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Russian Federation: Selected Issues Paper

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International Monetary Fund
Published Date:
September 2011
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V. Is Russia’s 2011–13 Budget Growth-Friendly?1

This chapter uses the IMF’s Global Integrated Monetary and Fiscal Model to examine the growth impact of the 2011–13 budget. It also examines an alternative package that would deliver the same amount of consolidation using growth-friendly instruments, and a more ambitious consolidation (“reform”) scenario, using the same instruments, to return the nonoil deficit to the government’s long-term target of 4.7 percent of GDP.

The model results suggest that the 2011–13 budget is unfriendly to growth as it relies mainly on increasing the payroll tax and cuts to government investment to achieve the planned consolidation. Were the government to rely instead (for example) entirely on cuts to transfers and government consumption, the same amount of consolidation could be achieved with a much smaller near-term output loss and a positive growth effect in the medium term. Finally, were the government to undertake a more ambitious consolidation (using growth-friendly instruments) to reach its long-term nonoil deficit target by 2015, there would be a positive impact on growth in the medium term.

A. Introduction

1. Russia implemented a massive (9 percent of GDP) fiscal expansion over 2007–09, which is being only partially reversed by the 2011–13 budget. Looking ahead, the composition of the fiscal consolidation in the 2011–13 budget is not supportive of long-term growth, as the budget adjustment relies mainly on an increase in the payroll tax and cuts in investment. The adverse impact of a higher payroll tax on the labor market would likely at least partially offset the positive effect of lower real interest rates from smaller deficits. Moreover, the current large nonoil fiscal deficit is incompatible with the government’s goals of economic modernization, macroeconomic stability, and fiscal sustainability. Accordingly, a reinvigoration of long-stalled public-sector reforms (including in pensions and health care) are called for to reduce the nonoil deficit to the government’s long-term target of 4.7 percent of GDP.

2. This chapter uses the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) to examine the growth impact of Russia’s 2011–13 budget. It also examines an alternative package that would deliver the same amount of consolidation using growth-friendly instruments, and a more ambitious consolidation (“reform”) scenario, using the same instruments, to return the nonoil deficit to the government’s long-term target.

B. The Model

3. This paper uses an annual six-country version of GIMF calibrated for Russia. The complete description of the model and the underlying theory can be found in Kumhof et al (2010); the main features relevant for fiscal consolidation can be summarized as follows.

  • The model is micro-founded with optimizing behavior by households and firms. Labor and capital supplies are endogenous in the model, allowing it to capture the impact of distortionary taxes and crowding out of private demand. In particular, government deficits crowd out private investment and net foreign assets in the long run and can lead to a higher real world interest rate, which is endogenous in GIMF.
  • There are two types of households, both of which consume final goods and supply labor. First, there are overlapping generations households with finite planning horizons as in Blanchard (1985). Second, there are liquidity-constrained consumers who do not have access to financial markets and who are consequently forced to consume their after tax income in every period. Both types of households experience a constant probability of death in each period and experience labor productivity that declines at a constant rate over their lifetimes. As a result, fiscal policies can have non-Ricardian effects (i.e. agents treat part of government debt as wealth, rather than realizing that higher (lower) future debt will be paid for via higher (lower) future taxes).
  • There are seven different instruments that can be used in GIMF for fiscal policy (Box 1). They are government consumption, government investment, consumption taxes, labor taxes, capital taxes, general transfer, and transfers to liquidity-constrained households.
  • There is a fiscal policy rule in the model that has two main functions. The first is to stabilize the government debt-to-GDP ratio, which eliminates the possibility of default and ensures dynamic stability. Second, the fiscal rule reacts as an automatic stabilizer to the business cycle to replicate the properties of the deficit in business cycles.
  • Credibility plays a very important role in the model (Box 2). Fiscal consolidation in general has a short-term contractionary effect through its direct impact on aggregate demand. At the same time, the reduction in the government deficit also stimulates private sector activities—particularly labor and investment decisions—by lowering future tax obligations and real interest rates. However, the magnitude of the expansionary effect of fiscal consolidation depends on whether agents believe the fiscal authority will follow through on its announced plans and there will be a sustained effect on the debt level. If agents perceive the consolidation as credible, they start to respond today to the future benefits of consolidation, for instance by raising consumption and investment, which will offset the drag on domestic demand from the fiscal consolidation. If agents perceive the consolidation as not credible, they expect that the improvement in the fiscal stance will be reversed in the future. In this case, agents will not respond to the positive side of fiscal consolidation until it becomes a fact, and the contractionary effect of fiscal consolidation will prevail in the short term.

