Increased Taxes Take a Bite out of Innovative Small Business
By Alec Luhn
August 26, 2011
An internal argument over higher taxes on business has been shepherded to a close by Russia’s prime minister Vladimir Putin in a decision that deals a blow to Russia’s innovation-based small businesses. The compromise also represents a setback for President Dmitry Medvedev, who has spearheaded attempts to stimulate small business, in the run-up to parliamentary elections this fall and the presidential election next spring.
At the crux of the argument was the payroll tax, which grew from 26 percent to 34 percent for most businesses when a new law came into force at the start of 2011. The increase especially affected small businesses, whose main expenses are often salaries and benefits. For small non-retail businesses, the tax increased from 14 percent to 26 percent.
In March, Medvedev called on lawmakers to lower the tax, but a solution was quickly mired in disagreement between the Economic Development Ministry, the Health and Social Development Ministry, and the Finance Ministry, which had Putin’s support. At the St. Petersburg Economic Forum in June, Medvedev announced that the government would lower the payroll tax from 34 to 30 percent, but thereafter the ministries disagreed over how to deal with the ensuing loss in revenue for the government pension fund. Medvedev’s spokesperson said income generated from the privatization of state enterprises could be used to help make up lost revenue for pensions, which will be raised in 2011 and 2012. The prime minister and president were left to break the stalemate.
In the end, the plan proposed by the Putin-backed Finance Ministry won. The new payroll tax for 2012-2014 still includes 30 percent of yearly salaries of up to 512,000 rubles ($17,700), but adds a 10 percent tax on salaries higher than this mark. Although the additional tax won’t drastically affect medium and large enterprises, where 90 percent of workers make less than 512,000 rubles a year, it could adversely affect many small businesses. Notably, innovative small enterprises such as IT businesses, who pay larger salaries to the highly qualified employees comprising their workforce, may be hit hard by the additional 10 percent tax.
In Russia, a small business is typically defined as a private company with fewer than 100 employees. The nation lags behind its peers in the size of its small business sector. According to data gathered for the Global Entrepreneurship Monitor project, Russia’s economy had the sixth lowest entrepreneurial activity of the 54 countries in the study, and total entrepreneurial activity here remained static between 2009 and 2010. According to expert estimates, small businesses pay about 10 percent of business taxes collected in the country.
The sector accounts for 25 to 30 million jobs nationwide, of which some 2.5 million are located in Moscow, and contributes about 20 percent of GDP. This number is small, however, compared to the United States, where the percentage is around 80 percent, and even to other countries in Eastern Europe. Poland, for instance, counts on small enterprise for 60 percent of its GDP. Furthermore, the number of entrepreneurs is growing very slowly: Russia had 950,000 small businesses in 1994 and has 1.2 million to today.
President Dmitry Medvedev has made small business a key part of his agenda and of his image as an innovation- and business-friendly president. In March, Medvedev called for addressing unemployment by financing small businesses, pledging to continue state subsidies for startups. The president proposed tax breaks for small business estimated at 41 billion rubles ($1.45 billion) over the next two years. In the lead-up to the March presidential election – Putin and Medvedev have not said which of them will run – the success of Medvedev’s efforts to reform the country’s business sector may very well inform his political future. He has positioned himself as a modernizer and friend to business, courting in particular Western investors, while Putin has continued to lash out at independent-minded companies and executives and to play up his image as a strong, conservative leader.
The federal budget already allocates 2 billion rubles ($70 million) to small business development each year, and regions are supposed to supply additional funding. The Moscow city government also invested 3 billion rubles ($100 million) in small business in 2010, including 1 billion rubles of federal funding, but no services or funds have been provided since January, when new mayor Sergei Sobyanin froze the financing program. In addition, the government has opened up several “technoparks” and business incubators, where small businesses, many of them using new technology, can enjoy reduced rental rates and other benefits. Critics have argued, however, that the existing funding and benefits are not sufficient to achieve significant growth, and the static entrepreneurial numbers seem to bear this out. They make the case that Russia needs to spend more than developed countries on small business development in order to narrow the gap.
Despite government stimulus, entrepreneurs face a number of hurdles. Perhaps the greatest challenge is finding startup capital. Although the government has provided startup grants to entrepreneurs, small businesses still seek billions of rubles in loans each year. Meanwhile, the microfinance industry is underdeveloped in Russia and lending rates are high. Most Russian organizations offer microcredit at interest rates between 20 and 30 percent. A new law passed in January launched a legal basis for microfinance that may eventually attract more lenders to this market and allay banks’ hesitancy to offer microcredit.
Even if microcredit takes off, however, the red tape and corruption for which Russia is well-known plagues small businesses, as well. Although the registration procedure for startups has been simplified and can be completed at “one window,” tax accounting and obtaining permits takes up a significant amount time and money for small businesses. Moreover, many small business owners are forced to pay bribes to pass technical and administrative inspections. Necessary documents such as sanitary and fire safety permits also present officials with a chance to extort bribes, and the cumulative effect greatly burdens entrepreneurs.
In effect, the January tax increase was just one more albatross around the neck of small business. The reduction to a 30 percent base rate with an additional 10 percent payroll tax on higher salaries will ease the burden on some small enterprises, but the innovational enterprises championed by Medvedev “the modernizer” will for the most part experience a greater tax load.
Many hopes have been pinned on the growth of small business in Russia. It has been championed as a way to lower unemployment and provide a wider variety of job opportunities. Furthermore, the expansion of small business will almost certainly be the key precondition for the emergence of a broad middle class in the country. Large-scale growth of this sector, however, does not seem possible due to problems including limited credit resources and administrative barriers.
In the face of small business’s troubles, even Medvedev seems to be lowering his expectations for small business growth. Whereas in the past the president has said at least 50 percent of the population should eventually be employed in small business, at a July meeting with entrepreneurs from Penza province he said that “30 to 40 percent of people, if not more” should become entrepreneurs.
Innovation businesses in particular are vital to the diversification of Russia’s energy-based economy, and their growth will be necessary to replace the state as the main driver of research and development and to make Russian products competitive on the international market. The 10 percent tax on highly paid employees will deal a significant blow to the latest generation of emerging innovation businesses. The Russian government needs to support these small businesses by offering more widespread and enduring grant programs to compensate for the new load it has burdened them with.
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