Military-style VAT: Why the Russian authorities are forced to raise VAT and how much it will help them

A shift in priorities: budget instead of credit

The Central Bank’s recent decision to cut the key interest rate by just one percentage point, to 17%, was quite unexpected. The most widely held analyst forecast ahead of the meeting had been a two-percentage-point reduction. This was supported by both the continuing slowdown in inflation and the sharp deterioration in economic dynamics.

Indeed, after the previous rate reduction (on 12 June) by two percentage points, monthly price growth remained low: June — +0.2%, July — +0.57%, August — –0.4%. Overall, price growth over the summer amounted to 0.37%, compared with +2% in the same period last year. Adjusted for seasonality, the annualised inflation trend for August was 3.5% (according to the Telegram channel ‘Hard Figures’), which is below the Central Bank’s target. The start of the new working year also showed no acceleration: the average daily price increase in the first half of September was 0.009%, almost half that of last year (0.016%).

However, the full set of data on inflation, inflationary factors and expectations is not entirely reassuring. Core inflation remains between 4–6%, Central Bank Governor Elvira Nabiullina noted at a press conference dedicated to the rate decision. This, however, is still not particularly high: in mid-2021 the figure was 8%, and in mid-2023 it was 6%. Meanwhile, food price inflation in annual terms still stood at 9.8% year-on-year in August, barely dipping back into single digits (compared with +10.8% in July). Inflation in the services sector has not slowed either: +11.3% y/y in July and +11% in August. In the survey conducted in August by ‘inFOM’, on behalf of the Central Bank,both perceived and expected inflation rose again following July’s increase in housing and utility tariffs. In the September survey, however, expectations fell slightly but remained high: respondents estimated current inflation at 15.7% annually and expected 12.6% over the next 12 months. Business price expectations, according to Central Bank surveys, fell markedly in Q2 (from 23.5% to 18.5%) but declined only slightly further in Q3 (to 18.1%).

Nabiullina cited lending as a pro-inflationary factor: lower interest rates led to some growth in the corporate segment. In June, corporate lending grew by 0.7% according to the Central Bank, and in July by 1.2% compared to June; in August, preliminary data growth accelerated slightly again. But even this is not a compelling argument against a more aggressive rate cut. The credit impulse remains negative, standing at –4.6% of GDP in July after –4.2% in June, the Central Bank noted in its latest ‘What The Trends Say’ report. This means that overall credit dynamics are still contributing to an economic slowdown, and their impact is even growing, albeit more slowly than before.

In general, the Central Bank has some grounds for concern about the sustainability of the disinflation trend, but these concerns are no more significant than the arguments on the other side. As we have previously noted, the question of whether the Russian economy is technically in recession is largely methodological: one method of seasonal adjustment shows there is no recession, while another, more meticulous one, shows that there is (→ Re:Russia: Drones Against Recession). Both President Putin and the head of the Central Bank insist there is no recession, citing labour market and consumer demand indicators. But their arguments are unconvincing: labour market indicators, wage dynamics and, accordingly, consumer demand are distorted by the sharp and artificial (war-related) contraction of the workforce and the simultaneous increase in demand for labour from the public sector. The result is a labour shortage and a wage spiral. This is a 'bottleneck' in the economy rather than a sign of robust economic activity. Meanwhile, industrial data point to a widespread fall in output across the vast majority of sectors, and business surveys indicate a sharp deterioration in conditions over the past three months.

What is surprising is not even that the Central Bank decided in favour of a small rate cut in this situation, but that the meeting on the rate was not preceded by a chorus of large businesses and government officials calling for a faster reduction, as was the case in late spring and early summer. On the contrary, virtually the only hint at the need for a rate cut, made by Sberbank CEO Herman Gref, was parried by President Putin, who effectively sided with the Central Bank, emphasising the importance of reducing inflation and the normality of the ongoing economic slowdown. In June, the emphasis of his statements was quite the opposite: 'stagnation or even recession' in the economy 'must not be allowed under any circumstances.' This is despite the fact that inflation figures are now objectively much better than they were three months ago, while economic indicators are worse.

This shift in priorities, however, seems entirely understandable in the context of the economic authorities’ intention to raise the VAT rate. Talk of a new round of tax increases began as early as August, and on 10 September The Bell reported, citing its sources, that VAT was planned to be increased from 20% to 22%

A week later, Reuters reported, also citing its own sources, that this had already been decided. Elvira Nabiullina indirectly welcomed the not-yet-announced decision during the press conference on the rate, stating that it was preferable to balance the budget deficit by increasing revenues.

