1. INTRODUCTION

Extensive use of barter and other noncash modes of payment, massive tax and wage arrears, growing mutual indebtedness in the enterprise sector--all of this is by now so familiar a part of the Russian economy that it is inescapable. The scale of demonetization in Russia today may be unprecedented in an industrial society. In 1997, more than 50% of all sales by industrial enterprises in Russia were nonmonetary.⁽²⁾ Over 40% of all taxes paid to the Russian federal government in 1997 were in made in nonmonetary form.⁽³⁾ The rate of demonetization of local and regional budgets is even higher.⁽⁴⁾ Nonpayment of wages and salaries is again on the rise. As of January 1, 1998, the average industrial worker was owed nearly two months' of back wages; in agriculture the average delay was 4.1 months.⁽⁵⁾

The conventional wisdom seems to be that this is a situation out of control. Inter-enterprise debt and tax arrears, one typical description goes, have combined to form a "vicious circle of bad debt, heavy borrowing and high interest rates which is choking off economic growth."⁽⁶⁾ The implication of the article from which this quote is taken, and others like it, is that the barter-and-arrears economy is a morass that sucks in innocent victims and ultimately threatens their ruin, or at least holds them back from achieving economic success.

The purpose of this paper is to argue that just the opposite is the case. We believe that economic performance in Russia is clouded by the existence of a virtual economy. The virtual economy is the result of a pretense that the Russian economy is much larger than it really is. The pretense that more value is produced than is actually the case is the cause of many of the puzzling phenomena in Russia today. The virtual economy, we believe, is a fairly well-organized system. Rather than being victims, its participants--which include not only enterprises, but also workers and governments--are largely willing players. And rather than representing a threat to them, it is the virtual economy that is their only hope for survival.⁽⁷⁾

To make our case, we present a very simple model of the virtual economy that we believe captures the essence of what is happening in Russia today. In a companion paper to this one, we analyzed the microeconomics of the typical Russian enterprise in the transition, as it chooses whether or not to restructure. There, we emphasized the role of the enterprise's endowment at the beginning of transition, not only of physical and human capital, but also of "relational capital," or contacts and connections with government officials and other enterprise directors. We showed that the possibility of using relational capital allows enterprises to survive without restructuring.⁽⁸⁾

In this paper, we step back and examine how the enterprise making this decision fits into the bigger economic system that characterizes the virtual economy. We believe that the stylized model we present below not only captures some of the most salient and unique features of the contemporary Russian economy, but it also provides a convenient framework to discuss the implications for two of the other sectors, in addition to the enterprise sector, that make up the virtual economy: the household sector and the government sector.⁽⁹⁾
 
 

ROOTS OF THE VIRTUAL ECONOMY

The roots of the virtual economy lie in the largely unreformed industrial sector inherited from the Soviet period. At the heart of the phenomenon are the large number of enterprises that still produce goods but destroy value. An enterprise destroys value when the value of inputs purchased from other enterprises exceeds the value of the output that is produced.⁽¹⁰⁾

To understand the phenomenon of value destruction it is important to begin with Soviet pricing. Raw material inputs were underpriced in the Soviet economy. Their prices were based on the operating costs of extraction, ignoring rent (that is, disregarding the opportunity cost of using the resources now rather than in the future). No doubt this harmonized with the goal of increasing production today; scarcity pricing might have induced more conservation, which mitigates against maximizing current production. This bias in raw material prices fed into the system of industrial prices. Heavy consumers of energy were, in effect, subsidized. So too were heavy users of capital, thanks to the absence of interest charges. In short, costs of production were calculated on the basis of an incomplete enumeration of costs.

In addition to incomplete cost-based pricing, the system was biased towards certain users. The same commodity would carry a different price if it were used by heavy industry or light industry. This would then feed into the calculation of costs of production of these goods, so that high priority sectors would appear to have lower costs of production than low priority sectors. This meant that the apparent distribution of productivities at the onset of transition, what we may think are efficient sectors, was liable to mask the true picture.⁽¹¹⁾

The fact that the pricing system disguised the relative efficiency of various activities means that only with economic liberalization would the true viability of these activities become apparent. Many sectors that appeared to be creating value turned out to be destroying value once prices moved to reflect costs. The extent to which the Soviet economy produced the "wrong things in the wrong way" could only be gauged after liberalization. This effect was magnified by the move to world prices.⁽¹²⁾ Many industrial enterprises could not cover costs once prices moved to market-clearing levels. Raising prices only led to unsold output. Price liberalization revealed the extent to which value added in the Soviet economy was really created in the energy and raw materials sector, but it had the effect of making reform appear to be the destroyer of the manufacturing sector.

How could a value-destroying sector survive six years of market reform? The reasons are complex, but the most important is that in Russia today enterprises can operate without paying their bills. This is possible because value is redistributed to them from other sectors of the economy. One way this is done is through tax arrears, which are in effect the continuation of budget subsidies in a different form. More important, however, is direct redistribution of value to value-subtractors from the value-producing sectors of the economy, primarily the resources sector.

It is important to understand the continuity with the past that is involved here. The Soviet economy appeared to be a large industrial economy. In fact, industry in the Soviet economy was subsidized by under-priced raw materials and insufficient charges for capital. The economy appeared to have a large manufacturing sector that produced value; in fact, large parts of the manufacturing sector destroyed value, but this was masked by arbitrary pricing.⁽¹³⁾ The roots of the virtual economy lie in the maintenance of this pretense.
 
 

A SIMPLE ACCOUNTING MODEL

We analyze the operation of the virtual economy by studying a simple static accounting model. The purpose is twofold. First, this model allows us to see how the parts of the economy interact. Second, the model demonstrates how the virtual economy masks the true state of affairs.

