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6 May 2016

Small Businesses Heading for the Exit

The Russian authorities are creating new state corporations and state-owned banks to “support” small businesses. In reality, however, small businesses only face tax hikes and extra-judicial demolitions of retail premises

High-tech solutions, innovation, science, education, space and medicine are challenging categories for the majority of countries of the world. Some of them lack financial resources, others cannot pool a sufficient number of highly-educated individuals within their territory. And then there is the issue of scientific and technological innovation establishments that develop over decades. Small businesses face none of these challenges. By and large, government intervention is not necessary - they could simply be left alone by the authorities. Unfortunately, in Russia, the situation differs.

Let us refer to some key figures. Let us take, as an example, last year’s report by the Ministry of Economy of the Russian Federation presented to the State Council which covers Russian and foreign statistics. According to the data presented in the report, nearly 95% of Russian small businesses are sole proprietors and micro-enterprises which employ fewer than 15 people with an annual turnover of no more than 60 million rubles (in the summer of 2015, the decision was taken to increase the turnover threshold to 120 million). The overwhelming majority of sole proprietors (74.9%) and small enterprises (69%) operate in the retail and service sectors.

All in all, we are speaking of approximately 18 million people employed by small businesses, 5.5 million of whom are sole proprietors. If we were to also include medium-sized enterprises, the figure would be approximately 25 million. There are 107 million voters (i.e. adults not deprived of liberty) in Russia, nearly 43 million of whom are retired. Moreover, 22 million people are not registered as employees (we do not refer to the unemployed as defined under ILO methodology but to those who do not apply to the authorities for assistance and are either dependents or work in the grey sector i.e. for small businesses). In fact, approximately one third of the population is employed by small businesses. Given these statistics, it is not so important that small businesses account for as little as 21% of GDP (46% in the USA and 49% in Germany, for comparison). Typically, people employed by small businesses are not wealthy –many business owners even struggle to make ends meet. Thus, the share of this sector as a proportion of GDP is lower than the share as a proportion of the population overall. Still, it is a huge sector of the economy that employs a significant number of people.

Russian officials, however, stubbornly refuse to understand that small business is about retail and services. They prefer to discuss high-tech solutions, agriculture, education, and turning Moscow into the capital of internet start-ups or small businesses becoming suppliers of equipment to Gazprom or Rosneft, ignoring retail entirely. Retail is excluded from all measures that support small businesses and does not benefit from the tax breaks that the “proper” business sectors count on. A recent example: the Ministry of Finance proposed excluding sole proprietors and the retail sector from the category of those who will enjoy tax allowances on imputed income until 2021. Following the notorious 2013 tax reform which brought about the increase of insurance premiums and which resulted in five million sole proprietors closing down, the government made concessions the following year and reduced premiums for those not involved in retail. Retail benefitted from no concessions whatsoever.

In 2014, the government announced the possibility of offering a two-year tax holiday to newly registered sole proprietors (subject to the approval of regional authorities). Retail did not fall under this law. It is safe to say that Russia’s political leadership exhibits persistent prejudice against retail i.e. the overwhelming majority of existing small businesses rather than the mythical “Russian Google.” And this is quite understandable: both President Vladimir Putin and Prime Minister Dmitry Medvedev, as well as the majority of ministers are former Communist Party of the Soviet Union (CPSU) members who were taught in school, and then later in the Komsomol and the party structures, that capitalists should be defeated. It is noteworthy that the Soviet Penal Code of the Russian Soviet Federative Socialist Republic contained two respective articles: Art. 153 “Private entrepreneurial activity and commercial agency” (up to 5 years of imprisonment) and Art. 154 “Speculative activity” (up to 7 years of imprisonment). Remarkably, the fact that Dmitry Medvedev spent three years working in business after the end of Anatoly Sobchak’s administration in 1996 is hushed up in his official biography. Apparently, this might not be the most fortunate credential for an official. This view is common among the powerful group of former siloviki who are part of Putin’s clan. And although many officials started to enjoy the fruits of the advent of the market economy, sometimes violating the law, this psychological peculiarity should not be overlooked.

Retail has been struck many painful blows. In 2009, Art. 24 of the Federal Law “On retail markets” was amended. According to the amendments, all marketplaces except for greenmarkets should be located in permanent facilities as of 2013. This requirement will also apply to greenmarkets from 2016. So far, annexed Crimea remains an exception. Marketplaces in their current form can exist there until 2020. The argument offered by the authorities was that they strive for so-called “civilized” trade, which was accompanied by lobbying by large retail chains. But while it is possible to find an investor to erect permanent structures in a big city, what is one supposed to do in a small town or in a rural area? In Moscow, too, the “civilization” of marketplaces was carried out and took the form of their mass demolition: more than 40 marketplaces were closed down and at least 150,000 people lost their jobs.

