Rule Evasion in Transitional Russia
The world is not thy friend, nor the world's law; The world affords no law to make thee rich; Then be not poor, but break it and take this.
Shakespeare, Romeo and Juliet
Policy reforms change the official rules. If people obeyed the rules, in both letter and spirit, reform would be a conceptually simple task. People, however, are quite ready to violate or circumvent rules, as a few minutes observing the behavior of drivers will make clear. Such evasive behavior would present little difficulty for reformers if the extent and direction of rule evasion or avoidance could be determined in advance. In practice, however, the ingenuity shown by individuals pursuing their own best interests cannot be anticipated by dispassionate (or even passionate) policy analysts. As a result, the potential for rules to be evaded clouds the relationship between policy changes and economic outcomes. The problem is exacerbated during a systemic reform in which countless rules are changing simultaneously, and the degree of enforcement of the new rules has not been established.
Rule evasion complicates policymaking in a second way. To the extent that evasion is illegal and punishment is a possibility, individuals will want to conceal their evasive activity. Thus, measures of economic activity often fail to account for evasive or underground behavior. Policymakers, then, may misun-
derstand the prereform conditions and choose inappropriate reforms. The problem is reproduced in assessing the impact of reforms, both because the starting point is misunderstood and because postreform evasive behavior may be uncounted. It cannot be assumed that unrecorded activity remains constant: systemic reform often changes the extent and character of hidden behavior.
Not all rules, of course, are created equal. A gross oversimplification is that laws that seek to prohibit voluntary exchanges (in the absence of negative third-party effects) are socially inefficient, while laws that prohibit or regulate coercive relations are good rules (see Epstein, 1995). Somewhere in between are rules that seek to tax or regulate, rather than to prohibit, voluntary exchanges. Breaking a bad law can result in a Pareto improvement. Breaking a good law probably makes society worse off.
While evasive behavior complicates the analysis of policies, it simultaneously can promote reform. Evidence of widespread evasion often will prompt a policy change. Wide-scale evasion of good rules, such as those against violent crime, will tend to be met with stricter enforcement or harsher punishment. Inefficient rules that are violated with abandon, however, will be more likely to be altered, or to become effectively dead letters through a lack of enforcement.
The transition from central planning to a "normal market economy" in Russia highlights the various roles played by the circumvention of rules in reform. The prereform economy included extensive second-economy dealing, very little of it captured in the official statistics.1 One paradox of reform is that despite significant liberalization, subterranean economic activity apparently has increased during the reform era. Tax evasion is rampant. Crime, including organized crime, is a serious problem. The circumvention of government rules is so pervasive that some commentators question the efficacy of any policy change.
The purpose of this chapter is to examine more closely Russian economic reform and evasive behavior. The next section reviews the prereform situation, while the section that follows investigates those aspects of rule circumvention that have become important during the transition. The final section is devoted to the specific conditions of Russia and the role evasion might play in future reforms.
RULE EVASION DURING THE SOVIET ERA
After 60 years of experience with a Socialist economy run by government agencies, nearly everyone seems to have devised ingenious ways to turn its shortcomings to his individual advantage (Schroeder, 1979:340).
Rules governing economic activity were pervasive in the Soviet Union. The annual plan was a major source of rules, guiding the allocation of goods within the state sector. Prices and wages within the state sector also were centrally determined. Furthermore, the state sector was itself very large as a result of rules that prohibited most forms of private economic activity.