Box 1.Fiscal Instruments in GIMF

There are seven fiscal instruments in GIMF that can be used to achieve fiscal consolidation.

Government investment. Government investment accumulates into a stock of public infrastructure (e.g. roads, schools, and health facilities) that affects the productivity of the domestic final good. A decrease in government investment will be harmful to growth as the productive capacity of the economy would be reduced.

Government consumption. Like government investment, government consumption accumulates into a stock of public durable goods (e.g. government employees and services, legal services, police, and school teachers) that affects the productivity of the domestic final good. However, the elasticity of aggregate output with respect to public durable goods is assumed to be much lower than for public infrastructure. As such, cuts to government consumption will not be as harmful to growth as cuts to government investment.

General transfers. In the model, these are lump-sum transfers (e.g. pensions) that are extracted directly from the budget constraint of both types of households based on their share of total consumption in the economy. Since the overlapping generations households have access to financial markets, they can adjust their labor and savings decisions in response to a cut in these transfers. Liquidity-constrained households cannot (see below). These transfers are considered to be non-distortionary since they do not directly affect the factors of production in the economy and as such, cutting them would be considered a growth-friendly way to achieve fiscal consolidation.

Transfers to liquidity-constrained households. These are transfers directly to liquidity-constrained consumers (e.g. social welfare programs). As liquidity constrained consumers consume their total income in each period, they respond to a cut in these transfers by an immediate reduction in consumption in the period when it occurs. The only offsetting reaction is a small increase in their labor supply (to try to earn extra income to offset the reduction in transfers).

Labor taxes. These taxes (e.g. payroll taxes, personal income taxes) affect the decisions of agents in the economy to supply labor. An increase in these taxes will induce agents to supply less labor, reducing the number of hours worked and thus, reducing the productive capacity of the economy.

Consumption taxes. These taxes (e.g. sales taxes, VAT, excises) are considered to be non-distortionary since they do not affect agents’ decisions to supply labor or capital.

Capital taxes. These taxes (e.g. corporate income tax) distort investment decisions. An increase in these taxes will lead to a fall in the level of investment and a reduction in the capital stock, which will reduce the productive capacity of the economy.

Box 2.The Role of Credibility in GIMF

The credibility of policies plays a very important role in the model. When policies are announced, households can either see them as immediately credible, only credible after some time has passed, or never credible. The extent to which policies are credible matters for their growth impact. For instance, fiscal consolidation in general has a short-term contractionary effect through its direct impact on aggregate demand. But when an announced fiscal consolidation is seen as immediately credible, the negative impact on growth will be ameliorated as market participants immediately expect that lower future real interest rates (from lower future overall deficits and debt stock) will lead to smaller primary deficits and create room for higher government spending or lower taxes, prompting them to smooth consumption and raise investment today, even before the full benefits of such policies are realized. Liquidity-constrained households do not have access to financial markets and cannot borrow to smooth consumption or investment, so their response to the announced fiscal consolidation is the same in both cases—that is, by reducing consumption if the level of transfers to these households is reduced, and increasing the number of hours of labor they supply to offset any income shortfalls.

C. The Growth Impact of the 2011–13 Budget and an Alternative Consolidation Package

4. The 2011–13 budget targets a reduction in the federal government primary nonoil deficit by 2.8 percent of GDP by 2013 (compared to the 2010 outturn), with nearly three-quarters of the consolidation coming from an increase in the payroll tax (from 26 percent to 34 percent, effective January 1, 2011) and cuts to the federal investment program.2 The remainder of the consolidation comes from reductions in government expenditures and transfers. Tables 1 and 2 below show the composition of the consolidation measures and how they are mapped into GIMF instruments.