The model is highly stylized. There are four sectors:

H ("HOUSEHOLDS")

G (a value-adding industrial sector, "GAZPROM")⁽¹⁴⁾

M (a value-subtracting industrial sector, "MANUFACTURERS")

B (a government sector, "BUDGETS")

The household sector (H) supplies labor and is the ultimate recipient of income. The government sector (B) collects taxes and distributes the proceeds in transfers. We assume, for simplicity, that it transfers all tax revenue to the household sector.⁽¹⁵⁾ There are two sectors of industry in our model: a resource-producing sector (G), whose output is used as an input for a final goods producer (M).⁽¹⁶⁾
 
 

3.1 PRODUCTION

We assume that G and H each produce 100 rubles of output (gas and labor) at no cost. Gas is used as an intermediate good in the production of M, which also uses the labor supplied by H. M's product has a market value of 100. In other words, M is a value-subtractor.⁽¹⁷⁾ We can illustrate the real flows in this economy with a schematic diagram (Figure 1).

We assume that all agents in this economy attempt to meet their obligations. No one conceals income. Thus, for example, M contracts to pay G and H the market value of the inputs (gas and labor) which they supply. All accounting (between enterprises and for tax purposes) is on the accrual basis--i.e., income and expense items are recognized as incurred, regardless of when they are actually paid.

The household sector requires a minimum of 100 in cash to survive. This is the only cash requirement in the system. The output of M can be sold for cash at any time, at its market value.

3.2 FISCAL CONSIDERATIONS

We make the simplest possible assumption with respect to the budget: all revenues are simply transferred to households.⁽¹⁸⁾ The budget collects revenue from the production sectors; there is no income tax in the model. The only tax in the economy is a value-added tax levied at a rate of 100%. B is obligated to transfer all taxes collected to H but cannot borrow. Unmet budget expenditure obligations will be considered budget arrears to H.

4. THE "VIRTUAL ECONOMY", OR WHAT APPEARS TO HAPPEN WHEN EVERYONE PRETENDS M'S OUTPUT IS WORTH 300

We now examine how this economy appears when virtual prices rather than actual market prices are used to value output. Specifically, we assume that M prices its output at 300 rather than 100.⁽¹⁹⁾ G and B accept this valuation. For now we treat the willingness of G and B to accept M's overpricing as an assumption, but clearly this is an essential point to be explained. To more clearly follow the transactions involved in this economy, let us assume that the inputs (gas and labor) are supplied to M and production occurs before any financial settlements are made.

An important consequence of virtual pricing is that it therefore appears, contrary to reality, that M is a value-adder. As the output (cash value of 100; "virtually" priced at 300) sits at M, waiting to be shipped out, the following claims prevail among the sectors:

These claims and obligations are the amounts each sector expects to pay and expects to receive. The crucial point, however, is that there are insufficient resources to meet all these obligations. All that is available in terms of value are goods (the output of M) worth 100 in cash if sold outside the system (exported or domestic sales), but nominally priced at 300 for transactions between M, G, and B. Hence, we must now examine how financial settlements are made in the virtual economy.
 
 
 
 

4.2 THE FINANCIAL SETTLEMENT STAGE IN THE VIRTUAL ECONOMY

To follow the settlements more clearly, we take each sector in turn.

We begin with sector M. Notice that because of virtual pricing M is no earning profits, so it has acquired an obligation to the budget. It now has 300 worth of claims, equal to the 300 virtual value of its output. Let us assume that the manufacturing sector allocates its output equally among all three sectors to which it has debts. That is, it allocates output virtually priced at 100 rubles to each of G, B, and H. If the virtual prices are accepted by G and B, this settles M's debt of 100 to G for gas deliveries, and 100 to B for tax payments. How about the wages of 100 which M owes to its workers? Although there are frequent cases of workers being paid in kind in Russia today, we assume initially that the workers in this model must receive wages in cash. Hence, M sells one-third of its output for cash to pay wages. Because the market value of M's output is 1/3 of its virtual value this means that workers receive cash wages of only 33. Thus M settles its accounts with G and B, but it ends up with wage arrears to H of 67.

G's settlement is straightforward. G takes the 100 (virtually priced) units of output it received from M and remits it to B as its tax payment in full. Because B credits G's tax obligations in full, at the virtual value, G does not suffer from M's over-pricing. Since G has no direct dealings with H, G's accounts are balanced.

What about the budget sector? B has now received 100 (virtual) in goods from M and 100 (virtual) in goods from G. Together, these have a cash value of 67, which B realizes and transfers to H. As a result, B's accounts with M and G are balanced. But B owes H 133.

Finally, households have received a total of 100: 33 from M, and 67 from B. H is still owed 67 by M and owed 33 by B in budget transfers.
 
 

4.3 COMMENTS

When all is settled, H has received a total of 100, which was assumed to be its minimal survival requirement. This means that from the households' standpoint, the system is viable, and that it can thus start again for another round. Of course, the minimum survival requirement in our model was arbitrarily set. In real life it is not. It is the minimum amount of cash needed for H to survive. It determines the "cash constraint" for the system." There are interesting alternative ways to think of the cash constraint. We could, for instance, have set the household survival requirement higher than 100. This would force the households to earn some cash outside the system in order to survive. Or we could have kept the same 100 minimum for H and allowed outside earnings to lower the cash requirement inside the system. Such an arrangement could be thought of as an implicit contract between M and H to allow outside earnings on job time, for example.

In this version of the model, it is only the total of income received by H that matters. This implicitly assumes that the household sector will redistribute amounts received in the form of wages and pensions to ensure survival of all members of H. A complicating condition would be to allow B to choose to fulfill part of its expenditure obligations in the form of in-kind transfers. It would then pass on some of M's output in natural form to H as budget spending (say, as hospital linens or subway construction...). This would complicate matters, since H could not easily reallocate those transfers within H.

The virtual economy operates because of three key conditions. First, and most important, G pumps value-added into the system. The rest of the economy just redistributes G's 100, ultimately to H. Of course, in the actual economy the lines between the value-adding and value-destroying sectors are more blurry. Conceptually, however, what matters is that there is a value pump that is operating to support the rest of the economy.