Raising VAT is an inflationary measure. It is a turnover tax and a tax on consumption, so while it is the most efficient instrument from a fiscal perspective, it will ultimately be passed on by producers to consumers. It was precisely this potential inflationary impact that Finance Minister Anton Siluanov cited in May 2024 as the reason why the government had decided not to consider a VAT hike scenario. However, a sharp shift in priorities occurred over the course of this summer – as the budget deficit widened and the outlook for the oil market worsened (→ Re:Russia: Excess Oil). While in spring and early summer the government’s main objective appeared to be the swift easing of credit conditions, even at the cost of somewhat higher inflation, its absolute priority is now to rescue the budget by increasing non-oil-and-gas revenues. And in order to deploy the most effective instrument – a VAT rise – it is necessary first to suppress the inflationary background as much as possible in the run-up to this step.

The many faces of VAT: catch-up growth, ‘development goals’ or confrontation aims

A VAT rate of 20% or higher should be considered high. Twenty-four countries out of roughly 135 that use VAT or similar turnover taxes apply such a rate. Apart from Uruguay and Argentina (22% and 21%, respectively), the list consists exclusively of EU member states. A 22% rate should be considered very high. Only 16 countries – just over 10% of the total – apply a rate at this level or above. Thirty-eight countries set rates between 18% and 20%, while just over half of the remaining countries are below 18%. The median rate is 16%. Most developing countries use rates below 18% as a tool for catch-up growth. According to IMF research, VAT revenues in developing countries average 4.7% of GDP, compared with 7.2% in advanced economies. In 2024, at a 20% rate, domestic and external VAT provided the Russian budget with revenues amounting to 6.7% of GDP. Raising the rate to 22% will bring this figure closer to the developed-country standard, but it will not make Russia a developed country.

It is also important to bear in mind that in Russia, 16% of tax revenues come from rent payments (this estimate was recently given by Minister Siluanov). This is a 'bonus' effectively paid into the Russian budget by the rest of the world. Normally, such a bonus allows countries to keep income and consumption taxes – including VAT – lower. In Azerbaijan, this figure is 18%, in Venezuela 16%, in Saudi Arabia and Turkmenistan 15%, in Kazakhstan 12%, in Bahrain 10%, and in the UAE 5%. A lower VAT rate is intended to support non-resource sectors that do not receive rent income and that suffer from an overvalued national currency in resource-based economies.

The Russian government's previous move to raise the VAT rate from 18% to 20% from January 2019 was a decisive rejection of this economic logic of catch-up growth and support for non-resource industries. That increase was semi-officially justified by the need to implement the so-called May Decrees issued by Putin in 2018, which aimed to reallocate the budget in favour of 'development goals', namely, increased spending on education, healthcare, and infrastructure. In the end, spending on education was never increased as a share of the budget, healthcare spending rose significantly only during the Covid-19 year of 2020, but spending on the national economy and housing and utilities did increase substantially. In 2018 these categories accounted for 15.3% of total spending; in 2019–2020, they rose to 17%; and by 2021, they reached 20%.

At the same time, in 2018 a new and quite strict fiscal rule was introduced, setting the oil-and-gas revenue price threshold for current expenditure at $40 per barrel. Moreover, after a period of relatively low oil prices between 2015 and 2017, prices began to rise again in 2018. This allowed the government to accumulate additional revenues aggressively in the National Wealth Fund (NWF). In 2019, the fund’s size doubled to $124 billion. In March 2020, another tranche of foreign currency purchased by the government was transferred to the NWF, bringing its volume to $165 billion, or 12% of GDP. By the end of 2021, when Putin was already actively preparing for the invasion of Ukraine, the fund’s assets reached a peak of around 14 trillion roubles, or $190 billion. And although only 60% of this was considered liquid, that still amounted to a substantial $115 billion.

Key points in the dynamics of the National Wealth Fund’s growth, 2018–2025

Thus, the increase in VAT ostensibly introduced to finance 'development goals' in reality enabled the accelerated accumulation of reserves, which were ultimately used largely for 'confrontational goals'. In total, between 2018 and 2021, according to our calculations, 12.8 trillion roubles were channelled into the NWF, which is equivalent to roughly 11% of GDP and four to five times the amount of revenue the budget actually received from the VAT increase. To be fair, most of this money was eventually spent: 2.9 trillion roubles on current expenditures, and 5.1 trillion provided as loans secured against the assets of major companies. However, the principal purpose of the remaining funds turned out to be the financing of the war in Ukraine and the confrontation with the West.

At the outbreak of the war, the NWF nominally held 13.6 trillion roubles, of which 9.7 trillion were 'liquid' funds. Today, the nominal volume of the fund has changed little – 13.1 trillion – but the amount of 'liquid' money remaining has fallen to 3.9 trillion, barely enough to cover the budget deficit accumulated over the first eight months of this year. Thus, it appears that 5.8 trillion roubles have been issued as loans secured against various assets, while the liquid share has declined to just 30% of the fund’s nominal volume.

