Black and Tarassova Institutional Reform in Transition PDF

Institutional Reform in Transition: A Case Study of Russia
Author(s): Bernard S. Black and Anna S. Tarassova

Source: Supreme Court Economic Review, Vol. 10, The Rule of Law, Freedom, and Prosperity
(2003), pp. 211-278
Published by: The University of Chicago Press
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Institutional Reform in Transition: A Case
Study
of Russia
Bernard S. Black
*
& Anna S. Tarassova * *
A decade
of experience
with the transition
from centrally
planned
to market economies has
taught
us that the
strength
of
a
country's market-supporting
"institutions"
powerfully af-
fect
transition success.
However,
the
necessary
institutions
are
rarely specified
in detail. This Article is an
early
install-
ment on a
larger project
that
begins
the task
of providing
this
missing
detail
through
a case
study of
Russia. We describe the
multiple legal,
institutional,
and microeconomic
reforms
that
Russia needed to
put
in
place
as
part of
its transition to a mar-
ket
economy.
We discuss the
important
and sometimes non-
obvious
synergies
between
different reform
elements,
and ex-
plain why controlling corruption
is a core element
of successful
transition,
which Russia
long neglected.
Our basic
message
is to stress the
complexity of reform,
the interrelatedness
of
reform elements,
and the
pervasive effect of corruption
in
*Professor of
Law,
Stanford Law School.
*
*Senior
Legal Advisor,
IRIS
(Institutional
Reform and the Informal
Sector)
at the
University
of
Maryland, College
Park. A revised version of this Article will be
pub-
lished as Bernard Black & Anna
Tarassova, Beyond
Privatization: Institutional
Prereq-
uisites
for
Transition
(A
Case
Study of Russia) (tentative title),
in Thomas Heller & Law-
rence
Liu, eds.,
The
Ecology of Corporate
Governance
(forthcoming 2003) ("Black
&
Tarassova, Beyond Privatization").
Citations to Russian laws and other sources are cur-
rent
through roughly Spring 2002,
but were not
updated
after that. We thank the Mi-
crosoft Rule of Law
Project
at Stanford Law
School,
Stanford
University
Center for
Russian and East
European Studies,
and
George
Mason
University
for financial
sup-
port.
For
helpful
comments on this
paper
and other
discussions,
we would like to thank
John
Donohue, Sergei Guriev,
Tom
Heller,
Erik
Jensen, Cally Jordan,
Ehud
Kamar,
Kate
Litvak,
Daniel
Mah, John McMillan,
John
Merryman,
Peter
Murrell, John
Nellis,
Larysa Snisarenko,Vasilisa Strizh,
Robert
Thorpe,
and Lena Zezulin.
? 2003
by
the
University
of
Chicago.
All
rights
reserved.
0-226-99962-9/2003/0010-0009$10.00
211
212 Institutional Reform in Transition: A Case
Study
of Russia
undermining reform efforts,
and the
potential for (mostly)
self-enforcing
laws to limit
bureaucracy
and
corruption.
TABLE OF CONTENTS
I. INTRODUCTION ................................. 212
II. SHOCK THERAPY IN RUSSIA AND
ITS OUTCOMES ...... . ............................217
A.
Enterprise
Privatization in Russia: Outcomes and
Im
plications
.....................................218
B. How Much Institutional Reform Was Possible? .......220
C. Recent Russian
Legal
and Microeconomic
Developm
ents ....................................222
III. THE CENTRAL ELEMENTS OF
INSTITUTIONAL REFORM ..........................223
A.
Anti-Corruption
Efforts and Control of
Organized
Crim e .................................226
B. Tax Reform ....................... ...............237
C. Formation and Growth of New
Enterprises
...........244
D. Commercial Law Reform ..........................253
E.
Building
Law Enforcement Institutions ..............258
F
Competition
and Trade
Policy
......................261
G.
Banking
Reform ..................................265
H. Land Reform .....................................268
IV. CONCLUSION: TOWARD COMPREHENSIVE
INSTITUTIONAL REFORM ...........................271
REFERENCES ...........................................274
I. INTRODUCTION
In the
early 1990s,
when the Soviet Union
collapsed,
most Western
economists
expected
a
painful
but
relatively quick
transition from
central
planning
to a market
economy
in the countries that were
part
of or controlled
by
the Soviet Union. The standard
prescription
was
"shock
therapy,"
which had four central
components: price
decon-
trol,
a stable
currency (made possible by
small
budget deficits),
hard
budget
constraints on state-owned
firms,
and
rapid privatization
of
state-owned
enterprises.
In Russia and most other former Soviet Union
countries,
the tran-
sition from central
planning
to a market
economy
has been much
tougher
and slower than almost
anyone expected
when the transition
began.
Russia's Gross Domestic Product
(GDP) plummeted
between
1991 and
1998,
and in 2000 was
only
64% of its level in 1990. Non-
military output
declined
by
a lower but still substantial amount. In-
Bernard S. Black and Anna S. Tarassova 213
come
inequality
soared from a Gini coefficient of 0.26 to 0.47. The
combination of lower
output
and
greater inequality
led to a
huge
in-
crease in serious
poverty.
Under a standard
poverty
measure
(income
under
$2/day),
Russia went from
negligible poverty
in 1990 to a
poverty
rate of around 25% a decade later. Life
expectancy dropped sharply.
So
did
birthrates,
as
people
lost confidence in the future.
Capital
fled
(perhaps
$200
billion
during
the
1990s),
investment
dropped,
and
Russia's
physical capital
stock deteriorated. So did its human
capital,
as education
quality
declined.'
How did these
problems change
the transition reform
prescription?
In broad
outline,
the first three
components
of shock
therapy
remain
sound advice
today. However, large enterprise privatization
was a dis-
appointment. Broadly speaking,
the institutional environment corre-
lates with
privatization
outcomes.2 Privatization in countries with
decent institutions
(in
Eastern
Europe
and the
Baltics)
often enhanced
enterprise productivity
and
restructuring,
and was
only moderately
corrupt.
In
contrast, privatization
in Russia and other former Soviet
Union countries with weak institutions did not-at least not
yet-
produce significantly higher enterprise productivity
or much restruc-
turing,
was
highly corrupt,
and created
powerful
new
oligarchs,
who
often
oppose
further reform.3
The more
important
new
learning
has been not what shock
therapy
got wrong,
but what it left out-the central role of
market-supporting
institutions in both transition economies and advanced
capitalist
economies.
However,
the transition and
development
economics
literature
generally
either discusses "institutions" in
general,
with
little
specificity,
or
investigates
how one or several institutions affect
1
The data in this
paragraph
is taken from World
Bank,
Transition: The First Ten
Years:
Analysis
and Lessons
for
Eastern
Europe
and the Former Soviet Union
(2002)
("World Bank, Transition").
2
See, e.g.,
Simeon
Djankov
& Peter
Murrell, Enterprise Restructuring
in Transi-
tion: A
Quantitative Survey_
J Econ Lit
(forthcoming 2002) ("Djankov
&
Murrell,
Enterprise Restructuring"), nearly final
version at
http://ssrn.com/abstract=238716
(Social
Science Research
Network);
John Nellis,
The World
Bank,
Privatization and
Enterprise Reform
in Transition Economies: A
Retrospective Analysis (working paper,
2002),
at
http://ssrn.com/abstract=288903 (Social
Science Research
Network)
("Nellis,
Privatization
Reform").
3
On the
political economy
of
privatization,
see Bernard
Black,
Reinier Kraakman &
Anna
Tarassova,
Russian Privatization and
Corporate
Governance: What Went
Wrong?,
52 Stan L Rev 1731
(2000) ("Black,
Kraakman &
Tarassova,
Russian
Privatization");
Nancy
Birdsall &
John Nellis,
Winners and Losers:
Assessing
the Distributional Im-
pact of
Privatization
(working paper 2002),
at
Science Research
Network).
We use the term
"enterprise privatization"
to refer to
large
enterprises, generally
with over 500
employees-the enterprises
that in Russia were
subject
to mass
privatization
or
case-by-case
sales. We do not discuss small
enterprise
privatization,
which was not controversial.
Study
of Russia
economic
growth, holding
all else constant. No one has
specified
in
detail which institutions matter for successful
transition, why they
matter,
or how
they
interrelate.
This Article
begins
the task of
supplying
this
missing
detail
through
a case
study
of Russia. We
explore,
at a middle level of
generality,
the
extensive
institutional, legal,
and microeconomic reforms
(which
we
refer to below
simply
as "institutional
reforms")
that underlie a suc-
cessful transition to a market
economy.
We discuss the
important
and
sometimes non-obvious
synergies
between different reform elements.
We
place privatization
of state-owned
enterprises
in context as
only
one element of that
larger
reform
package.
We
explain why
con-
trolling corruption
is a core element of successful transition. Com-
parative
success at
doing
so
may
be a
key
reason
why
some Eastern
European
and Baltic countries have
undergone
much more success-
ful transitions than other Eastern
European
or former Soviet Union
countries.
Finally,
we
explore
the
important
role that
(mostly)
self-
enforcing
laws and other reforms can
play
in
limiting corruption
and
other bureaucratic obstacles to
growth.
This multifactor
approach
to reform contrasts with the
"Washing-
ton consensus" advice
dispensed early
in the transition
by
Western
economists and multilateral lenders. This advice focused on macro-
economic shock
therapy, placed enterprise privatization
at the core
of microeconomic
reform,
and treated other institutional reforms
as of
secondary importance,
to be
pursued
later when
political energy
permitted.
Figure
1 below is our effort to
capture,
in a
single chart,
the
princi-
pal
reform elements and the
major relationships among
them. Arrows
indicate the causal connections that we consider to be most
impor-
tant;
two-headed arrows indicate bicausal connections. Solid arrows
between
major
reform
groups
indicate
general
connections between
these
groups;
the solid arrows substitute for a host of
(omitted)
dashed
arrows between
particular
reform elements. We
explain many
of these
connections in Part III.
Figure
1 has the
rough shape
of a
building.
We
place
laws in the far
left and far
right
columns.
Market-supporting
laws can be seen as the
structural
supports
for the
"building"
of institutional reform. With-
out these
supports,
the
building
is
unlikely
to stand. With
them,
but
without
enforcement,
it will be an
empty
shell. We
place
"anti-
corruption
effort" and "enforcement and
regulation"
in the center of
Figure 1,
because we believe
they
must be a core focus of
any
serious
institutional reform effort.
Figure
1 contains an
unruly
forest of
arrows, pointing
in all direc-
tions. That is
precisely
the
point.
Each box is
important;
each arrow
makes
logical
sense. We worked hard to
simplify
the forest of
arrows,
.- O T . .. . . A,- .---U.T,O.. O . T
PUBLIC LAW REFORM DEMOCRATIZATION OTHER REFORMS
-
ANTI CORRUPTION EFFORT ECONOMIC REFORM
1COMMERCIAL
LAW
k ----
----------
----
4k
CBB
-- ^. BFtWBBaI- "- RB'- ---IB
....( ' Constitutional
Reform
| '.-{1Environr~ntl
Protection
~'"'?--"
o.o
,/ ......
Cm ',
'
,,',, /'
-"Macro &
Mecro-microcon Policy ~ .-
__e
~v
--""'
--""-'""M
--''' .'-*^-''-'-""/r!/ ,.-.' ~~~~--4,'
=
"
"O X \" '
~
'
Price Decontrol, Stable
/
Property LawI.
r i ~ - --
.ew Con,,,o.
~'-: . . . .
nizd /re
E l ecto-microEal SyAdy . .'
|
New ConstitLution
<--- ,...J
Electoral
System and
.,l.--'".---;,'.,^^q ,NoB-prOffl?.<-' | / { ,,''
\ Administrative Reformn
ist rai d- f- d
Currency, (Roughly)
Balanced
BudgW .,-
~ Contract Law
LPai
ntary
.-.----
,
_R ...'/'
/ /
- '_ !
Reduce Govemtment Role,
Commrcal La
|
Criminal Law
l^--::'-'--. p-' QtnfrC Democratic
L-l'*''--^, >','-' -1r""-;'"r
^
1-
-- - - - -
---*''T
!
; /""-'\Y1, \'? /
t
'
^"C .K
'. !
i
.---''' [,--''
Freedoms
'
ligion, Culture, Etc.
|Judicial Training
and e . Tax Reform & Tax Law -
....
.Enivronental Law ------,-'
\ \"?\ .-... ..--'," S i mpif
Customs Du.
!
"'/.es.'""/"rd Law
|.
------------
----I
'
'Central Bank, Private
k'.." ?
Seue-- C ,it La
Private Pension Law
B
S Net'-,-
R PoiPe
and C i
4 I J CBCommercial BanksyLaw
EState
Pension Law
. Unemployment Benefits,
. C
.--,'Investigts' [/ --
NBBpABBIOIgatBaabatt'La PBABBWBOBBBCABBBB
.,---|
1?"9
T
aHpuaing Development Boting
Rules
Civil Procedure:
regular courts;J
,,'' .-'
^
,.--"" \ ^T ^
~
^''\ \\ \\'>^:'y^9-^'\~^ // \\\
CoWRulate GovemRance
|
|
Welfare Law
[
Urban Land Antimonopoy Law
1
PBBBIBPBBBBBLAB--)
Central Ban
\j'f\ \\ \
S I
r'
*'
\
C BABiBBBkural BLandtpCla Lgri~~ABalLan
|Administra-ive
iolaons LawP 1e
c , a _-
,,
'i
/
Bad
Law
a
|L
I/';'-,
:
T '!
.... '--------' {----Bses----,Small- Bus..........s --- ' Company
Law
-B ,y
Private Arbitration Development Registration
of Legal Entit?es
-" ,'/." '"... .
---
---Labor Market
Flexbl.'"-'-
Labor Union Law
WeIt LAB, '' 'S BIEnforcement
Pr=Ba
'Aus for'BaEpo y Law
A /Judi A rbitraion --If--
,
-
'-
-
Gove rnent
C ProcurementL
----
\N
',5
-;---i
.
. . . . t~ R' ".gBIB-~-t - yAgNA' ,NB ,',\
'
, LI"/I- L,bII-----
L
----"--Roads, Rail, Electric Power, Foreign Investmert Law
(-razh
''
/
''' \
'elecommunications, Water, Airports | ,
I -
-1~..L
--
\ LABBAMNAII~
FI
Ay<~
I
SCurrency
Law
-------L
*
Distribution
System
Reform
|
- -
""""*
^
^--''' --' StateLaw
on
Licensing |
I
e ..-UeAytf -I P....tBANaIBo s [--p'AA" LAB\:Foreian Investment 1
, '
--
'
Direct Investment
tH
1,ng, . .. ;) . . \\timon
y is
CiBAPortfolio Iy nvestment:
/" ...... ',
'
Finance Ministry
j,
,-- Land RegistrYion
Se ....--iasc+ ....siBBA onN 4 0
t PABIABIBIBANNIANI I
i
~ Portfolio Investment ~-....
Figure
1. Elements of institutional reform in Russia.
Cr
U1
Study
of Russia
often
using
a
single
solid arrow to do the work of
many
dashed
arrows,
and
grouping
several reform elements
together.
For
example,
under
"Commercial Law Reform," we combined
property law,
contract
law,
and commercial law into one
box,
and combined
banking law,
se-
cured credit
law,
and
bankruptcy
law into connected boxes. A detailed
analysis
of the institutions that
support any
one area of microeco-
nomic reform would
produce
an even
larger
set of
complementary
institutions and interconnections.4 Yet the
complexity
illustrated
by
Figure
1 remains
overwhelming.
Taken
together,
the dozens of
impor-
tant reforms and hundreds of
relationships
between them
pose
the
central
problem
of transition reform.
Many
reforms are
needed,
most
are
interconnected,
all can't be achieved at once. Yet the shock ther-
apy
shortcut did not deliver the desired results.
The economic
problems
in Russia and other transition countries
have enlivened but not resolved a
long-running
debate between
"grad-
ualists" and "shock
therapists."
The
gradualists
believe that these
problems
reflect the
impracticality
of the
"big leap" approach,
ex-
emplified by rapid
mass
privatization. They
advocate a slower tran-
sition to a market
economy
that stresses institutional
reform,
with
privatization
to follow over time. The shock
therapists accept
the im-
portance
of institutional
reform,
but believe that
gradualism
can be-
come a
recipe
for no reform at all.
We do not
directly
enter the
gradualism
versus shock
therapy
battle
in this Article.
Instead,
we
map
out the terrain on which the battle
must be conducted. This Article will
likely
offer comfort to both
camps.
For
gradualists,
our effort to document the
many important
reforms and their
interrelationships
will confirm the
folly
of rush-
ing
to
privatize
and
trusting
that the institutions to
support priva-
tized
enterprises
and
capital
markets will
emerge
over time. For
shock
therapists,
the
complexity
of institutional reform will re-
inforce their belief that
waiting
for institutional reform is like wait-
ing
for
Godot-you
can wait as
long
as
you want,
to no avail.
A word on the basis for and
scope
of this Article. We
rely extensively
on our
personal knowledge
of reform efforts in Russia and several
other former Communist countries.5 We address here
only
micro-
4
For detailed
analysis
of the institutions that
support capital
market
development,
see Bernard
Black,
The
Legal
and Institutional Preconditions
for Strong
Securities
Markets,
48 UCLA L Rev 781
(2001).
5
Anna Tarassova was a senior
legal
advisor to the Russian Privatization
Ministry
dur-
ing
Russia's mass
privatization period
and later a senior
legal
advisor to the Russian Se-
curities Commission. She
participated
in
drafting many
of the basic laws and Presidential
decrees that
supported
Russian
capital
markets. Bernard S. Black
worked,
often
together
with Anna
Tarassova,
on several Russian
capital
markets laws and
decrees, including
joint
stock
company law,
securities
law,
and limited
liability company
law. He has also been
an advisor on
privatization, corporate governance,
and
capital
markets
legislation
in
economic and related institutional and
legal reforms,
not macroeco-
nomic or
political
reform. We
only indirectly
address the difficult
policy question
of
sequencing-which
reforms to
pursue
in what
order. As with
gradualism
vs. shock
therapy,
our
goal
instead is to
map
the terrain on which
sequencing
choices must be made.
We do not seek here to
prove
the
importance
of the institutions we
list
below,
nor the causal nature of the interconnections between
them. We believe that these interconnections are consistent with
the
emerging empirical
literature on institutional reform. But we cite
the
empirical
literature
sparingly-this
is a
"thought piece";
not a lit-
erature review.
This Article was written
primarily
in
2001,
with limited
updating
sparingly
after that. Were we to rewrite from scratch
today,
we would
be more
optimistic
in
assessing
Russian institutional reform under
President Putin. We could also offer a series of
examples
of how law
reform can
squeeze corruption out,
or at least
down,
sometimes even
when no one
goes
to
jail
for
corruption.
There is a
huge
distance still
to
travel,
but small
signs
of
progress
continue to accumulate. Russia's
progress
in
developing market-supporting
institutions
parallels
con-
tinued economic
growth,
not all of which reflects
high
oil
prices.
We
think this is not
happenstance.
This Article
proceeds
as follows. Part II summarizes the outcomes
from Russia's first decade of transition. Part III is the core of this Ar-
ticle. We discuss
systematically
the
principal
institutional reforms
that we believe influence the
pace
and success of economic transi-
tion,
and their
relationships
with each other and with other reforms.
Part IV concludes.
II. SHOCK THERAPY IN RUSSIA AND ITS
OUTCOMES
Russia
pursued
shock
therapy
well in some
areas,
and less well in
others.
Still, by
1994 or
1995,
most of the elements of shock ther-
apy
were
reasonably
well established. The
early hyperinflation
had
moderated and the ruble would remain
reasonably
stable until 1998.
The
budget
was in deficit but not
outrageously so,
if one
ignored
non-cash subsidies to
money-losing
firms "administered"
through
nonpayment
of
enterprise
debts to each other and the
government,
as well as the
government's delay
in
paying
its own
obligations.
Most
prices
were
decontrolled, though energy notably
was not. Most enter-
Armenia,
the Czech
Republic, Mongolia, Ukraine,
and
Vietnam,
as well as several non-
transition countries. Anna Tarassova has advised on
capital
markets and commercial
law in
Armenia, Belarus, Kazakhstan, Macedonia, Moldova, Mongolia,
and Ukraine.
Our
prior writing
on Russia and transition reform is cited elsewhere in this Article.
Study
of Russia
prises
were
privatized,
and most of the rest were on their
way
to be-
ing privatized.
The area where Russia was most deficient was
budget
constraints on
firms,
which often remained soft. The subsidies usu-
ally
came
through suppressed energy prices
and tolerance of
nonpay-
ments,
rather than cash transfers from the
government
or loans from
state-controlled banks.
