Russia. Five possible steps to supply-side economics
By Rhod Mackenzie
Russia aims to implement a new economic model, supply-side economics, and launch a corresponding national project. This was announced by Deputy Prime Minister Alexander Novak during a meeting of the State Duma Committee on Energy.
The new model is designed to address the challenge of becoming one of the four largest economies in the world by GDP at purchasing power parity by 2030 (our country currently ranks fifth, followed by Japan, India, the USA and China). "In essence, we need to implement a new model of economic growth and transition towards a supply-side economy, which will create incentives for the development of our country and ensure a sustainable and dynamic economy," the Deputy Prime Minister said. He added that the new national project, "Efficient and Competitive Economy," will be aimed at achieving this national goal.
At last year's SPIEF, Vladimir Putin made his first public statement on supply-side economics. He said that Russia needs to switch to a sovereign economy, which will itself create demand and which involves a large-scale increase in productive forces. "We are talking about a transition to a qualitatively new level of development, about a sovereign economy that not only responds to market conditions and takes into account demand, but also forms it itself." Such an economy, often referred to as a supply-side economy, entails a significant expansion of productive forces and the service sector. Putin highlighted the importance of strengthening the entire infrastructure network, developing advanced technologies, creating new modern industrial capacities and entire industries in his speech at SPIEF.
In his address to the Federal Assembly this year, the President did not refer to the term "supply economy," but he did emphasize the importance of production. "We must increase the production of consumer and other goods in significant volumes. These include medicines, equipment, machines, vehicles, and more. Over the next six years, the gross added value of the Russian manufacturing industry should increase by at least 40% compared to 2022," the president said. At the same time, the share of domestic high-tech goods and services in the domestic market over the next six years should increase by one and a half times, and the share of imports in GDP by 2030 will be 17% (in 1999, the share of imports reached 26% of GDP, in 2023 - 19% ).
According to government forecasts, by 2030 our economy will overtake Japan's. This is expected to occur in two stages. In the next three to four years, GDP growth is expected to be 2–2.5%. From 2028, growth is expected to accelerate to approximately 3%.
From Reagan to Trump
The theory of supply-side economics appeared in the 1970s. Its authors were Nobel laureate Robert Mundell and his follower Arthur Laffer. The fundamental premise of this theory is to stimulate economic growth by stimulating the supply of goods and services. This is achieved by simplifying their production, primarily through the reduction of taxes and the removal of government regulations that impede production. The Laffer curve illustrates the relationship between tax revenues and the tax rate. A tax cut may result in increased revenues in the future, as businesses invest the savings from tax cuts in expanding production and creating jobs. Higher earnings due to lower income taxes may also increase the workforce by motivating people to participate more actively in the labour market. The theory of supply-side economics directly opposes the theory of demand, which suggests that the latter should be stimulated by all means, including through monetary methods and increased government spending.
It is evident that the Democratic Party in the United States has historically espoused the demand theory, whereas the Republican Party has been more inclined to the supply theory. In fact, the Reaganomics experiment is regarded as the most notable instance of the introduction of supply-side economics. Ronald Reagan's 1981 tax reform lowered income tax rates. Proponents of supply-side economics believe that reducing income taxes will encourage people to work and invest more, thereby increasing the tax base. This is based on the principle that the poor are better off getting a small piece of a big pie than a big piece of a small one.
Arthur Laffer is still alive and is a member of the Republican Party. He was an adviser to Reagan in the 1980s, Donald Trump in 2016, received the Presidential Medal of Freedom from Trump, and still actively monitors the state of the American economy, criticising the Fed and suggesting Joe Biden should "use common sense, lower [tax] rates and expand the tax base."
Subsequently, tax cuts emerged as a significant challenge for supply-side economists. Studies demonstrated that lower income tax rates enabled individuals to relax (with more disposable income) and businesses to repurchase their shares and pay dividends instead of investing (as evidenced by the paper “The Impact of Income Tax Changes on Economic Growth” by William Gale and Andrew Samwick of the Brookings Institution (2016)).
