental strategic moves took place under Putin's leadership. First, at the beginning of 2000 he established the Ministry of Economic Development and Trade to deal precisely with the task of promoting long-term economic growth. This new ministry immediately began to dominate the debates over tax reform inside the government and to represent the government's position in private negotiations with the ROCs and public debates in the Duma. It thus replaced the Ministry of Finance, which had spearheaded the government's previous approach to tax reform (see, e.g., Samoylenko 1998, 2) and which financial analysts and ROCs alike agree was fixated on fulfilling short-term budgetary requirements.⁵¹

Then, at the end of 2000, Putin supported the formation of a special “working group” composed of government officials, Duma deputies, and the ROCs to discuss the remaining aspects of the tax code, especially those that were of special concern for the ROCs, such as the corporate profits tax and the mineral tax.⁵²

The Ministry of Economic Development and Trade in these discussions advocated dramatic cuts in tax rates as a way to simultaneously stimulate investment in long-term and new oil projects⁵³ and increase tax compliance across sectors.⁵⁴ By advocating a flat tax on corporate profits of 24%, for example, the government was committing to a much lower share of the oil companies' profits in exchange for the full disclosure of their actual profits. In fact, the Russian Tax Ministry actually anticipated a decrease in tax collection in 2002 because of the new profits tax (Pravda, June 12, 2001). Morevoer, the Ministry of Economic Development and Trade, unlike the Ministry of Finance, supported the flat tax on personal income and corporate profits tax because they believed that it would eventually expand the government's tax base by encouraging investment in other economic sectors (i.e., beyond the oil sector) and reducing the size of the illegal economy.⁵⁵ They were also behind the more recent proposals to compensate companies “for losses resulting from adjustment of transfer prices for tax purposes”⁵⁶ and to establish a flat mineral tax pegged to the world market price of oil. The latter, in particular, was deliberately designed to guarantee a more stable revenue flow to both the ROCs and the government over the long term.⁵⁷ The formation of this group thus conveyed to the ROCs not only that the government remained committed to tax reform, but also that it remained committed to working with the Duma to enact tax legislation. At this time, the Russian government also provided additional assurances to the ROCs—in both public and private forums—that it would not make significant changes to the tax code for at least three years after it was adopted in 2001, which is considered to be a fairly long period of time in Russia.⁵⁸

Finally, as each side became more secure with their reciprocal reassurances, their respective strategic moves became increasingly bold. Thus, in order to reassure the ROCs that the Russian government would cease to arbitrarily expropriate their profits and assets, Putin met with the Russian oligarchs in mid-2000 in Moscow, where he informed them privately and then announced publicly that “[he] would stay out of business, if [they] stayed out of politics” (see, e.g., Feifer 2000).⁵⁹

The reaction of the ROCs was universal relief because they viewed this public announcement as a credible commitment to respecting their property rights because Putin had effectively tied his hands by raising the costs of renationalizing their assets.⁶⁰