The second key condition for the operation of the virtual economy is that both G and B accept M's overpricing of its output at 300 rather than 100. This means that they underwrite M's pretense that it is a value-adding operation. Of course they will only accept this pretense if it is in their own interest to do so. We have already seen that G will play along if it can use the inflated value of output to pay taxes.⁽²⁰⁾

As for B the issue is more complex. Certainly budget authorities would in general prefer taxes paid in cash rather than in goods with inflated prices. It is frequently the case, however, that governments are faced with accepting taxes in kind or not collecting at all. Faced with this choice offsets are typically accepted; some tax receipts are better than none. But this is not the whole story.

Offsets often arise out of a conflict between different agencies of government or between different levels of government. That is, with not enough value to go around, offsets (payment of taxes in kind) may serve the purpose of "tying" budget receipts to one particular recipient to the exclusion of others. Take, for instance, the case of a conflict between ministries. When the Ministry of Finance restricts the budgets of important ministries (e.g., defense, Minatom), rather than reduce purchases the ministries continue to order output but are unable to pay. These debts are then canceled in lieu of the tax obligation of the enterprise. Tax offsets thus become a means for one particular agency of the government to continue to acquire output when there is insufficient revenue to support the expenditure of all.⁽²¹⁾

The third key condition is that there has to be a buyer outside the system who supplies cash by buying some of M's output--enough for M to meet its cash constraint--at the market price. That is, the system is not self-contained.

4.4. THE REAL ECONOMY: NO ONE PRETENDS THAT M'S OUTPUT IS WORTH MORE THAN 100

This section compares the apparent outcome of the virtual economy to what is really happening beneath the pretense. All that is necessary is to assume that no one, including M, pretends that M's output is worth anything other than the 100 it actually is worth. Note that we are not examining the equilibrium adjustment of the system to the elimination of value destruction. Rather, we simply account for the actual value of the flows in the system.

Again it is useful to begin with M. Because the value of its output is really only 100, in a non-virtual economy M would have to report a loss of 100 instead of a profit of 100. It therefore would have no tax obligation. With sales revenue of only 100, M could not pay both G (to whom it owes 100 for gas) and H (to whom it owes wages of 100). It would have to apportion the 100 it does have between them.

The simplest assumption to make is that M pays equal shares to each of its creditors, that is, 50 to H and 50 to G. This leaves M with wage arrears of 50 to H and inter-enterprise arrears of 50 to G. Of course, these arrears numbers are arbitrary, depending on how M pays its bills. It is important to note that, however, M's payments are apportioned, the sum of payments will equal 100, as will the sum of the arrears.

Turning to the remaining sectors, G remits to B the 50 it receives from M. Since on a accrual basis G owes B a total of 100 in VAT, this leaves G with tax arrears of 50. B's only revenues are what it receives from G, since M has produced no value added and thus owes no taxes. B transfers to H the 50 it received from G. B still has budget arrears of 50. H survives because it receives 100 (50 from M and 50 from B).

It is important to recognize that these proportions could be changed, depending on how M initially allots fulfillment of its obligations to G and H. Again, H always receives 100. Whatever M pays to G will eventually be passed on, via B, to H.
 
 

5. COMPARATIVE MACRO INDICATORS, VIRTUAL AND REAL:

It is interesting to compare how the economy appears to be performing in the virtual economy regime with how it is actually performing according to the underlying reality, as we do in Table 1.⁽²²⁾ This provides some perspective as to why agents may prefer the virtual economy. Examining the results in Table 1, we obtain a surprising result: On nearly all counts, the virtual economy's aggregate performance indicators (sales, profits, GDP, output) are going to look better than the real economy's.

First, consider the budget. The planned budget in the real variant is only half the size that it is in the virtual variant. What does that mean? The larger virtual budget is accompanied by larger arrears in relation to planned budget outlays. Households are, in fact, no better off in the virtual economy. But moving to the real economy means that (nominal) pensions are cut by 50%. Of course, in practice total household income is the same in both variants, because value added actually produced is identical. In reality, nothing changes as we move from the real to the virtual economy. But the pretense is what counts. In moving from the virtual to the real variant, the perception will be: "You cut pensions in half!"

Turning to arrears, we have already noted that the arrears picture will depend on the decision by M of how to allocate payments between H and G. It was assumed above that each received half of the cash value of M's product. In the general case, let the proportion used for H's wage payments be "w." Then G will receive "100-w". Final household income is always 100 (since that is still the total product that can be allocated). The wage arrears will be offset by budget arrears, since what is paid to G (and passed through B to H) could always be paid directly to H in wages. The greater the share of M's product paid directly to H in wages, the greater the amount of total arrears and the greater the number sectors that have arrears of one kind or the other. This is evident from Table 2.

In the virtual variant, arrears problems exist between M and H ("wage arrears") and between B and H ("pension arrears"). In the worst real variant, there are now two qualitatively new kinds of arrears problems between G and M ("inter-enterprise arrears") and between G and B ("tax arrears").

Finally, of course, the virtual economy masks the non-viability of M. In the virtual economy, M appears to add value of 100. In the real variant, M is a clear loss-maker. Therefore, any attempt to shift from the pretend virtual world to the honest real world would be very unpopular. It would mean slashing pensions, irritating Gazprom by branding it as a tax delinquent and demanding more cash taxes from it, and threatening the bankruptcy of the manufacturing enterprise and complete loss of jobs and wages for the population.

6.   WHY DO THE SECTORS PARTICIPATE IN THE SYSTEM?

The comparison between the virtual and real variants shows the incentives for the sectors to continue to hide the underlying reality once they are in this system. But the question is, why be in it at all? We consider the position of each sector in turn.