Observers who
compared
how well Russia followed the strictures
of shock
therapy
to how well Eastern
European
countries like Po-
land, Hungary
and the Czech
Republic predicted
an economic re-
bound
starting
in the mid-1990s. That the rebound didn't
happen
tells us that shock
therapy
alone is not
enough
for a successful tran-
sition. That lesson forms the
background
for this Article's effort to
describe the institutional reform details that shock
therapy ignored.
We
begin
in this
part
with a
quick
look at
privatization.
This is the
area where Russia most
closely
followed the shock
therapy prescrip-
tion,
but also an area
where,
in
hindsight,
there is no consensus on
whether the
prescription
is
helpful
if institutions are weak.
A.
Enterprise
Privatization in Russia: Outcomes and
Implications
Russian
privatization
has been described as "the sale of the
century."
In some
ways,
it was the
"giveaway
of the
century."
A
large percent-
age
of the value of Russia's
enterprises, especially
its natural re-
sources
firms,
ended
up
controlled
by
a handful of well-connected
"kleptocrats"
or
"oligarchs" (we
use the term
"oligarchs" here).
The
purchase prices
were trivial fractions of
enterprise
value.
Often,
the
oligarchs
and other
enterprise managers
had stolen much of the
pur-
chase
price
from the
government
or diverted it from the
enterprise.6
We and others have examined Russian
privatization
in
prior
work.
Russia's initial mass
privatization
has
defenders,
as flawed but still
better than the available alternatives. In
contrast,
the
highly corrupt
one-at-a-time sales of Russia's
largest enterprises are,
in the words of
the
rarely-so-blunt
World
Bank, "universally regarded
as a
poor
choice
of a
privatization strategy."7
In our
view, rapid enterprise privatization
is
likely
to
(and
in Rus-
sia, did)
lead to massive insider
self-dealing
unless a
country
has a
good
infrastructure to control
self-dealing (which
Russia
wholly lacked).
6
On the rise of the
oligarchs,
see, e.g., Crystia Freeland,
Sale
of
the
Century:
Rus-
sia's Wild Ride
from
Communism to
Capitalism (Times Books, 2000);
David Hoff-
man,
The
Oligarchs:
Wealth and Power in the New Russia
(Public Affairs, 2002)
("Hoffman,
The
Oligarchs");
Paul
Klebnikov, Godfather of
the Kremlin: Boris Bere-
zovsky
and the
Looting of
Russia
(Harcourt Trade, 2000) ("Klebnikov, Godfather of
the
Kremlin").
7
World
Bank,
Transition at 76
(2002) (cited
in note
1).
Second,
in
Russia,
the
profit
incentives to restructure
(rather
than
loot)
privatized enterprises
and create new businesses were often
swamped
by
a hostile business environment that included extensive
corruption
and
organized crime,
a
punitive
tax
system,
and an
unfriendly
bu-
reaucracy. Third, corrupt enterprise privatization
can undermine
po-
litical
support
for future economic
reform,
because the
population
associates this reform with
corruption
and theft and the beneficiar-
ies of
privatization
use their wealth to further
corrupt
the
govern-
ment and block reforms that
might
constrain them.8
In
effect, enterprise privatization
has both direct and indirect ef-
fects on economic
performance.
In the first decade of Russian transi-
tion,
the direct effects were small.
By
the end of
2000,
there was little
evidence of
productivity improvement
in
privatized firms, compared
to
"corporatized"
but state-owned
counterparts.
There was some evi-
dence of internal
changes
in
privatized
firms that
may
lead to better
future
performance.
In
contrast, privatization
often
improves
firm
performance
in better institutional environments.9
It remains
possible
that
will show
produc-
tivity improvements compared
to state-owned
counterparts
even in
weak institutional
environments, merely
more
slowly.0l
But a decade
is a
long
time to wait for
significant productivity gains
to
emerge.
While
enterprise privatization
had
only
small direct effects on the
performance
of Russian
firms,
it had several
negative
indirect effects.
First,
the
oligarchs
became
major
corrupters
of
government.
An al-
ready corrupt government
became more so.
Second,
the combination
of the blatant
corruption
of the
privatization program,
massive trans-
fers of wealth to a limited number of well-connected
insiders,
the
lack of
any significant
benefit to
ordinary
citizens from the voucher
privatization program (which
was
promoted
as
returning
the coun-
try's
wealth to the
people), huge
increases in
poverty
and
unemploy-
ment,
and declines in real
wages
for most of those who
kept paying
jobs,
contributed to a
political
backlash
against
economic reform. As
a current Russian
joke
has it:
"Everything
the Communists told us
8
See
Black,
Kraakman &
Tarassova,
Russian Privatization
(2000) (cited
in note
3).
On the connection between
inequality
(fostered
by privatization
with weak institu-
tions)
and future
growth, see, e.g.,
William
Easterly, Inequality
Does Cause Under-
development:
New Evidence
from Commodity Endowments,
Middle Class Share and
Other Determinants
of
Per
Capita
Income
(Center
for Global
Development Working
Paper, 2002),
at
www.cgdev.org.
9
For a
survey
of the evidence on
privatization
in transition
economies,
see
Djankov
&
Murrell, Enterprise Restructuring (2002) (cited
in note
2).
For a
survey
of the evi-
dence on
privatization
in
general,
see William L.
Megginson
&
Jeffry
M.
Netter,
From
State to Market: A
Survey of Empirical
Studies on
Privatization, 39 J
Econ Lit 321
(2001).
10
See Thane
Gustafson, Capitalism Russian-Style (Cambridge
U
Press, 1999).
Study
of Russia
about Communism was a lie.
Unfortunately, everything they
told us
about
capitalism
was true."
Third,
the
oligarchs
combined with man-
agers
of
and
corrupt government
officials to
op-
pose many
of the institutional reforms that are central to sustained
economic
growth.
In our
view, privatization
is
likely
to foster economic
growth
in a
transition
economy only
if
many
of the other institutional reform el-
ements are also
present.
Just as
partial price
decontrol can be worse
than no
decontrol,1l
privatization alone can be
counterproductive,
both
economically (by deepening corruption)
and
politically (by
under-
mining popular support
for further reforms and
introducing
new
opponents
of further
reform).l2 Moreover,
the details of the
privatiza-
tion
plan
matter. For
example,
a weak institutional environment can't
support
the
dispersed ownership
created
by
voucher
privatization,
and
privatizing
nonviable
companies simply
fosters
managerial
theft.
B. How Much Institutional Reform Was Possible?
In
retrospect,
there is
widespread agreement
on the
importance
of in-
stitutional reform to successful transition. In an ideal
world,
these re-
forms should
precede
or at least
accompany enterprise privatization.
But in a less than ideal
world,
there is no consensus on how much in-
stitutional reform was feasible in Russia
during
the
1990s,
nor on
whether
rapid enterprise privatization, despite
weak
institutions,
was
better than the available alternatives. Gradualist
authors,
who in-
clude both economists and
political scientists,
believe that the Rus-
sian
government
could have done
significantly
better at institutional
reform,
if President Yeltsin had made this reform a
political priority.
13
Shock
therapist authors, generally economists,
defend
rapid privati-
zation as the best that could be done under bad circumstances.
The debate on this counterfactual
question
is as much about
po-
litical as about economic
feasibility.
Gradualists must also believe
that their
preferred approach
is
politically
feasible. Shock
therapists
argue
that
privatization
in the former Soviet Union was
likely
to be
" See Kevin M.
Murphy,
Andrei Shleifer & Robert W
Vishny,
The Transition to a
Market
Economy: Pitfalls of
Partial
Reform,
107
Q J
Econ 889
(1992);
Gerard
Roland,
Transition and Economics:
Politics, Markets,
and Firms ch. 6
(MIT Press, 2000).
12
For a
simple graphical
model in which
oligarchs
and other insiders benefit from
partial
reform but then
oppose
further
reform,
see World
Bank,
Transition at xxii
(2002)
(cited
in note
1).
13
See, e.g.,
Stefan
Hedlund,
Russia's "Market"
Economy,
A Bad Case
Of Predatory
Capitalism (UCL Press, 1999) ("Hedlund,
Russia's 'Market'
Economy"); Jerry
E
Hough,
The
Logic Of
Economic
Reform
In Russia
(Brookings Institution, 2001) ("Hough,
Eco-
nomic
Reform
in
Russia").
then or
(almost) never,
and "never" would have
produced
still worse
outcomes. Each side can cite
supporting examples.
Gradualists can
compare
Russia's
comparative
failure to the success of
gradual
reform
in
Poland,
Hungary,
and China.14 Shock
therapists
often
recognize
the
importance
of
market-supporting institutions,
but counter with ex-
amples
like Belarus and
Ukraine,
which have neither
privatized large
enterprises
nor reformed their
institutions,
and are in worse economic
shape
than
Russia.'5
On the merits of
privatization
with weak insti-
tutions,
the World Bank-which offers a
good
measure of conventional
wisdom-has moved from a
strong pro-privatization
stance for most
of the 1990s to
rough equipoise today.16
We contribute to this debate
by considering,
with some
care,
the
complexity
of the
institution-building process
that the
gradualists
prefer,
and the shock
therapists
think was unrealistic. We do not ad-
dress the counterfactual
question
of how much institutional reform
Russia was
capable
of in the
early 1990s,
had this been a
priority
for
President Yeltsin and his domestic and
foreign
advisors. In
brief,
one
of us
(Black)
believes that
directing political energy
toward insti-
tutional
building plus staged privatization
could have
moderately
improved
Russia's economic
position,
but is
agnostic
on how much.
The other
(Tarassova)
believes that it was
politically
feasible for Rus-
sia to
pursue
much better
policies
in the
early 1990s,
but is
skepti-
cal that Boris Yeltsin had the interest or
capacity
to
pursue
extensive
institutional reform or attack
corruption,
no matter what advice he
was
given.
14
See, e.g., Grzegorz
W.
Kolodko,
From Shock to
Therapy:
The Political
Economy
of
Postsocialist
Transformation (Oxford
U
Press, 2000);
Janos Kornai,
The Road to a
Free
Economy: Shifting from
a Socialist
System:
the
Example of Hungary (WW.
Nor-
ton &
Co., 1990); Janos Kornai,
Ten Years
After
"The Road to a Free
Economy":
The
Author's
Self-Evaluation,
in Boris Pleskovic and Nicholas
Stern, eds,
Annual World
Bank
Conference
on
Development
Economics 49
(World
Bank
2000);
Peter
Murrell,
What is Shock
Therapy?
What Did It Do in Poland and
Russia?,
9 Post-Soviet Affairs
111(1993).
15
See,
e.g.,
Anders
Aslund,
Russia's
Collapse, Foreign Affairs, Sept./Oct. 1999,
at
64;
Anders
Aslund, Building Capitalism:
The
Transformation of
the Former Soviet Bloc
(Cambridge
U
Press, 2002);
Andrei Shleifer & Daniel
Treisman,
Without a
Map:
Polit-
ical Tactics and Economic
Reform
in Russia
(MIT Press, 2000) ("Shleifer
&
Treisman,
Without a
Map").
Andrei
Shleifer,
in
particular,
is
acutely
sensitive to the
importance
of laws and other
market-supporting institutions,
as his other research demonstrates.
16 See World
Bank,
Transition at xxviii
(2002) (cited
in note
1) (noting
the "difficult
choice between
(i) privatization
to ineffective owners in a context of weak
corporate
governance
with the risk of
expropriation
of assets and income of
minority
sharehold-
ers . . . and
(ii)
continued state
ownership
in the face of ... limited institutional ca-
pacity
to
prevent
asset
stripping by
incumbent
managers");
see also
Nellis,
Privatiza-
tion
Reform (2002) (cited
in note
2) (gradualist
author who still concludes that Russian
mass
privatization
was
preferable
to the available
alternatives).
Study
of Russia
C. Recent Russian
Legal
and Microeconomic
Developments
In the
roughly
three
years
since Vladimir Putin
replaced
Boris Yeltsin
as President of Russia
(and
since we wrote our earlier article on Rus-
sian
privatization),
there has been some
improvement
in Russia's busi-
ness environment. Russia has had sustained economic
growth
since
the crisis
year
of 1998. Much of this
improvement
reflects
higher
oil
prices.
But some of Russia's economic
growth likely
reflects business
restructuring.
The Putin
government
has
sharply
lowered
marginal
in-
come tax rates for
individuals,
to a
single
flat rate of 13%
(the
effec-
tive
marginal
tax on
wage
income is
roughly 37%,
if one includes
the 38% social
safety
net tax that is
nominally paid by employers).
It has
proposed
tax relief for small businesses. Smaller businesses
still
pay
mafia
gangs
for
protection,
but anecdotal evidence
suggests
that
protection payments
are
becoming
less onerous as a fraction
of revenue.
The
oligarchs
remain
enormously powerful, though perhaps
some-
what less so. Two
major oligarchs,
Boris Berezovski and Vladimir
Gusinski,
made
unforgivable
mistakes
by supporting
Putin's
political
opponents
in the 2000 Presidential election
(Gusinski)
or
criticizing
him after the election
(Berezovski). They
are now in
exile,
with dimin-
ished
power
and wealth.
Improved
economic conditions contribute
to Putin's
popularity,
and
help
to
give
him the
political
stature he needs
to limit the
oligarchs' power
and
pursue
economic reforms.
(A
more
cynical
view is that Putin's
authority
comes less from
popularity
than
from reassertion of
government
control over most mass
media, plus
his
strong
ties to his former
employer,
the Federal Securities Bureau
(FSB;
the successor to the
KGB).
A
sign
of
improved
conditions:
Foreign
investment is
trickling
in.
Foreign
investment is still
only
a trickle
compared
to other transition
economies
(whether
measured relative to
population, GDP,
or
likely
investment
opportunities),
but at least it is a
stronger
trickle than in
the late 1990s.
On the other
hand,
bureaucrats remain
extensively corrupt.
So do
courts, especially
at the local level. Criminal
prosecution
and civil
lawsuits are often used
by
those in
power
as tools
against
their less
powerful
enemies. The
oligarchs
are
still,
for most
purposes,
above the
law. So is the
government.
It is
simply
more
likely today
that the
central
government (if
not
many regional governments)
is
equal
to or
even above the
oligarchs.
In
Russia,
this is an
improvement.
While the business environment has
improved only modestly,
the
legal
basis for a market
economy
has been
strengthened by
a
surge
of
lawmaking
over the last three
years.
Table 1 lists
important
new
Table 1. Russian
Legal
Reform Since 2000
New in 2000:
low 13% flat income rate tax on individual income.
New in 2001:
Part III of Civil Code
major
revisions to
joint
stock
company
law
(adopted 1995)
law on
licensing (replaces
1998
law)
law on
registration
of
legal
entities
anticorruption
law
investment fund law
New in 2002:
land
code,
the first in the
post--Communist period
land
provisions
of the Civil Code
major
revisions to law on
pledge
of real
property (adopted 1998)
labor
code,
the first in the
post-Communist period
law on the Central Bank
civil
procedure
law for the arbitrazh courts
(the
courts that handle
disputes
between
legal entities)
administrative violations code
corporate governance
code
(nonmandatory, adopted by
Securities
Commission)
Expected
in 2003:
land
registration system
simplified
tax for small businesses
major
revisions to the
bankruptcy
law
(adopted 1998)
laws,
or
major
amendments to
existing laws, adopted
since 2000.
These laws
improve,
sometimes
greatly,
on their
predecessors. Some,
including major
laws on land and
labor,
are the first laws of their kind
that Russia has
adopted
since the 1991
breakup
of the Soviet Union.
We discuss the
likely
effect of these laws below.
They
offer the
po-
tential, though
not the
certainty,
for continued incremental
improve-
ments in Russia's business climate.
III. THE CENTRAL ELEMENTS OF
INSTITUTIONAL REFORM
If
was not a first-order driver of Russia's eco-
nomic
performance,
what
might
have been? In our
view,
Russia im-
plemented half-heartedly
or not at all a
large
number of institutional
reforms that are of core
importance
in the transition to a market econ-
omy.
The core institutional reforms that
strongly
influence the suc-
cess and
pace
of Russian transition include the
following
broad cate-
gories,
which we list in
rough
order of estimated
importance:
Study
of Russia
1.
Anti-corruption
efforts
(including
control of
organized
crime)
2. Tax reform
3. Macro-economic
policy, including
hard
budget
constraints
on firms
4.
Encouraging
small business
development
5. Commercial law reform
6.
Building
law enforcement institutions
7.
Competition
and trade
policy
8.
Enterprise privatization
and
restructuring
9.
Banking
reform
10. Land reform
We do not defend these crude
priority rankings
in this Article. In
brief,
microeconomic institutions like
corruption
control can
plausi-
bly
be more central to economic
growth
than macroeconomic factors
like a stable
currency
because of interaction effects. A
country
with
sufficiently
weak institutions isn't
likely
to
get
its macroeconomics
right,
or
keep
it that
way.17 Moreover,
a
large body
of
empirical
litera-
ture links the first seven reform areas
(other
than tax
reform,
which
depends
on fine details and is hard to
study empirically)
to economic
growth.
This cannot
yet
be said of the
remaining categories.
We
place enterprise privatization
well down on this list because we
believe that it will
likely
be of limited value if
pursued
too
early,
when
higher priority
areas are
largely
unaddressed. In
addition, privatiza-
tion without more
may encourage looting
rather than
restructuring.
In
Figure
1 and the list
above,
we therefore refer to
enterprise privati-
zation and
restructuring,
as related but discrete areas of reform.
The list above is
only partial. Figure
1 includes
many
other im-
portant
areas of institutional reform. But we believe
analysis
of even
this
partial
list will illustrate our core
arguments
about the
complex-
ity
and interconnectedness of institutional reform.
Below,
we discuss
each of these areas
except
macro-economic
policy (which
is outside
the
scope
of this
Article)
and
privatization,
which we addressed in
earlier work.
The list above and our
analysis
below is
specific
to Russia. Other
countries
may
have fewer or different reform needs. For
example,
Poland
already
had
private agricultural plots,
so little need to
privat-
ize and reform
agricultural
land.
Still, many
of the reforms and inter-
connections will be relevant to a number of transition countries.
Figure
2 contrasts our assessment of the
top priorities
for Russian
17
See Daron
Acemoglu,
Simon
Johnson, James
Robinson &
Yunyong Thaicharoen,
Institutional
Causes,
Macroeconomic
Symptoms: Volatility
Crises and Growth
(working paper 2002).
Shock
Therapy
Russian Institutional Reform
(early
1990s
Washington Consensus)
(this Article)
Priority
High
macro and macro-micro
reform:
1 |control
corruption (and organized crime) |
Priority
price decontrol
stable
currency/small
deficits
/
2
Itax
reform
hard
budget
constraints on firms
macro and macro-micro
reform:
|Enterprise privatization
3 price decontrol
stable
currency/small
deficits
hard
budget
constraints on firms
4
|encourage
small business
development
5 commercial law
reform
Lower
IEverything
else
\
6
building
law enforcement institutions
Priority
7
competition
and
trade policy
8
and
restructuring |
9
banking
reform
10 land reform
1 l+
many
other core institutional reforms
Figure
2.
Comparing
shock
therapy
to institutional reform.
transition reform to the shock
therapy prescription
of the
early
1990s.
The macroeconomic and macro-micro reform elements that were the
core of shock
therapy
remain
highly important, though
a bit less so.
Privatization becomes much less
important,
and the
emphasis
shifts
to
privatization plus restructuring,
where the extent of restructur-
ing depends heavily
on other reform elements. Most of the reform
space
in the Institutional Reform column in
Figure
2 is
occupied by
the
"everything
else" that the shock
therapists
never
clearly
defined
and
thought
could wait.
Shock
therapy
is a
simple strategy-do
a few
things well,
and all else
will follow.
Moreover,
those few
things are-conveniently-amenable
to
top-down
control
by
a few dedicated reformers. Prices can be decon-
trolled
by
executive fiat. Inflation will be low as
long
as the
government
controls the
budget
deficit. This too is
achievable,
in
principle, by top
down fiat. So are hard
budget
constraints on firms. Privatization is
harder,
but how it is achieved is of
secondary importance-the
core
need is to find some
means, any means,
to
get
the
job
done.
In
contrast,
the essence of institutional reform is
complexity
and in-
terrelatedness. Reformers must do
many things well,
or the valuable
steps
that are taken will be
swamped by
the
negative
effects of other
Study
of Russia
steps
left untaken.
Moreover,
the most
important steps
are
highly
chal-
lenging.
An
anti-corruption campaign requires top-down
commit-
ment,
sustained over time. It
depends
on hundreds of details. Reform-
ers must
wage
an in-the-trenches battle
against opposition
from
bribees within the
government
and well-connected bribers.
They
must
attack the
many
outlets that
corruption
will
find,
or else the total
corruption
burden
may
not
change
much.
A.
Anti-Corruption
Efforts and Control of
Organized
Crime
We
begin
our tour of the core elements of reform with control of cor-
ruption
and
organized
crime because we see a
strong anti-corruption
effort as central to successful reform.
