Russian Prime Minister Dmitry Medvedev has dropped a mini-bombshell by announcing Russia will introduce a preferential tax regime, but remained vague on when the new regime will be introduced.

Talking about increasing taxes, and income taxes in particular, has been taboo since President Vladimir Putin took office a decade and a half ago, so the prime minister’s comments suggest the government is taking increasingly desperate measures to cope with desperate times.

“We need to reconfigure the tax system so that it not only raises money for the budget, but also stimulates the creation of advanced, competitive products and services outside the raw materials sector, to strengthen the balance of regional and local budgets, helping them create new sources of revenue,” Medvedev told delegates at a conference of the ruling United Russia party on June 27. 

It is necessary not only to introduce preferential tax regimes, but also to reduce the administrative burden on taxpayers as a whole, improving the tax administration system, fees and contributions to non-budgetary funds, the premier said.

When Putin came to power he immediately launched a politically motivated attack on the oligarchs who had effectively taken control of government. But less well reported at the time was his decision to launch the first Russian radical economic reform plan, eventually dubbed the “Gref Plan” after the minister of economic development German Gref who authored and implemented it. Gref is now CEO of state lender Sberbank.

The main plank of this plan was to introduce Russia’s flat tax regime (13% income and 24% corporate profits) that has been sacrosanct ever since. The flat tax regime has been credited with helping to turn Russia’s economy around, aided by steadily rising oil prices from a $10 per barrel low in 1999.

Under the previous president Boris Yeltsin, Russia was what Brookings Institution academics Clifford Gaddy and Barry Ickes dubbed the “virtual economy“, where business was done largely on barter and as no money changed hands, no taxes were paid. The state lived hand to mouth by cajoling one-off payments from Gazprom, which had negotiated itself special tax exemptions. The country was in a permanent state of crisis and in its desperation to tax any business with any visible money, tax rates sometimes exceeded 100% of profits. At a stroke, Putin’s flat tax regime put an end to this chaos and laid the groundwork for the birth of a normal state.

Today, Russian taxes rates are amongst the lowest in Europe and are hugely popular with the public, who pay the lowest rates of income tax in Europe. The introduction of a means-tested system that Medvedev is suggesting is a radical change in policy that is being forced on the government by economic realities. Russia could afford the flat taxes in the noughties thanks to huge inflows of petrodollars that were used to supplement budget spending. But following the collapse of oil prices in December 2014 the cost of a barrel of oil is expected to be “lower for longer”, and in effect Russia will have to change from being a petro-economy to a normal one. That means the population will have to pay more tax like everywhere else.

“We want to build an economy that provides domestic sources of growth, rather than external quotes on commodity exchanges,” Medvedev told the United Russia congress. “We have maintained and will continue to strive to maintain a balanced budget, thus ensuring the fulfilment of social obligations to our citizens.”

While no concrete proposals on what the new tax regime will look like have been offered, Medvedev’s comments are another sign that the government is in the process of totally overhauling its economic model. The state has already said that it will raise retirement ages, scrapping the Soviet-era 55 years for women and 60 for men and phasing in 60 years and 65 years respectively over the next six years. But this by itself will not be enough.

Medvedev is also suggesting the new regime will contain special tax exemptions for strategically innovative industries that Putin highlighted Russia needs in his recent keynote speech at the St Petersburg International Economic Forum (Spief).

One of the ideas under discussion is a radical reduction in insurance premiums with a complementary increase in VAT, the most important revenue generator that accounts for about a third of the government’s tax take.

“This may bring salary payments out of the shadows, to support domestic producers and to help close the budget deficit. The increase of VAT could be up to 25% at least [from the current low 18%], and premiums ideally reduced to 20%,” a source close to the talks told Interfax.

In the short term, duties on oil production will certainly be introduced next year and are already part of the 2017 draft budget that has been submitted to the Duma and will be debated after the summer recess.

Medvedev also told the United Russia delegates that real wages will be maintained at their current levels and allowed to increase slowly in line with the pace of economic growth. This is a line straight out of Plan K, the grand economic reform programme that is being prepared by former finance minister and co-chairman of the presidential economic council Alexei Kudrin.

However, the politics of monkeying about with the tax code are tricky, as in addition to the parliamentary elections in September, Putin has to face re-election in 2018. In a sop to the anger Medvedev caused in May when he told a pensioner in Crimea complaining about their reduced payments “We don’t have money!”, the prime minister offered to restore the 2017 indexation of pensions to the inflation rate of the previous year. Currently, pensions are indexed at 4%, less than the rate of inflation.

And something has to be done soon. The government is currently using its reserve funds to fill the deficit, but it can’t keep that up forever: budget revenues for the five months of 2016 decreased by 13.3% y/y and the deficit this year should come in at a bit more than 3% of GDP. Finance Minister Anton Siluanov is planning to reduce the deficit to 2% in 2018 and 1% in 2019 (assuming an average oil price of $40).