The motives of the M sector are the most obvious. If it were not in this system, it would likely be out of business altogether. It is a value-subtracting enterprise. The director presumably gains utility from his position. He will prefer to stay in an enterprise that everyone pretends is successful than to concede failure. It is the survival motive which is the key motivating factor of enterprises in the M sector, and this is critical to the operation of the virtual economy.⁽²³⁾

The household sector is not being fully compensated for the labor it supplies to M. It might therefore appear that it is supplying net value-added to the system (like G). Why does it then participate? The important point to remember is that H is also receiving payments from B. In total, it is being compensated for the labor it supplies to the system. If the system were to break down, H would be unemployed. The key question for households concerns the alternative jobs that are available: Can members of H earn more than 100 elsewhere, net of adjustment costs? Unless H believes it can be employed outside the system (in the "new" economy), it will remain in the system.⁽²⁴⁾

Gazprom's reasons for remaining in the virtual economy are more complex. G is the net supplier of value-added to the system. In our example, it would be no better off outside the system because we assume that in any case it would have to pay VAT at a rate of 100% if it exported the 100 rubles worth of gas that it now supplies to M. But this assumption is made only for convenience. The question thus remains, why does G stay inside the system?

The fundamental reason why G continues to play is that it is able to keep some of its earnings. To use the term we will discuss in more detail below, some of the value is permitted to leak out from the system into the pockets of G's owners. This leakage is sanctioned as a side payment to keep G pumping value into the system. In the case of Gazprom it involves allowing it to keep export earnings. In a sense, sustaining the virtual economy involves a sharing of the value produced by G. To better understand that, it is worthwhile considering Gazprom's place in the Russian economy.
 
 

6.1 THE PRIVATIZATION LOTTERY

As explained in Section 2, above, the Soviet economy was characterized by value creation in the resource sector and value destruction in industry. The preferences of the leadership were biased towards defense and industry, however, and it was important that it appear that these sectors were producing value. The price system was adjusted accordingly. Because all property was state-owned the returns to specific assets were irrelevant. Hence, arbitrary pricing resulted in artificial returns to activities in the Soviet economy.

Because values were redistributed according to these preferences, and because the true nature of production was distorted from view, agents had little idea of their true value in a market economy.⁽²⁵⁾ But agents derived their social identity, and sense of self-worth, from their position in the Soviet economy.

Privatization in Russia involved demarcating assets into specific bundles and assigning ownership to them. In a market economy these assets would have different values than in the Soviet economy. This is the essence of market reform, to improve the allocation of resources and make apparent the true value of resources. But because the agents in the economy could have little idea of the market value of their assets, human or physical, in the vastly different economy of market reform, privatization in Russia was tantamount to giving agents a lottery ticket.

The outcome of the lottery, to simplify a bit, was that Gazprom was the winning ticket. This is not surprising because we know that the resource sector was the value producing sector in the Soviet economy. Now suppose that after the privatization lottery, property rights are completely enforced and that the government absents itself from the issue of distribution. Then shareholders of Gazprom would have valuable assets, and all other agents would hold assets with no market value. Call this the lottery distribution, L.

We can consider an alternative to the L-distribution. Suppose that Gazprom is broken up rather than privatized, and that the assets are equally distributed to all citizens. Call this the E-distribution. This presents the extreme opposite case to the L-distribution.

What happens when agents are unwilling to accept the L-distribution? There is no unique way to understand how assets should be redistributed from the Soviet regime. Russia is a democracy, so we would expect this to be a political issue. But if we assume that there exists some minimally acceptable level of inequity among the Russian population, it follows that there will be limits on how much value owners of Gazprom can obtain. As a result, there has to be a mechanism to redistribute some of the value produced by Gazprom among the other lottery-ticket holders.

This means that we have yet another important way to conceptualize the meaning of the virtual economy: It is a way of making Russia's privatization lottery more equitable. It is a means of paying off on more tickets. The redistribution of G's value makes other tickets have positive, rather than zero, value. It is the outcome of a bargaining game between agents in the economy over the value of the lottery tickets. The reason that this game is played is because it is politically impossible to enforce the L-distribution in a democracy in which equity norms differ substantially from those of the L-distribution. Consequently, Gazprom must pay off other parts of society to retain its share of the value that is produced. This bargain determines where the economy ends up between the L-distribution and the E-distribution. But because the L-distribution reflects the market value of the assets, redistribution of value in the virtual economy represents the postponement of reform.
 
 

7. LEAKAGE

So far we have considered the virtual economy as a closed system. Value is pumped in by G to be redistributed within the system, with part of that value being destroyed by M in the process. But there is another way the system can lose value. Value may "leak" out.

Leakage from the virtual economy takes several forms. It can be legal or illegal, sanctioned or unsanctioned. The value that leaks out may stay inside the country or may be transferred abroad (capital flight). The most important distinction, however, is whether the leakage is good for the system or bad for it. Good leakage can be thought of as a necessary cost of keeping some participants in the game. That would be one way of thinking about the role of Gazprom. In our example, Gazprom contributes all of the value it produces to the system. As a privatized company one would assume that its owners would prefer to export all the gas for hard currency.⁽²⁶⁾ But this is politically impossible. In practice, Gazprom is allowed to siphon off (and pocket) a certain share as payment to keep it performing its role in the system.

While some leakage is thus good for the virtual economy because it makes the system work (like the Gazprom cut), other leakage is damaging (like the theft of wage funds by an enterprise director, which makes it more difficult to meet the cash constraint, or a manager's diversion of cash from taxes). Viewed in the context of leakage, the relationship between corruption and economic reform takes on greater complexity. Reducing corruption is typically considered a key element in accelerating economic reform. In Russia's virtual economy, the opposite may in fact be the case. If reducing corruption results in less leakage from the system, more value remains to support the continued operation of loss-making enterprises.
 