Table 1:Consolidation measures in 2011-13 Budget
GIMF

Instrument

1/
Measure% GDPDetails
Revenue1.6
tau_lIncrease in payroll tax1.6Increase in payroll tax rate from 26 to
34% to finance pension fund
Expenditure0.7
govconsLabor compensation and payroll contribution0.9Planned 20% reduction in civil service,
but not backed by specific measures
govconsCompensation for works and services0.0
ignoreServicing of government (municipal) debt-0.5
govconsUnrequited transfers to entities0.4Includes subsidies to municipal and
private sector entities
govconsUnrequited transfers to budgets1.4Includes transfers to regional
governments
transferSocial security0.2
govinvInvestment0.4Cuts to federal investment program
govconsOther expenditures-2.1Includes undistributed items for 2012
and 2013
Total2.3
Total ex. interest increase2.8

GIMF instruments are: tau_l = labor tax; govcons = government consumption; govinv = government investment; transfer = general transfer

Source: Ministry of Finance and IMF Staff estimates

GIMF instruments are: tau_l = labor tax; govcons = government consumption; govinv = government investment; transfer = general transfer

Source: Ministry of Finance and IMF Staff estimates
Table 2:2011-13 Budget Consolidation Measures by GIMF Instrument(percent of GDP)
Share of total
2011201220133-year totalcondolidation
Labor tax1.6000.0000.0001.60057.0
Government consumption0.2540.0470.2860.58720.9
Government investment-0.2260.4360.2220.43215.4
General transfers0.134-0.0210.0770.1906.8
Total1.7620.4620.5852.809100.0
Memorandum items:
Federal nonoil primary deficit-10.5-10.0-9.52.8
Federal nonoil deficit-11.2-10.9-10.42.3
Source: Ministry of Finance and IMF Staff estimates
Source: Ministry of Finance and IMF Staff estimates

5. For the simulation of the growth effects of the 2011–13 budget, the instruments used are as follows:

  • Increase in labor tax. This is a direct mapping from the increase in the payroll tax.
  • Decrease in government consumption. The 2011–13 budget includes plans for a 20 percent reduction in the civil service, which contributes to a 0.9 percent of GDP reduction in the government’s wage bill. The budget also includes a reduction in subsidies to municipal and private sector entities (“unrequited transfers to entities” in the economic classification presentation of the budget) of 0.4 percent of GDP, which we have mapped into government consumption. Transfers to regional governments will be reduced by 1.4 percent of GDP, which is mapped into government consumption since we assume that regional governments will reduce their consumption by the same amount. Finally, the 2011–13 budget includes undistributed items in 2012 and 2013 which amount to a 2.1 percent of GDP increase in government consumption.3 The net impact of all these measures together is 0.6 percent of GDP over three years, or about one-fifth of the total consolidation.
  • Decrease in government investment. This is a direct mapping from the cuts to the federal investment program.4
  • Decrease in transfers. The decrease in transfers is a cut in social security expenditures, which we have assumed maps into a cut in general transfers.5

6. As the government intends to keep the 2011–13 budget measures in place in subsequent years as well, we model the adjustment in the overall deficit as permanent. As discussed above, credibility plays an important role in the assessment of fiscal policy efforts (text chart). We examine, as upper and lower bounds on the growth impact of the consolidation package, scenarios where the package is seen as credible immediately or credible only in 2014 (i.e., each year agents in the economy see the consolidation but expect it to be fully reversed the subsequent year, until the entire amount of the announced consolidation is in place at the end of 2013).

Impact of credibility on baseline package

7. The initial impact of the consolidation is contractionary, as one would expect. In the fully credible scenario, the near-term impact on growth is more muted than in the scenario where the package becomes credible in 2014, since agents are able to foresee the entire reduction in the deficit and adjust their decisions accordingly (e.g., by adjusting savings, investment, consumption, labor supply, etc). But since the adjustment relies mainly on growth-unfriendly instruments like the increase in the payroll tax and cuts in government investment (recall the discussion in Box 1), the negative effects on growth are not reversed in the medium term.

8. It is possible to construct an alternative scenario that delivers the same size and phasing as the 2011–13 budget, but uses more growth-friendly instruments. Indeed, the authorities have recently proposed to reduce, from 2012, the distortionary increase in the payroll tax that was introduced in the 2011 budget. In the alternative scenario modeled here, about three-quarters of the consolidation is achieved through cuts to transfers, with the remaining one-quarter coming from cuts to government consumption. If the package were seen as credible in 2014, the growth impact would be less negative than the baseline scenario in the short run, and would become positive in 2014 (see text chart). If the package is seen as immediately credible, there would be an instantaneous positive impact on growth.