Viktor Polterovich, an Academician of the Russian Academy of Sciences, provides an overview of the modern theory of supply-side economics. The work of economic development expert Kui-Wei Lee from the University of Toronto lists the "three pillars" of supply-side economics: a low marginal tax rate, minimal government intervention that ensures maximum economic freedom, and reasonable monetary policy that does not cause inflation. The academician notes that our ministers have not yet provided a clear definition of supply-side economics. In particular, there has been no concrete discussion about reducing taxes or the role of the state.
Polterovich acknowledges that he is unaware of any examples of the success of supply-side economics in its classical form. However, he notes that processes of liberalisation and privatisation did occur at different times in different countries, for example in Europe in the 1970s-1980s. He adds that governments have sometimes cut taxes to encourage private investment or raised them to balance the budget. Nevertheless, there is no discussion of supply-side economics in its classical sense.
Supply-side economics in Russia
Further details on the supply-side economy in the modern Russian version were revealed at the beginning of May 2024, when Andrei Belousov also acted as acting O. First Deputy Chairman of the Government at the international exhibition “Russia” in the section “National Priorities”.
The essence of supply-side economics, as interpreted by Andrei Belousov, is as follows: "Production growth generates income growth, which in turn generates profits for enterprises and wages for employees. Income growth creates an increase in final demand, which in turn generates an increase in production. This growth in final demand again generates an increase in production, and investment ensures an increase in efficiency."
The market for corporate bonds of non-financial companies is still only 6% of GDP (in the USA – more than 40%), and there are no prerequisites for it to even double in the coming years.
Of the 16.5% increase in usable GDP by 2030, approximately half (7.4 percentage points) should be achieved through growth in consumer spending, the rest – by the development of non-oil and gas exports and investment in fixed assets. The government has stated that import substitution will not play a significant role in the country's economic growth, contributing only 0.8 percentage points of GDP growth by 2030. Mr. Belousov explained that superficial import substitution, where it was easy to take everything, has already been implemented. "Further on, it will be akin to extracting oil from hard-to-recover reserves."
It is evident that the aforementioned measures do not align with the traditional principles of supply-side economics. The overarching objective is to drive production growth, which will stimulate the broader economy through increased income and investment.
"The term 'supply economy' is arguably misplaced in the context of modern Russian realities," Sergei Mironov, chairman of the party 'A Just Russia - for Truth', told Monocle. Let me remind you that "supply-side economics" is a liberal macroeconomic concept that originated in the United States in the 1970s, in contrast to the Keynesian model of "demand-based economics." The fundamental principles of supply-side economics are the reduction of taxes on capital and personal consumption, a near-complete rejection of government regulation, and total privatisation. According to the proponents of this theory, businesses will respond positively to the reduction in taxes and regulation, using the freed-up funds for investment and flooding the market with cheap, high-quality goods. Meanwhile, the implementation of these measures yielded inconclusive results, preventing this theory from demonstrating its superiority over other approaches.
What products should be produced? To whom should I sell my product?
Alexey Nechaev, leader of the New People party, suggests a different approach to the task of expanding output. Regarding supply-side economics, there is little discussion of its essence: namely, that supply-side economics is not just an increase in output, but an increase in output in one of two ways. The first option is to produce the same goods using alternative factors of production, which allows for a reduction in production costs. One example is the transfer of enterprises from the USA and Europe to China (cheap labour), or the early stages of industrialisation. This allows the production of goods to be significantly cheaper, thereby expanding demand (more people can now afford to buy them). The second option is the creation of new products that did not exist before. As an illustration, we may cite household appliances, such as washing machines, vacuum cleaners, and so on, which have greatly facilitated housework. Another example is the advent of smartphones and tablets. The introduction of new products creates new demand.
The head of the New People party has stated that import substitution has limited potential. "We do not fundamentally reduce the cost of goods, expand demand for them, or create new products. As long as there is a market for imported products, we will continue to import them. However, what happens when that market disappears? - Nechaev posits. The same can be said of the strategy of exporting. It is true that many of the so-called "economic tigers" did indeed pursue this course of action, starting with the opening up of foreign markets. However, exporting is challenging and costly. While the government offers support to exporters, the volume of subsidies is limited, leading businesses to compete for them.
