Thursday, July 19, 2012

Creative class accounting

It was American economist Richard Florida, who coined the term “creative class”. He described the phenomenon in his “Rise of the Creative Class”. Strategy-2020 by Vladimir Putin has introduced the term to Russian political science and economics. According to authors, it is the creative class that bears the innovative thinking and the entrepreneurship spirit. The hopes for the timely modernization are still pinned to it — deprived of that, Russia is destined to become yet another “third world” country.

However, in the winter of 2011 the term “creative class” was used to dub the “angry mob” of citizens, hundreds of thousands of whom have hit the Moscow streets, defying the election results. The majority of them is bound to entrepreneurship in one way or another. Alas, in order to survive they have to apply their creative skills to accounting, rather than technological innovation. By the way, Russians have heard of “creative accounting” long before they came to know about “creative class”. Unfortunately, the phrase served as a popular euphemism for the “off-the-record accounting”. The existing taxation system gently pushes the “creative class” towards the “dark side”, while the methods of tax management deprive it of any options.
Myriads of three-line-long contracts that cover payments in cash, well-settled practice of cashing the sham contracts out, mickey-mouse companies and other components of the modern Russian business scene have turned the vital part of the economic life into a nutrient environment for corruption and, perhaps, the most criminal occupation of our time.
We may argue the hell out of what part of economics is off-the-records exactly, but no one knows the precise percentage. Ministry of finance has recognized the recent attempt to amend the Labor Code in order to prohibit paying the wages in cash — allegedly to legalize the turnover — for what it was, the banking lobby, which has very little to do with bringing the economy out of shade.
Economic behavior of the business entities is submitted to a natural law of minimizing the losses and maximizing the profits and no punishment will ever change the status quo. There is the only way out of that — to change the tax legislation, describing each tax with precision and clarity that allow no misinterpretations and make the misdeeds unprofitable. This change doesn’t mean lowering the taxes — the goal is to change the business philosophy instead. The Tax code currently in force and the infinity of bylaw acts that regulate its application leave a huge space for its interpretation, giving birth to bureaucratic rule and instigating business to proceed with the “creative accounting”. The conclusion is simple: tax rules must be very specific, unequivocal and protected against sly tax-evading combinations. So why don’t we take the path of changing the existing situation with the profit tax for companies, following the example of Europe?
According to the tax legislation currently in force, “taxpayer reduces the earned revenues for the amount of his expenditures”… Expenditures are the substantiated… losses that the taxpayer incurred. Substantiated losses are defined as the money equivalent of economically justified expenditures, estimated”(Art. 252 of the Tax Code of the Russian Federation). If you ever tried to explain tax authorities officer that these exact expenditures were “economically substantiated”, you must have a pretty clear idea of what I am talking about. The very definition of “economical grounds” is quite vague and leaves plenty of space for the discretion of a bureaucrat, investigator and then a judge. Well, each of them has his own idea of economic justification in this particular business! Opinion of the entrepreneur is of no interest to them. So “pay the cash down, sir, the hell you need your wealth for”.
There is but one way out of this taxation dead-end: to allow companies list any expenditures as economically grounded, i.e. acknowledge any expenditures but those, which the legislators will deem necessary to unequivocally ban. At that, the restriction must be crystal clear (for instance, prohibiting to list purchase of air transport as a prime cost expenditure for the companies not engaged in air traffic). The rest must be allowed.
Advantages of the transparent turnover
Imagine the situation, when accompany owner will be able to build himself a house, listing the construction costs as the prime expenditures, i.e. completely excluding these expenditures from the taxable base. What will it lead to? The consequences are many and varied. For instance, a house will be the property of the company then, rather than its owner. Paying for the construction materials and for the labor he would have to demand the sellers and the contractors to write the invoices with actual figures (the greater they are — the more he will be able to save on taxes). The latter ones, in return, would have to file honest reports to the tax authorities, since making out the invoice means the need to record the incomes as received. This may seriously confine the opportunities of using underhand cash and will increase the taxable base for VAT, uniform social tax and profit tax.
Each extra economic entity, involved into the legal money turnover, will inevitably become one more taxpayer. Making out invoices and recording incomes in their entirety as received (otherwise, the very first inspection will expose this misdeed in no time) will force the company to pay VAT from each legal bargain, and mind that this tax has a doubled “weight factor” in the budget as opposed to the profit tax. All the participants of legal deals will have to pay small, yet fair tax to the budget.
This decision has one more important feature. Imagine living in a house and driving a car that belong to your company. Every single thing in the house is not yours either. You will protect this company better than the apple of your eye. A thought of causing troubles with tax inspection (setting it up, using the neo-Russian term) or not fulfilling contract obligations will never occur to you. Life without a roof over your head, a car and everything else makes a gloomy prospect. In Europe businessmen ask for invoices, while fueling their cars up, purchasing equipment and even office accessories. Their business card will surely contain the taxpayer’s identification number and all the appropriate company details for making out the invoice, which is why any tax check will easily find the off-hand cash.
Without doubt, if we imagine just for a second that these steps are taken, it would help to bring the major part of Russian economics out of shadow and draw the era state governed by rule of law closer. The permission to list all expenditures as prime cannot be applied to all the sectors of economy though. Large businesses might do without it, since it is the small and average businesses that have to hide their revenues. Yet another important aspect of the proposed innovation is the reduction of the amount of non-recorded cash, which indeed is the nutrient environment for corruption.
Forestalling the objections that it would decrease the profit tax, I would like to denote that it is not a major budget-forming element at all. In 2010 the collected profit tax for Russia in general made up merely 255 billion rubles or 3.07% of all the gathered taxes. Given the effect of inevitable increase of legal accounting, once the proposed model is adopted, these losses will be partially compensated with VAT and other taxes, paid by companies involved into the legal money turnover. As for the legalization of economic life and the decline of corruption — well, those are utterly priceless.
And if we add the released creative capacity of the creative class — which would be free to upgrade the country, instead of dedicating its talents to “creative accounting” — the entire thing is surely worth trying.

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