 

7.1 "A TAX CRACKDOWN": THE GOVERNMENT REFUSES TO ACCEPT THE OVERPRICING OF M'S OUTPUT
 
 

Anti-corruption is not the only intended reform goal that becomes complicated by the virtual economy. Tax reform is even worse. Nonpayment of taxes may result from two causes. The first is the nature of the virtual economy itself, which makes some nonpayment of taxes almost inevitable. The second is connected to leakage.

In the pure virtual economy, there are no tax arrears. (Cf. Table 1.) But as soon as the government demands that the virtual economy participants pay some taxes in cash, there will almost inevitably be tax arrears even if, as the model assumes, no one actually evades taxes.⁽²⁷⁾ To begin to understand the complexity of tax reform in the virtual economy, we examine, in this section, the implications of a "tax crackdown" by the government, i.e., a campaign to try and secure more cash to the budget. This turns out to be an intermediate variant between the virtual variant first described and the underlying real process. In the end it would likely be perceived by the virtual economy's participants as worse than both.

To see this, assume now the government decides it does not want to continue to accept tax offsets/barter payments. M continues to price its output at 300 and G accepts that price. M therefore delivers one-third of its output (virtual value 100) to G. As in the original scheme, M pays H the cash value of one-third of its output, i.e. 33. M's arrears to H are 67.

The key difference is that now B refuses to accept G's and M's offer to each remit 100 (virtual value) worth of M's output as tax payments. B demands that they remit their taxes in cash. M still has a tax obligation of 100, since it continues to price its output at 300. It remits 33 in cash and has tax arrears of 67. G will also remit 33 in cash and have tax arrears of 67. In the end, the tax crackdown variant will be the same as the real variant except that in addition to all the aforementioned problems, M, too, will have a tax arrears problem. In other words, this is worse in this respect than the real variant.

The situation will also appear to be worse than in the pure virtual economy. After the tax crackdown, the wage arrears remain the same (67). The cash value of tax revenues to the budget is the same (67). The budget arrears to H are the same (133). But now there is a major new problem which did not exist at all in the virtual economy: tax arrears. Both producers in the system, the value-adder G and the value-subtractor M, are declared to be tax delinquents. This despite the fact that the point was to improve tax discipline!

Of course, if the cash tax collection policy is pursued vigorously enough, the likely outcome is that the budget actually will collect more value from M, but only because M pays less to either G or H, or both, in order to have more cash to deliver to B. This means either increased wage arrears, or increased debts to G on the part of M, or both. This is precisely what happened in the Russian economy in the first quarter of 1998.⁽²⁸⁾ Once again, the outcome is completely predictable as long as one keeps in the mind that the cash tax collection campaign did nothing to change the fundamental fact of the virtual economy: There is still not enough value being created to meet all the claims. The tax crackdown just temporarily shifts the flow of value relatively away from G and H and toward B.

The remarks above related to the tax crackdown's effect on M. The impact on G may be quite different. If G is earning additional cash on the side (that is, outside the virtual economy, as a form of ), the government's demand that G pay more cash will be tantamount to changing the rules for G's participation in the system: it will be the same as raising the net contribution that G makes. This could be accomplished, but presumably only if the government had a credible threat of punishment or retaliation if G failed to go along (for instance, dispossessing the current owners, whether through "nationalization" or "privatization").

Of course, the idea with the crackdown may be that by forcing G and M to pay cash to the budget, this will force G in turn to refuse to accept the inflated price of M's output--i.e., to impose the full real variant. If so, that would have even worse political consequences, including the possible bankruptcy of M. To avoid this consequence, G only has to tolerate M's arrears (possibly by borrowing money outside the system).⁽²⁹⁾
 
 

8. THE ROAD TO RUIN

Our goal in this paper was to develop a simple model of the virtual economy. The essence of the virtual economy stems from two factors: (1) An important share of the economy is not creating value, but destroying it, and (2 ) most of the participants in the system pretend this is not happening. Value-subtraction and pretense are core elements of this peculiar system. The result of these elements are the phenomena that draw most attention: barter, veksels, and tax offsets. But these phenomena are merely mechanisms to make the virtual economy operate.

It is especially important to underscore the role of pretense. Because of the pretense that there is more value being produced than there actually is, there are exaggerated claims on the value that is produced. The pretense is the root cause of the nonpayments difficulties that plague Russia. There is less value produced than there are claims on it. In particular, this is the problem of Russia's budgets. The apparent low rate of tax collection on the revenue side and the failure of the government to meet its spending obligations on the outlays side, most notably the unpaid wages and pensions, both result.

In our simple model the virtual economy can continue to reproduce indefinitely. The system appears to be self-sustaining, as long as Gazprom continues to pump value into the system. Of course Gazprom is not the only value producing sector in the economy. New private enterprise is also a value creating sector. But it is critical to note that new private enterprise is not independent of the virtual economy. The continual need for cash of the virtual economy is an inhibiting factor to the development of the new private sector. Taxation falls heaviest on this sector which cannot pay taxes via tax offsets and other machinations. Because the virtual economy needs an infusion of value to survive it acts as a check on the potential of the private sector to grow. A functioning private sector is needed as a source of cash and value, but its potential is circumscribed by the pressure that comes from the virtual economy.

A key element of the virtual economy is the continued existence of a value-destroying sector. The distinction between value creation and value destruction is fraught with confusion. Hence it is useful to discuss the issue.

The most basic notion of value destroying activity (negative value added) is that the market value of the purchased resources used to produce output exceeds the market value of the output itself. Because value added is the difference between the market value of output and the market value of purchased inputs, when this difference is negative it means that the enterprise adds negative value to these resources. In such cases, the enterprise has transformed the inputs in a manner that actually makes them worth less than what was started with.

It is important to note that value destruction does not mean that the products are without value. An enterprise may produce a useful product and destroy value; value destruction means that the purchased input costs of producing the product exceed the market price. This is important to keep in mind, especially in the wake of liberalizing external markets. Exposure to world prices may mean that domestic producers that were able to cover their material costs at domestic prices may no longer be able to at world prices. Thus any assessment of value destruction depends on the opportunities foregone.