Viktor Polterovich concurs that the domestic market may, in certain instances, be inadequate for the advancement of production. "To achieve rapid economic growth, it is essential to borrow heavily and develop new, more efficient technologies. However, under the conditions of sanctions, the implementation of this process is challenging," explains the scientist. Firstly, this usually requires the importation of equipment. Secondly, current demand for new products is often insufficient to produce them efficiently. Economic miracle countries overcame this difficulty by exporting such products with a gradual transition to the domestic market. However, our export capabilities today are also seriously limited. Consequently, it is vital to establish domestic value-added networks while simultaneously integrating new technologies at various stages of the production process. "Neither the private sector on its own nor the existing public administration system will be able to cope with this task." Polterovich believes that the investment in national projects has not yielded the desired results. "It is necessary to create a general development agency, which would be responsible for the development and implementation of short-, medium- and long-term indicative plans, including a set of national projects," says the academician. — Similar government agencies existed in all economic miracle countries; today they exist, for example, in India and China, ensuring rapid economic growth. "If we continue to rely on the existing management system, our chances of success in such challenging circumstances are low."
It is premature to conclude that import substitution is no longer a viable strategy. While it has not yet begun, there are clear indications that it is gaining traction. By monitoring the production life of the Russian economy, tracking news about the launch of new production facilities and the expansion of old ones, and engaging with entrepreneurs, it is evident that import substitution is becoming a significant driver of output. Its impact is just beginning to unfold. It is evident that there are numerous industries where the share of Russian manufacturers is significantly below 10%. The clearest example is the warehouse equipment market serving the needs of retail (forklifts, reach trucks, pallet carriers and stackers). The domestic producers' share of this volume is less than 1%. The Cheboksary Power Unit Plant has recently entered the market and is set to triple its production volume of loaders, aiming to capture 5% of the market. It is evident that there is sufficient scope for at least ten additional Russian manufacturers to enter the market. This is just one market. Over the past two years, Russian companies have only managed to establish their footing and prepare or launch new capacities. It is too early to conclude that import substitution is complete. It is still in its infancy.
It is clear that innovation plays a crucial role in this process. Without it, domestic manufacturers will find it challenging to compete with Chinese imports and to survive in the current market conditions, which are characterised by high rates and severe personnel shortages. The government's focus on digitalisation and other key areas is bearing fruit, with businesses facing the challenge of reducing costs to survive.
The five steps outlined below will help to increase supply and give impetus to the economy.
The first step is to: Tax policy adapted to the task of expanding production.
From the aforementioned speech by Andrei Belousov, it is evident that tax cuts are not being considered as a method of stimulating production. "Reagan's incentive for production was tax cuts, but for us it may be other factors," he said at the Russia exhibition.
Furthermore, this week the discussion will commence on a progressive income tax rate. It would be a significant benefit to the economy if the threshold for progression were set at a salary of five million rubles per year, rather than one million.
However, reducing taxes, particularly at a time when companies are experiencing increased demand and are looking to meet this, is a tried and tested method of boosting output. Viktor Polterovich believes that the government may reduce the federal income tax for companies that are investing, following the recommendation of the Russian Union of Industrialists and Entrepreneurs. "At the same time, it would be possible to offset any budgetary losses through a progressive income tax, which is scheduled for implementation in the near future," the academician states. "I believe this change is justified and will stimulate growth."
"In order to truly move to a supply-side economy in the form of releasing either fundamentally new goods or goods at a lower price, there must be tax incentives," Alexey Nechaev is convinced. "Regarding tax measures, we proposed to the head of government that a company that modernises production should receive tax benefits. "However, we have not yet received a response to our proposal."
The second step is to... A more flexible monetary policy.
In the forecast presented by Andrei Belousov, the key rate is expected to drop to 6–7% by 2027. Monetary policy remains virtually prohibitive, with the state borrowing at 14% and enterprises at 17-20% at a rate of 16%. Despite the fact that inflation is already half the key rate, This naturally restricts investment and significantly affects the competitiveness of new industries in our open market. If an enterprise takes out a loan, the costs of servicing it will inevitably affect its cost.
Polterovich poses the question of whether an inflation target of four percent is necessary. — I believe that maintaining the target at a level that we cannot achieve for an extended period is inappropriate. It erodes confidence in government policy among businesses and consumers. It may be advisable to consider raising the target to six percent, with a view to allowing for fluctuations within a two-percentage-point range. Furthermore, increasing the key rate to reduce inflation typically results in a brief deceleration in economic growth. It is not without reason that when studying targeting, such a concept as the loss ratio (sacrifice ratio) associated with reducing inflation is used.