1. The Pervasive Effects of
Corruption
Prompted by
the transition
experience,
economists' views of cor-
ruption
have
changed radically
in the last decade. In the "old
view,"
corruption
was not so bad.
Often,
it served as useful
grease
for bu-
reaucratic wheels. It was better for businessmen to
pay
bribes and
get
something
done than to have bribes forbidden and
get nothing done,
in the face of an
uncooperative bureaucracy.
In a static view of the
world,
this charitable view of
corruption
fol-
lows from the Coase
Theorem,
in which the initial allocation of
prop-
erty rights
doesn't affect
outcomes,
as
long
as
bargaining
is costless.
In
effect,
a
regulation gives
a bureaucrat a
property right
to control
whether a business
project
is undertaken. The absence of
regulation
gives
this
property right
to the
entrepreneur.
The
entrepreneur's
need
to bribe the bureaucrat to
permit
the
project
to
go
forward won't af-
fect whether the
project
is
undertaken, merely
who benefits from it.
This view has
multiple problems. First,
it sees bureaucrats as
passive
bribe
recipients, using property rights
handed to them
by
the
state to
respond
to
requests
for
permissions by entrepreneurs.
In a
thoroughly corrupt society
like
Russia,
bureaucrats also wield
reg-
ulations as a
weapon
to extract bribes. Tax
inspectors
threaten to
impose high taxes;
fire and
safety inspectors
conduct numerous in-
spections, seeking
a bribe each
time;
traffic
police stop
drivers who
have done
nothing wrong;
universities sell admissions instead of
awarding
them to the most
qualified applicants,
thus
devaluing
the
diplomas
awarded to all
graduates;
and so on. This is
why,
in
Figure
1,
we treat Administrative Reform as a
subcategory
under Anti-
Corruption
Effort.
Second,
rules are not static.
Corrupt
bureaucrats do not
merely ap-
ply
a fixed set of
rules,
that
(for
whatever
reason) give
the bureaucrats
power
to
grant permission
or not.
Instead, corrupt
bureaucrats have
a
strong
incentive to dream
up
new rules and new
permissions,
ex-
pand
their
regulatory turf,
and act as if
they
have
discretionary
au-
thority
even for ministerial tasks.
Third,
the old view of
corruption posits
either a
single permission
for which the
entrepreneur
must
pay
a
single bribe,
or else centralized
corruption,
in which one
payment
to a senior official leads to obtain-
ing
all
necessary permits.
If the
entrepreneur
needs 50
permissions
from different
bureaucrats, bargaining
costs
multiply.
The bureau-
crats, acting collectively,
would
rationally
not extract so much in
bribes that
they
kill the
project.
But in a
country
like
Russia,
where
corruption
is
decentralized,
bureaucrats cannot
easily
act
collectively.
They
face a collective action
problem-each
wants a
large piece
of
the bribe
pie, yet
if each maximizes his own
piece, they
are
likely
together
to kill the
project.18
This
problem gets
worse if the
permissions
are
sequential,
rather
than all at once. The cost that the
entrepreneur pays,
in bribes and
initial business
plan development,
to
get
to bureaucrat 26 become a
sunk
cost,
that can be recovered
only
if bureaucrat 26 is bribed suc-
cessfully.
The existence of this sunk cost lets bureaucrat 26-and
27,
and 28-extract a
larger
bribe.
Fourth,
the
availability
of
corruption
income undermines
budget-
ary
controls on the size of the
bureaucracy,
which will tend to
expand
despite
low official
salaries,
as
long
as unofficial income is attractive.
An
example: During
the
1990s,
the number of
employees
of the Rus-
sian central
government grew by 60%,
even
though
the
government's
economic functions were
reduced, government wages dropped sharply
due to
inflation,
and were often
paid
late even then.
Fifth,
the
quality
of
government
will decline.
People
will
go
to
work for the
government expecting
to be
paid through
bribes. Ideal-
ism and a commitment to
government
service will
disappear.
More-
over, corrupt
bureaucrats will undermine honest
ones-ironically,
often
through
false
charges
of
corruption.
Governments will
spend
money
on
high-corruption,
low-social-return
projects,
when other
projects provide higher
social returns but fewer
corruption opportu-
nities. Bureaucrats will use
nontransparent procedures
to hide their
activities from external
scrutiny.
Even decisions that don't affect
bureaucrats'
personal
incomes will often be made and
implemented
poorly,
because
less-smart, less-skilled,
and less-motivated
people
are
making
and
implementing them,
and because
government proce-
dures are
nontransparent
and
ill-designed.
Sixth, corrupt
bureaucrats will
fight
reforms that reduce bribe
18
See Andrei Shleifer & Robert W.
Vishny, Corruption,
108
Q J
Econ 599
(1993).
Study
of Russia
opportunities through political opposition, introducing
technical
changes
to
proposed
rules that undermine
clarity
and
magnify
bribe
opportunities, adopting bribe-promoting
rules and
procedures
when
implementing
new
laws,
and in-the-trenches refusal to
change
old
ways
when the rules
change.
An
example.
Cause and effect can't be
proven,
but in our
view, opposition
from the Finance
Ministry
and
the tax and customs
police
is a core reason
why
efforts to reform Rus-
sia's
obviously
broken tax
system
went nowhere in the 1990s and
move
slowly today. Top
officials want tax revenue and sensible mar-
ginal
rates. But almost
everyone
else in the Finance
Ministry
and
the tax
police
cares more about
preserving
bribe
opportunities
than
collecting
taxes and
may prefer marginal
rates that would be confis-
catory
if
anyone paid
them.
Seventh, legislators
are not
likely
to
produce good
market-oriented
laws,
if in addition to the usual
array
of
political
concerns and
special
interest
lobbying,
their votes are for sale to the
highest
bidder. In
Figure 1,
we indicate this and the
tendency
of bureaucrats to
oppose
corruption-reducing
reforms
through
a solid double-headed arrow
connecting Anti-Corruption
Effort to Commercial Law Reform.
Eighth,
the old view of
corruption implicitly
saw bribes as a side
payment
within a
system
that otherwise
provided reasonably
secure
enforcement of contract and
property rights.
But a
corrupt govern-
ment will
likely
be
accompanied by
a
corrupt police force, prosecu-
tors,
and
judiciary.
In
Russia,
contract
beatings
or
killings
of business
rivals
(or
borrowers who don't
repay
their
loans)
are
part
of the busi-
ness
landscape.
Low level
thugs
are sometimes
prosecuted
for these
crimes,
but those who order the
killings
are
rarely prosecuted
and
even more
rarely
convicted. Judicial decisions are
reportedly
for sale
at all levels of the arbitrazh court. The
price simply gets higher
as one
goes
further
up
in the
appellate
courts.
Ninth, corruption
lets
existing
firms ward off
competition, by
brib-
ing police
and bureaucrats to harass and sometimes
jail
their adver-
saries,
or look the other
way
when a firm hires
thugs
to
harass, beat,
or kill its
competitors.
This
practice
can chill the
growth
of new enter-
prises-which
is at the core of
post-transition
economic
growth.
Tenth,
a
corrupt government
often
goes
hand-in-hand with
pow-
erful
organized
crime.
Organized
crime becomes a further obstacle
to
enterprise growth, especially
for new
enterprises.
In
Russia,
it
is the rare small business that does not
pay
for
"protection."
Pow-
erful
organized
crime also becomes another means for
subverting
bureaucrats, judges,
and
prosecutors.
Sometimes a threat of vio-
lence-directed
against
an
initially
honest
prosecutor
or
judge-will
accomplish
what a bribe alone cannot.
Eleventh, corrupt governments privatize badly. They
sell enter-
prises cheaply
to bad
owners,
when
higher prices
and better owners
were available. After the initial burst of mass
privatization,
Russia's
case-by-case
sales of state-owned
enterprises,
and its
remaining
shares
in
partly privatized companies,
were
notoriously corrupt.
Yet the
gov-
ernment resisted the World Bank's efforts to foster
transparent
auc-
tions. Bad owners then further
corrupt
the
government, may
loot
businesses even when
building
value is a viable
alternative,
and often
oppose
rule-of-law reforms that would restrict asset
stripping.19
Nor
will
good
owners
easily emerge
after
privatization,
to invest in
privat-
ized
enterprises. They
will fear-often with
good
reason-that their
investment will be stolen.
Twelfth, corrupt governments regulate competition badly. They
tend to
preserve existing
domestic
monopolies, promote
new
monop-
olies,
and restrict
import competition.
In a vicious
circle, private
rents
promote corruption (to
create and
preserve
these
rents),
and
corrupt
governments protect
and foster rents
(to promote
the bribes that
rents make
possible).
A recent
example:
The
Antimonopoly
Minis-
try
sat
quietly
in 2001 when two
oligarchs, Oleg Deripaska
and Ro-
man
Abramovich, bought
control of all three
major
Russian alumi-
num smelters.
Thirteenth, corrupt governments
often neither
impose
hard bud-
get
constraints on firms nor dole out subsidies in a
plausibly
rational
manner. The combination of bad
owners,
weak
competition,
and soft
budget constraints,
all fostered
by corruption, goes
far toward ex-
plaining
the
poor performance
of
privatized
firms in Russia and the
slow
growth
of unsubsidized new firms.
Fourteenth, corrupt
economies are
likely
to
generate
less reinvest-
ment. Even well-connected
enterprise
owners have short time hori-
zons,
because
they
can be
prosecuted
if the
government changes
(Gusinski
and Berezovski offer
examples). They
are
especially
reluc-
tant to invest in fixed
assets,
which are
easily expropriated.
Less well-
connected
enterprise
owners fear
expropriation by
the
government
or
by
better-connected
competitors,
and face
competitive disadvantages.
Fifteenth, corrupt
economies have
special
trouble
attracting
for-
eign investment,
both direct
(accompanied by managerial
and techni-
cal
know-how)
and
portfolio. Foreigners
are
especially
vulnerable to
19
We
present
an informal model of the decision of an
enterprise
controller to build
value or loot in
Black,
Kraakman &
Tarassova,
(2000) (cited
in
note
3).
For a formal model of this decision and the interaction between
looting
and
support
for
legal reform,
see Karla Hoff &
Joseph
E.
Stiglitz, After
the
Big Bang?
Ob-
stacles to the
Emergence of
the Rule
of
Law in Post-Communist Societies
(working
paper 2002).
Study
of Russia
expropriation.
In
Russia, foreign
direct investors can tell
any
num-
ber of horror stories about how their investments turned
sour,
when
someone-their Russian
coventurer,
the
enterprise's
former man-
agers,
or their current
competitors-persuaded
the
government
or
the courts to intervene
against
the new owners.
Foreign-controlled
firms are also at a
competitive disadvantage
in
bribing
bureaucrats
for needed
permits, importing goods
without
paying
customs du-
ties, avoiding taxes,
and
paying
mafia when
necessary.
Portfolio
investors have their own stories about mistreatment
by controlling
shareholders.20
Sixteenth,
the need to
negotiate
bribes and
protection payments
with
government
officials and the
mafia,
and
satisfy
the extra
permit
requirements
that a
corrupt system generates,
distracts firm man-
agers
from
profit-generating
activities. In a recent
survey,
Russian
managers report spending
18% of their
time,
on
average,
on
govern-
mental and
regulatory matters, compared
to the 10%
reported by
Pol-
ish
managers.21
Seventeenth, corruption
fosters a
general
business climate of dis-
honesty.
There is evidence that "trust" or "social
capital"
is an
impor-
tant
component
of economic success.22
Corruption
undermines trust.
Eighteenth, corrupt
countries are more
prone
to macroeconomic
shocks. In
good times,
insiders treat outside investors
tolerably well,
the better to raise funds in the future. But when the
economy sours,
the insiders often steal what
they
can while
they can, exacerbating
the
shock.23 This
positive
feedback effect
likely
contributed to the sever-
ity
of Russia's 1998 financial crisis.
Nineteenth, corruption
undermines
political support
for further
economic reform. Citizens see
corruption
as an
outgrowth
of
sup-
posedly
market-oriented
reforms,
and fear that further reform will
20
We recount some of these stories in
Black,
Kraakman &
Tarassova,
Russian Pri-
vatization
(2000) (cited
in note
3).
21
See Simon
Johnson,
Daniel
Kaufmann, John
McMillan &
Christopher Woodruff,
Why
Do Firms Hide? Bribes and
Unofficial Activity After Communism,
76 J Pub Econ
495
(2000) ("Johnson
et.
al, Why
Do Firms
Hide?").
22
See,
e.g.,
Francis
Fukuyama,
Trust: The Social Virtues and the Creation
of
Pros-
perity (Touchstone Books, 1995); Jonathan Temple
& Paul A.
Johnson,
Social
Capabil-
ity
and Economic
Growth,
113 Q
J
Econ 965
(1998);
Paul S. Adler & Seok-Woo
Kwon,
Social
Capital:
The
Good,
the
Bad,
and the
Ugly,
in Eric
Lesser, ed, Knowledge
and
Social
Capital
89
(Butterworth Heinemann, 2000); Luigi Guiso,
Paola
Sapienza
&
Luigi Zingales,
The Role
of
Social
Capital
in Financial
Development (Ctr.
for Research
in Sec. Prices
Working Paper
No.
511,2001),
at
Science Research
Network).
23
See Simon
Johnson,
Peter
Boone,
Alasdair Breach & Eric
Friedman, Corporate
Governance in the Asian Financial
Crisis,
58
J
Fin Econ 141
(2000).
invite further
corruption. Meanwhile,
the beneficiaries of
corruption
often understand that
competitive
markets will drive out the rents
that
permit corruption,
and also
oppose
reform. We indicate the vari-
ous connections between
corruption
and economic reform in
Figure
1
through
a solid double-headed arrow
connecting Anti-Corruption
Effort to Economic Reform.
Twentieth, corrupt
countries are often less than
fully
democratic.
Government connections offer
large
rents to
insiders,
which the in-
siders can
preserve by supporting friendly politicians.
Russia's oli-
garchs,
for
example, basically bought
Yeltsin's 1995
reelection,
de-
spite
his
extremely
low
popularity, through
a massive media
campaign.
They
thereafter all but owned the
government during
his second term
as President.
Conversely,
democratic countries are
likely
to be some-
what better at
controlling corruption
in the
long run, perhaps
be-
cause there are
stronger
avenues
(elections,
free
press)
for citizens to
express
their concerns.
Figure
1 indicates the bicausal connection be-
tween Democratization and
Anti-Corruption
Effort
suggested
in this
and the
previous paragraph through
a solid double-headed arrow.24
Twenty-first
and
last, corrupt countries,
even if
tolerably
demo-
cratic,
tend to be
politically
less stable. Citizens
disrespect
state in-
stitutions and are
susceptible
to a
demagogic appeal by
a would-be
"strong
ruler" who
promises
to attack
corruption (but likely
won't do
so once in
power).
Corruption's
tentacles
spread everywhere. Corruption importantly
affects almost
every major
microeconomic reform. In
Figure 1,
we list
fourteen
major
areas of economic reform:
* macroeconomic and macro-microeconomic
policy (price
lib-
eralization,
stable
currency,
hard
budget constraints)
*
and
restructuring
*
tax reform and customs duties
*
land reform
(urban
and
agricultural land)
*
banking
reform
*
capital
market
development
*
competition
and trade
policy
*
housing
reform
(housing privatization, mortgage lending,
and
condominium
creation)
* small business
development
24
The statements in text on the link between
democracy
and
corruption
are inten-
tionally
mild. The available
quantitative
evidence does not
support
a
strong
connec-
tion between
democracy
and level of
corruption. Moreover,
there are numerous ex-
amples
of
tolerably
democratic but
highly corrupt
countries
(including
Russia
today)
and
mostly noncorrupt dictatorships (including
Russia under
Joseph Stalin).
Study
of Russia
* labor market
flexibility
* government
procurement
* infrastructure
development (roads, rail,
electric
power,
tele-
communications, water, airports)
* distribution
system
reform
*
foreign
investment
(both
direct and
portfolio investment).
One can debate whether these are the
right
elements to list. But our
point
here is that
corruption directly
affects all of these areas
except
labor market
flexibility. Any
area that involves
obtaining
or
keeping
rents
(hard budget constraints, enterprise privatization,
land
reform,
competition
and trade
policy,
and distribution
system), government
permits (small
business
development,
often
foreign investment), pay-
ments to or from the
government (tax reform, banking
reform
(espe-
cially
the Central
Bank), government procurement,
and infrastruc-
ture
development),
or is sensitive to enforcement of contract and
property rights (banking, capital markets, housing reform,
and for-
eign investment)
is
powerfully
affected
by
the extent of
corruption.
Corruption
also has
important
indirect effects. Consider
housing
reform as an
example. Existing housing,
as a fixed asset in
place,
is
vulnerable to
government inspectors seeking
bribes and mafia
gangs
who seek
protection payments
or control services to
apartment
build-
ings (garbage,
electrical and
plumbing, painting,
and other
repairs).
New
housing requires government permits
and often new infra-
structure,
which is sensitive to
corruption. Mortgage lending
re-
quires
the
ability
to file liens with a
government
office and to fore-
close
promptly
on a
delinquent borrower,
which will be
impeded by
judicial corruption.
In
Figure 1,
we indicate the
likely
causal connection
running
from
corruption
control to microeconomic reform
through
arrows con-
necting anti-corruption
effort to each of these areas of microeconomic
reform. For some economic reform areas
(Macro
& Macro-micro Eco-
nomic
Policy, Enterprise
Privatization and
Restructuring,
Tax
Reform,
and
Competition
and Trade
Policy),
we believe that economic reform
also contributes to the
anti-corruption
effort. We indicate this in
Fig-
ure 1 with double-headed arrows.
2.
Corruption, Growth,
and Institutions:
Empirical
Evidence
Our
qualitative picture
of the connection between
corruption
and
weak institutions is
potentially subject
to
empirical testing.
Causa-
tion
likely
runs both
ways,
with weak institutions
contributing
to
corruption
and
corruption contributing
to weak institutions. But cor-
relation,
at
least,
can be tested. Broadman and Recanatini offer a test
similar in
spirit
to this Article. The authors
develop simple
corre-
lations for 21 transition
countries, including Russia,
between
(i)
a
corruption
index
developed
in 1999
by Kaufmann, Kraay
and Zoido-
Lobaton,
and
(ii)
measures of institutional
development
in transition
countries in
1999, developed by
the
European
Bank for Reconstruc-
tion and
Development.25
In
pairwise correlations, corruption
corre-
lates
strongly
and
significantly
with each of their six measures of
institutional
development (openness
to
trade, infrastructure,
low bar-
riers to
entry,
hard
budget constraints,
effectiveness of
legal
institu-
tions,
and effectiveness of
bankruptcy law),
as well as a measure of
democracy.26
Corruption
also correlates
negatively
with
growth
rates and in-
vestment rates
(as
a
percentage
of
GDP),
and
per capita
GDP.27 For
transition
economies,
Broadman and Recanatini find a
pairwise
cor-
relation coefficient between
corruption
and
per capita
GDP of r
=
0.83.28 For a
large cross-country sample, Kaufmann, Kraay
and Zoido-
Lobaton find a
strong
correlation between
corruption
and
per capita
GDP after
controlling
for five other broad measures of
political
and
market institutions.
They
also find evidence consistent with
corrup-
tion
affecting
GDP
indirectly, through
its effect of their other mea-
sures on GDP.29
3. The Extent of Russian
Corruption
and
Organized
Crime
Reliable statistics on
corruption
are not
available,
almost
by
defini-
tion. But Russia ranks
notably badly
on
qualitative surveys.
For ex-
ample,
in
2001,
Russia ranked 81st in
Transparency
International's
Corruption Perception Index,
which ranks 91 countries from the least
25
See Daniel
Kaufmann,
Aart
Kraay
& Pablo
Zoido-Lobaton,
Governance Matters
(World
Bank
Policy
Research
Working Paper 2196,
Oct.
1999) ("Kaufmann, Kraay,
&
Zoido-Lobaton,
Governance
Matters"); European
Bank for Reconstruction and Devel-
opment,
Transition
Report
1999: Ten Years
of
Transition
(2000) ("European Bank,
Transition
Report
1999").
26 See
Harry
G. Broadman & Francesca
Recanatini, Corruption
and
Policy:
Back to
the
Roots,
5
Policy
Reform 37
(2002) ("Broadman
&
Recanatini,
Corruption
and Pol-
icy").
The authors also
report ordinary
least
squares regression results,
which are less
interesting
for our
purposes
because
they
treat
corruption
as a
dependent variable,
to
be
predicted by
the institutional
variables,
rather than as an
independent
variable that
predicts
the
strength
of institutions.
27
See Paolo
Mauro, Corruption
and
Growth,
110
Q J
Econ 681
(1995).
28
Broadman &
and
Policy
Table 1
(2002) (cited
in note
26).
