Economics of Planning, Vol. 22, Nos 1 2, 1988, Printed in Great Britain

Exchange Rates, Tax-subsidy Schemes, and the Revenue from Foreign Trade in a Centrally Planned Economy

Colin Lawson*

Introduction The role of foreign trade in Soviet public finance has been raised by several authors in the past decadeJ This paper develops the debate on the growth and importance of the budgetary revenues from foreign trade, by discussing three related questions; what are the effects of exchange rate changes on the domestic economy; what is the function of the tax-subsidy (preisausgleich) system; and what is the budgetary impact of balance of payments changes? The focus of the debate is thus widened from national income accounting to include the transmission of external disturbances to the domestic economy via the public sector budget constraint.

As the exchange rate system is the most important mechanism affecting the transmission of external disturbances to the domestic sector of a market economy, it is interesting to examine its effects in centrally planned economies (CPEs). It will be shown that although the theory of exchange rates under central planning predicts that exchange rate changes have no real consequences, the method of valuation of income from the foreign sector means that in practice such changes may influence the level of aggregate demand, at least in the Soviet case . 2

The tax-subsidy system is discussed because in standard descriptions of central planning it is allotted the important role of uncoupling foreign and domestic prices, and so protecting the domestic sector from the influence of foreign inflation. It will be argued that as well as separating internal from external prices the tax-subsidy is designed to effect the taxation of foreign trade, and so to help minimise the visibility of taxation. Finally, we emphasise the importance of these tax revenues from foreign trade as a major link between external and internal disturbances.

The Effects of Exchange Rate Changes

In the classic CPE the exchange rate, R, the unit price of foreign currency, has only an accounting function. As long as the state monopoly of foreign trade is exercised in a highly

* University of Bath. Initial research for this paper was carried out under ESRC grant H RP 7417/1. ~Two recent contributions to the debate are Alec Nove, 'Some Statistical Puzzles Examined', Soviet Studies,

XXXVIII, no. 1, January 1986, pp. 98 102, and Thomas A. Wolf, 'Foreign Trade and National Income Statistics in the Soviet Union: A Comment ' , Soviet Studies, XXXIX, no. 1, January 1987, pp. 122-28.

ZGeneral discussions of foreign trade accounting practices may be found in several sources, e.g. Thomas A. Wolf, "Exchange Rates, Foreign Trade Accounting, and Purchasing-Power Parity for Centrally Planned Economies, World Bank StaffWorking Papers No. 779, 1985. The impact of terms of trade changes on the domestic economy of a CPE has been widely discussed by, amongst others, F. Holzman in Foreign Trade Under Central Planning (Cambridge Mass, 1974).

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Exchange rates, tax-subsidy schemes, and the revenue from foreign trade 73

centralised way, and individual enterprises or associations are neither encouraged nor allowed to make export or import decisions, the exchange rate, strictly the commercial exchange rate, has no economic function. 3 If foreign trade decisions are less centralised and firms may choose whether to engage in foreign or domestic sales, then exchange rates may affect real variables by influencing those decisions. To date such cases are of no importance in the Soviet economy, and so this potential influence for exchange rates is ignored.

Whether the reform of foreign trade institutions and decision-making in the Soviet Union currently under way will eventually force a reassessment of this position is unclear. The available documents, while couched in language which suggests fundamental change, are insufficiently precise to allow any firm prediction of a more active role for the exchange rate. For example, Shamrai, in a recent and apparently authoritative account of the proposals, does not mention exchange rates, but following past practice speaks of 'differentiated currency coefficients applicable in export and import calculations' to 'ensure the economic regulation of exports and imports'. 4 But he adds that 'currency coefficients, however, will not settle all problems. Parallel to them the mechanism for regulating foreign economic trans- actions might include some other levers, also applied all over the world (taxes, customs duties, etc)'. 5 The coefficients which Shamrai refers to do not appear to correspond to the commercial exchange rate, and it is also clear from his remarks that the new incentive and control system is still evolving. In addition, as the Soviet economy has a well attested ability to absorb reforms without fundamentally changing its mode of operation, it is sensible to assume that in practice nothing has changed until faced with compelling evidence to the contrary. This chameleonic quality of Soviet economic actors and institutions probably ensures the continuing relevance of the traditional analysis of the CPE. And in this paper we proceed on that assumption.