The prevalence of rules within the Soviet economy was matched by evasion of the rules. The rigidities of central planning virtually required informal or illegal activity, even for state-owned enterprises, to meet the plan. Many goods were allocated illegally outside the plan. Price controls were evaded by bribes, whether monetary or in kind. Private economic activity flourished underground. Theft of state property was common enough that it became an accepted practice, almost a standard component of compensation.2 Leonid Brezhnev was reported to have said, "No one lives on wages alone. I remember in my youth we earned money by unloading freight cars. So, what did we do? Three crates or bags unloaded and one for ourselves. That is how everybody lives. . . ."3 Indeed, the second economy probably helped bolster the planning system by compensating for planning errors or shortcomings and by contributing to higher living standards. That some forms of economic crime in the prereform system were accepted and perhaps even socially beneficial is highlighted by the lack of social opprobrium attached to them.4
Almost from the beginning of Soviet power there was significant evasion of the economic rules.5 But it was only during the Brezhnev era that the second economy began to expand noticeably (Millar, 1988; Treml and Alexeev, 1993). Sixty years was enough time for people to devise "ingenious"—and generally illegal—methods of making the most of central planning.
Early Gorbachev-era reforms attempted to legalize some of the existing activity and encouraged more private enterprise. The consequence was a
whole new set of loopholes for various forms of spontaneous privatization. The possibility for state-owned enterprises to deal with private cooperatives broke down the wall separating cash and "noncash" rubles—the latter being accounting rubles employed in state-sector trade. As noncash rubles were quasilegally monetized, control over the money supply was loosened, which in turn led to higher inflation. With price controls in the state sector, inflation enlarged the gap between official prices and prices in the parallel markets. A self-reinforcing mechanism was thereby established: the larger price gap further increased the incentive to evade restrictions and spontaneously privatize; more and more goods were diverted out of the state sector in ways that led to money creation; there was more inflation, followed by an increased gap between fixed and free prices; and so on. Eventually, price controls and central planning were jettisoned, after they already had lost a good deal of their significance (see Leitzel, 1996/1997).
Wide-scale evasion of the economic restrictions of the Soviet economy thus paved the way for market reform. Nevertheless, as suggested above, the smaller-scale evasion that occurred throughout the Soviet era probably helped maintain the system. Why did pre-Gorbachev evasion serve as a substitute for reform, while the later wide-scale evasion promoted economic liberalization?6 Two factors would seem to be important in determining the extent to which evasion leads to liberalization: the net social benefits of liberalization and the distribution of the benefits. Massive reforms will tend to be enacted when they offer significant net social benefits and when relatively few are harmed by them—a notion formalized in the "political cost-benefit ratio" of Rodrik (1991).7 Wide-scale evasion, however, by generating a de facto, informal reform, improves the political cost-benefit ratio for liberalization. Legalization of the existing market activity can then proceed with diminished distributional consequences, while still offering social benefits by removing the need to conduct economic activity with stealth.
In essence, if an economy has, by and large, become marketized, it will be better if the markets are legal; alternatively, if the existing informal marketization is not too extensive, liberalization will result in significant redistributions. The tendency for large reforms to be postponed until large-scale evasion has already produced an informal transition can be detected in a wide variety of circumstances. Monetary reforms, for instance, often follow massive flight from the domestic currency.
More generally, the tendency for widespread evasion to lead to better policies, as opposed to simply different ones, is likely to be greater in systems
where the policy process is responsive to individual preferences. With a reasonably responsive political system, wide-scale evasion is a force that promotes the efficiency of policies. Evasion of "good" rules (such as those against violent crimes) will be met with tighter enforcement, whereas the political cost-benefit ratio favors the abandonment (or massive reform) of socially inefficient policies.
A further consideration in the relationship between rule evasion and reform is the extent to which evasion is visible or understood by policymakers. While individual acts of evasion tend to be hidden, the existence of widespread evasion often becomes common knowledge—as was the understanding of the informal economic system in the Soviet Union. Widespread evasion of rules, then, is likely to come to the attention of policymakers. There is thus a two-stage process through which wide-scale evasion contributes to better policies.8 First, widely evaded policies are likely to be disproportionally represented among those policies that come under reconsideration; second, political economy considerations are likely to favor socially desirable changes—either stricter enforcement of good rules or a change or liberalization of bad policies.