Impact of credibility on alternative package

D. The Impact of Further Consolidation

9. Russia’s current federal government nonoil primary deficit is 8.4 percent of GDP above the government’s long-term target of 4.7 percent of GDP, which is consistent with fiscal sustainability and equitable intergenerational use of the oil wealth.6 To reduce the nonoil deficit to its long-term target by 2015, while relying on growth-friendly instruments to do so, the authorities could choose from a menu of the following measures that would yield more than the needed 8.4 percent of GDP in savings (Table 3):

Table 3.Potential Fiscal Savings
MeasureGIMF instrumentSavings (in percent of GDP)Notes
Gradually phase out poorly-targeted social assistance programstransfers1.0
Increase pension age to 65 for both men and womentransfers2.0-3.0Short-run savings would be lower
Reduce early pensionstransfers0.7
Reduce/eliminate tax expenditurestransfers (and tau_l, tau_k if applicable)< 4.0As noted by Finance Minister Kudrin in 2010. Excludes potential savings estimated by WB from unifying VAT rates and reducing VAT exemptions, reported separately below
Improve capital budgeting practicesgovinv0.4
Reduce wages as part of civil service reformgovcons0.9Already in 2011-13 budget
Further reduce subsidies to support public or private enterprisesgovcons1.3Originally part of crisis-related stimulus. Includes 0.4 percent of GDP already in 2011-13 budget
Improve efficiency of expenditures at regional levelgovcons1.1
Increase excise taxes on tobacco, alcohol and gasoline to average level in G20 countriestau_c0.7
Improve VAT tax administration, minimize VAT exemptions and reduced ratestau_c1.0
Total< 13.1-14.1
Source: Ministry of Finance, expert, IMF and World Bank estimates
Source: Ministry of Finance, expert, IMF and World Bank estimates
  • Further reduce transfers. World Bank (2011b) estimates that gradually phasing out poorly targeted social assistance programs could yield savings of 1 percent of GDP.7 Pension reforms to increase the pension age to 65 for both men and women could yield significant savings (2-3 percent of GDP, based on expert estimates, though these savings would mainly be realized in the long run. Hauner (2008) and Gurvich (2010) come to broadly similar conclusions). There also seems to be scope to reduce early pension payments (i.e. pensions paid to those who have not yet reached the legal retirement age). The Ministry of Health notes that the number of recipients of early pensions has now reached 34 percent of old-age pensioners and is continuing to grow.8 Potential savings from reducing such early pensions is on the order of 0.7 percent of GDP, based on estimates from the authorities. Further savings could be achieved by further elimination of tax expenditures (beyond the World Bank recommendation to minimize VAT exemptions and reduced rates). Current estimates by government officials put the cost of tax expenditures at 5 percent of GDP, so there is scope for significant savings if their use were curtailed.9
  • Improve the efficiency of government investment. World Bank (2011b) estimates that improving capital budgeting practices (e.g. introducing performance-based contracting in road maintenance and increasing competition in road maintenance contracts) could yield expenditure savings of nearly 0.5 percent of GDP.
  • Further reduce government consumption and improve efficiency. The government should maintain the currently planned cuts in government consumption, and further reduce subsidies to support public or private enterprises. World Bank (2011b) estimates that there is scope to reduce such subsidies by a further 0.9 percent of GDP, while improving the efficiency of expenditures at the regional level could yield savings of just over 1.0 percent of GDP.
  • Increase consumption taxes. The government should replace the lost revenue from the planned partial reversal of the distortionary increase in the payroll tax. For instance, excise taxes on tobacco, alcohol and gasoline could be increased to the average levels of G20 countries. VAT revenues could also be increased by improving tax administration, eliminating exemptions and unifying the reduced and standard rates at 18 percent. The World Bank (2011b) estimates that the combined impact of these measures would be 1.7 percent of GDP, which would more than offset the 1.6 percent of GDP generated by the increase in the payroll tax.

