TCS Daily

Slouching Toward Prosperity

By Peter J. Boettke - September 27, 2002 12:00 AM

Russia is finally on its way to becoming a normal economy. After a decade of failed reforms and false starts, it seems as if Russia has turned the economic corner.

Rejecting seventy-four years of communist, command-and-control, prescriptions, Russia has recognized the need for fiscal responsibility and a reduction in the size and reach of government. At last week's World Economic Forum European Economic Summit new Presidential economic advisor Andrei Illarionov echoed these sentiments as the prime lesson of Russia's 1998 economic crisis.

Unusual for Russian economic pronouncements, significant facts back Illarionov's boast about the success of the economic policies he has advocated since emerging as Russian President Vladimir Putin's main economic thinker.

In terms of growth statistics Russia has done remarkably well over the past few years, growing GDP by 8% in 2000, 5% in 2001, and 4% so far this year. While room for improvement remains, the clear message from the President's office is one of a committed effort to see those improvements realized. As Putin recently stated in his April 18, 2002 State of the Nation address: "The main thing now is to create conditions in which the citizens of Russia can earn money and, while deriving advantage for themselves, invest it in the economy of their own country."

The obstacle standing in the way of success, Putin stated, was the "cumbersome, inflexible and ineffective state apparatus." Impediments to reform must be torn down and Russia must become "a prosperous and affluent country, so that living here is comfortable and safe, so that people can work freely, earn a living for themselves and their children, without restriction, so that they aspire to come to Russia, rather than leave it."

To overcome those obstacles, after much trial and error, Russia has turned to basic market principles - transparent government involvement, respect for private property, open trade and low tax rates - to spur economic growth.

One of the most significant changes in Russia under Putin is the establishment of a 13% flat tax on personal income that went into effect in January 2001. The economic results, so far, have been extremely encouraging.

The flat tax has helped to mitigate one of Russia's most vexing economic problems - the previously on-going and expanding black-market activity in an economy supposedly free from intrusive state influence. Continuing black market activity, of course, sends a strong signal to any student of the Russian economy that instituted reforms lack credibility and are incompatible with individual incentives for above ground economic initiative. A direct consequence of this credibility gap was a growing lack of tax compliance in the country.

In establishing the flat-tax, Russia has stumbled upon a key tenet of the economist Hernando DeSoto's The Mystery of Capital. DeSoto argues that economic actors will realize the full benefits of exchange only when property rights are formally recognized, and people engage in economic activity in above ground and transparent markets. When the flat tax was first enacted, many Russia watchers predicted that Russian citizens might continue to favor the less expensive services available in the underground economy. However, joined with other Russian reforms - including increased security of private property rights and movement toward the establishment of the rule of law - greater faith that the government was committed to reinventing the Russian economy has led citizens to increasingly engage in above-ground and transparent transactions.

As a result, the 13% flat tax was enough to induce considerable compliance and generate a "supply-side" success story. Government revenues in 2001 increased in real terms by 28% over 2000 - even while the Russian economy slowed.

Russia's economic work is not complete. The country owes more than $40 billion to foreign lenders and continues to suffer a high inflation rate. But the right to private property in land is now allowed, prices are primarily free to adjust to market conditions and the tax system has been simplified and fixed.

A flat tax not only simplifies matters for economic actors, but credibly commits the government to a restrained fiscal policy. It is one of the few policy options that works to 'tie the rulers hand' and reduce the scope of government intrusion and, thus, attacks directly the "cumbersome, inflexible and ineffective state apparatus" Putin complained of in his State of the Nation address.

As Illarionov has said, Russia is learning its economic lessons. And, the most important of these lessons is that without private property, freedom of pricing, sound money, fiscal responsibility and open trade there is no freedom to prosper.

Russia's 2,000 year history has been one of one dashed utopian dream after another. Despotism and tyranny has been its fate. Let us now hope that this great country has turned the corner and is now slouching toward a future of increased freedom, enhanced social cooperation and generalized economic prosperity.

Peter J. Boettke is a professor of economics at George Mason University and the Director of the Global Prosperity Initiative at the Mercatus Center at George Mason University and the author of The Political Economy of Soviet Socialism, Why Perestroika Failed and Calculation and Coordination on the Russian economy.

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