Negative value added is a clearly a much more severe condition than lossmaking. An enterprise loses money when the revenue (market value) it receives is less than the cost of production. Costs of production, however, include non-purchased inputs (labor and capital services), so an enterprise can be lossmaking without destroying value. Indeed this is normal: negative value added requires that losses exceed the cost of primary inputs. Any enterprise that uses capital and labor services will incur costs in addition to the value of purchased inputs. Negative value added is significant because it means that the application of labor and capital to the inputs result in less value than what the process began with.

What happens when an enterprise is able to delay paying for its material inputs? Suppose that in any period enterprise I pays only the fraction of its material costs. Then it is possible that the enterprise is financially solvent even if it is actually destroying value. This would be true when:

where _i is profits of enterprise I, w represents the unit costs of primary inputs, l, P_i is the price of good I, z_i is the output level of the firm, and P_m is the price of materials, M. This is possible when material arrears are larger than wage costs, . Notice that in this case some other enterprise is essentially lending to enterprise I. A natural case would be natural gas and the materials purchased are from Gazprom. This is the canonical case considered in this paper. On average, of course, arrears on inputs and on sales will balance out. But a truly profitable firm can subsidize the production of a value destroyer. Indeed, this is the essence of the virtual economy.

Because SNVA is so strict it useful to work with a weaker notion of negative value added (WNVA). It is useful to include the costs of replacing capital explicitly. Suppose that revenues are sufficient to cover material costs and wages exactly. In this case the enterprise loses revenue at the rate of its capital costs. Because revenues are insufficient to cover the depreciation of capital, the productive capacity of the enterprise is decreasing over time. It may be useful to think of this situation--where revenues are insufficient to cover depreciation--as one where value is being destroyed in the weak sense. The capacity to produce national income, in this case, is transient. Over time national income will fall as capital must be replaced.

We must be careful with this notion. Consider the situation of an enterprise with large sunk costs earning negative profits. Because the assets are sunk the opportunity cost of using these resources in production is zero.⁽³⁰⁾ As long as revenues exceed the variable costs of production it is advantageous for the firm to continue production. In such a situation production adds to national income. But this is not a case of SNVA because in this case.

An interesting case in the Russian context occurs when the nominal wage rate exceeds the opportunity cost of labor. This is important in cases where workers continue to work at enterprises even when wages are not paid in full. Let  be the true opportunity cost of labor, where . Then it is possible that at nominal (virtual) wages the enterprise is a lossmaker but at the actual opportunity cost of labor it may not be:

1
 
 

In this case the enterprise actually is profitable at the true opportunity cost of labor, although it is not at nominal prices. Because the workers receive less than they are promised it is sometimes argued that these arrears represent lending by the workers to the enterprise. In fact, however, if the enterprise pays the promised level of wages (where they get the revenue is another story) this is actually a gift to them.

But this also means that at such an enterprise it may not be appropriate to speak about wage arrears.⁽³¹⁾

Labor is not fully compensated because nominal wages exceed the true value of labor's contribution. Note, however, that even at the inflated level of wages the enterprise is producing value added.

It is important to emphasize that whether an enterprise produces value or not depends on market opportunities. For example, an enterprise may produce value at domestic prices but destroy value at world prices. If the economy is closed, production at this enterprise contributes to national income. Once the economy is open, however, continued production destroys value. Many post-Soviet enterprises are in this position: the change in relative prices caused by external liberalization renders enterprises that were value producing in the Soviet period, value destroying in the post-Soviet period.⁽³²⁾

Given the inherited production structure it could be the case that many (most) industries are not producing value added at world prices. This may call for temporary protection, especially if the industries do produce value at domestic prices. Normally, one might think that a sufficient devaluation of the domestic currency would solve the problem of protected domestic sectors, because with a depreciated currency domestic manufacturing will be more competitive because of the increased cost of imports. But if technologies are rigid and energy dependent,⁽³³⁾ then both material prices and manufacturing prices will rise in tandem; relative prices and hence (negative) profitability will be unaffected. This problem is exacerbated when a large share of the economy is in heavy industry and manufacturing. This may suggest a role for temporary protection until the viability of different sectors can be assessed.⁽³⁴⁾

It is also important to note that the response to value destruction must depend on how transient is the phenomenon. When prices are liberalized it may be the case that value added is negative at some enterprises because production must adjust to the new world prices. What is critical to note about Russia, however, is that negative value added in 1998 can no longer be ascribed to transient lack of adjustment. Industrial production has, according to official statistics, shrunk by 50% since 1991. Some of this decline in production must be the abandonment of production that was destroying value. But in 1998 any value destroyers that still exist cannot be due to slow adjustment; rather, it is due to the active adaptation of enterprises to the virtual economy.

Russian enterprises suffered two types of shocks that affect the calculation of value added. Internal liberalization--freedom for agents to choose what to produce and consume independent of central planners, thus setting domestic prices freely, etc.,--and (2) external liberalization--introducing world market prices. Because these changes occurred at the same time we do not really know what "Russian" (free market) domestic prices were/are, so we don't know which enterprises might have been value-adding at these never-existing domestic prices. It could thus be argued that by combining the internal and external liberalizations, reform created too big a shock to enterprises. It may have made the distance needed to catch up to the world market too large for most enterprises. Realizing that, enterprises may have given up on adjustment, and retreated inward, eventually ending up in what we now call the virtual economy.

Suppose, instead, that there had been only internal liberalization, while fairly heavy protection against the world economy was maintained. Might not then more enterprises have attempted a first stage of adjustment, thus at least giving us a better sense for deciding which would be viable in a second phase of adjustment, with or without protection?

It is important to note that negative value added occurs fundamentally because of a lack of property rights. Some agents are unable to enforce the their rights to income streams. It is this conflict which keeps value destroyers operating.
 