29
See
Kaufmann, Kraay
&
Zoido-Lobaton,
Governance
Matters,
Table 2
(1999)
(cited
in note
25);
Daniel
Kaufmann,
Aart
Kraay
& Pablo
Zoido-Lobaton,
Governance
Matters II:
Updated
Indicators
for
2000/01
(working paper 2002).
Study
of Russia
to most
corrupt places
to do business.30 Anecdotes of Russian
corrup-
tion abound. We offer below some brief
examples.31
The Kremlin
(the
executive
branch).
In Yeltsin's
Russia,
as in
Suharto's
Indonesia,
the father ruled and the children
(in Russia,
Yelt-
sin's
daughter
and
son-in-law) profited.
So did
many
others with
secure
political
connections. President Yeltsin didn't
object
if
loyal
aides stole. In the first half of the
1990s,
for
example,
Yeltsin
ignored
massive
corruption
of the
military
under Minister of Defense Pavel
Grachev. Grachev
supported
Yeltsin
against
the Russian Parliament
in
1993; nothing
else mattered. The second half of the 1990s saw the
emergence
of the
powerful
and
famously corrupt
Yeltsin
"family"-
a
group
of
insiders, including
his
daughter,
Tatiana
Dyachenko,
her
husband,
and the head of the Kremlin
administration,
Pavel Borodin.
Western views of Yeltsin often note his
acceptance
of
corruption
but do not ascribe
personal
fault. Yeltsin is
said,
for
example,
to have
"tolerated an enormous amount of
corruption."32
Russian views
are often less charitable. Russia's Nobel Prize
novelist,
Alexander
Solzhenitsyn, explains:
I feel that Yeltsin
permitted
an enormous devastation of Russia.
One
might
have
imagined
that
things
could not have
got
worse
than the
point
to which Communism had
brought
us.... On
the
contrary.
Yeltsin
managed
to
bring
Russia even lower. He
supported
thieves. Our national riches and resources were
pri-
vatized
nearly
for
free,
and even the new mobsters are not asked
to
pay
rent.33
Legislators.
Russian law
grants immunity
to members of the Rus-
sian
legislature,
for crimes committed before or
during
their time in
office. There are cases of known criminals
using
their stolen funds
to run for and win election to the Duma
(the
lower house of Russia's
bicameral
legislature),
in order to avoid
prosecution.
Once
there, they
can be
prosecuted only
if the other members of the Duma vote to re-
30
See
Transparency International,
2001
Corruption Perception
Index,
at www.
transparency.org (2001).
Russia's 2002
ranking improved
to a tie for 71-76
(out
of 102
countries).
See
2002
Corruption Perceptions
Index,
at www.
transparency.org.
We
explore
the recent
legal
reforms that
may
underlie this
improve-
ment in Black &
Tarassova, Beyond
Privatization
(cited
in note
*
*).
31
For a
good
overview of Russian
corruption
and its
effects,
see Mark Levin &
Georgy Satarov, Corruption
and Institutions in
Russia,
16
European
J Pol Econ 113
(2000) ("Levin
&
Satarov, Corruption
and
Institutions").
32
Hough,
Economic
Reform
in Russia at 7
(2001) (cited
in note
13).
33
See David
Remnick, Deep
in the
Woods,
New
Yorker, Aug. 6, 2001,
at
32,
37
(in-
terview with
Solzhenitsyn).
move their
immunity-a
vote that is difficult to obtain because the
other members could be
prosecution targets
the next time.
Bureaucrats. Bureaucrats are
thoroughly corrupt
in Russia. The
centrally planned economy
of the former Soviet Union
operated
with
many
fewer bureaucrats than Russia's
partially privatized economy
does
today,
even
though
Russia's
population today
is about half of
the Soviet Union's
population
in
1991,
and there are fewer admin-
istrative tasks to be
performed.
The salaries of bureaucrats are not
attractive.
However,
a
single
bribe can
greatly
exceed official
salary,
with minimal risk of detection or
prosecution.
Police and
prosecutors. Tolerably
honest
policemen, prosecutors
and
judges
are essential to enforce laws in a market
economy.
There is no
reason to believe that Russian
policemen, prosecutors
and
judges
are
more honest than bureaucrats. Police officers are
underpaid
and thus
bribable. A more or less standard schedule has even
emerged
for rou-
tine offenses. For
example, "[I]n Moscow,
the bribe for
avoiding pun-
ishment for drunk
driving
...
[varies]
from
US$100 to
US$300,
de-
pending
on the model of the car."34 Drivers of
mid-range foreign
cars
pay
more than drivers of domestic
cars;
drivers of new Russian-made
cars
pay
more than drivers of older cars. Drivers of black Mercedes
sedans with frosted
glass
windows are not
stopped.
The traffic
police
know better. Contract murders are
rarely
solved. And
"[p]ressure by
the law enforcement bodies on one's business
competitors
can be
arranged
in
exchange
for bribes."35
A November 2001
poll
found that 51 % of Russians do not trust the
Interior
Ministry, compared
to 48 % in a
comparable poll
in March 2001.
Periodic
anti-corruption campaigns
center on
petty bribe-taking-for
speeding
tickets and
payoffs
to
police
officers
by
street
gangs-and
have no visible effect on the
graft
at the
top.36
The Russian Prosecutor General's Office has a
reputation
for
being
"not
very
suitable for the exercise of
justice."37
This reflects both cor-
ruption
and
incompetence,
which feed on each other. Honest
prose-
cutors leave in
disgust
or are forced out. Those who remain are nei-
ther honest
nor, usually, very competent. They
also know that an
investigation
of a
major
businessman or
government
official is
likely
to be
quashed by
their
superiors; unlikely
to
improve
their
promotion
34
Levin &
Satarov, Corruption
and Institutions at 123
(2000) (cited
in note
31).
35 Id at 123.
36
See Roman
Kupchinsky, Policing
the
Police,
RFE/RL Crime, Corruption,
and
Terrorism Watch
(Nov. 22, 2001).
37
See Yulia
Latynina,
Paternalism's Roots
Deeper
Than the
Law,
Moscow
Times,
Nov.
9,
2001.
Study
of Russia
prospects;
and
perhaps
not
good
for their health. When the Prosecu-
tor General
brings corruption charges against
senior officials
(several
such suits were
brought recently
under President Putin
against
cab-
inet members who are holdovers from the Yeltsin
administration),
a
likely
reason is to
provide
an excuse to remove them. There is no rea-
son to
expect
their successors to be less
corrupt.38
Mafia.
The term "Russian mafia" has become a household word
worldwide, together
with the Russian term for
protection-"krisha,"
meaning
"roof." The mafia is a
daily
menace to small businesses in
Russia.
Any
business with fixed assets or which relies on
truck, rail,
or air
transport
is vulnerable. The unofficial tax
imposed by organ-
ized crime falls most
heavily
on small
businesses,
which can't afford
to hire their own
security force,
and face the added risk that
larger
companies
will hire mafia enforcers to threaten new
competitors.
Complaining
to the
police
is not
only
useless but
dangerous.39
Government-mafia ties also
impede press reporting
of
corruption,
which can be an
important
check on
corruption.
In
Russia, aggressive
journalist reporting
of official
corruption rarely produces jailed
of-
ficials,
and rather
frequently produces
dead
journalists.
In
Figure 1,
we indicate the
two-way
connection between a free
press
and anti-
corruption
efforts
(free press supports anti-corruption efforts,
and the
anti-corruption
efforts
strengthen
the
press's ability
to
play
this
role)
through
a double-headed arrow.
Legal
controls on
corrupt activity.
A measure of both the extent of
corruption
and the
difficulty
of
controlling
it are the
large loopholes
in
existing anti-corruption
laws.
Many
activities and conflicts of
interest are outside the
scope
of
existing
law. Direct
bribery
is unlaw-
ful,
but
many
indirect forms of
bribery
are not. Here are three
simple
examples that,
to our
knowledge,
remain
legal
in Russia
today.4
*
A bureaucrat
(or
his close
family members)
maintains an
ownership
interest in a
private enterprise,
and takes actions
that benefit the
private enterprise.
*
A bureaucrat
(or
his close
family members)
receives a loan
from a
private source,
at a below-market rate of interest
(the
38
We discuss
judicial
corruption
in Part III.E below.
39
On the connection between the Russian mafia and the Russian
government,
see
the Kremlin
(2000) (cited
in note
6); Stephen Handelman,
Comrade Criminal: Russia's New
Mafiya (Yale
U
Press, 1997).
40
See Levin &
Satarov, Corruption
and Institutions at 125-26
(2000) (cited
in note
31).
loan,
as a
practical matter,
will not be
repaid
if the bureaucrat
delivers the favors that he has
promised
in
return).
A
private enterprise employs
a bureaucrat's relatives at in-
flated
salaries,
or in
positions
that
carry
no actual
responsi-
bilities.
Is the
corruption
level
improving? Probably.
There are some
signs
of
improvement
under President Putin. Putin himself is
apparently
hon-
est.
Still,
his choice for Prime Minister was a so-called
"reformer,"
Mikhail
Kasyanov,
who was
known,
in his former
position
as Finance
Minister under President
Yeltsin,
as "Misha 2
percent."
The
govern-
ment also
quashed
a Swiss
investigation
of Pavel Borodin for
money
laundering,
that was far
enough
advanced so that the Swiss had Bo-
rodin arrested in New York. Putin and his advisors have
spoken pub-
licly
about the need to control
corruption
and the mafia.41 The
gov-
ernment has announced various
anti-corruption initiatives, though
often with limited
follow-through.42
We are
hopeful
that Russian
corruption
is
getting
a bit better un-
der Putin. At the
least,
it is no
longer getting rapidly worse,
and some
aspects
are
improving.
We offer recent Russian
examples
in Part III.C
and III.D of how new laws can
sharply
reduce
particular
sources of
corruption.
Figure
3 illustrates our
qualitative
sense of how the level of Russian
corruption
has varied over
time, including
the
steep
increase in cor-
ruption
between 1991 and
2000,
under President Yeltsin's
nonbenign
neglect.
We
might place
the
corruption
level in 2002 at 90 or 95-
modestly
better than at the end of the Yeltsin
era,
but still
very
bad.
B. Tax Reform
1. The 1990s: Russia's
Confiscatory
Tax
System
Corruption
and
organized
crime
impose large
unofficial taxes on
business
activity.
Official taxes can be
equally important.
It is a close
question
whether
corruption
and
organized
crime or the tax
system
41
See,
e.g.,
Address
by
President Vladimir Putin to State
Duma, April 2, 2001,
at
www.strana.ru.
42
Russian
journalists
are often
pessimistic
about Putin's
ability
and will to
fight
corruption.
Some
suggest
that the
anti-corruption campaign
launched
by prosecutors
is
principally
a
struggle among
Russian
political clans,
with the new St.
Petersburg
clan around President Putin
using corruption charges
to take influence
away
from
the
groups
who
prospered
under President Yeltsin. See Yulia
Latynina,
Paternalism's
Roots
Deeper
Than the
Law,
Moscow
Times,
Nov.
9,
2001.
Study
of Russia
100-'
B
Relative
Coruption
80--
60*j
40j,1-
20/ '
-. |
20
1917 1928 1930 1953 1960 1985 1990 2000
Numerical Qualitative
Score
Impression
Comments
5
negligible
Stalin
0
noticeable but not Khrushchev
important Comparable
to U.S.
today
25
significant
End of Brezhnev era
Russia when Soviet Union
collapsed
in 1991
50 bad
Comparable
to Russia before the 1917
revolution
100 awful Russia's level in 2000
Figure
3. A
qualitative picture
of Russian
corruption.
The
graph (top) conveys
our
qualitative
sense of the level of Russian
corruption
at different
points
in time. The
qualitative
scale we use is described in the chart
(bottom).
was the
largest drag
on business
activity
in Russia
during
the 1990s.43
Russia's
enterprise
tax rules
during
the 1990s embodied almost
every
flaw one can
imagine.
The tax rules
imposed confiscatory marginal
income tax
rates,
were
changed frequently
and
arbitrarily,
were en-
forced even more
arbitrarily,
and all this effort
produced
ever smaller
amounts of revenue.
The heart of the
problem
can be summarized this
way.
Russia col-
lected
negligible
amounts of individual income
taxes,
because almost
no one
paid
them. This
placed huge
stress on
collecting
taxes from
enterprises, likely
more stress than even a
well-functioning system
of
enterprise
taxation can bear. The United
States,
for
example,
collects
negligible
income taxes from
nonpublic companies
and ever smaller
amounts of revenue from
public companies,
as a
percentage
of GDP.
43
For a
prominent
Russian economist's views on the
importance
of tax reform to
Russian economic
development,
see
Roy
Medvedev,
Post-Soviet Russia: A
Journey
Through
the Yeltsin Era
(George
Shiver
trans.,
Columbia U Press
2000) ("Medvedev,
Post-Soviet
Russia").
1
Russia made this
problem
worse
by controlling
domestic
energy
prices,
thus
reducing
the
profits
of oil and
gas
firms. Yet oil and
gas
was the one sector that was
potentially profitable enough
to
pay large
taxes. At the same
time,
Russia faced
strong pressure
from the Inter-
national
Monetary
Fund
(IMF)
to control its
budget deficit,
as a con-
dition for IMF loans that would
help
the
government
close the re-
maining gap
between revenue and
expenditures.
Meanwhile,
whatever funds the IMF lent were
generally stolen,
while the
government
covered its deficit
by
a combination of not
pay-
ing
its bills and
borrowing
at astronomical real rates of
interest, thereby
increasing
next
year's
deficit and next
year's pressure
for more tax rev-
enue. Government
nonpayments
created more
corruption
and lower
tax
collection,
as businesses bribed bureaucrats to make
payments
or
negotiated
to offset taxes due to the
government against payments
that the
government
owed to them. Businesses often met
pressure
for more tax revenue
by paying larger
bribes to tax
officials,
which
made tax officials
happy
but didn't close the deficit.
Senior tax officials understood the need for a drastic overhaul of
the tax
system,
but reform efforts failed
repeatedly,
because the ex-
isting system
had
many supporters-including everyone
in the fi-
nance
ministry
and the tax
police
who benefited from
corruption
opportunities
and
managers
of
profitable
businesses who believed
that the
existing system
worked well
enough
for them. Reform also
meant
lowering
tax rates and would
likely produce
a near-term rev-
enue
decline,
which would
displease
the IMF.44
This
pyramid
scheme
collapsed
in
1998,
when the ruble crashed
and the
government
defaulted on its debt.
Thereafter,
an oil
price
spike
rescued the
government, produced
a
budget surplus,
and re-
duced the
pressure
to collect more tax revenue. But the
underlying
enterprise
tax rules remain little
changed.
2. Recent Tax Rate Reforms
Recent
reforms
in individual tax rates. In
2001,
Russia reduced in-
dividual income tax rates to a flat 13% of income. This excludes the
38% social
safety
net
levy
on
wage income, nominally paid by
em-
ployers.
The effective income tax rate on
wage income, including
this
levy,
is 37%. The lower tax rate increased income tax collection from
individuals
by
47% in 2001 versus 2000. At some
point, people
would
rather declare some of their income and
pay
a low
marginal
tax
rate,
than hide their income and bribe tax
inspectors.
The increased rev-
44
For discussion of the
politics
behind Russia's tax reform
(or
lack
thereof)
in the
1990s,
see Shleifer &
Treisman,
Without a
Map (2000) (cited
in note
15).
Study
of Russia
enue should reduce the
pressure
to collect business
taxes,
and make
it easier to reform the business tax rules. The lower rates also re-
duce the feedback from
high
tax rates to
corruption
of the tax
police.
The Putin
government
also
proposed
in 2002 to reduce income
taxes on small businesses. For the formal income tax
rules, then,
there are
signs
of
improvement, though
still far to
go.
3. Some
Remaining
Problems
Below,
we illustrate Russia's need for tax reform
by exploring
four
problems: high
effective
marginal
tax rates on business
income;
tax
collection
procedures;
customs
duties;
and
pension
reform.45
Business income tax rates. The tax
system
in Russia for business in-
come is
confiscatory.
Combined total
marginal
income tax rates on
businesses, taking
into account the effect of rules that
deny
deduc-
tions for
many ordinary
business
expenses,
are
commonly
on the or-
der of 100-110% of
profit.46
The effective
levy
can be
higher still,
be-
cause tax
inspectors convey
information about business
profits
to
the
mafia,
who exact their own levies. These income taxes are in ad-
dition to
steep
value-added taxes
(20-23%
of value
added)
and retire-
ment and other social levies
(roughly
40% of workers'
pretax pay).
Businesses cannot
pay
these rates and
stay
in business. There are
two basic means of
reducing
taxes:
hiding profits
and
bribing
tax in-
spectors
to
charge
less tax on the
company's apparent profits
and not
search for hidden income. Most Russian businesses use both strate-
gies. Many
small businesses
try
to
stay
hidden
altogether.
This limits
their
growth
and makes them more vulnerable to mafia extortion.
As
corruption
and tax avoidance
deepen,
businesses face a further
45
The Russian tax
system
has other
problems
as well. These include the weak in-
centives of local
governments
to foster local business
growth
and thus local tax
base,
because local
payments
to the central
government budget impose
a
confiscatory
tax on
marginal
local tax revenue. See Ekaterina V.
Zhuravskaya,
Incentives to Provide Local
Public Goods: Fiscal
Federalism,
Russian
Style,
76 J Pub Econ 337
(2000).
This
prob-
lem was
partly
resolved
by
a
change
in 2000 in the method used to
compute
local
obligations
to the central
budget.
There is also a
tendency
for different levels of
gov-
ernment to tax the same
income,
without effective coordination rules or
political
constraints that
prevent
cumulative overtaxation. See Daniel Berkowitz & Wei
Li,
Tax
Rights
Tragedy of
the
Commons?,
76
J
Pub Econ 369
(2000).
46
These estimates are based on discussions
by
Anna Tarassova with business
people
in Russia and with officers of the International Finance
Corporation (IFC)
about the
tax rates on IFC's Russian
operations. (The
IFC is a
for-profit subsidiary
of the World
Bank.)
problem.
If
they pay
more taxes than their
competitors, they
will find
it hard to earn a decent
profit.
For
example,
businesses that
pay
full
social taxes for their
employees
are
disadvantaged
cannot
easily
com-
pete
with other businesses which
pay
less of these taxes.
Thus,
busi-
ness owners must
avoid,
as best
they can,
both income taxes and
"pass-
through"
taxes like value-added tax and social taxes.
Managers
of Russian
companies
with outside shareholders
usually
keep
two sets of accounts: a
public
set for the tax authorities and out-
side
shareholders,
and a
nonpublic
set for
managers
and insider share-
holders. There can be additional sets of accounts if the chief execu-
tive officer does not want to be honest with other insiders.
Often, only
two officers
fully
know the
company's
financial situation-the chief
executive officer
(general director)
and the chief accountant.
Tax collection
procedures.
Russian tax
inspectors
have
huge power,
if
they
believe that a
company
isn't
paying enough,
in a combination
of tax
payments
and bribes. For
example,
Russian law lets tax
inspec-
tors seize a
company's
bank accounts and other assets to
pay
taxes that
the
inspector
claims are due. The tax
inspector
can also infer the com-
pany's
estimated
profits
based on observable metrics that
may
have
little
relationship
to
profit,
such as
type
of
business, geographic
area
served,
number of
employees,
or
square
feet of office
space.47
A law-
suit
against
the tax
inspectorate
could take a
long
time to
resolve,
and
could
prompt
the tax
inspectorate
to undertake additional checks of
the
company's
books or
impose
extra fines for minor violations.
Cash in a bank account is both a source of assets that
inspectors
can seize and evidence that the
company
has the
ability
to
pay
taxes
(or bribes).
One
popular
solution in the 1990s was recourse to barter.
A noncash transaction avoids
creating
visible
cash,
and makes it
easy
for businesses to hide
profits
from tax
inspectors
and outside share-
holders alike.
Conversely,
the decline in the last few
years
in
barter,
intercompany debts,
and
unpaid wages
is a
positive sign.
A small
change
in the
banking
rules in 2000 has reduced the risk
of
holding.
Before
2000, companies
could have
only
a
single
bank
account;
now
they
can have as
many
accounts as
they
like. This lets
companies
scatter their funds
among multiple accounts,
some hard
for
anyone-including
tax
inspectors
or mafia-to find.
(To
be
sure,
this
practice
also makes it harder for
legitimate
creditors to collect
claims
against
the
company.)
For
export industries,
transfer
pricing (selling
to an
intermediary
47
See Simon
Ostrovsky,
Small Business Now A
Big Deal,
Moscow
Times,
Nov.
12,
2001.
Study
of Russia
offshore
company
controlled
by management
at a below-market
price,
which then resells at the world
price)
remains
hugely popular.
Trans-
fer
pricing
avoids
taxes,
reduces visible sources of
cash,
and
deposits
profits offshore,
free of claims
by
tax authorities and
minority
share-
holders alike.