In the classic CPE the exchange rate is used to translate the revenues and expenditures of the Ministry of Foreign Trade from foreign currency to valuta terms - - but that is about all. In general no consistent attempt is made to link domestic and foreign currency prices, so normally Pi~ePi*R, where the asterisk indicates a foreign currency price, and Pi is the domestic currency price. Consequently, as the Ministry, or rather its specialised foreign trade enterprises, conduct their business with domestic enterprises in domestic currency, the valuta and domestic price transactions will be unequal. Profits or losses which arise in this way are precisely counterbalanced by Treasury tax-subsidy (preisausgleich) schemes. 6 Thus the Ministry is relieved of the financial consequences of the discrepancies between domestic and valuta prices.

3Because theory suggests that R has a passive role, and should not enter the behavioural equations of a model of a CPE's foreign sector, it is absent from the models Brada (1980, 1982) and Portes (1980). See JosefC. Brada, "Real and Monetary Approaches to Foreign Trade Adjustment Mechanisms in Centrally Planned Economies: A Recon- ciliation'. European Economic Review, 19 (2-3), 1982, pp. 229-44 and 'On the Adjustment of Centrally Planned Economies to External Economic Disturbances: Discussion', in Paul Marer and John Michael Montias (eds), East European Integration and East- West Trade, (Bloomington, Indiana, 1980), pp. 111 8 and Richard Portes, 'Internal and External Balance in a Centrally Planned Economy' in Egon Neuberger and Laura D'Andrea Tyson (eds), The Impact of lnternational Economic Disturbances on the Soviet Union and Eastern Europe (Pergamon Press, New York, 1980), pp. 93-I 10.

4yuri Shamrai, 'Reorganising the System of the USSR's External Economic Ties and the State Monopoly of Foreign Trade', Foreign Trade, no. 4, 1987, pp. 8-9.

~Ibid, p. 9. See also 'Documents on the Reorganisation of the USSR Foreign Economic Ties', supplement to Foreign Trade, no. 5, 1987.

6Early descriptions of the preisausgleich system can be found in Edward Ames, 'The Exchange Rate in Soviet- Type Economies', Review of Economics and Statistics, 35, November 19583, pp. 337-42; Frederic L. Pryor, The Communist Foreign Trade System (Cambridge Mass, 1963); P. J. D. Wiles, Communist International Economics (Oxford, 1968). These and other treatments have been synthesised and extended by Thomas A. Wolf in 'On the Adjustment of Centrally Planned Economies to External Economic Disturbances', in Paul Marer and John Michael Montias, op cit.

74 Colin Lawson

But even in a system where changes in the exchange rate arc not intended to have real effects, under certain circumstances there will be budgetary effects, which if improperly handled will have monetary effects which in turn will impact on the real economy in a perverse way. Specifically it can be shown that if there is a foreign currency imbalance then a change in the exchange rate will change the profits of the Ministry of Foreign Trade. To see this, write these profits (~) in domestic currency as,

= Qm(Pm - Pro*R) + Qx(Px*R - Px) (1)

Where Q refers to quantity and the subscripts x and m to exports and imports respectively. Thus the first term in (1) gives the profits on imports, in domestic currency, and the second term the profits on exports. In (1) a devaluation will raise or lower profits depending on whether there is a foreign currency balance of payments surplus or deficit.