10. As a final scenario, we examine the effects of a front-loaded consolidation (“reform” scenario) of 8.4 percent relying on growth-friendly instruments (Table 4). Specifically, the reform scenario relies on reaching the government’s long-term nonoil deficit target by 2015. As in the alternative growth-friendly scenario above, the bulk of the consolidation (nearly three-quarters) is achieved through a reduction in transfers, with the remainder coming from a reduction in government consumption. As the consolidation is front-loaded, it builds credibility and quickly reduce current fiscal vulnerabilities (for instance, as recommended in IMF (2011, forthcoming)).

Table 4.Additional Budget Consolidation Measures by GIMF Instrument To Reach Nonoil Deficit Target(percent of GDP)
201120122013201420155-year totalShare of total

consolidation
Government consumption0.4710.5760.4980.2880.3672.226.2
General transfers1.3291.6241.4020.8121.0336.273.8
Total1.8002.2001.9001.1001.4008.4100.0
Source: IMF staff estimates
Source: IMF staff estimates

11. As in the baseline scenario, the credibility of the package matters greatly for the effects on growth (see text chart). In a scenario where the package is immediately credible, among other effects, agents perfectly foresee the reduction in interest rates that would follow such a consolidation and immediately increase consumption and investment which boosts growth. A more realistic assumption might be for agents to fully believe that the amount of consolidation they see each period is permanent (also called “earned credibility”). In this case, the initial contractionary effects of the consolidation package are muted (since the consolidation is front-loaded and agents perfectly foresee the benefits of the consolidation). In Russia, since the fiscal policy framework needs strengthening given where it is now, it is more likely that the authorities would have to build “credibility by doing”.10 In this case, agents see the consolidation as credible starting in 2013. The impact on growth is initially more negative than in the “earned credibility” case, but becomes positive in 2013 and converges to the “earned credibility” case subsequently. Last, if agents only believe that the consolidation package is credible once the entire package has been put in place (i.e., in 2016), the short-term contractionary growth effects are the largest. But even in this case, the impact on growth is positive once credibility has been achieved.

Impact of credibility on reform scenario

12. Compared to the baseline scenario, the reform scenario has a strongly positive impact on growth. This is as a result of the front-loaded and large adjustment undertaken, and the fact that the adjustment relies on growth-friendly instruments. Indeed, even when the government has to earn credibility (“credibility by doing”), there is a positive impact on growth already in 2013. The credibility of the fiscal authorities could be improved by strengthening the fiscal framework (see IMF (2011, forthcoming). This would lead to a virtuous circle where near-term fiscal vulnerabilities are reduced (as the overall deficit moves into surplus), and the positive effects on growth from the fiscal consolidation package could be realized sooner than if the framework were not strengthened.

E. Conclusions and Recommendations

13. The results of the model simulations suggest that the 2011–13 budget is unfriendly to growth. The simulations also suggest it would be possible to design an alternative package, using growth-friendly instruments, to achieve the same amount of consolidation as in the 2011–13 budget which would minimize the near-term drag on growth and have a positive impact on growth by 2014. Finally, the results of a reform scenario where the nonoil deficit is reduced to the government’s long-term target by 2015 suggest that, if this consolidation relied on growth-friendly instruments, was front-loaded, and accompanied by a strengthened fiscal policy framework, it could have a positive impact on growth as early as 2013. It is worth noting, however, that the credibility effects for the simulations presented here may be overstated, given the absence of a debt overhang in Russia. Moreover, expansionary fiscal contractions have become controversial lately—as noted in IMF (2010), the idea that fiscal austerity triggers faster growth in the short-term finds little support in the data. However, fiscal consolidation is likely to be beneficial over the long term as lower debt is likely to reduce real interest rates and the burden of interest payments, allowing for future cuts to distortionary taxes. These effects will likely crowd in investment and increase output in the long term.