Customs duties. Customs duties are both
part
of tax reform
(because
they
are a tax on
imports)
and
part
of
competition policy (because they
affect the
ability
of
imports
to
compete
with
domestically produced
goods).
Seen as a
tax, they
are
corruption prone. They
also exhibit the
same
interplay
between
high
rates
that,
if
paid,
would make
imported
goods uncompetitive,
both
against
domestic
goods
and
against
im-
ported goods
on which full duties aren't
paid,
and internal
opposition
to reform. Senior tax officials understand that lower rates are easier to
enforce and
might produce
more rather than less
revenue,
but some-
how rates often aren't lowered. Plausible
political explanations
in-
clude internal
opposition
from customs
police
anxious to
preserve
their income and businesses who now skirt the
import
duties and
fear the
stronger import competition
that lower duties
might bring.
Pension and social
safety
net taxation. Russia entered the 1990s
with a
huge old-age pension problem.
The state was the sole source of
pensions, paid
on a
pay-as-you-go
basis. Retirement
ages
are low
by
developed country
standards at
age
55 for women and
age
60 for men
(offset
for men
by
low life
expectancy,
which was
recently
in the
low
60s). Plus,
the
population
is
rapidly aging.
The
government
insti-
tuted a stiff
wage
tax to fund
pension
and other social insurance ob-
ligations, currently
38% of
wages
with no
upper wage
limit: 28% for
pensions
and 10% for other social
obligations.
This raises the effec-
tive
marginal
rate on
wage
income from the nominal income tax rate
of 13% to an effective flat rate of 37%.
During
the
1990s, many
firms avoided
paying
social
safety
net taxes.
The state
pension agency's
efforts to collect tax arrears were limited
and selective
(one suspects
the influence of side
payments
to the
pension officials). Any
firm that
paid
the full levies faced a
large
com-
petitive disadvantage,
while the
pension agency
faced a
huge
deficit
which limited the
government's ability
to lower the
pension-related
wage
tax.48 There is some evidence that collection is
improving.
How-
ever,
the
pension agency's
finances remain
opaque,
and the
agency
48
Our discussion of Russia's
pension-related wage
tax and its state
pension agency
are based on conversations with Lena
Zezulin,
who is an
expert
in this
rarely publi-
cized but
important
area.
has refused World Bank offers of
assistance,
which would
require
dis-
closing
its financial results to the Bank.
4. Connection to Other Reforms
Tax reform is
closely
connected to a host of other reforms. We in-
dicate these connections in
Figure
1 with thirteen
arrows, many
two-headed to indicate a bicausal
relationship. First,
for the reasons
discussed
above,
there is a
strong
bicausal connection.
Second,
the current tax
system strengthens
mafia extortion
possi-
bilities. At the same
time,
the close connections between mafia and
tax
inspectors
would lead
many
individuals and businesses to hide in-
come even under sensible tax rules.
Third,
tax reform connects
importantly
to macro and macro-
microeconomic reform. A more sensible
system
could
produce higher
revenue,
which would assist in
reducing budget
deficits and thus con-
trolling
inflation.
Conversely,
harder
budget
constraints on
money-
losing
firms would reduce
government
revenue
needs,
and thus facil-
itate
improved
tax
policies.
Good macroeconomic
policies
can also
contribute to business
profitability,
which raises tax revenues and
per-
mits lower
rates,
which over time should enhance tax
compliance.
Fourth, enterprise restructuring
can
improve profitability,
which
can increase tax revenues. At the same
time,
a broken tax
system
en-
courages
tax avoidance and
discourages
the new investment that is
needed for
restructuring.
Fifth,
as discussed
above,
there is a
strong two-way
connection be-
tween tax reform and
pension
reform.
Sixth,
tax reform is an
important precursor
to
banking
reform and
capital
market
development.
Both
require strong
financial
reporting,
which is
precluded by
the current tax rules.
Conversely, banking
re-
form can affect tax
collection,
as illustrated
by
the
example
above of
how
allowing companies
to hold
multiple
bank accounts can limit
tax
inspectors' power.
Seventh,
tax reform
directly
affects both small business
develop-
ment and
foreign
investment.
Foreign-owned businesses,
in
particu-
lar,
face a
comparative disadvantage
in
hiding
income or
negotiating
for lower taxes.
Eighth, reforming
the taxation of farms and other
agricultural
en-
terprises
is an
important accompaniment
to
agricultural
land reform.
Ninth, lowering
customs duties is
important
for
greater
com-
petition.
Tenth,
tax reform
requires
reform of tax law and trade law.
Eleventh,
tax reform would be
importantly
assisted
by
administra-
Study
of Russia
tive reform of the tax collection
procedures,
and of the Finance Min-
istry's opaque process
for
adopting
tax
regulations.
Business culture
of dishonesty
and
bribery.
Twelfth and
finally,
if
managers
must
"negotiate"
a
company's
taxes with tax
inspectors,
corruption
and
dishonesty
become more
deeply
embedded in Rus-
sia's business culture. There is no natural
place
in
Figure
1 for
general
business culture-of
legal compliance
on the one
hand,
versus dis-
honesty
and
bribery
on the other hand.
Still,
this culture is
surely
im-
portant
for
many
areas of microeconomic reform.
Competition pol-
icy,
small business
development (facilitated by
trust
among trading
partners), government procurement,
and infrastructure
development
come
readily
to mind.
C. Formation and Growth of New
Enterprises
When transition
began,
almost all Russian
enterprises
were
massively
overstaffed.
Many
were
nonviable,
but even the viable ones needed
to reduce their
workforce,
often
drastically. Displaced
workers would
need
jobs.
New
enterprises,
often in the consumer
goods
and ser-
vices sectors that had been
neglected
under
Communism,
were the
only plausible
source of new
jobs.
Thus,
transition success
depends
heavily
on the formation and
growth
of new
enterprises.49
1. Evidence on Small Business Formation and Growth
Some transition countries have succeeded in
fostering
new business
growth.
Poland is one
example;50
China is another.
Russia, however,
has
performed poorly
on most of the dimensions that affect the ease
of
forming
new businesses. A
respectable summary
statistic on the
obstacles
facing
new businesses is the Index of Economic Freedom
published by
the Fraser Institute. In their most recent
(2000) survey,
Russia tied for 116th out of 123
surveyed
countries
(almost
the same
as its 117 rank in
1995).51
49
Early gradualist
authors
stressing
this
point
and the
importance
of market insti-
tutions in
supporting
new
enterprises
include Peter
Murrell,
Evolution in Economics
and in the Economic
Reform of
the
Centrally
Planned
Economies,
in
Christopher
Clague
& Gordon C.
Rausser, eds,
The
Emergence Of
Market Economies In Eastern
Europe
35
(Blackwell Publishers, 1992) ("Clague
&
Rausser,
The
Emergence of
Market
Economies"),
and Anne
Krueger,
Institutions
for
the New Private
Sector,
in id at 219.
50
See,
e.g., Jeffrey Sachs,
Poland's
Jump
To The Market
Economy (MIT Press, 1994);
Simon
Johnson,
Private Business in Eastern
Europe,
in Oliver
Jean
Blanchard,
Kenneth
A.
Froot,
&
Jeffrey
D.
Sachs, eds,
The Transition in Eastern
Europe
vol.
2,
245
(U
Chicago Press, 1994).
51
Fraser
Institute,
Economic Freedom of the World
2002,
at www.freetheworld.com.
Table 2. Small
Enterprise Employment
Share in Various Russian
Regions (1999)
Region
Smaller
Enterprise
Share of
Employment
St.
Petersburg
24%
Moscow 20%
other 11
regions
mean = 5.5%
(min
=
3.7%,
max =
7.4%)
A
respectable summary
statistic on
entry
of new businesses is
the share of "smaller
enterprises" (under
500
employees)
in total em-
ployment.
This is because most state-owned
enterprises
were either
large
(over
500
employees)
or
tiny (local
retail and
repair shops
and
the
like).
In
1998,
Russian
enterprises
with under 500
employees
ac-
counted for 19% of total
employment-the
same level as in 1993. In
contrast,
successful transition economies like Poland and
Hungary
had 45-55% of
employment
in smaller
enterprises by 1998,
with the
percentage rising steadily throughout
the 1990s.52
For
many
Russian
regions,
this data overstates the
viability
of small
business. Table 2 summarizes the results of a 1999 World Bank sur-
vey
of 13 Russian
regions.
The share of
employment
in smaller
enterprises
was well under
10%, everywhere except
Moscow and
St.
Petersburg.53
2. Factors
Affecting
Small Business Formation and Growth
In our
judgment,
a number of factors contribute to the cumulative
burden on small business.
Figure
1 indicates the factors we consider
most
important through
a cluster of
eighteen
arrows that run be-
tween Small Business
Development
and other factors.
Many
of these
arrows are
two-headed, suggesting
the
strong
interaction between
small business
development
and other institutional reforms.
First,
the cost of
corruption
and
organized
crime falls
especially
heavily
on small
businesses,
for the reasons discussed in Section A.
One
study reports
that an
average
Russian
shop
is
inspected
83 times
per year (versus
half that in
Poland),
and is fined after 19% of the
inspections (versus
9% in
Poland).54
Russian
shops
almost
surely
also
52
See World
Bank,
Transition at 39-45
(2002) (cited
in note
1).
53
Harry
G.
Broadman,
The
Regional
Dimensions
of
Barriers to Business Transac-
tions in Russia: An Overview
("Broadman, Regional Dimensions"),
in
Harry
G. Broad-
man
ed,
Unleashing
Russia's Business Potential: Lessons
from
the
Regions for
Build-
ing
Market Institutions
1,
5
(World
Bank Discussion
Paper
No.
434, 2002)
54
See
McKinsey
Global
Institute, Unlocking
Economic Growth in Russia exhibit
33
(1999) ("McKinsey, Unlocking
Economic
Growth").
Study
of Russia
Table 3. Bribes and Protection
Payments
in Poland and Russia
(1999)
t-statistic for
Activity
Poland Russia difference in means
Extralegal payments
for 20% 91% 17.3
government
services
Unofficial
payments
for 19% 92% 18.3
licenses
Payments
for
"protection"
8% 93% 29.9
pay
unofficial "fines"
during many inspections. Struggles
like these
also drive
many
businesses to
operate
in the shadow
economy.
But
then the business must
stay
small
enough
not to be noticed. A World
Bank
study (July 2002)
finds no recent
improvement
in the overall
permit
and bribe burden
facing
smaller
enterprises.55
Conversely,
small
business,
if it
develops,
can become a
powerful
political
force
supporting
an
anti-corruption
and
anti-organized
crime
effort. We illustrate these connections in
Figure
1
through separate
2-headed arrows from
Anti-Corruption
Effort
(in general)
and Control
of
Organized
Crime to Small Business
Development.
Some illustrative data on how
corruption
and
organized
crime af-
fect small businesses: Table 3 indicates the stark differences in the
extent to which firm
managers
in Poland and Russia
report
that a
typ-
ical firm in their
industry (i) pays
bribes to receive
government
ser-
vices, (ii) pays
bribes to receive
licenses,
and
(iii) pays
for mafia
pro-
tection.56
Second,
the burden of
oppressive taxation, including
the
wage
tax
to fund state
pensions,
falls
disproportionately
on small businesses.
These businesses have
greater difficulty negotiating
with tax
inspec-
tors and state
pension
officials for a
payment they
can afford. Cor-
ruption
and the business tax burden are
linked,
because one
way
for established firms to
discourage
new
competitors
is to bribe tax
inspectors
to harass their
competitors.57
This is shown in
Figure
1
55
See Center for Economic and Financial Research and World
Bank, Monitoring of
Administrative Barriers to Small Business
Development
in
Russia,
Round 1
(Summer
2002),
at
www.cefir.org/papers.html;
Victoria
Lavrentieva,
Red
Tape Growing for Firms,
Moscow
Times, July 30,
2002.
56
The data in this table is from
Johnson
et.
al,
Why
Do Firms Hide?
(2000) (cited
in
note
21).
57
Medvedev,
Post-Soviet Russia
(2000) (cited
in note
43),
stresses the tax burden on
small business as a
principal
cause of Russia's failure to
develop
a
strong
small busi-
ness sector.
through separate
arrows from Tax Reform and State Pension Reform
to Small Business
Development.
Third,
new businesses need various
permits.
Russian rules
require
many permits.
Each
requires management effort, delays
business start-
up,
and has a bribe cost. Some
quantitative
and anecdotal data: A
World Bank
study
found that the
average
new business is
required
to
obtain
permissions
from "20-30
agencies
and receive 50-90
approved
registration
forms."58 It also takes three months to
register
a
typical
Russian
shop,
versus three weeks in Poland.59
Many permits depend
on
regulatory
discretion rather than
compliance
with known
rules;
this enhances
corruption opportunities.
Senior Russian officials are aware of this
problem.
President Putin's
economic
advisor,
Andrei
Illarionov, recently
held
up
a chart on na-
tional television
depicting
over 500
steps
that are
legally required
to
start a business in Russia.60 A new Law on
Licensing (2001)
reduces
the number of businesses
requiring
a
government
license from 200 to
about 20. But the
permit
burden is hard to eradicate
through top-
down
reform,
when
corrupt
bureaucrats resist reform in the trenches
and
regularly
invent new
requirements.
Fourth,
businesses need
multiple
licenses to
operate.
In
Russia,
these lead to
frequent inspections,
intended to find
(or invent)
viola-
tions that would cost more to cure than the bribe the
inspector requires
to
ignore
the offense. A 2000
survey reports
that the
average
Moscow
business had its certificates to sell various
goods
checked more than
120 times. About 90% of small business revenues come from the sales
of
products
that
require
a
certificate,
and the
average company
in the
survey reports having
37 certificates.61
Fifth,
small businesses need
capital,
which could
potentially
come
from banks. Small businesses also
rely
on banks to
deposit cash,
for
inter-enterprise payments,
and for
currency
for
import
and
export
transactions. Russia has institutions called
banks,
but these banks
rarely
lend to
enterprises,
lend trivial amounts to small
enterprises
and are not safe
places
to hold cash. We discuss the Russian
banking
system
in Section III.G below.
An alternative source of
capital
for small business is the
savings
of
friends and
family,
but in the
1990s,
this too was often not available.
In
1992,
the
government
froze all individual
savings accounts,
held
s8
Harry
G.
Broadman, Reducing
Structural Dominance and
Entry
Barriers in Rus-
sian
Industry,
17 Rev Industrial
Org
155
(2000) ("Broadman,
Structural
Dominance").
59
See
McKinsey, Unlocking
Economic Growth exhibit 33
(1999) (cited
in note
54).
60
See Sharon
LaFraniere, Cleaning Up
Russia's Culture
Of Corruption, Washing-
ton
Post,
Dec.
29, 2001,
at 18.
61
See
Igor Semenenko, Unraveling
the Red
Tape
That Binds Small
Businesses,
Moscow
Times, Apr. 10,
2001.
Study
of Russia
in the state
savings bank, Sberbank, ostensibly
to reduce
monetary
overhang
and thus limit inflation.
Hyperinflation
occurred
anyway,
which
destroyed
the value of these
savings
and thus the
potential
for
entrepreneurs
to
rely
on
family
and friends for the
capital
to start or
expand
a business.
Sixth,
small businesses need land to
operate on,
both owned and
leased. That makes urban land reform an
important
factor in small
business
development.
Urban land reform can also stimulate demand
for construction of new office and industrial
space
and allow an out-
let for Russia's
pent-up
demand for
housing,
which was
notoriously
scarce under Communism.
Construction,
in
turn,
is fertile soil for
small businesses.
Agricultural
l'and reform can facilitate
growth
in
agricultural production,
and thus in the businesses that
supply farms,
or
carry
their
produce
to market. We discuss land reform in Section
III.H below.
Seventh,
small businesses need the
flexibility
to hire and fire work-
ers
quickly.
Labor market
regulations
that
impede
firms'
ability
to
fire
discourage
new
hiring. Conversely,
if small businesses are suc-
cessful,
more
jobs
will be
available,
which can make it
politically
easier to relax labor market
regulations.
It took Russia until 2002 to
amend its Communist-era Labor Code.62 The old Labor Code was ridic-
ulously protective
of
employees;
the revised code is somewhat less
so. Other Communist-era labor laws and
regulations
remain in
force;
and it is too soon to tell how much difference the new Labor Code
will make. The
rigid
labor rules are often not
fully enforced,
but still
affect an
employer's
cost to
get
an
employee
to
agree
to a
"voluntary"
departure.
The risk of
employee
lawsuits also causes small
employers
to be reluctant to hire someone
they
don't
personally
know.63
Eighth,
small businesses
require
infrastructure:
roads,
rail and air-
ports
are needed to
purchase
materials and sell finished
goods.
Rus-
sian roads are terrible and often
getting
worse from lack of
repair.
Nor
has the
government gone
the route of some
developing
countries and
permitted private
toll roads between
major
cities.
Quick
and reliable
access to electric
power, water,
and telecommunications are also
needed to start a business.
Ninth,
an
important
bottleneck for
many
small businesses is the
preexisting government monopoly
over distribution-the
trucking
62
Labor Code of the Russian Federation of 30 December
2001,
No. 197-FZ.
63
On Russia's limited labor
mobility
and its
causes,
see
Harry
G. Broadman &
Francesca
Recanatini,
Is Russia
Restructuring?
New Evidence on Job Creation and
Destruction
(World
Bank
working paper 2001),
at
http://ssrn.com.abstract=274318
(Social
Science Research
Network) ("Broadman
&
Recanatini,
Is Russia Restruc-
turing?").
and rail
system. Entry
in this business is
easy
in
principle-it
can
even occur at the level of one driver and one truck.
However,
for
long-
distance
transport,
the
government monopoly
is often enforced
by
corrupt
officials and
mafia,
who tax truck
traffic,
hijack
trucks en
route,
and otherwise
disrupt
new
entry.
Some drivers hire assistants
to sit in the
passenger
seat with an automatic
weapon
loaded and
ready.
Even
then, driving
is a hazardous
profession, goods
are often
delayed,
it take
many
bribes to cover
any appreciable
distance-and
in
Russia,
most distances are
appreciable-transport
costs are cor-
respondingly high,
and there are few
ways
to ensure
against
loss of
goods
in transit.
Tenth, many
small
enterprises
could be involved in
importing
or
exporting
consumer
goods, machinery,
and business
supplies. Thus,
trade
barriers, including
customs duties and
currency regulations,
importantly
affect new business success.
Eleventh,
new
enterprise growth
interacts with
enterprise
restruc-
turing
as both cause and effect.
Competition
from new entrants can
stimulate
restructuring
of
existing enterprises. Conversely,
restruc-
turing
of
existing enterprises
can free
up surplus land, buildings,
and
equipment,
that new
enterprises
can
buy
or lease
cheaply-a process
that has contributed
importantly
to new business formation in Po-
land,
but far less so in Russia.
Also, many
Russian
enterprises
were
highly vertically integrated,
so that
they
would be less vulnerable to
supply disruptions. Large
factories
produced
as
many
of their
inputs
as
possible,
and often built
housing,
ran
company stores,
and some-
times made shoes and
grew vegetables
for their workers. Deinte-
gration
could offer
entry opportunities
for new businesses. There is a
stark contrast between
Avtovaz,
the
largest
Russian automobile com-
pany,
which made as
many
car
components
as
possible itself,
and the
web of thousands of often small and
highly specialized suppliers
that
surrounds General Motors or
Toyota.
Twelfth,
new
enterprise growth
interacts with hard
budget
con-
straints
(a component
of macroeconomic
policy)
as both cause and ef-
fect. If
employment
in new
enterprises grows,
it is
politically
easier
for
government
to reduce subsidies to older
enterprises
that sustain
the
enterprises
and associated
jobs. Thus,
new
enterprise growth
fa-
cilitates
hardening
of
budget
constraints.
Conversely,
subsidies to
existing businesses,
and the inflation and
price
controls that accom-
pany
these subsidies in
Russia,
inhibit new business
entry.
Thirteenth,
new
enterprise growth
both
strengthens
overall mar-
ket
competition,
and is fostered
by competition
and trade
policy
that
encourages competitive
markets and new
entry.
Fourteenth, appropriate
laws can facilitate small business devel-
Study
of Russia
opment.
One need is a suitable form of
legal entity.
The best form
is the limited
liability company (similar
to the German
GmbH).
The
necessary
law
giving
the details of this
entity
form was not
adopted
until 1998. Small business
development
is also fostered
by
the laws
that
support
the other reform areas discussed above that
impact
small
business
development.
Fifteenth and
conversely,
if small businesses remain in the infor-
mal
economy, they
can't
rely
on official enforcement of
contracts,
so
commercial law reform reaches them less
directly.
Sixteenth,
small business
development
is
supported by
a
general
social culture of
trust,
which facilitates
arms-length contracting
be-
tween business
people
who don't know each other well.