In the case of the Soviet Union, high levels of evasion also served to erode the communist regime's ideological underpinnings. The departure from Marxist-Leninist principles was so severe that it could not help but be noticed. It "had all gone rotten," as Shevardnadze said to an agreeing Gorbachev in 1984, and thanks to their privileged positions, they may have been among the last to know.9
The history of lawbreaking in the Soviet Union is not a promising legacy for a country interested in developing respect for its new rules. The credibility of reforms requires a belief not only that new policies will be sustained, but also that they will be enforced. The toleration of widespread evasion in the prereform period could lead to a general distrust in the government's commitment to any proposed rule change. Both the desire and the capability of the government to implement reform may be called into question.
EVASION IN TRANSITION
The criminality and corruption of the former regime has already become standard operating procedure in the new (Handelman, 1995:8).
Liberalization during the Russian transition has resulted in substantially loosened controls on private economic behavior. Forms of rule breaking that were prevalent in the prereform system, such as circumvention of price con-
trols or ''speculation," are, for the most part, no longer against the rules.10 Nevertheless, there remains a good deal of corruption, illegality, and underground activity. Why?
First, the rule changes during the reform era do not represent a simple legalization of preexisting activity. The more-or-less general prohibition against private economic activity has been replaced by a host of new regulations and taxes at different levels of government. The liberalization has been far from complete, and private activity officially remains much more tightly controlled than in the United States, for example.
Besides generating a large change in the rules, the transition also has brought increased uncertainty as to what the rules really are. Laws are murky, changing, and contradictory. Even high-level constitutional questions remain unresolved. The "division of powers and responsibilities [among Russian Federation members] is as clear as an old-fashioned London fog" (Hanson, 1995:28). In the Russian legal environment, a well-intentioned entrepreneur would have a difficult time knowing the relevant rules.
In some instances, de facto rules are informal, reflecting the powers of government authorities. Consider the case of local price controls. Most localities in Russia officially control the prices of only a handful of goods—though often these controls apply to the most important household goods and services, particularly apartment rents, utilities, basic foodstuffs, and local transport fares. But informal restrictions can be much more severe. Threats by a government official to make life difficult for those who fail to hold to informal strictures are all that is required. The director of a local antimonopoly committee noted that he had the power to imprison for up to 3 years any enterprise manager who ignored his edict, and because he had this power, he had not had to use it, as no one had ignored him. In the same locality, the owner of a private bread store indicated that his biggest problem was the "state racket" and the need to keep on the good side of local officials.11 Local control of commercial real estate provides one important source of official leverage over private businesses. The continuing practice of selling identical goods to different customers at different prices—with the traditional state-sector customers receiving the lowest prices—is another indication that some elements of the planning system have outlived the system's formal apparatus.
Taxes provide a fertile area for evasion even in a developed market economy, so it should be no surprise that they offer significant potential for evasion in a transitional economy. Russian tax rules are complex, murky, and
frequently evaded. Here is what awaits the foreign investor in Russia with respect to taxes:
The incoherent and ever-changing tax codes which characterize the current system mean that foreign firms are often unable to calculate even their present tax bills, despite employing large amounts of resources and paying consultants to identify precisely what they owe and where responsibility for taking a decision about tax liabilities ultimately lies. In the event, tax bills are often calculated on a the basis of prolonged negotiation with officials from a variety of governmental departments (Halligan and Teplukhin, 1995:124).
When all relevant taxes are included, rates have been quite high, providing the incentive for underground operation or other forms of evasion—and simultaneously improving the soil for the growth of organized crime. In May 1995, the chairman of Goskomstat estimated that output hidden for purposes of tax evasion accounted for 20 to 22 percent of gross domestic product (GDP), though even this could be a substantial understatement.12 The Tax Police uncovered 9,000 cases of large-scale tax evasion during the first 9 months of 1995 (OMRI Daily Digest, No. 104, Part 1, 30 May 1995).