 

REFERENCES
 
 

Bosworth, B., and G. Ofer, Reforming Planned Economies in an Integrating World Economy. Brookings, Washington, DC, 1995.

Buckberg, E., and B. Pinto, "How Russia is Becoming a Market Economy: A Policy Maker's Checklist," unpublished mimeo, September 1997.

Gaddy, C. G. and B. W. Ickes., "Russia's 'Virtual Economy'." Foreign Affairs, Vol. 77, number 5, September/October, 1998.

________, and ________, "To Restructure or Not to Restructure: Informal Activities and Enterprise Behavior in Transition," Davidson Institute Working Paper, May 1998.

Ericson, R. E. "Priority, Duality, and Penetration in the Soviet Command Economy," RAND Note N-2643-NA (Santa Monica, Calif.: RAND Corporation, December 1988).

K. Hendley, B. W. Ickes, and Randi Ryterman, "Remonetizing the Russian Economy," in H. G. Broadman, ed., Russian Enterprise Reform: Policies to Further the Transition, The World Bank, Washington, DC, November 1998.

Ickes, B. W., and R. Ryterman, "From Enterprise to Firm: Notes for a Theory of the Enterprise in Transition," in Robert Campbell and Andrzej Brzeski eds., Issues in the Transformation of Centrally Planned Economies: Essays in Honor of Gregory Grossman, Westview Press, 1994.

McKinnon, R.I., The Order of Economic Liberalization. 2^nd edition, Baltimore, Johns Hopkins University Press, 1993.

Thompson, W., "The Price of Everything and the Value of Nothing? Unraveling the Workings of Russia's Virtual Economy," mimeo, Birkbeck College, September 1998.

1. We are grateful to seminar participants at Brookings, Columbia, and the National Bank of Finland, and especially to Rick Ericson, Ed Dolan, Gregory Grossman, Gur Ofer, John Steinbrunner, and Pekka Sutela for helpful comments and discussion.

2. See Hendley, et al.,(1988) for a discussion of barter in the Russian economy. When the focus is narrowed to the largest enterprises this ratio rises to 73%. [Karpov percentage of nonmonetary sales was 73% for the 210 largest enterprises. REB figure for barter was only about 50%, but REB sample does not include enterprises over 2,000 employees--i.e., the REB and Karpov samples are probably mutually exclusive.]

3. [From my data on the budget. I have to get the actual cites from earlier documents, since we excluded the original footnotes from later versions of papers. In 1995 and 1996, 24% of all federal taxes were paid in non-monetary form; in 1997 the non-monetary share was 41%.]

4. For a sample of 39 regions (of Russia's total 89), the average share of nonmonetary tax revenues in 1996 was 60% to regional (oblast, kray, and republican) budgets and 43% to local (district and city) budgets. OECD Economic Surveys, Russian Federation 1997, Paris, 1997, p. 181.

5. [Need source.]

6. This phrase was taken from an AFP release dated 30 April 1998, by Jon Boyle, "Reformers tighten grip on economy as Chubais takes over at UES."

7. Our use of the term "virtual economy" is an extension of the language used in the December 1997 report of the so-called Karpov Commission. Set up in 1996 by the Russian government to study the problem of nonpayments and arrears in the economy, the body's official title was the Inter-Agency Balance-Sheet Commission, under the chairmanship of P. A. Karpov. The report concluded, among other things, that barter, by its use of "nonmarket or 'virtual' prices, [created] illusory or 'virtual' revenues, which in turn lead to unpaid or 'virtual', fiscal obligations." In Gaddy and Ickes (1998), we suggested that the appropriate name for the sector of the current Russian economy that operates in this nonmonetary realm is "virtual economy."

8. Barry W. Ickes and Clifford G. Gaddy, "To Restructure or Not to Restructure: Informal Activities and Enterprise Behavior in Transition," draft, May 1998.

9. Our paper is purposefully simplified, and thus we make strong assumptions to clarify the argument. For an interesting analysis of some of the details of how the virtual economy operates, see Thompson (1998).

10. For a more detailed discussion of the concept of value subtraction, see the Appendix.

11. See [Ericson (1996)] for an analysis of the implications of arbitrary pricing on the apparent and actual production of value added in the Soviet economy. [Ericson (1988)] was the first study to formalize the dual nature of the Soviet economy in terms of priority (military) and nonpriority sectors.

12. This point was emphasized in Bosworth and Ofer (1995:80).

13. It is perhaps more correct to say that the end-users in the Soviet regime -- the Communist Party -- placed such a high value on the output of the defense sector that value was produced. The problem is that with the end of the regime that value of that production has shrunk dramatically.

14. Strictly speaking Gazprom is not the only supplier of value into the system. Value is produced by other energy producers (e.g., Lukoil), new enterprises, as well as those enterprises that have successfully restructured. Gazprom is the most important example, and because of its role in supplying energy (via supplies to electricity producers), it has the widest impact on the economy. It also means that value is pumped directly to lossmaking enterprises, since they all consume energy.

Inside the Russian economy, Gazprom's role is widely recognized. Consider the following quote by the CEO of one of the major power companies in Russia, Mosenergo, Nestor Serebryannikov:

"The main income in the country comes from the resource-extracting industries, the production and sale of gas and oil. Gazprom is the salvation of the government and the creditor of the rest of industry, including the energy production sector." [Ekonomika I zhizn', Moscow edition, no. 15 (April) 1998, p. 12.]

15. As we suggest in Gaddy and Ickes (1998), however, the government has an important role in the virtual economy as the referee between competing interests. We ignore this is in the simple version of the model.

16. This is a stylized model. We are not asserting that value added in Russia is only produced in the resource extraction sectors, nor do we assume that all manufacturing enterprises are value destroying.

17. Note that in this example, manufacturing is actually not a value destroying sector. It loses money on production because costs exceed revenues. But the value of output is equal to the value of purchased inputs, so it is only a destroying value in the weak sense, see the appendix.