Conversely,
small business
development
creates a middle class of business
people
who must deal
fairly
with
strangers,
and thus can foster
general
so-
cial trust. If
Figure
1 included a box for social
trust,
there would be a
two-headed arrow between it and Small Business
Development.
Small business
development
and
political support for reform.
Fi-
nally,
small business
development
both fosters and is fostered
by
a
general
democratic
culture;
in
contrast, oligarchy
often thrives in an
autocracy
or a weak
democracy.
Numerous small businesses
might
have
provided political support
for some of the economic reforms that
proved
elusive in Russia in the 1990s. This effect would be both direct
(because
small business owners would
support
institutional
reforms)
and indirect
(because
small businesses would foster a
larger
middle
class that would
support reforms,
while
reducing unemployment
and
the
resulting nostalgia
for the
security
that Communism
provided).
We indicate this connection in
Figure
1
through
a two-headed arrow
between Democratization and Small Business
Development.
Transition
led,
in all
countries,
to
higher
income
inequality.
This
was
expected,
because Communism had
artificially suppressed
in-
come
inequality.
An
unexpected
outcome was that the worse the
transition
experience,
the
greater
the increase in
inequality.
For ex-
ample,
Poland's Gini coefficient
(a
standard measure of income in-
equality)
rose
modestly
from 0.28 in 1987-1990 to 0.33 in
1996-1998;
while Russia's soared from 0.26 to 0.47 over the same
period. By
com-
parison,
the U.S. Gini coefficient is about 0.43. Russia's less-well-off
people
were hit with a double
whammy-GDP
shriveled and their
share of GDP shrank as well.64 Greater
employment
in new busi-
nesses
(which are,
on
average,
more
productive
than older enter-
prises)
could have cushioned this fall.
64
The Gini coefficient data is from World
Bank, Making
Transition Work
for Every-
one:
Poverty
and
Inequality
in
Europe
and Central Asia
(2000).
A
regulatory
bottleneck
example: Registering
a new
company
(as
of 2001).
An
example
of how the
permit requirements
for
forming
a
new business
operate
on the
ground.
Under the Russian laws on
joint
stock
companies (1996),
limited
liability companies (1998),
a small
company
must file a charter that can
potentially
be
quite
short.
Only
a few items of information are
required.
The
reality
was otherwise. We describe here the situation in Mos-
cow,
which is one of the
friendliest regions
areas for new business
formation
(see
Table 2
above), prior
to the
July 1,
2002 effective date
of the law on
registration
of
legal
entities. We discuss the effect of
the new law below. In the late 1980s and
early 1990s, starting
a
private
business often took several
weeks,
but the outcome was
predictable:
upon
submission of several
required documents,
the
enterprise
would
be
registered.
Small
presents
were
appropriate
but not
necessary.65 By
the late
1990s,
the Moscow
registration
office had added its own
requirements
for
company
charters.
Examples
included a statement
that the
company
will assist the
government
in the
eventuality
of
war,
or that "Documents that have historic value should be
deposited
in the
city
archives."66 The
obligatory
bribe was modest in some
reg-
istration offices
($100
or
so)
but could run
$1,000
or more in others.67
After
registering
as a
legal entity,
a
company
must obtain a seal.
In
Moscow,
if more than 10
days elapse
between
registering
a com-
pany
and
filing
a sheaf of documents with the local tax
authorities,
the
company
is fined
5,000
rubles
($175).
Firms needed to either
pay
extra to obtain a seal
quickly
or
pay
the
fine,
because the tax office
would
reject
an
application
from a
company
with no seal.
Each tax office had its own routines.
Getting
into one tax office re-
quires
the filer to
get
in line
by
6 a.m. At
another,
filers must
put
their
names on a list a month before
turning up.
There
are,
of
course, people
who for a fee can
promptly
usher filers in to see the tax
inspector.
Once the tax office
accepts
the
company's papers,
the
company
must
open
a bank account and return to the tax office with its bank ac-
65
Our source here is the
personal knowledge
of Anna
Tarassova,
who was in
charge
of
company registration
for the
Gagarinski region
of Moscow
during
1989-1991.
66
See
Igor Semenenko, Unraveling
the Red
Tape
That Binds Small
Businesses,
Moscow
Times, Apr. 10,
2001. A business must
register
with the
registration
office and
the tax office for the
region
where its business is
located,
so there is limited
competi-
tion between
registration
offices or between tax
offices,
which could limit the bribe
that
any
one office could demand.
(There
is still Tiebout
competition
for business
reg-
istrations,
since
companies
can choose where to locate their
business.)
67
In the fall of
2000,
Anna Tarassova was told
by
a
private lawyer,
who works for a
U.S. law firm in Moscow and often
registers
new
companies
with the Moscow
Regis-
tration
Office,
that
many
Chamber officials travel
regularly
to
Cyprus (or
another
place
outside
Russia)
to
deposit
cash in U.S. dollars into their
private
bank accounts. The
trip
alone costs a
multiple
of official salaries.
Study
of Russia
count
details,
which
requires paying
another fee to an
expediter.
Private facilitators will handle all
necessary
details for a rather
larger
fee.68 After
(or
sometimes
before) registering
as a
legal entity, many
enterprises
must obtain a license to
carry
out
particular types
of ac-
tivities. Licenses were
required
for more than 200
types
of
activities,
with
many
activities described
quite broadly.69
Shuttle trade: One outcome of the burden on small business has
been to shift some
growth
in small businesses to Russia's
neighbors,
especially
Poland and
Turkey. Wages
in
many
Russian
regions
are low
enough
for Russia to
produce
its own low-cost
clothing
and shoes.
Indeed,
thousands of
textile, clothing,
and shoe
producers emerged
in
the
early
1990s. But
they
found business conditions
hostile,
and their
number has been
shrinking-from roughly 17,000 registered
firms in
1996 to
13,000
in 1999.70
A common substitute is "shuttle
trade,"
in which tens of thou-
sands of Russian citizens
repeatedly
travel to
Poland, Turkey,
and
other
nearby countries, buy clothing
and other consumer
goods,
return to
Russia,
and sell the
goods
there. The shuttle traders bribe
customs officials to
ignore
most of what
they bring
in. In
many
cities
(Moscow
is a
partial exception), they
sell their
goods
in street mar-
kets,
which are less vulnerable to mafia extortion than retail stores
because a street trader has few seizable assets and no stable location
to be
"protected."
The shuttle traders are small businesses of a
sort,
but
they rarely expand beyond
a
single
individual or
family.
3. Reform of the
Company Registration
Process
The Russian news on obstacles to small business formation is not at
all bad. The anecdote we offered above on
registration
of new
compa-
nies in
Moscow,
written in
2001,
is now obsolete. Under a new law on
registration
of
legal entities,
effective
July 1, 2002,
a
company's
char-
ter must be
registered
within 5 business
days,
if it contains a short
list of
required
items. The
registration
office cannot add additional re-
quirements
and must
provide
written reasons for refusal to
register
a
company.
The law on
registration
of
legal
entities also creates an im-
portant
switch of
resonsibility:
The old
company registry
offices were
closed and the
people
who worked there were
discharged.
New com-
panies
now file their charters with the tax office. The tax office has
different incentives than the old
registry
office. It wants to
register
68
In
Moscow,
facilitator fees are on the order of
$300.
One can also
buy
an
already
registered
shell
company
for around $500.
69
Law on
Licensing
art. 17
(1998).
70
See Broadman &
Recanatini,
Is Russia
Restructuring?
at table 6
(2001) (cited
in
note
63).
companies
so it can collect taxes.
Early reports
are that the tax of-
fices are
complying
with the 5 business
day
time
limit,
and not de-
manding
either bribes or extra charter terms. The bribes have
disap-
peared,
without
anyone going
to
jail
for
corruption.
A second
potentially important change:
A new Law on Licens-
ing (2001) chops
the number of businesses
requiring
a
government
license from over 200 to about 20. This law has had limited effect
thus far. Some bureaucrats have
simply
substituted
newly
invented
regulatory permissions
for the
repealed
license
requirements.
The
next
step
in the battle will be for the
government
to
explicitly
limit
bureaucrats'
authority
to create new
requirements
for
permissions.
Still, eliminating legally required
licenses should at least reduce the
level of bribes. A bureaucrat who seeks a bribe to
provide
a
permis-
sion,
where the
permission requirement may
exceed his
authority,
cannot demand as
large
a bribe as a bureaucrat who has
legal
author-
ity
to shut down an unlicensed business.
D. Commercial Law Reform
Almost
every
area of microeconomic reform rests on a
legal
founda-
tion. Taken
together,
the
necessary market-supporting
laws form a
complex,
interconnected web. The
complexity
of the
process
is
sug-
gested by
the 25 laws we list in
Figure
1 under Commercial Law Re-
form,
the 14 additional laws we list under Public Law
Reform,
and
the
multiple
connections between these laws and different areas of
microeconomic and other reforms.
The absence of law favors the well connected and
unscrupulous.
Laws that
aren't
honestly
enforced are little
better,
and can sometimes
be
worse,
as those without
scruples manipulate
the laws for
personal
gain.
Russia's 1998
bankruptcy
law offers an
example.
Instead of
creating
a
way
for creditors to enforce
claims,
it has thus far
mostly
provided
a new
way
for insiders to
expropriate
wealth from
minority
shareholders and creditors
alike,
often assisted
by apparent
bribes to
judges
and
bankruptcy
trustees.71
1.
Self-Enforcing
Law Reform
The
example
in Part III.C of reform of the
and
licensing
laws can be seen as one
example
of a more
general
inter-
connection
among
law
reform, corruption control,
and law enforce-
71
See,
e.g.,
Ariane
Lambert-Mogilansky,
Constantin Sonin & Ekaterina
Zhuravskaya,
Capture of Bankruptcy: Theory
and Evidence
from
Russia
(Center
for Economic and
Financial Research
Working Paper
no.
3, 2000),
at
www.cefir.org/papers/html; Black,
Kraakman &
Tarassova,
Russian Privatization at 1755-56
(2000) (cited
in note
3) (pro-
viding examples
of
manipulation
of
bankruptcy
court
proceedings).
Study
of Russia
ment. In an environment where
police, prosecutors, judges,
and
leg-
islators are all
bribable,
it can be hard to know where an attack on cor-
ruption
should start.
Often,
one
place
to start is with law reform.
Many
laws can be de-
signed,
at least
partially,
to be
self-enforcing,
and to reduce either
oppor-
tunities for
corruption
or bureaucratic incentives to demand bribes.
A
simple example
involves the
power
of
competition
to
squeeze
out
rents. Bribes are a form of
rent,
that will shrink if law reform that
per-
mits
competition
between
regulators.
To return to our
company reg-
istration
example,
an alternate reform could have let
companies reg-
ister at
any
one of the 10 or so
offices in the
City
of
Moscow, regardless
of where their main offices were located. This
would let
entrepreneurs register
at whichever office offered the best
combination of service and
price (official registration
fee
plus
unoffi-
cial
bribe).
To be
sure,
this
strategy
is
imperfect.
It
might
work
only
in
Moscow,
St.
Petersburg,
and a few other
large
Russian cities that
have
enough company registrations
to sustain
competition among
registration
offices. But at least in those
cities,
it could reduce bribes
to an efficient
level,
where bureaucrats can
charge
bribes
only
in
return for actual work
effort,
and have incentives to
provide superior
service,
for which
they
can
charge
more.72
A second
recurring strategy
is to
design
laws that lawmakers have
reasonable incentives to enforce.
Thus,
in the
example,
tax officials have a
stronger
incentive to
register companies
than
company registry officials,
because
doing
so facilitates the tax
officials' core
job
of
collecting
taxes. "Tax federalism" offers a second
example: regional
officials will have
stronger
incentives to collect
taxes,
and
adopt business-friendly policies,
if
they
can
keep,
at the
margin,
a
large percentage
of the revenues that
they
collect. Russia
got
this tax federalism issue almost
entirely wrong
in the 1990s. New
rules
(as
of
2000)
for
computing regional
tax
obligations
let
regions
keep
a much
larger
share of incremental revenues.
A third
recurring strategy
is to take bureaucrats out of an area en-
tirely,
or
replace discretionary
decisions with harder-to-influence ob-
jective
standards. For
example,
if customs duties are
repealed,
bribes
to customs officials will
disappear
as well. If
government
licenses
to
operate
certain
types
of businesses are
repealed,
bribes to obtain
these licenses will
disappear
as well. If local
university
officials sell
admissions,
admission decisions based on oral examinations can be
replaced
with decisions based on standardized test results.
A fourth
strategy
is to reduce the cost of
opposing
a
government
action. An
example: Corrupt
traffic
police
were a
major problem
in
72
See Shleifer &
Vishny, Corruption (1993) (cited
in note
18).
Russian cities. The
police
would
stop
motorists and collect bribes.
They
did not care much whether
any
rules were
actually
violated. If
a motorist wouldn't
pay
a sufficient
bribe,
the traffic
police
would
take
away
the driver's license. The driver would then need to travel
to the central office of the traffic
police,
wait in a
very long line,
and
pay
a small
fee,
to
get
his driver's license back. For most
motorists,
the nuisance cost of the
trip
to the central office exceeded the cost of
the bribe.
Russia's new Administrative Violations Code
(2002)
removes the
authority
of traffic
police
either to collect fines themselves or to take
away your
driver's icense.
Instead,
if the
police
find a
violation, they
issue a citation. The driver can then either
pay
a fine to the court
by
mail,
or
go
to court to contest the violation. This hasn't eliminated
traffic
police corruption,
but it has
greatly
reduced the level of
pay-
ments.
First,
the maximum bribe is now limited to the size of the
fine,
because the motorist can now
say, ok,
write out a citation and
I will
pay
the fine.
Second,
the traffic
police
have less incentive to
stop
motorists who have not done
anything wrong.
Some mo-
torists will refuse to
pay
and will
go
to court to contest the violation.
That will cost time and effort for the traffic
policeman,
and could
give
a
policeman
who
stops
motorists for invented violations a bad
reputation.
2. The Role of Outside Advisors in the Law Reform Process
Early
in the transition
period, though
less so
recently,
Russia and
many
other transition countries relied on outside advisors
(ourselves
included)
to
supplement
limited internal
expertise
on the content of
market-supporting
laws. The best laws
derive,
in our
judgment,
from
a combination of local drafters'
knowledge
of local
conditions,
and
outside advice on the
problems
that must be addressed and
practical
problems
that
particular proposals might
face.
Local
knowledge
is critical. The
necessary
laws must be drafted to
meet local
conditions;
to be consistent with other laws
(consistency
is almost
impossible
to achieve if laws are
hastily drafted,
or differ-
ent laws are based on advice from different
consultants,
often from
different
countries),
and to be
reasonably
enforceable.73 Outside ad-
visors too often recommend what
they
know from their home coun-
try,
with limited
thought
about the weaknesses of their home coun-
try
law or whether it can be
transplanted
to
foreign
soil.
Transplants
73
On the need for law drafters to take into account limited
judicial
and adminis-
trative enforcement
capacity,
see Bernard Black & Reinier
Kraakman,
A
Self-Enforcing
Model
of Corporate
Law,
109 Harv L Rev 1911
(1996).
Study
of Russia
are
especially unlikely
to take well when
proposed
for a civil law
country by
advisors from a common law
country,
unless the advi-
sors
adapt
their advice to reflect the differences between these le-
gal systems.74
Sometimes,
new laws must be
adopted
in several
steps,
rather than
jumping
from the near absence of commercial law under Commu-
nism to
fully developed laws,
lest the laws be too
complex
to under-
stand or administer. Some
laws-notably banking
and securities
law-require supplementation through
administrative
agency
rules.
At the same
time,
outside advice can be
important. Especially early
in
transition,
local drafters don't know
enough
about a market econ-
omy
and the
problems
that the law must address. In
Russia,
for
example,
a
group
of Russia's best
legal
academics drafted a new Civil
Code,
which was
adopted
in several
parts beginning
in 1995. The
Civil Code is
technically
excellent. It is
internally consistent,
core
terms are
usually defined,
and the same words are
generally
used
with the same
meaning
in different sections of the law.
Unfortunately,
the drafters took an academic
approach
to
drafting
that stressed
pure
civil law
theory (which they
were
expert in),
and
paid
too little atten-
tion to the needs of market
participants (which they
knew less
about).
As a
result,
the Civil Code creates a number of obstacles to de-
velopment
of
market-supporting
laws.75
The drafters also wrote the Civil Code to be at least
arguably
su-
perior
to other laws
governing
civil law
relations, including many
of
the commercial laws listed in the
right
hand column of
Figure
1. If
so,
these
problems
can
probably
be fixed
only by amending
the Civil
Code.76 This has sometimes become an obstacle to commercial law
reform. As a
practical matter,
amendments to the Civil Code
require
support
from the
original drafting group,
which sometimes is not
available or would cause extended
delay. Thus,
drafters of individual
laws often choose-as we did in our work on the
joint
stock
company
law and the limited
liability company
law-to conform individual
laws to the Civil
Code,
rather than
seeking
to amend the Civil Code
in tandem with
adopting
the new
law,
or
writing
rules that contradict
the Civil Code
(these
rules
may
be invalid and will at best sow near-
term confusion about which rules
control).
74
On the
pitfalls
in
transplanting
laws from one
country
to
another,
see Katharina
Pistor,
Daniel Berkowitz & Jean-Francois
Richard,
Economic
Development, Legality
and the
Transplant Effect, _ European
Econ Rev
(forthcoming 2002).
75
For brief criticism of the Civil Code
provisions relating
to
joint
stock
companies,
see Bernard
Black,
The Russian Civil Code: A
Straightjacket for Joint
Stock
Compa-
nies,
International Practitioner's Notebook 33-36
(August 1995).
76
See Civil Code of the Russian Federation art. 3.2.2
(addressing
the need for norms
of civil law contained in other laws to conform to the norms of the Civil
Code).
Drafting good
laws also takes time. The Russian reformers were
in too much of a
hurry
to wait for
market-supporting
laws to be
drafted.
They
relied instead on a
smattering
of ill-drafted
early
laws
and a
flurry
of
hastily
drafted Presidential
decrees,
each
addressing
the crisis of the moment. The decrees were often
ambiguous, poorly
drafted, internally inconsistent,
and inconsistent with other decrees
and laws.
The reformers believed that
early
errors could be fixed
through
later amendments. The
reality
is far more
complex.
A law or
decree,
once
adopted,
creates a
constituency
of beneficiaries. The
oligarchs
and other
gainers
from the looseness and
ambiguity
in the
early
laws became
important opponents
of clearer or
tighter drafting.
Moreover, privatization
is a one-shot event. It will
likely degenerate
into extensive
self-dealing by managers
and
controlling
sharehold-
ers,
with adverse
consequences
for
enterprise restructuring
and the
level of
corruption,
unless a
country
both
adopts good privatization
rules and
develops
a
good
infrastructure for
controlling
self-
dealing.77
Connection to
enforcement.
Even
technically
well-drafted laws can
founder when enforcement is absent. The
bankruptcy
law
again pro-
vides an
example.
It was drafted with extensive assistance from Man-
fred
Balz,
a
top
German scholar and the
principal
drafter of the
highly
regarded
German
bankruptcy
law. Quibbles
aside,
the Russian bank-
ruptcy
law is
internally consistent,
has no
major
inconsistencies
with other
laws,
and
mostly
makes sensible
policy
tradeoffs. But it
assumes that
judges
and
bankruptcy
administrators are
honest;
the
procedure
for creditors to choose trustees will not be
rigged by
false
claims; judges
can
distinguish
valid from invalid
claims;
and insiders
will not collude with sham creditors to
put
solvent firms into bank-
ruptcy.
Those
assumptions
are fine for
Germany,
but
fatally
flawed
for Russia.
Government
regulations.
If Russian laws are often
imperfect
and
sometimes
downright bad, they
are far better than most
government
regulations. Regulations
are
typically
issued with no advance
public
notice and comment. Few
government
bureaucrats are well
qualified.
Some care more about
improving
their own standard of
living
than
writing
sensible
regulations.
For
many bureaucrats, especially
at
regional
and local
levels,
the
optimal regulation imposes arbitrary,
inconvenient
requirements;
extends the
regulator's
turf as
widely
as
possible,
and
gives regulators
lots of
discretionary authority. Sadly,
77
See Black, Kraakman &
Tarassova,
(2000) (cited
in note
3).
Study
of Russia
many government regulations
come
uncomfortably
close to this
"ideal."
During
much of the
1990s,
the Central Bank's
currency reg-
ulations were a
good example-though
the Central Bank and the cur-
rency
rules are much
improved
in the last several
years.
E.
Building
Law Enforcement Institutions
A market
economy
rests on secure
property
and contract
rights.
Yet
legal rights
are no better than their enforcement. Good
enforcement,
in
turn, depends
on a number of
supporting
institutions. We indicate
the
principal
connections with arrows in
Figure
1.
