The 2025 Crossroad: Russian authorities will have to choose between two scenarios for the Russian economy

Destabilising mechanisms of fiscal policy in 2022-2025

The current situation in the Russian economy is characterised by high inflation rates, despite over a year of Central Bank interest rate hikes, alongside GDP growth that masks disparities: military and defence-related production is expanding, while civilian industries are stagnating.

The heightened role of Russia's fiscal policy in macroeconomic regulation over recent years presents an intriguing case for economic analysis, showing how macroeconomic stability can be severely disrupted without a significant public finance deficit.

The war in Ukraine necessitated reallocating financial, material, and labour resources to fund military production and logistics, as well as fulfilling contractual obligations for military personnel. The key instrument of this reallocation was a dramatic shift in the size and direction of budgetary financing. The budget became a tool for increasing and redistributing resources from the civilian to the military sector. Given the overall scarcity of financial and labour resources, this redistribution became an inflationary factor.

Inflationary pressures began to mount following the launch of the first budgetary stimulus in 2022, reflected in a sharp 27% surge in federal budget expenditures. Nearly all additional funding was directed toward military production and activities under the 'special military operation' (SMO). Roughly $50 billion of this funding came from emission-based sources and was drawn from the National Wealth Fund (NWF). Importantly, these withdrawals were not offset by the Central Bank selling equivalent amounts of foreign currency reserves on the market.

The second significant move to increase budget expenditures involved effectively abandoning the 'budget rule,' which had capped the use of oil and gas revenues at a benchmark price of $45 per barrel. Previously, revenues exceeding this threshold were saved as reserves to limit full utilisation. These reserves have now been deployed to finance current expenses.

In theory, greater utilisation of oil and gas revenues should have led to a stronger ruble, which could have mitigated inflation. However, due to challenges in importing and paying for foreign goods – rising transactional costs in foreign trade and the failure to repatriate export revenues (effectively equating to capital outflows) – the ruble depreciated instead. By the end of 2024, the ruble had fallen over 50% against the dollar and yuan compared to its average 2021 exchange rate, prior to the 'military operation' in Ukraine.

This chain of events triggered price increases, which seem to have been only partially captured by Rosstat's estimates. In 2023, non-oil and gas revenues rose by over 25% without significant tax hikes (aside from a windfall profit tax generating approximately 600 billion rubles, 2.5% of total budget revenues). VAT collections grew by 27%, indicating both a recovery in imports after their 2022 collapse and an increase in wholesale and retail prices beyond Rosstat’s reported figures. A similar pattern emerged in 2024: tax revenues, especially VAT, grew further, but this time without the import recovery effect. Price increases became the dominant driver of revenue growth.

It should be noted that, in addition to consumer price inflation, regularly reported by Rosstat, questions also arise about how GDP deflators – measuring producer price growth – are calculated. The share of military production in the economy has grown significantly, but detailed statistics on this sector are not disclosed. This obscures the pricing mechanisms for military goods and makes it difficult to determine what portion of the taxable base growth stems from increased production versus price inflation.

Dynamics of key federal budget revenue categories of the Russian Federation, 2019-2024, billion rubles

The accelerated spending in 2024 was driven by an unplanned increase in the deficit to 3.5–4 trillion rubles, financed through remaining balances in the Federal Treasury accounts, potentially from the National Wealth Fund (NWF), and indirectly via Central Bank purchases of OFZ (federal loan bonds) through state banks. Plans for 2025 continue to envision an expansion of budgetary financing to further redistribute resources in favour of the military-industrial complex.

Non-oil and gas revenue growth in 2025 is projected at 18%, with approximately 3.5 trillion rubles (10% of the growth) coming from higher taxes and fees. The list of tax changes is extensive, starting with increased corporate income taxes and personal income taxes. Additionally, a range of measures aimed at increasing budget revenues is planned, such as collecting 172.6 billion rubles in fines and penalties from the population, 17.3 billion more than in 2024. This means relevant agencies will have quotas for fines collection.

Overall, beyond the new taxes, the projected revenue growth appears modest. However, the Ministry of Finance is no stranger to leveraging pricing effects on revenues. It is reasonable to expect actual revenues to exceed forecasts by 3–5 trillion rubles, while expenses will also surpass the planned 41 trillion rubles due to higher inflation, reaching 3–5 trillion rubles more. These additional funds are likely to be directed toward defence and 'special military operation' expenses. In this case, military and defence-industrial spending could amount to 16–18 trillion rubles, or $160–180 billion (at an exchange rate of 100 rubles per dollar). As a result, the 2025 budget could trigger another inflationary shock.

For the first time, the 2025 budget marks a shift toward reducing real spending on social obligations. For example, despite a modest pension indexation, the ratio of pensions to the average salary is set to decline from the previously achieved 35% to 25%.

The 2025 crossroads: two scenarios and the inevitable choice

The key feature of fiscal policy from 2023 to 2025 is its inflationary nature, driven not only by deficit financing but also by the significant reallocation of expenditures toward unproductive military production and subsidies for industries addressing military needs. This shift has drained financial and labour resources from civilian sectors.

The Central Bank traditionally relies on raising interest rates to combat inflation. However, with the continued expansion of unproductive spending, this policy will have only a partial effect on prices while exerting a significant negative impact on the activity of civilian sectors. To counterbalance income growth in the military sector, the Central Bank would have to impose compensatory restrictions on incomes in the civilian sector, maintaining high interest rates on corporate and consumer credit to align demand with supply capabilities. The accumulated imbalance appears to be so significant that this policy risks causing a decline in civilian production.

There are two options to increase real military expenditures: raising taxes or reducing social and infrastructure-support obligations. Social obligations can be reduced nominally or diluted in real terms through inflation – this approach is already in effect. Increasing the tax burden (also already underway) is another factor suppressing economic activity in the civilian sector. The negative consequence of this approach to revenue consolidation is a decline in real production in civilian industries. This, in turn, creates the risk of crossing a threshold where inflation becomes self-sustaining, leading to the danger of entering a regime of runaway inflation.

All of this raises the need for a political decision: a choice between halting the expansion of government spending or plunging the economy into a prolonged period of poorly controlled inflation. Under current conditions, the threat of runaway inflation can likely only be countered by curbing demand growth from the public sector and maintaining the Central Bank’s anti-inflationary rate for a sufficient period to activate its effects. However, in such a scenario, the military-political confrontation would have to be at least frozen.

Thus, in 2025, a decision must be made to adjust fiscal policy starting in 2026. If the decision to 'freeze' is implemented, it will take several years to stabilise the economy, going through a recession that could be severe under the current sanctions regime. If this decision is not made, the economy will enter a regime of poorly controlled inflation, slowing growth, and declining living standards with no means of compensation. Exiting this scenario will be extremely difficult. Moreover, it will accumulate long-term negative consequences and risks, which at some point could escalate into political risks.