18. For even further simplicity of exposition, assume that the transfers are pensions.

19. The rate of overpricing of output in the virtual economy model is chosen arbitrarily here. The point is to choose a price that makes M into an apparent value-adder. But, in fact, a rate of overpricing of 300% is roughly consistent with what we know about many enterprises' actual practice. According to the Karpov Report, Commodity output used for the purpose of tax offsets is typically overpriced by a factor of two. Barter goods used in transactions between enterprises are overpriced by a factor of 2-2.5. Promissory notes (veksels) may have a nominal value up to five times the cash value. [Source: the Karpov Report]

20. This is clearly the case in our example where all G's profits are taxed away. G is then indifferent as to the form in which it pays taxes. In the actual case G's willingness to accept virtually priced output depends on how much taxes it owes. G will accept virtually priced output that it can pass on in tax payments.

21. Tax offsets are also accepted by local governments as a means of appropriating a larger share of taxes than would be possible if taxes were paid in money. Taxes paid with money would be split between federal and local levels according to sharing rules. If taxes are paid to the local government in kind this precludes transferring the federal share to Moscow.

22. It is important to emphasize that this comparison is between the virtual economy and the underlying reality. A further interesting comparison would focus on outcomes when full adjustment out of value destroying activity is accomplished. Clearly in that case welfare would be enhanced. Our point, however, is to show why that adjustment, which clearly represents a potential Pareto improvement does not occur.

23. See Ickes and Ryterman (1994) for a discussion of the theory of survival-oriented enterprises. A recent paper by a pair of economists from the IMF and World Bank argues that "barter is also very much a survival response engaged in by firms that do not have a ready market for their product. In this, they are aided by local governments, which might prop them up through their procurement efforts...Increasingly the subsidy seems to be coming from natural monopolies like Gazprom, RAO UES and local electric utilities, and the railroads" (Buckberg and Pinto 1997: 16).

24. And, of course, there are people who have left the virtual economy to find jobs in the new economy.

25. This effect was enhanced by the predominance of the shadow economy in the Soviet Union. The cascade of payments that spread through the system -- the "loot chain" as Gregory Grossman has called it in parallel with the food chain -- meant that the income of a typical person was a convolution of formal and informal activity. This makes it very hard to estimate how one would fare in a liberalized economy, because of the effect this may have on the loot chain.

26. Notice that even if Gazprom faces constraints on its capacity to export in hard-currency markets, it still has the option of keeping gas in the ground. Faced with the option of selling at a discount to domestic consumers or keeping the resource for the future when domestic customers could pay a higher price or new export markets could be found, a secure private owner would certainly choose the latter. This is especially so when tax liabilities accumulate according to the virtual value of sales rather than the reduced value of discounted sales. As with the case of greater exports, a policy of keeping gas in the ground would enhance the likelihood that Gazprom would be re-nationalized.

27. It is only in the case that enterprise M uses all of its product to pay G and none to pay H, that there are no tax arrears. See Table 2's "real"case where w = 0. But w = 0 means that M pays nothing to its own workers in wages.

28. [Data on additional taxes collected versus increase in wage arrears.]

Representatives of Russian labor have pointed explciitly to the trade-off between tax arrears and wage arrears. Mikhail Shmakov, the head of Russia's Federation of Independent Trade Unions is calling for an article in the Civil Code that would obligate enterprises to pay their wages before taxes. Vadim Borisov, the director of the Institute for Comparative Labor Relations Research in Moscow, an organization that is helping the unions in their campaign to eliminate wage arrears, said "the government's recent efforts to squeeze more taxes out of industrial enterprises to pay public sector workers was only worsening the problem of private sector wage arrears..... 'Industrial enterprises are paying taxes before wages, they are moving more of their accounts into the shadow economy, and they are increasing the use of barter. All these tendencies are continuing the demonetization of the economy,' he said." [Financial Times, 9 April 1998, p. 2]

29. As an example of how Gazprom can relieve pressure on the manufacturing sector by borrowing money outside the system, consider this news: "Russian gas giant Gazprom is to press ahead with a bond issue this month worth some one billion dollars as part of a borrowing programme needed to make up for customers' unpaid debts, ITAR-TASS reported. ... Further unsecured and convertible bond issues will follow this year to increase the company's 1998 borrowing to two billion dollars, [Gazprom chairman Rem] Vyakhirev said."

"Last week, Deutsche Bank announced it would lead a syndicated loan to Gazprom worth 230 million dollars."

AFP release May 5, 1998.

Comment: The government squeezes Gazprom to pay cash taxes so it (the government) doesn't have to borrow so much on the bond markets. Also, so that Gazprom will squeeze its own customers to pay in cash, etc. But Gazprom turns around and mortgages future gas exports by borrowing cash, thus refusing to tighten the cash constraint for the enterprises. The result: no change at all! Gazprom borrows to keep the cash constraint eased instead of the government.

30. Assuming that there are not operating costs of using the capital.

31. But if we think about the promised excess portion of the wage--the part over and above the true value of labor--as being part of the redistributionist "deal" that the virtual economy represents, then it becomes more complicated. There may be some extra amount to the true wage that ought to be regarded as "equitable." Arrears are tolerated to a certain level, but not beyond. This is analogous to the deal with Gazprom, how much of its export earnings it is allowed to keep, how much it subsidizes the rest of the economy, etc.

32. This is especially so in the defense sector. In the Soviet period the output of this sector was highly valued by end-users (the Party), so the value of production exceeded its costs. With liberalization, however, the value placed on this output has fallen dramatically.

33. As in McKinnon's substitution model (1993).

34. Hughes and Hare (1992) estimate the share of output in industries with negative value added (at quality adjusted world prices) at Bulgaria (50.8\%), Czech Republic (34.8\%), Hungary (34.6\%), Poland (8.4\%), and Soviet Union (22.3\%).