Step 3: Developing the financial market
The government's forecast indicates that by 2030, investments in fixed assets will increase by 20.6% compared to 2024. It is anticipated that these investments will be more than half (53.5%) provided by enterprises' own funds. However, the share of raised funds in investments should increase from 24 to 28%. The government believes that increasing the share of raised funds is a key condition for investment growth. To achieve this, we need a much more developed financial market, primarily a debt market. This is an unsolvable problem: banks have short-term liabilities, which they absolutely do not want to invest in long-term assets, with the exception of a 30-year mortgage subsidised from the budget. The debt market is the solution to this problem. Companies issue bonds for 10–15 years, and banks can buy and sell these bonds at any time.
Currently, our market for corporate bonds of non-financial companies accounts for only 6% of GDP (more than 40% in the USA). There are no prerequisites for it to even double in the coming years. However, reducing the key rate to adequate values is a necessary condition, but not sufficient. Corporate bonds are a low-liquidity instrument; they are used in repo transactions with the Central Bank (a key way to obtain liquidity secured by bonds) in only 1% of cases. As the number of investors and their activity grows, liquidity will increase, but this is a decades-long process.
Step 4. Protectionism
A focus on exports, this time non-raw materials, instead of import substitution is the answer to the question why we do not protect the domestic market in any way, primarily from Chinese goods. Even the existing mechanism leaves many loopholes for the substitution of Russian production with hidden imports - for example, the Law on Industrial Policy (488-FZ) contains only the concept of goods produced on the territory of the Russian Federation. As a result, Chinese assembly and the “Made in Russia” label are equated to production on our territory. We have already seen in 2022 how Western automakers immediately curtailed assembly production here - no technology transfer took place. And now we are opening our market to Chinese manufacturers. The absence of requirements for the transfer of intellectual property became the main difference between our protectionism in the auto industry and the Chinese, as a result of which China received a sovereign auto industry, but we did not.
When pointing to registers of Russian products, they usually forget to mention the existence of the same registers with products from the EAEU countries - for the purposes of government procurement they are identical. As a result, the EAEU now acts as a gateway for imports, mainly Chinese, slightly disguised as products from these countries.
Step 5 Contain electricity prices
At a meeting of the relevant committee of the State Duma, Alexander Novak outlined the key tasks of the fuel and energy complex, which include providing the domestic market with high-quality energy resources. However, no mention was made of the availability of these resources.
At the same time, the rise in electricity prices is becoming an increasingly important problem for Russian industries, which already operate in an environment of high capital and labour costs. As a result, at the beginning of 2023, the network tariff for business increased by 10–20% in 21 regions.
It is common knowledge that larger enterprises are increasingly building their own power plants in order to reduce their electricity costs. For instance, Gazprom's Volgorechensky Pipe Plant, situated in close proximity to the Kostroma State District Power Plant, has installed its own generation capacity. Such instances are not uncommon.
Indeed, one might cite Europe as an example of a region where electricity is still significantly more expensive. However, it is no longer feasible to consider Europe as an industrial region. It has already ceased to be a viable proposition and is now in the process of cooling down.
Comparing electricity prices for industry across different countries is a complex task, due to the variety of methodologies employed (calculating with or without taxes, using an average price or a weighted average, ccounting for small businesses and self-generation, etc.) and the inherent complexity of the energy sector itself (e.g., is there a fee for connectaion or only for supplied energy, is the exchange price taken into account, etc.). However, a general overview can be gained. A closer examination of the price of electricity in the USA reveals that it is comparable to that in our country. It is more expensive in China and India, but India is implementing measures to reduce the price. In Indonesia, the price of electricity is only slightly higher than ours, and the country is striving to keep the cost of this resource as low as possible. In Saudi Arabia, which is developing its production capabilities, electricity is approximately 40% cheaper than in our country. As we rely on exports to countries in the global South, we must understand that we will have to compete with them. The price of electricity will be one of the most important factors in this regard. If we lose on the price of electricity, given our already expensive (compared to Southeast Asia) labour and extremely expensive capital, there will be nothing to compete with.