We have already noted that in a classic CPE a change in R has no effect on export or import decisions. A change in R does not then alter the quantity of resources at the command of either the state or its agents. In the same way, a change in Jz consequent on a change in R does not signal any change in control over domestic resources, unless prices in domestic currency are directly influenced by a change in R. Thus, if prices in domestic currency are not directly influenced by a movement in R, if ~z changes directly with R and if ~ is then transferred directly to the state budget, any attempt to spend the increased profits on domestic resources would involve money creation and inflationary pressures.

This analysis raises two interesting questions: what is CPE accounting practice, and does it conform to sensible standards of public finance? The issue arises because it is not satisfactory for central planners to treat ~ as an unambiguous indicator of resources available to the state. Rearranging (1) gives:

= ( P m Q m - PxQx) + R(Px*Qx - Pm*Qm) (2)

Looked at in this way ~ is composed of financial flows which originate in two distinct ways. It is the sum of the Ministry's profits on domestic operations ( P m Q m - P x Q x ) , and its profits on foreign currency account measured in domestic currency R(Px*Qx - Pm*Qm).

The Ministry's profits on domestic operations represent a genuine command over domestic resources. For example, if the price of imports to domestic enterprises is raised this is equivalent to a tax on them, and the yield from the tax is reflected in increased profits for the Ministry of Foreign Trade. Conversely for lower rouble prices for imports.

However, changes in the profits on foreign currency account measured in domestic currency do not reflect changes in domestic resources at the command of the state or its agents. We have already seen that the determination of R was essentially arbitrary. There- fore, the valuation of such profits is essentially arbitrary. Even if R were not arbitrary, the same conclusion on the state's command over resources would hold, for what is being valued is the change in gold, foreign exchange reserves, and foreign indebtedness. For example, concentrating on (Px*Qx-Pm*Qm) , it is obvious that a ceteris paribus change in Px* or Pm* alters foreign currency reserves, but this should have no immediate impact on the domestic budget. However, a ceteris paribus change in Qx or Qm will, from the first term in (2), change the Ministry's profits on domestic operations. This change correctly reflects variations in domestic resources at the command of the state. Additional budget changes, caused by changes in the Ministry's profits on foreign currency account, would only provide misleading information about domestic resource availability.

For example, a unit rise in export procurement will, ceteris paribus, result in fewer resources being available for domestic use. To avoid inflationary pressures the budget must shrink by Px. The successful sale of the exports increases foreign exchange earnings by Px*, but in itself this does not increase domestic resources at the planners' command. Nor will they increase until the volume of imports is increased.

This point is reinforced if we view these transactions in terms of the links between the physical plan and the financial plan. Although textbooks lay much emphasis on the role of

Exchange rates, tax-subsidy schemes, and the revenue from foreign trade 75

the financial plan in a CPE as a checking device to ensure the correct financing and efficient monitoring of the physical plan - - here we want to emphasise its anti-inflationary role. If the physical plan is feasible and the financial plan precisely fits and reflects the physical plan, then to avoid inflation a unit rise in exports must be matched by a reduction in available financial demands on the domestic economy.

The implication of this argument is that variations in expression (2) do not correctly reflect the required budget changes caused by foreign sector disturbances. The logic of the system of the preisausgleich requires a clear separation of the domestic and foreign currency conse- quences of such disturbances. If a, the profits of the Ministry of Foreign Trade are treated as a budget revenue then, as we have already seen, if trade is unbalanced in foreign currency terms, the exchange rate will influence the level of effective demand. In addition, the proper non-inflationary budget consequences of foreign disturbances will be miscalculated. If the correct procedure is followed, and only the Ministry's profits from domestic transactions are treated as budget revenue, then this still constitutes an important transmission channel between domestic and international disturbances.

Disturbance transmission will occur if, as in practice is often the case, domestic and foreign prices are linked, or if the volume of imports or exports are changed] The budgetary trans- mission channel is obviously additional to the consequences that changed trade volumes have for production or labour supply. Changes in foreign currency balances may allow or require later changes in trade v o l u m e s - - b u t when these occur their budget consequences will again be correctly signalled through variations in the ministry's profits on domestic trade.