Growth of organized crime has been one of the most visible results of the Russian transition. Mafia protection offers its clients the benefit of decreased uncertainty.13 One set of rules—those involving the enforcement of private contracts, debt collection, and relations with government officials—becomes more standardized, at the cost of increased violence and strong-arm tactics. Those who are caught up in this system would probably prefer a world of government-supplied, inexpensive protection and legal stability, but there is little they can do about it individually. (Another frequently employed substitute for public protection, however, is to deal only with those with whom one has strong personal connections.) In this sense they are in a similar position to that of prereform enterprise managers who were required to deal on black markets.14 A survey of Western firms that have invested in Russia indicates that the largest obstacle to foreign direct investment is the legal uncertainty; fear of crime or the mafia is a relatively minor concern.15 For many Russian businesses, as for most Western firms, security and protection are a standard business expense.
Increased uncertainty about the future during transition tends to reduce effective time horizons. To the extent that breaking the rules entails some risk of a future punishment, including a loss of reputation, individuals will be more willing to run such risks in less stable settings. Similarly, the punishment that accompanies some forms of rule breaking has been undermined during the transition. Corruption, for example, is generally punished by the loss of one's official position. As the private sector grows, however, dismissed state officials have less to lose from corrupt behavior. This assessment seems most applicable to street-level police officers. Police have relatively high-paying alternatives as private security guards, and their marketability in the private sector cannot be diminished greatly by previous bribe taking.
Evasion and Reform
As suggested earlier, the benefits of evasive activity depend on the quality of the rules being evaded. Evasion of the economic restrictions of the planned economy often was socially beneficial, and in many instances even promoted plan fulfillment.16 In a liberal market economy, however, widespread evasion can be quite detrimental.17 Present-day Russia has neither a planned economy nor a liberal market economy. Whether evasion currently is offering positive net benefits is impossible to know. Evasion of continuing price controls and excessive government regulation probably improves the economy. Simultaneously, tax evasion can contribute to higher inflation (if there is monetization of the increased budget deficit) and increased uncertainty, and violent criminal activity has a chilling effect on some would-be entrepreneurs. Further, an environment of widespread illegality can be unfair, and certainly contributes to a perception of unfairness. Individuals who do well in such circumstances often are those with the fewest scruples about breaking rules.
Evasion of rules in one area tends to induce responses in other areas. For example, the possibility for policemen to earn money through bribes lowers their official salaries. And while firms are evading their legal obligations to the state in tax payments, the state is evading its legal obligations to firms in terms of payments for goods, which in turn is partly responsible for delayed or nonpayment of wages and further tax evasion, and so on.
Widespread evasion of rules in a transitional economy can still provide an impetus toward efficient policies. The significantly increased responsiveness of the Russian government that has come about with democratization would seem to augment this effect. The rules themselves, however, are not nearly so inefficient to begin with, so the marginal social gains from evasion-induced rule changes presumably are reduced relative to the prereform situation. Nonetheless, the ability to evade rules during transition helps prevent increased government regulation, and in the case of tax evasion is leading to simplification and rate reduction in the tax code. In other areas as well, the potential for corruption serves to limit the amount of discretion available to governmental officials.
. . . in several very important respects the development of a backward country may, by the very nature of its backwardness, tend to differ fundamentally from that of an advanced country (Gerchenkron, 1952)
It is always tempting to judge events in Russia by the standards of developed market economies. Nevertheless, the application of Western standards frequently is misleading, as I have argued elsewhere with respect to barter, monopoly power, and organized crime (see, for example, Leitzel, 1995:41-45, 100-108, 127-130). The economic outcomes that we see in the United States represent the aftermath of a long (and continuing) evolutionary process of rule making, individual responses, amended rules, new responses, and so on. Policy changes in such near-equilibrium settings then take on the character of, in Schroeder's (1979) famous phrase, a "treadmill of reform." Policymakers respond in marginal ways as problems become apparent. Over time, tremendous changes can occur, but primarily they are the result of a relatively slow, evolutionary policymaking process.