1. Elements of Enforcement
The first need is for
good laws, plus
a tradition of
interpreting
laws
against fraud, self-dealing,
and the like
flexibly enough
to reach
clearly improper
behavior.
Russia, by now,
has
respectable
commer-
cial laws to
enforce,
but the laws are often
interpreted technically
and
inflexibly.
Self-enforcing
law can matter here too. Not
many
laws can be
fully
self-enforcing.
But
many
can be drafted to be more or less so. The
more
self-enforcing
a law
is,
the less it draws on scarce
judicial
talent.
The less the law calls for
discretionary
judicial
decisions,
the less it
draws on scarce
judicial
talent and the less
prone
it is to
corrupt
de-
cisions. The more the law
permits
effective
private
rather
public
en-
forcement,
the less it draws on scarce
prosecutorial
or administative
resources.
The second core need is for an
independent judiciary. Corruption
in law enforcement and in the
judiciary
can undermine even the best-
written laws.
Meanwhile, corruption
in the executive branch and the
legislature
reduces the likelihood that
corruption-reducing
laws
and
regulations
will be
adopted.
Third, strong organized crime,
which substitutes enforcement
by
hired force for enforcement
by
an
impartial judiciary,
is
similarly
an-
tithetical to a
healthy
market
economy.
Fourth,
much enforcement can come
through private
lawsuits.
But
public enforcement-especially
of criminal
penalties-is
also
needed,
and
requires skill, training,
salaries sufficient to attract tal-
ented
people
to serve as criminal
prosecutors
or in the enforcement
arms of
regulatory agencies,
and a
budget
sufficient to let enforce-
ment authorities hire a
reasonably
sized enforcement staff.
Fifth, private
enforcement often
depends
on the civil
procedure
rules that
govern
lawsuits. In
Russia,
these are
largely
carried over
from the Communist
period,
and are not
adequate
to handle
complex
commercial lawsuits.
Sixth,
because a skilled
judiciary
will not
emerge overnight,
private
arbitration can be a valuable substitute. But the effectiveness
of arbitration
depends
on the
judiciary respecting
arbitral
awards,
which
requires appropriate
civil
procedure rules,
and on a
procedure
for
enforcing
arbitral awards. In
Russia, foreign
investors often in-
clude arbitration
provisions
in
joint
venture and other investment
contracts,
often win arbitration
cases,
sometimes
get
Russian courts
to
uphold
the arbitral
decision,
but
rarely actually
collect
anything.78
Seventh,
a free
press
is
important
for enforcement. The
press
can
both
expose corruption
and
pressure
the
government
to
bring
a case
that
prosecutors might
otherwise cover
up.
An
example: corporate governance.
Russian
companies
are notori-
ous for various
abuses.
Corporate governance
practices
are
regulated by
a
panoply
of
laws, including
the Civil
Code,
the
joint
stock
company law,
and securities laws and
regulations.
These laws and
regulations,
taken as a
whole, provide
a reasonable
level of investor
protection.
Russia's
abuses
arise nonetheless because the laws are
routinely
either
ignored
or
interpreted
in a
narrow, highly
technical manner.79
2.
Judicial
Reform
Russia has a
functioning
court
system, including
a
separate system
of
"arbitrazh" courts that resolve commercial
disputes
between
legal
entities.
However,
the
judiciary
has been
minimally
reformed since
Soviet times. The courts are slow and
many
arbitrazh
judges
are not
experienced
in
resolving complex
commercial law matters.
Judicial
quality
and
experience
in commercial matters is worse
in the
regular courts,
which handle all
disputes,
even commercial dis-
putes,
with an individual as
plaintiff
or defendant. For
example,
suits
by
individual shareholders
against companies go
to the
regular
courts.
78
See, e.g., Jeffrey
M.
Hertzfeld,
Russian
Corporate
Governance: The
Foreign
Di-
rect Investor's
Perspective,
at
6-7,
in
Organization
for Economic
Co-operation
and De-
velopment, Corporate
Governance in Russia
(Conference Proceedings 1999),
at
http://
www.oecd.org/daf/corporate-affairs/governance/roundtables/in-Russia/ 1999/index.htm
("Russian
courts have been
regularly refusing
to
recognize
and enforce international
arbitration awards rendered
against
Russian
parties.").
79
See,
e.g., Black,
Kraakman &
Tarassova,
(2000) (cited
in
note
3);
Dmitri V.
Vasilyev, Corporate
Governance in Russia: Is There
Any
Chance
of
Improvement? (working paper 2000; original
in
Russian).
Study
of Russia
A not
infrequent
tactic used
by
local officials is to
procure
a share-
holder lawsuit
claiming
some violation of the
company
law
proce-
dure for shareholder
voting,
and obtain a local court decision
barring
the
company
from
holding
the
meeting.
It is often
cheaper
and
surely
faster for the
company
to make the local officials
happy
than to
ap-
peal
the
judgment
and
get
a
higher
court to rule that the violation
is either nonexistent or too technical to
justify blocking
the share-
holder
meeting.
Salaries for
judges
in Russia are a
tiny
fraction of those for
good
private lawyers. Thus, good lawyers
don't
apply
to become
judges;
the
best
judges
often leave the
judiciary;
and those who remain
expect
to
supplement
their official
salaries,
which
average
about
$200
a
month,
by taking
bribes. Honest
judges
can also become demoralized when
their
counterparts
are
corrupt
and when
corrupt superiors
remove
them from
important
cases.80
Better
pay
and
professionalism,
inculcated
through training,
can
help.
But
judicial corruption
is also connected to
corruption among
the
police
and
prosecutors. Judges
are less inclined to be honest if
they
are
unlikely
to be
prosecuted themselves,
know that
police
and
prosecutors
can be bribed not to
bring
cases
against
mafia and other
insiders,
and know that
police
and
prosecutors
will neither
protect
the
judge
from mafia-enforced threats
by litigants
nor
prosecute any-
one if the threat is carried out.
Many
courts also suffer from
poor facilities-including crumbling
buildings, poor telephone, copying,
and other
equipment,
and min-
imal law libraries.
Support
staff is also weak. Just as a
good lawyer
can
earn far more in
private practice,
so can a
good legal secretary.
Case overload is a
huge problem.
The
typical
Russian trial hears an
average
of 500 cases
per year,
about two
every working day.
Russia's
arbitrazh courts considered
634,363
lawsuits in the
year 2000,
9%
more than the
year
before. The additional cases included a
5,000%
jump
in the number of tax cases.
A further
problem
is that
judges,
both at the trial level and the first
appellate level,
are
closely
tied to local
regions,
which makes them
more
susceptible
to bribes and local influence. When a local
judge
is-
sues a home-town biased
decision,
one often cannot tell whether the
reason is
corruption,
the influence of the local
mayor
or
governor,
or
simply
the
judge's
desire to
curry
favor with his local
peers.
80
See,
e.g.,
Lee S.
Wolosky,
Putin's Plutocrat
Problem, Foreign Affairs, Mar./Apr.
2000,
at
18,
27
("In
cases
involving
the
oligarchs,
trial and
appellate judges
are rou-
tinely
bribed.
Failing that, judges
who evince a
dangerous predisposition
to
impartial-
ity
are
reassigned
without
explanation by superiors
who are
presumably
on the
take.").
In
Ukraine,
in one of the secret
recordings
made
by
President
Kuchma's
bodyguard,
the Prosecutor General
reports
on a
legal
case
against
a
lawyer
who worked for the
opposition
in the 1999
elections,
and was then
charged
with
"spreading
false information about the
president."
The
judge hearing
the case
downgraded
the
charge
and
ruled that Kuchma should be called to
testify.
On the
tape,
Kuchma
telephones
the local
governor
and instructs him to have the
judge
tortured.81
Many
Russian
regions
are
likely
similar to Ukraine.
Put all this
together,
and a recent
survey
of Russian
corruption
re-
ports
bribes to
judges
as one of the
major categories,
with total bribes
estimated at
$274
million
(following only
bribes for health care
($600
million), university
admission
($449 million),
and traffic
policemen
($368 million).82
F.
Competition
and Trade
Policy
1. The
Importance
of
Competitive
Markets
Competition-from
other domestic
companies, imports,
and ex-
ports
to world markets-can force
managers
to
improve enterprise
efficiency, squeeze
out rents and
accompanying opportunities
for
large-scale corruption,
and
improve entry opportunities
for new busi-
nesses.
Competition
can also create
political pressure
for the institu-
tional
change
that businesses need to
compete effectively.
The weak
empirical
connection between
privatization
and firm
performance
contrasts
sharply
with the
strong
connection between
competition (both
domestic and
import competition)
and firm effi-
ciency.83
The Chinese
example
of
township-village
enterprises,
which
are
government-owned
but face hard
budget
constraints and
compete
vigorously
in domestic and world
markets,
also
suggests
that
competi-
tion is often a
stronger spur
to
efficiency
than
private ownership.
Exposure
to international markets can
play
a central role in
strengthening
domestic
competition. Imports directly
introduce com-
petition. Exports
introduce
competitive pressure,
because domestic
81
See Patrick
Tyler,
Thousands March in Kiev Over Political
Crisis,
New York
Times,
Feb.
7,
2001.
82
See Bribes
Keep
Russia
Efficient, RFE/RL
Business
Watch, May 28,
2002.
83
See
Djankov
&
in note
2).
For a
Russia-specific study,
see
J.
David Brown &
John
Earle,
Competition
and Firm
Perfor-
mance: Lessons
from
Russia
(Stockholm
Inst. of Transition Econ.
Working Paper
No.
154, 2000),
at
Science Research
Network) (non-
technical version
published
as Market
Competition
and Firm
Performance
in
Russia,
9 Russian Econ Trends
[March
2000]).
Study
of Russia
firms must
compete
in the
global marketplace. Imports
can also
spur
technological progress,
which is an
important predictor
of economic
growth.84
A
possible exception
is the
potential
for
rapid penetration
of
imports
into a
previously
closed
economy
to decimate domestic
producers
and
impede
rather than
promote restructuring.85
2. Russia's Failure to Foster
Competition
Russia
began
the transition
period
with
multiple
barriers to
compe-
tition. Privatized
enterprises
were often
monopoly providers
in their
region;
the
poor
business climate
discouraged
new
entry;
trade bar-
riers limited
import competition; poor
road and rail
transportation
and state-owned distribution
monopolies
limited
import
and inter-
regional competition.86
Russia has
yet
to
seriously
address these
problems.
Formal and in-
formal trade barriers remain
high.
These and other
problems
led the
European
Bank for Reconstruction and
Development
to rate Russia
as
only
a 2+ on a 1-5 scale for
competition policy.87
Antimonopoly Ministry-Theory
and Practice. In
developed
coun-
tries,
the institutions that
promote competition
include
competition
laws
(known
in the United States as "antitrust"
laws),
and
competi-
tion authorities who can
challenge anticompetitive practices,
in-
cluding price fixing
and
mergers
that create market
power.
Success
and
prestige
for the
competition authority's employees
and leaders
depends
on
achieving
this
goal,
while lax enforcement can lead to
criticism
by
the
press,
the
legislature,
and executive officials. This
public oversight helps
to offset the
pressure
on the
agency
when it
must act
against
incumbents with substantial market
power,
some-
times
despite opposition
from sectoral ministries.
In a
corrupt environment, however,
the
competition authority
is
unlikely
to be effective. Russia is no
exception
to this
generalization.
Russia established the
Antimonopoly Ministry (formally
the Min-
istry
on
Antimonopoly Policy
and
Support
of
Entrepreneurship)
as
its
competition authority
in 1992. But the
Ministry (then
named a
"Committee")
was seen as a
political
backwater and staffed with weak
84
See William
Easterly,
The Elusive Quest
for
Growth: Economists' Adventures
and Misadventures in the
Tropics
ch. 9
(MIT Press, 2001) ("Easterly,
Elusive
Quest")
(stressing
the
importance
of
technological imports
for economic
growth).
85
See
Djankov
&
in note
2).
86
On Russian barriers to
competition,
see
Broadman, Regional
Dimensions
(2001)
(cited
in note
53); Broadman,
Structural Dominance
(2000) (cited
in note
58).
87
European Bank,
Transition
Report
1999 at 24
(2000) (cited
in note
25).
leaders,
who then hired weak staff.88 An
early
Committee action was
to establish a
"monopoly register,"
which listed thousands of medium
size
companies
as
monopolies
and
subjected
them to stricter rules
and
costly reporting.
The basis for the Committee's decision to list
some
companies
and not others was not
publicly stated,
and
many
listed
companies
had no market
power. Companies
then had to bribe
Committee officials to be taken off the
register.
The
Antimonopoly Ministry
has
improved
somewhat in the last
several
years.
Its lists of
monopolies
still often make little
sense,
but
listed firms can sometimes hire
lawyers
to obtain removal from the
list without
paying
bribes
(though
bribes work
too).
An
example: farmers'
markets. In Soviet
times,
Russian cities and
towns
traditionally
had farmers'
markets,
where
private producers
could sell home
grown
or
produced vegetables, fruits,
cut
flowers,
beef, honey,
etc. In
major
farmers' markets in
large cities,
one could
find
fruits, vegetables
and flowers from other
republics
within the
Soviet
Union, including
ones that were thousands of miles
away.
By
the
1980s, managers
of farmers' markets in
big
cities were often
corrupt
and had connections to mafia
groups.
Farmers
paid
smallish
bribes to market
managers
to be allowed to sell in the market.
Today,
farmers' markets in
big
cities in Russia are often well-
organized
businesses run
by
mafia. For
example,
the Moscow farm-
ers' markets are run
by
the Chechen
mafia,
with
appropriate payoffs
to the
police
and
city
officials. One can
buy guns
and
drugs
there al-
most as
easily
as
vegetables.
No real farmers are allowed to enter
these markets.
Instead,
the sellers are wholesalers who
buy
from
farmers at
low, monopsonistic prices.
The markets in different re-
gions
of Moscow collude to set
prices
at
supracompetitive
levels.
International
competition.
Russia retains
high
tariff barriers and
other informal obstacles to trade. Its
disinclination, thus, far,
to seek
to
satisfy
the criteria for World Trade
Organization (WTO)
member-
ship
is a
signal
of this failure.
The
import process
is
thoroughly corrupt. Monopoly privileges
to
import
or to
export particular items-including oil, cigarettes,
and
alcohol-provide
rents for favored
persons
and
provoke
occasional
wars between
competing
mafia
groups.
For some
important import
items
(personal computers
and
components, automobiles),
the com-
88
The source for this statement is Anna Tarassova's
personal knowledge, including
familiarity
with Leonid
Bochin,
who headed the Committee
during
1993-1997. See also
New Head
of
Russian
Antimonopoly
Committee
Appointed,
Jamestown Foundation
Monitor, Sept. 8,
1997.
Study
of Russia
bination of
high
tariffs and
corruption
has closed the Russian market
to
anyone
who
imports honestly.
For
example,
the market
price
of a
nearly
new German automobile
(bought
or stolen in Western
Europe
and then
"smuggled"
into
Russia)
is
radically
less than the
price
that
an
importer
could sell at after
paying
the
high
official
duty.
Effective
competition
and trade
policy
is connected to a number of
other reforms. We show these connections with arrows in
Figure 1;
bicausal connections are shown with two-headed arrows.
First, corruption
almost ensures that
competition-reinforcing poli-
cies will be weak. Those who now earn
monopoly
rents will
pay large
sums to
keep them;
officials will
promote
new rents so
they
can skim
a
portion
of the
rents;
older firms will bribe officials to harass new en-
trants;
and so on.
Second, organized
crime offers a
potent
means for those with mar-
ket
power
to
discourage competition.
Consider
agriculture
and truck
transport-two
industries that have low
entry
barriers and limited
economies of
scale,
and are
highly competitive
in other countries. In
Russia,
a combination of official
corruption,
mafia threats
against
private farmers,
and mafia
holdups
and
hijackings
of
private
trucks
who seek to circumvent the local distribution
monopoly prevents
ef-
fective
competition
in these industries. A mafia-enforced threat of
violence
against
cheaters is also an effective
way
to enforce cartel
pricing
and market division schemes.
Third,
subsidies to
existing
firms deter new
entry.
In some indus-
tries,
new entrants can survive because their
greater efficiency
out-
weighs
the available
subsidy,
or because
they
offer niche
products
that their subsidized
competitors
cannot match. In other
industries,
especially commodity industries, large
actual or available subsidies
to
existing
firms
preclude
effective
competition.
Fourth,
administrative
reform, especially reducing
the
permit
bur-
den on new
entry,
is an
important precursor
to
strong competition.
Fifth,
in
many industries, competition
will come
mostly
from new
businesses.
Thus,
the factors that
impede
creation and
growth
of new
businesses will also reduce
competition. Conversely,
weak
competi-
tion
policy discourages
new business creation.
Sixth,
customs
duties,
informal trade
barriers,
and
currency
con-
trols are
important
obstacles to international
competition.
Seventh,
an
antimonopoly law, plus
effective
regulatory
enforce-
ment of this
law,
can be an
important
element of
competition policy.
Eighth, enterprise privatization
and
restructuring,
can foster com-
petition, especially
if the
privatization plan
includes
breakup
of mo-
nopoly
state-owned
enterprises
where feasible.
Conversely, strong
competition
can foster
enterprise restructuring.
Ninth,
the state
monopoly
over distribution is
largely
intact in
many
Russian
regions.
This
monopoly
is
especially
harmful because
it limits
competition
across a host of industries.89
Tenth, openness
to
competitive entry
and low trade barriers will
encourage foreign
direct
investment,
which will create
pressure
for
enterprise restructuring,
which will then enhance
competition.
We
indicate these
relationships
in
Figure
1
through
arrows that
(i)
con-
nect
Competition
and Trade
Policy
to
Foreign Investment; (ii)
connect
Foreign
Investment to
Enterprise
Privatization and
Restructuring
(a
two-headed arrow because
and restructur-
ing
can
provide good opportunities
for
foreign investment,
both di-
rect and
portfolio);
and
(iii) completing
the
circle,
connect
Enterprise
Privatization and
Restructuring
to
Competition
and Trade
Policy
(again
a two-headed
arrow).
G.
Banking
Reform
1. Problems with the Russian
Banking System
A market
economy requires
a
functioning banking system,
that can
collect
savings
from
individuals;
funnel these
savings
to
profitable
enterprises, especially
smaller
enterprises;
allow
enterprises
to
safely
hold cash in bank
accounts;
facilitate
inter-enterprise payments;
and
facilitate the
currency exchange
and
currency hedging
that is
impor-
tant for
import
and
export
transactions. Of
these,
Russian banks of-
ten offer
only
the last two.
There were no
private
commercial banks in the Soviet Union un-
til
1988,
when the Law on
Cooperatives permitted
their creation.
By
the
early 1990s,
there were about
1,500
commercial banks in
Russia,
with 500 in Moscow.
Few, however,
are banks in the normal under-
standing
of the word.90 Most neither attract
significant deposits
nor
conduct
arms-length lending. Rather, they
were created to facilitate
conversion of
cheap non-monetary
state credits into valuable
cash;
to
engage
in
currency operations;
so the state could offer soft loans at
subsidized interest rates to the
enterprise
that created the
bank;
and
to hold state
funds,
where at best the state would receive far-below-
89
On the connection in Russia between
competition
and the distribution
system,
see
J.
David Brown &
John Earle, Competition-Enhancing
Policies and
Infrastructure:
Evi-
dence
from
Russia
(Stockholm
Institute for Transition Economics
Working Paper
No.
161,
2001),
at
Science Research
Network).
90
On the activities of the Russian
banks, see, e.g., Hedlund,
Russia's 'Market' Econ-
omy (1999) (cited
in note
13); Hoffman,
The
Oligarchs (2002) (cited
in note
6).
Study
of Russia
market interest and often the funds were stolen. Most remain mini-
mally unregulated.
Other than the state
savings bank, Sberbank,
which remains
major-
ity
state-owned and does little
lending,
the new
private
banks hold few
deposits
and thus have few funds to lend in
any
event. Russians distrust
banks,
with
good
reason. At the
beginning
of the
transition,
the Gaidar
government
froze all individual
savings accounts,
held in
Sberbank,
and then confiscated these
savings through high inflation,
not com-
pensated
for
through
interest rates. This ensured that few Russians
will hold
savings
in
banks,
which leaves banks with little
capital
to
lend.
Many ordinary
Russians instead hold their
savings
in U.S. dol-
lars
(or
other hard
currencies)
under "mattresses," or outside Russia
entirely.
Distrust of banks was reinforced in the 1998
crash,
when
many
banks went insolvent and were then looted of their
remaining
assets. The Central Bank did not act either to
prevent
the
looting
or
to recover stolen assets. Domestic Russian banks are
similarly
not a
reliable
place
to
deposit enterprise
funds.
The
system
for domestic
inter-enterprise payments
has
improved.