Dynamics and structure of the National Wealth Fund, 2018–2025, billion roubles

Military-style VAT: effects and consequences

Comparative studies of the effects of VAT increases in different countries paint a rather mixed picture, as the specific conditions and economic parameters vary widely. Overall, it is safe to say that raising VAT has a negative impact on economic growth. Budget revenues, on average, increase by around 0.3–0.5% of GDP for each percentage point rise in the VAT rate. The pass-through of a VAT hike into consumer prices tends to be incomplete. For example, a study of the consequences of the VAT increase in the Netherlands in 2012 shows that just over 80% of the rate rise was passed on to final consumers. Prices for durable goods tend to rise the most, and high-income groups are disproportionately affected, while the main burden of the incomplete pass-through is borne by large companies. However, according to IMF estimates, the pass-through in developing countries may be significantly lower, at 0.3–0.5% for each percentage point of the rate increase.

According to a study by Central Bank analysts, between July 2018 (when the VAT hike was announced) and April 2019, the contribution of the VAT increase to inflation amounted to 0.55–0.7 percentage points. However, these figures may not fully reflect the overall effect of the rate increase. In the first quarter of 2019, the new rates had not yet come into effect, so the figures mostly reflect a preventive rise in prices in anticipation of the hike. However, this study, like a number of others in different countries, indicates that consumer activity and price growth begin as soon as a tax rise is announced. Consumers rush to purchase durable goods before they become more expensive. Given the significant increase in household savings held in deposits in recent years, an announcement of a VAT hike could trigger a consumer boom and, in itself, become an inflationary factor. Nevertheless, the impact of the 2019 rate increase on inflation was moderate overall and in line with the profile observed in developing economies. At the time, the inflationary effect was also mitigated by the strengthening of the rouble as a result of rising export revenues.

The most recent example of a sharp VAT increase abroad comes from Estonia. There, the rate was raised in two stages (in January 2024 and July 2025) from 20% to 24% as a 'defence tax': Estonia is expanding its defence capabilities to counter potential Russian aggression. Experts at the Bank of Estonia estimated that the inflationary effect of the first stage of the increase, from 20% to 22%, was 1.6 percentage points, which the Dutch study’s conclusion of an 80% pass-through. It is too early to assess the effect of the second stage, but the Estonian Ministry of Finance forecasts a contribution to price growth of 0.8 percentage points by the end of the year and 1 percentage point next year. The Estonian budget’s revenues grew by 0.4% of GDP in the first half of 2025 (the effect of the initial two-percentage-point rise). At the same time, experts soberly estimate that the tax measures will reduce the country’s GDP by 1.2% in 2025, by 0.3% in 2026, and by a further 0.3% in both 2027 and 2028.

Most likely, the Russian government has its own calculations regarding the potential consequences of a VAT increase. In any case, when assessing the impact, it should be borne in mind that the measure will almost certainly be implemented against a backdrop of economic contraction, declining export revenues and a weakening rouble. The VAT rise will act as a brake on reductions in the key interest rate and, consequently, on credit rates, at least until its inflationary effects have fully materialised.

The primary goal of the current VAT increase is to reduce the structural deficit that has emerged over the years of war and sanctions – the systematic excess of spending over revenues. Over the past three years, despite relatively high oil prices, budget revenues have amounted to less than 90% of actual expenditure, and the deficit has averaged around 3.3 trillion roubles per year (1.9% of GDP), according to data from the Ministry of Finance. However, it is highly likely that the budget deficit will continue to widen due to falling oil and gas revenues. If in January–February this year these revenues were still at the same level as in the first months of 2024, preliminary budget data shows that by January–August they had fallen to less than 80% of last year’s level. At the same time, oil prices are highly likely to continue declining in the autumn months. The government’s draft budget for next year is based on a price of $59 per barrel, which may prove to be an overly optimistic figure.

Federal budget expenditure and revenue, 2021–2025 (January–August), billion roubles

In addition to the VAT increase, the government appears to be preparing a range of other initiatives aimed at raising the fiscal burden on citizens and the economy. These include measures to improve tax collection, raising thresholds or abolishing preferential tax regimes, and increasing the progressivity of personal income tax (PIT). However, even under the most optimistic estimates of their combined effect, these measures would cover only about half of the structural deficit. At the same time, against the backdrop of declining external revenues and GDP, the return on raising the tax burden may prove significantly more modest due to the effect known to economists as the ‘Laffer curve,’ when a constant tax increases eventually yield diminishing returns for budget revenues as the tax base contracts, and at a certain point revenue growth simply stops.

Thus, even after the VAT rate increase, the Russian budget will face considerable strain in financing expenditure at its current level. This will be especially true if oil prices continue to slide. On the other hand, the conclusion that a VAT rise clearly signals a decision to continue the war next year also appears premature. Even if military operations were to cease, the Kremlin would maintain defence spending at a high level, while the budget would remain highly vulnerable amid declining oil export revenues and shrinking export opportunities as a result of sanctions.