Accounting Practices and the Taxation of Foreign Trade

The actual Soviet budget accounting process for the profits from foreign trade is not completely clear. It is clear that the ministry's profits on domestic trade enter the State budget. But the treatment of the domestic value of foreign currency (valuta) balances is in doubt. 8 Treml has noted that the calculation of the domestic value of a valuta surplus is made by multiplying by the average ratio of domestic to foreign trade export prices, but argues that '[i]t is impossible to say on which side of the budget ledger the converted foreign exchange losses or gains are entered'. 9 Birman is not clear on the issue, but his quotations from Ladygin and Zotova's textbook suggest that it is ~ in (2) above that is treated as a budget revenue. They state that:

Foreign currency earnings in transferable roubles from [exports] . . . are recalculated [sic] in internal roubles at a ratio of 1:1 . . . . The difference between [this and] the amount of the payment to the supplier of an export good [is] entered in the accounts of foreign trade

7The practice of linking domestic and foreign prices is more common than the role of the preisausgleich under classic central planning would suggest. It is now clear that the Soviet Domestic price for imported Western machinery is normally the price in foreign currency multiplied by the official exchange rate. (P. Bunich, 'Samofinansirovanie osnovnogo khozyaistvennogo zvena', Vopro�9 Ekonomiki, no. 10, [986, pp. 14-24). A similar practice may apply to Soviet imports of machinery from Eastern Europe. I am indebted to Philip Hanson for this reference.

q t is worth noting that there is a puzzle in Soviet national income accounting practices which is related to the budget accounting problem discussed in this paper. Special earnings of foreign trade, (here the profits of the Ministry of Foreign Trade), are included in national income produced. In calculating national income utilised, production losses and the foreign trade balance are subtracted, though it is not precisely clear how the latter is valued. The puzzle arises from that fact that in current prices national income produced and utilized appear to move in step, yet in constant prices the former has for some years been growing at about 0.5% per annum faster than the latter. 1 am indebted to Philip Hanson for drawing my attention to this unresolved problem.

Wladimir G. Treml, 'Foreign Trade and the Soviet Economy: Changing Parameters and Interrelations', in Neuberger and Tyson (eds), op cit, p. 198, f.n. 3.

76 Colin Lawson

associations either as a negative amount ( . . . a subsidy from the state budget) or as a positive amount (a revenue paid to the budget).

This is Qx(Px*R-Px) from equation (1). They continue:

The difference between [the costs of and revenue from imports, calculated as for exports, is] paid to the budget by foreign trade associations in the form of customs revenues. At the same time there may be subsidies for exports. The overall difference for all goods constitute[s] the amount of income from foreign trade in the state budget, l0

Therefore, this source suggests that equation (1) represents the actual budget revenues from the Ministry of Foreign Trade. If this is correct then incorrect budgetary practices are followed. Their importance depends on the degree of imbalance in the foreign exchange budget. Unfortunately, lack of information prevents confirmation of the existence of this problem, or an assessment of its practical importance, although its influence is likely to be small in comparison to the important budget revenue raising function of foreign trade.

The contribution of foreign trade to the budget has grown rapidly in recent years, and arises partly from a growth in trade and partly from the difference between valuta and domestic value of imports. Treml has noted that as early as 1976 the earnings from foreign trade accounted for 13% of budget revenues and that their rapid rise has 'enabled Soviet fiscal authorities several rounds of wage adjustments and tax reductions'. 11

It is difficult to believe that the growing importance of this source of taxation is merely a consequence of the growing importance of trade, and not a deliberate policy, for the taxation of the foreign sector has such obvious advantages. First, it is an administratively convenient point at which to tax the surplus of the economy, and the Ministry of Foreign Trade is a convenient, single tax gatherer. As we have seen, the tax is levied on domestic enterprises by driving wedges between the domestic procurement price for exports, and their value to the ministry, and between the cost of imports to the ministry and the price charged to domestic enterprises. The burden of the tax can fall either on employees, in the form of lower wages and smaller bonuses than would otherwise have been paid, or on consumers in the form of higher prices--perhaps because of the authorities' willingness to grant production subsidies.