As a
result,
the earlier
practice
of
making payments
in
cash,
carried
in suitcases
by couriers,
has diminished. Cash is still sometimes
used to avoid
taxes,
but this reflects
problems
with the tax
system,
not the
banking system.
The Central Bank is more honest than it used to
be,
but remains
a trouble
spot. Exchanging
rubles for
foreign currency
can be chal-
lenging.
The Central Bank
requires compliance
with
complex
and
frequently changing currency regulations.
These rules have no meas-
urable effect on
capital flight
but
complicate ordinary
business trans-
actions and
foreign
investment.
They
are also a source of bribe rev-
enue for at least some Central Bank officials.91
A
healthy banking
sector
requires progress
in a number of other
areas. We list the
principal
interconnections below. These are also
shown with arrows in
Figure 1;
bicausal connections are shown with
two-headed arrows.
91
On Central Bank
corruption, see, e.g., Torrey Clark, Report:
Central Bank a Cor-
ruption
Hotbed,
Moscow
Times,
Nov.
28,2001;
J,.
BaciebeB,
fH.
,Jpo6bimeB
&
A.KOHOB,
O6,beKTHBHbIe
npeanocCbIJKH KOppynIHH
B
JeSATejbHOCTH IUeHTpaJIbHOrO
6aHKa Poc-
CEIHCKOii
(eaepaunr (Dmitri Vasilyev,
Pavel Droboshev & Alexei
Konov, Objective
Pre-
conditions
for Corruption
in the Activities
of
the Central Bank
of
the Russian Feder-
ation,
PowerPoint
presentation,
Nov.
2001),
at
www.carnegie.ru/english/news01.htm
(Moscow Carnegie Center);
Levin &
Satarov, Corruption
and Institutions at 122
(2000)
(cited
in note
31).
First, corruption,
most
directly
at the Central
Bank,
and
organized
crime
impede
the
growth
of the
banking sector,
as well as its
ability
to
carry
out core
banking
functions.
Banking
is a
dangerous
business.
Some borrowers
prefer
to hire mafia and
fight
with
guns
rather than
repay
loans. Others
employ
this
strategy
after the bank hires its own
mafia enforcer for a
delinquent
loan.
Conversely,
the
vulnerability
of
bank accounts to demands
by
tax
inspectors
and
mafia,
foster a cash
economy,
which in turn fosters
corruption.
Second,
tax reform is a
prerequisite
to a
stronger banking
sector.
Some reforms that would
specifically
affect the
banking
sector:
* a ban on tax
inspectors seizing
bank accounts without
legal
process;
*
changing
the rules that allow tax
inspectors
to infer a firm's
profits
from external
measures, including
the existence of
cash in a bank
account;
* sensible
marginal rates,
that
enterprises
could afford to
pay.
Third, imposing
hard
budget
constraints on firms is a
precondi-
tion to
banking
sector
development.
A conventional
way
to soften
budget
constraints is
through
state-directed
lending,
either
by
state-
owned banks or
by private
banks with close
government
ties. These
soft loans use funds that otherwise
might
be directed to
profitable
loans,
and make it hard for banks to
develop
the internal controls
needed to make
good
credit decisions.
Fourth, banking
sector
development requires
extensive reform of
the Central
Bank,
a
huge bureaucracy
that is
improving,
but often re-
mains neither honest nor
competent.
Fifth,
the
banking
sector
depends
on a substantial number of market-
supporting
laws and
closely
related
institutions, including banking
law;
secured credit law and a
system
for
recording security interests;
bankruptcy
and
insolvency law;
a
good
financial
accounting system;
land reform and land
law, mortgage law,
and a
system
of land
regis-
tration
(because
loans secured
by
real estate will
likely
be a
major
lending opportunity); currency law;
and
general
civil and commercial
law
governing
financial contracts.92
Sixth,
banks need to be able to enforce loan
contracts,
which re-
quires
an honest and
competent judiciary,
and an effective mecha-
nism for
enforcing awards, including seizing
collateral for secured
loans.
Seventh,
there is a
strong
correlation between
banking
sector
92
See,
for
example,
Ross
Levine,
Norman
Loayza
& Thorsten
Beck,
Financial In-
termediation and Growth:
Causality
and
Causes,
46 J
Monetary
Econ 31
(2000);
Ross
Levine, Law, Finance,
and Economic
Growth,
8 J Fin Intermediation 8-35
(1999).
Study
of Russia
strength
and
capital
market
development,
because banks need to
raise
equity capital
and the
banking
sector and
public capital
markets
often
rely
on the same institutions.93
Eighth, competition policy (allowing entry
of new
banks, including
foreign banks)
can be an
important impetus
for
banking
sector reform.
Ninth, banking
sector reform is an
important prerequisite
for
a number of other reforms
including
small business
development,
housing reform,
and
foreign
investment.
H. Land Reform
1. Russia's Partial
Attempts
at Land Reform
Land reform has two main elements: urban land
(for housing
and
enterprises)
and
agricultural
land. Land users need
property rights
that are
stable,
verifiable
(through
a
registration system), transferable,
and
subject
to
pledge
and foreclosure
(to permit
secured
lending).
Land
rights
can come either
through
land
ownership
or
long-term
leases of state-owned land. In the
long run, ownership
is
preferable,
because
leasing
can be inflexible and
keeps
the
government
as
owner,
with
accompanying corruption
risk.
Urban land. In the near term if Russia had
privatized
urban land
when it
privatized enterprises,
the outcome
might
have been a land
grab by
the well
connected,
in
parallel
with the scramble for control
of
enterprises. Enterprise ownership
of the land the
enterprise
sat on
would have
provided
an additional asset for the
managers
to sell for
personal gain.
The
company would,
for
example,
sell its land to a
company
owned
by
the
managers
for below market value and then
lease the land back for above the fair market rent.
For the most
part,
Russia has not
privatized
urban land. In some
major cities, including
Moscow and St.
Petersburg, enterprises
can
obtain
reasonably long-term
leases from the
city government.
The
granting
of leases is
corrupt
and
opaque,
and the lessee faces some
risk that the
government
will invent an excuse to break the lease. But
at least leases are available. In
many
other
cities,
leases are short or
available
only
to favored insiders.
Here,
the 2002 Land Code should
help,
at least when combined with a land
registration system
that
should be launched in 2003.
93
See Ross Levine & Sara
Zervos,
Stock
Markets, Banks,
and Economic
Growth,
88 Am Econ Rev
537,
543
(1998) (finding
a 0.65 correlation between
banking
sector and
stock market
size,
both relative to
GDP).
Apartment
privatization
and murder. The
example
of
apartment pri-
vatization offers a
cautionary
lesson about the risks of
privatization
in a weak institutional environment. In the
early 1990s, many
Rus-
sian cities
privatized apartments by giving
them to the
people
who
lived in them. In
part,
this had
good outcomes,
as those with desir-
able
apartments
but low incomes sold or rented them to others and
moved to
cheaper apartments. Many apartments
were then renovated
by
their new owners.
But there were also
unexpected
outcomes.
Many elderly
Russian
citizens who were sole owners of
apartments
were
reported missing.
What
happened? Elderly
owners of
apartments
were
approached by
real estate
agencies,
often controlled
by
the mafia. When a
likely
can-
didate
emerged-usually
an
elderly single
woman in a valuable
apart-
ment,
without close
family,
murders were
arranged,
documents were
falsified to transfer
ownership
to a
"buyer" (or perhaps
the owner
signed
documents first and was then
murdered),
and
government reg-
istration
agencies
were bribed to
register
the transactions. The num-
ber of cases is not
known,
but in Moscow
alone,
for a number of
years,
hundreds of bodies would show
up
each
spring
in shallow
graves,
when
the snow melted.
Many
other bodies were
likely
never
officially
re-
ported-the Ministry
of Internal Affairs "hides" numerous murders
to make Russia's criminal statistics look less
shocking.
Almost none
of these murders were solved.94
Agricultural
land. Russia took some
early steps
to reform
agricul-
ture,
but these had limited effects. Under a 1991 Presidential
Decree,
collective and state farms and related
agricultural enterprises
were
converted into
joint
stock
companies.95 Management
and farm work-
ers became shareholders in these
companies. However,
in
practice,
little has
changed
on these farms. The same workers continue to
work for the same bosses. The bosses often sell the farm's
output
to
an
intermediary company
that
they
control at a below-market
price,
which then resells the
output
at the market
price,
with the bosses
pocketing
the difference. We have
argued
elsewhere that
enterprise
94
Russian
journalists
sometimes write about outcomes of
apartment privatization
in Russia. There were also several movies on the
subject
shown on the Russian TV.
The
story
in one movie involved a real estate
agency sending young
women to
pose
as
nurses to
single
old
people
in St.
Petersburg.
These "nurses"
gave injections
that in a
course of
days
or weeks caused death. The cause of death looked similar to a heart at-
tack because of the nature of the
injected drug.
See also Fen
Montaigne,
Russia Ris-
ing,
Nat'l
Geographic,
November
2001,
at
2,
22
(estimating
that
1/3
of St.
Petersburg's
50,000
homeless
population
were victims of real estate
fraud).
95 Decree of the President of the Russian Federation of December
27,
1991 No 323.
"On
Urgent
Measures on
Executing
Land Reform in the RSFSR."
Study
of Russia
privatization
weakened the
government's oversight
of
enterprises
and
thus facilitated transfer
pricing
and other forms of theft.96 Conversion
of state and collective farms into
private joint
stock
companies
had a
similar effect for farms.
Agricultural
land itself was not
privatized,
so the farm's
ownership
of its land remained unclear.
Moreover,
the
joint
stock
company
form
does not let shareholders withdraw their share of a firm's
assets,
and
thus was not conducive to the reformers' desire to
permit
individual
farmers to claim a
prorata
share of the farm's land and
machinery.
The
1996 Law on
Joint
Stock
Companies
therefore
exempts agricultural
companies
from
regulation by
this
law, leaving
these
companies
in le-
gal
limbo.
During
the
1990s, attempts
to include in the Civil Code the
basis for
private
land
ownership
were
regularly
defeated in the Duma.97
The Yeltsin
government protested
that it had tried to reform land and
could do no
more;
the
likely reality
was that it didn't
try very
hard.98
Agricultural
land
privatization
and
agricultural
reform was con-
strained
by
a combination of farmers' fears about outcomes
(leading
them to
support anti-privatization
Communists and
Agrarians); po-
litical
opposition
to reform
by
local
nomenklatura,
who could skim
profits
from former state and collective farms that were converted to
joint
stock
companies;
local
corruption; organized crime,
which the
nomenklatura often turn
against
farmers who
attempt private
farm-
ing;
and lack of distribution
system reform,
which leaves
private
farm-
ers no
good way
to
get
their
goods
to distant markets. The failure of
many entrepreneurs
who
attempted private farming
in the 1990s has
persuaded
other farm workers that the miserable status
quo
is better
than the
privatization
alternative.
The
political logjam
that stalled
privatization
of
agricultural
land
was
finally
broken in 2002. However it remains
premature
to
specu-
late on how successful the new land law will be.
Land reform is
closely
connected with a number of other reforms.
The
principal
connections are shown with arrows in
Figure
1.
96
See
Black,
Kraakman &
Tarassova,
(2000) (cited
in note
3).
97
Part I of the Civil Code was
adopted
in 1995.
However,
the effective date of Civil
Code
Chapter 17,
which addresses
private ownership
of
land,
was
postponed
until en-
actment of a new land code. See Federal Law "On Enactment of Part One Of the Civil
Code of the Russian
Federation/'
art. 13
(1995).
98
We are not sure
why
the 1991-1992
agricultural
reform was handled so
badly.
One
possible
reason is that the
Ministry
of
Agriculture
was dominated
by persons
who were
likely
to be losers from effective reforms.
They
were not interested in
reform,
and
per-
haps
succeeded in
sabotaging
the
early
efforts.
First,
as our
apartment privatization story
makes
clear,
land re-
form
requires
control of
corruption
and
organized
crime.
Second, agricultural
land reform
depends
on distribution
system
reform. Farmers who can't
get
their
goods
to market can't take ad-
vantage
of a market for
agricultural
land.
Third,
land reform
depends
on
legal precursors, including
land law
and a land
registration system. Lending against
land value
depends
on
secured credit law and an effective foreclosure
procedure.
Fourth,
farmers need to borrow
against
their land to
buy
machin-
ery, fertilizer,
and
seed,
and survive bad
years.
That
requires
a bank-
ing
sector that is interested in
making
these loans.
Fifth, agricultural
reform will work
poorly
without a favorable
overall small business climate that can foster small farms and
agri-
cultural
support
businesses.
Sixth,
tax
simplification
is
important.
Farmers in Russia can nei-
ther understand the
complex
tax rules that
apply
to all
businesses,
including farms,
nor afford to hire an accountant. A much
simpler
"land tax" is needed.
Seventh,
customs duties and other trade barriers affect the
prof-
itability
of
export crops
and the cost of
importing
modern
seeds,
fer-
tilizers, pesticides,
and farm
machinery.
Eighth,
land reform is a
precursor
to
housing
reform.
IV. CONCLUSION: TOWARD COMPREHENSIVE
INSTITUTIONAL REFORM
Our
exploration
in Part III of core institutional reforms and how
they
interrelate, complex
as it
was,
offers
only
a
partial picture.
There are
many
other
important
reforms and
interconnections,
outlined in
Fig-
ure
1,
that we did not discuss at all. To do
so,
we would have needed
to write a book rather than an article.
The microeconomic reforms we discuss in Part III are linked-
both
politically
and
economically-to
a broad
range
of democrati-
zation
reforms, including
constitutional
reform,
free
press
and me-
dia,
an electoral
system
that fosters
noncorrupt elections,
and
parliamentary
reform that
provides
lawmakers with
professional
staff and allows lawmakers to be
prosecuted
for
corruption
and other
crimes. Those
linkages
are
beyond
the
scope
of this Article.
Reforms that foster
political support
for economic reform are also
important.
These include environmental
protection rules,
medical
care and education
reform,
freedom of
religion,
creation of
nonprofit
organizational forms, pension reform,
and social
safety
net reform
(so
that
enterprises
can shed the social services
they provided
under
Communism).
Study
of Russia
Another
highly complex subject, only
touched on in this
Article,
is the
timing
of different reforms.
Everything
cannot be done at
once,
and
sequencing
matters. For
example,
if
privatization precedes
law
and enforcement
capacity,
theft and
self-dealing
will be
rampant,
and the winners from
privatization
will further
corrupt
the
govern-
ment.99
Similarly,
land reform will do farmers little
good,
and
may
lead to wholesale transfer of farmland to well-connected
private
own-
ers,
unless small farms are
viable,
which
requires
the
supporting
in-
stitutions we discuss in Part III.H.
Initial conditions
strongly
affect both the needed reforms and their
sequencing. Russia,
for
example,
needed
agricultural
land reform and
therefore also needed its
precursors, including
distribution
system
reform.
Poland,
in
contrast, began
the transition with
private farming
well established.
Moreover,
farmers could
transport
their
goods
to
market themselves. Distribution
system
reform was
simply
not the
major
concern that it is in Russia.
Sequencing
has a
political
dimension as well. Russia's
rapid pri-
vatization,
in a weak institutional
environment,
created a new
oligar-
chy
that now
opposes
reforms that will limit their rents. At the same
time,
the confluence of
growing corruption,
extreme wealth for a
few,
and
poverty
for
many
fostered
public suspicion
of further reforms.
The confluence of
oligarch money
and
public suspicion complicates
and slows future reform efforts.
In the
early
1990s Russian reformers and their Western advis-
ors
hoped
that
rapid
mass
privatization
would be a fast reform that
would
invigorate
economic
growth.
Boris
Fedorov,
a reformer who was
briefly
Finance Minister in the
early 1990s,
describes Russia's micro-
economic reform
policy
as "the lack of micro-economic
policy
in
the usual sense of the word."'00
Hindsight
teaches that there is no
magic
bullet. There is
only
a
carefully executed, sensibly sequenced,
multipronged
reform
strategy.
Privatization is
only
one
component
of that overall
strategy.
At the core of that
strategy
is a
sustained,
multiheaded attack on
corruption.
This must involve an attack on the
preconditions
for
corruption, including underpaid
and
poorly paid
officials and
judges;
discretionary
enforcement
authority,
the
aggregate
license and
per-
99
Black,
Kraakman &
Tarassova,
(2000) (cited
in note
3).
For
an effort to discuss the
sequencing
of institutional
reform,
see Simon
Johnson,
John
McMillan &
Christopher Woodruff, Entrepreneurs
and the
Ordering of
Institutional
Reform-Poland, Slovakia, Romania, Russia,
and Ukraine
Compared,
8 Economics
of Transition 1
(2000).
100
Boris G.
Fedorov,
Macroeconomic
Policy
and Stabilization in
Russia,
in Anders
Aslund, ed.,
Russia's Economic
Transformation
In The 1990s 119
(Pinter
Publishers
Ltd.,
1998).
mit
burden,
oppressive taxation, high tariffs,
barriers to
competition,
organized crime,
and on and on and
on,
as well as a direct attack on
corrupt
individuals. For
us,
President Yeltsin's indifference to
corrup-
tion was the
single biggest
missed
opportunity early
in the Russian
transition. President Putin has attacked
corruption
in his
speeches,
but has not
yet
mounted the sustained
campaign
that is needed.
In such a
campaign, self-enforcing
laws that
suppress
both the
opportunity
and incentive for
corruption
are as
important
as direct
prosecution
of
corrupt
individuals. Free trade offers a
simple example.
Russia has
completed
some
important
new
laws,
but much more re-
mains to be done.
Competition
limits
rents,
and
accompanying oppor-
tunities for
corruption.
Freer trade fosters
competition, squeezes
out
corruption among
customs
officials,
fosters small business
develop-
ment,
and
spurs restructuring privatized enterprises.
Russia could
follow other transition countries like China and
Georgia
in
meeting
the conditions for WTO
membership. Georgia,
for
example,
is as cor-
rupt
as
Russia, yet
was able to
join
the WTO in
1999,
once
Georgian
President Eduard Shevardnadze decided that
membership
was
impor-
tant and insisted on the
necessary
internal reforms.?01 Russia has
yet
to
attempt
a similar action. President Putin
recently
reaffirmed Rus-
sia's
unwillingness
to decontrol domestic
energy prices,
a
precondi-
tion for WTO
membership.'02
Knowing
what not to do is
important too,
because the
political
energy
to
support
reform is a scarce resource.
Treating privatization
as a
top priority
can distract attention from other reforms
that,
should
precede
or at least
accompany privatization.
To take another
example,
Russia has
enough large companies
so that it needs a securities com-
mission to
regulate
them.
However, developing
a securities market
and securities commission in a
country
with few
public companies
is at best
pointless
and
likely counterproductive.
Yet U.S.-financed
advisors comtinue to
promote
this
strategy
in
many less-developed
countries.
In the late
1990s,
for
example,
U.S. advisors in Armenia
(where
Anna
Tarassova was
working
on commercial law reform at the
time) pro-
moted
public
stock markets for a
small, landlocked, desperately poor
country
that has
negligible
natural
resources,
no truck or rail access
to
neighboring
countries
(the
available truck and rail roads were dis-
rupted by
Armenia's war with
Azerbaijan
and Russia's war with Che-
101
The discussion of
Georgia
is based on the
personal knowledge
of Robert
Thorpe.
Georgian
President Shevardnadze created a
high-level
WTO accession
committee,
in-
cluding
ministers and heads of
government agencies
who had to
adopt
the
necessary
reforms. He made it clear that
uncooperative
ministers would be
replaced.
102
See
Jeanne Whalen,
Russia to
Keep Subsidizing
Oil
Industry, Despite
Please Ac-
tion Will
Likely
Prevent Nation
from Joining
WTO,
Wall Street
Journal, Aug. 30,
2002.
Study
of Russia
chnya),
where insiders had
stripped
most factories of all moveable
machinery
and sold it in
Turkey
or Russia. In
Ukraine,
the well-staffed
securities
commission,
with
only
a handful of
public companies
to
regulate, regulates nonpublic companies instead,
thus
contributing
to
the burden on small business. Armenia and Ukraine would be better
off,
for
now,
without a securities commission. Ukraine will need one
when it
privatizes
its
large enterprises,
but Armenia
(or Afghanistan)
won't need one
any
time soon.103
In the
end,
transition reform is a
long, hard,
multifaceted task. The
most
important
reform-a sustained
anti-corruption campaign-
is
perhaps
the hardest of all. Yet if decades of often failed efforts
to assist economic
growth
in
developing
countries have
taught
us
anything, they
have
taught
that if the
government
and
judiciary
are
thoroughly corrupt,
other efforts to
promote growth usually go
no-
where.104 So too, we
believe,
for transition. Institutions must come
first,
not second.
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Institutional Reform in Transition: A Case Study of Russia

Author(s): Bernard S. Black and Anna S. Tarassova

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