14. Given these findings, IMF staff recommend the following:

  • The growth-unfriendly and distortionary increase in the payroll tax, as well as cuts to government investment should be replaced with growth-friendly alternatives such as decreases in general transfers, government consumption, or an increase in the consumption tax.
  • The fiscal framework should be strengthened to enhance the credibility of adjustment. As recommended in IMF (2011, forthcoming), this would include focusing on the nonoil deficit as the anchor for fiscal policy, avoiding excessive use of supplemental budgets, and replenishing the Reserve Fund.
  • The government should implement a more ambitious fiscal consolidation than planned in the 2011–13 budget to reduce the nonoil deficit to the government’s long-term target by 2015. If this were to be done credibly and using growth-friendly instruments, there could be a significant positive impact on growth already in the short-to-medium run.
Appendix I: Model Results

Russia: Russia 2011-13 Consolidation Package; Credible from 2014 Russia: Survey

Russia: Russia 2011-13 Consolidation Package; Credible immediately Russia: Survey

Russia: Russia 2011-13 Growth-Friendly Consolidation Package: Credible from 2014 Russia: Survey

Russia: Russia 2011-13 Growth-Friendly Consolidation Package: Credible immediately Russia: Survey

Russia: RUS 5-yr Consolidation to Reach Nonoil Deficit Target: Credible immediately Russia: Survey

Russia: RUS 5-yr Consolidation to Reach Nonoil Deficit Target: No Credibility Russia: Survey

Russia: RUS 5-yr Consolidation to Reach Nonoil Deficit Target: Earned Credibility Russia: Survey

Russia: RUS 5-yr Consolidation to Reach Nonoil Deficit Target: Fully credible from 3rd year Russia: Survey

References

    BlanchardOlivier (1985) “Debt, Deficits, and Finite HorizonsJournal of Political Economy Vol. 93 pp. 223247.

    GurvichEvseyThe Reform of 2010: Have the Long-Range Problems of the Pension System Been Solved?Zhurnal Novoy ekonomicheskoy assotsiatsii No. 62010.

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    HaunerDavid (2008) “Macroeconomic Effects of Pension Reform in RussiaIMF WP 08/201.

    IMF 2011 (2010) “World Economic Outlook: Recovery, Risk, and Rebalancing”.

    KlyuevVladimir and StephenSnudden (2011) “Effects of Fiscal Consolidation in the Czech RepublicIMF WP 11/65.

    KumhofMichael DougLaxton DirkMuir and SusannaMursula (2010) “The Global Integrated Monetary and Fiscal Model (GIMF)—Theoretical StructureIMF WP 10/34.

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    World Bank (2011a) “Social Expenditure and Fiscal Federalism in RussiaReport No. 54392-RU.

    World Bank (2011b) “Russia Public Expenditure ReviewReport No. 58836-RU.

1

Prepared by Charleen Gust with Daehaeng Kim. Thanks are due to Vladimir Klyuev and Stephen Snudden for graciously sharing the source code for the model shocks in Klyuev and Snudden (2011) and for helpful discussions, Oksana Dynnikova for invaluable assistance in mapping the 2011-13 budget, and Derek Anderson for providing technical assistance for TROLL.

2

Ideally, the general government nonoil primary balance should be used to assess the effect of fiscal policy on growth. However, as the budget for the general government is not available on an economic classification basis, we have used the second-best option of the federal government nonoil primary balance.

3

This also includes 0.5 percent of GDP to ensure that the total amount of consolidation over 2010-13 sums to the change in the nonoil deficit over this period.

4

Since government investment in Russia may not be as productive as in other countries as a result of inefficiencies in planning and implementation and weak governance, the model results may overstate the negative impact of the budgeted cut in investment. To fully realize the productive impact of government investment spending, Russia should improve public procurement processes and public financial management.

5

World Bank (2011a) notes that social assistance is not well-targeted to the poor and this is why we map the cut in social security into general transfers, rather than transfers to liquidity-constrained households.

6

As discussed in the previous chapter.

7

We model this in GIMF as a reduction in general transfers, given that they are not currently directed exclusively to liquidity-constrained households.

9

These are preliminary estimates and will need to be confirmed through a more rigorous inventory of tax expenditures, as planned by the authorities in the next few months. Until this data is available, tax expenditures (other than for VAT) are assumed to be coded as general transfers in the model. Once the data on tax expenditures becomes available, it will be possible to properly assign these as effective increases in the respective tax rate.

10

The term “fiscal policy framework” refers to the collection of rules and institutions that influence how the government sets its budget. See previous chapter for a discussion of the current fiscal policy framework in Russia and recommendations to improve it.

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