Second, there may be an economic advantage in switching taxes from final outputs to imports, for taxes are thereby gathered at an earlier stage of production. If the enterprises are more successful at loss avoidance than profit maximisation, then taxing raw materials, intermediate and capital goods, reduces the impact on total tax yield of lax cost control which erodes the tax base of enterprise profits. If production problems cause sizable variations in the ratio of realised to planned enterprise profits, and the above loss-avoidance assumption holds, then taxing imports rather than profits will produce a more predictable tax yield.

Third, taxing imports and exports may be considered a more acceptable method of taxation than alternatives, because it is less visible to the population and so less likely to cause criticism than say an income tax. And, finally, shifting taxes to imports and exports allows the wage rises and income tax reductions Treml mentions. Such policies may be followed for social purposes, or to increase incentives. For these reasons the Soviet authorities may not only have welcomed, but may also have pursued a switch of revenue sources from the domestic to the foreign sector. In this way the preisausgleich system, which had its origin in a desire to separate foreign and domestic prices to insulate the domestic economy from foreign business cycles, has acquired a second major function as an instrument of taxation.

~~ N. Ladygin and N. A. Zotova (eds), Sotsialisticheskaya Economicheskaya Intergratsiya: Uchebnoe Posobie (Moscow, 1977), pp. 308-10, quoted in Igor Birman, Secret Incomes of the Soviet State Budget (The Hague, 1981), pp. 67 8.

HTreml, op cit, p. 198, f.n. 3.

Exchange rates, tax-subsidy schemes, and the revenue from foreign trade 77

Conclusions

It has been argued that while in the traditional analysis of the classic CPE the exchange rate has only an accounting function, inappropriate methods of national income accounting can lead to changes in the exchange rate generating changes in the real economy, provided that trade in unbalanced in foreign currency prices. This thesis was explored by examining the way the profits from foreign trade were calculated by the Ministry of Foreign Trade, and then transferred to the state budget. It was shown that the correct measure of the state's increased command over domestic resources from engaging in foreign trade, derived from the implicit taxes on that sector, was the ministry's profits on its domestic operations, the first term in (2). However, evidence was presented which suggested that its profits on foreign currency account measured in domestic currency, the second term in (2), were also passed over to the state budget. This implies that transferred profits from foreign trade will overstate the underlying command over resources when there is a balance of payments surplus, and understate them when there is a deficit. The consequence of this is that the domestic economy faces a series of erratic, though small, inflationary and deflationary impulses, regardless of changes in the exchange rate.

The theoretical role of the preisausleich system was explored in some detail and it was argued that, although the system has been designed to insulate the domestic economy from external disturbances, there were clear reasons why it had come to play a major part i n revenue raising. Specifically, it is administratively convenient to tax resources at their point of entry into or exit from the economy; the taxation of foreign trade widens the tax base and reduces the visibility of the tax system. But, of course, this grafting onto the preisausgleich of a second major function of revenue raising does lead to the development of a further channel through which external disturbances can pass into the domestic economy. That is external disturbances impact on the domestic economy not only through the production and welfare effects of changing exports and imports, and through whatever tenuous links are allowed between foreign and domestic prices, but also insofar as those disturbances affect the ministry's profits from foreign trade. In short, foreign economic disturbances show up in variations in the position of the non-inflationary government budget constraint. To that extent the second function of the preisausgleich impairs its ability to perform its original insulation function. In a minor way, the successful non-inflationary performance of the insulation function has always required adjustments in the government budget constraint. But the growth in the importance of foreign trade taxation has magnified the importance of this phenomenon, and led to a trade-off between the two functions.

(Revised manuscript received September 1988)