The massive reform that Russia has undergone, however, has not shared that character. Rather, the public policy changes, and individual responses, have been far from marginal, even as the initial post-Soviet conditions have continued to exert enormous influence over the Russian economic and political environment. The system of public finance and the social safety net, both of which were largely implicit in the planning system, have had to be overhauled completely. Commercial banking and its regulation have developed from ground zero. Private farming, which was permitted in the form of small private and garden plots in the old system, has expanded enormously. By mid-1993, there were already more than 250,000 full-scale private farms; individual garden plots were estimated to be responsible for 70 percent of Russian vegetable output and 90 percent of the potato crop in 1996 (Wegren, 1995:48; on individual garden plots, see Gurushina, 1996). Legal private business in general has mushroomed: there were more than 900,000 private enterprises in
Russia by the end of 1995, including more than 120,000 that had been privatized (see Blasi et al., 1997:Table 1, 189).
With such large changes across a wide spectrum of policy areas in such a short period of time, it is not surprising that there have been opportunities to evade the new rules. Privatization offered a very significant, one-time opportunity for evasive activities that included, besides insider machinations to retain control of enterprises, bogus voucher investment funds and counterfeiting of vouchers.18 In many cases the enforcement of the new policies (such as the value added tax) had to start from ground zero. The development of a financial market also presented entirely new types of crimes that Russia had no experiencing with policing. Nevertheless, the policy situation, like the macroeconomic environment, appears to be becoming more stable. Strengthened resolve with respect to macroeconomic stabilization has decreased access to legal "loopholes" in tax laws and limited the subsidies through which localities can sustain price controls. Many severe violent crimes showed downward trends in 1995; in 1996, murder and attempted murder again decreased, as did recorded crime overall.19
The current situation in Russia, however, remains far from a U.S.-style market economy. Here is a description of the reforming Russian economy, circa October 1995, from former acting prime minister Yegor Gaidar (1995):
. . . the main problem of present-day capitalism that has formed in Russia is as follows. It is the problem of the utmost intertwining of property and power. If we look at the operation of the Russian enterprises, the work of government agencies, in Moscow, in the regions, we will see constantly the closest intertwining of business and bureaucracy. In the majority of cases the success of an enterprise depends not on the ability of the director or the owner to organize normal production, but on his ability to correctly give bribes, on whether he has sufficiently high patrons, his ability in this connection to secure for himself a set of individual benefits and exceptions from the rule, his ability to get cheap money out of the budget, and so on.
The continued entanglement of the government in the economy is quite stifling and shows little signs of diminishing. This entanglement is the most important source of the uncertainty over what the laws actually are—the de facto law essentially remains at the discretion of local officials, upon whom the local judiciary also is dependent.
Relative to the Soviet system, however, the current situation seems to be an improvement. Certainly there has been a massive increase in private economic activity, despite the barriers of state and mafia extortion. And the legal norms governing state-private interaction in the United States are inappropriate in the Russian context (see Posner, 1995; Rapaczynski, 1996). Of surveyed Russians, 70 percent do not expect fair treatment from the state; 45 percent do not expect fair treatment from grocery stores, either (Rose, 1995:39). In such circumstances, high levels of corruption that allow citizens to buy services from government officials for a bribe in the same way they can buy bread at the grocers may not be such a bad outcome.20 There is some evidence that the analogy is not far-fetched: ". . . Moscow newspapers list the going rates for whatever ostensibly free government service you may need" (Germani, 1995:2A).
The transition period in Russia has been marked by radical changes in the official rules and by significant individual responses to the new rules—including widespread evasion. A return to a normal policy regime—a treadmill of reforms—might be quite welcome after the momentous changes of the past few years. With small policy changes and time, state involvement in the economy can "wither away" to levels more consistent with long-term growth.
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