Under the pretext of curbing alcoholism and discouraging smoking, a ban on the sales of beer in kiosks and stores with an area of less than 50 square metres was introduced on January 1, 2013 and kiosk vendors have been banned from selling cigarettes since June 1, 2014. Not surprisingly, this has led to the closure of tens of thousands kiosks since these high-margin goods accounted for more than half of their sales revenue and were precisely the goods which attracted foot traffic. A paradoxical situation occurs when large retail chains are permitted to sell alcohol and cigarettes while small businesses are not. In many countries in the world, restrictions relating to such products are drafted conversely.

Those who have been to large cities in the United States and Europe are struck by the high cost of living in Russia. The same multinational brands whose production and logistics arms around the globe have long been established are much more expensive in Russia despite the fact that the level of disposable income is much lower. So what’s the secret? The fact of the matter is that there is an acute shortage of retail space in most Russian cities. In Moscow, where almost one-fifth of Russia’s turnover is generated, the coverage of shop floor space is just over 850 square metres per 1000 residents and shows little signs of increasing (the figure is even lower in Russia as a whole – approximately 630 square metres per 1000 inhabitants). In large European cities, there is usually not less than 1500 square metres of shopping floor space per 1000 inhabitants and nearly 2000 square metres in large U.S. cities.

The shortage of retail space, according to the laws of market economy, leads to an increase in rental rates which constitute the primary cost for retailers. At the same time, a substantial part of retail space belongs to hypermarkets in large Russian cities. The monthly rent of a standard pavilion of 20 square metres in a large A-class shopping center can reach 300,000 - 400,000 rubles. Given the need to pay a multi-month advance, it is clear that this format suits only large businesses.

It does not occur to the Russian authorities that production is inextricably linked to retail. Small manufacturers are dying out along with small trade formats, since that’s how they sell their produce. The authorities see the solution in somehow forcing retail chains to buy from local producers. It’s useless. The retail chain format was tailored to work with big businesses: they need huge quantities of standardized production; severe penalties are paid even in the case of the slightest disruption to supplies; large working capital is necessary to offer various rebates in retail chains. The specific nature of such an operation requires that a producer actually agrees upon credit terms with the retail chain, thereby the latter does not act as a seller of goods but rather a seller of shelves, and hence, adopts no commercial risk.

In their draft “Concept of promotion of small and medium-sized enterprises until 2030”, the Russian authorities follow a conceptually strange route – despite a number of individual reasonable measures. They have created a state corporation and its bank (SME-bank) and they expect that these entities, funded by the state at a refinancing rate below the market rate, will offer loans to small businesses with favorable interest rates. Not surprisingly, miracles typical of state corporations were reported: state loans have been taken out at a rate of 4% and issued at a rate of 26%, which is more costly than the typical credit terms of a commercial bank.

The Russian authorities speak of small businesses’ access to systems of procurement of the state and state-owned companies. However, they refuse to provide for advance payments, even in the case of long-term suppliers of reputable standing. The agreements stipulate virtually the opposite: the contractor is to contribute contract performance security (up to 30% of the initial price), which, in fact, means that before the execution of contract (and the ordering party might as well file civil claims which may prompt lengthy trials), the contractor suffers losses with no advance payment at all. Moreover, should the state-owned corporation delay payments for completed works, no significant penalty is provided for. As a result, only those who are certain that they are definitely going to be paid thanks to their friendships with officials take the risk of cooperating based on government contracts.

Besides, there is a problem of abuse by siloviki in relation to small businesses. On the initiative of Sergey Sobianin, the Mayor of Moscow, Art. 222 item 4 of the Russian Civil Code was amended to the effect that regional authorities can recognize any building as an unauthorized construction in an extra-judiciary manner (and with no compensation). This is a direct contravention of Art. 35 item 35 of the Russian Constitution, which did not, however, prevent Sobianin from tearing down more than 100 outlets having ownership rights overnight and Sergey Ivanov, the Chief of Staff of the Presidential Administration, from supporting him. Similar examples of abuse of power also take place in Saint Petersburg. It is beyond doubt that many governors will approve of Sobianin’s interpretation of the law: “One cannot hide behind ownership papers”. Actually, this phrase expresses everything one needs to know, not only about small business, but also big business in Russia.

And small businesses are, as it stands, closing down in Russia: the share of small and medium-sized enterprises in the turnover of enterprises dropped from 34.2% in 2013 to 32.4% in 2014. Given that employment in the budgetary sphere is also declining, people have nowhere to turn. Thus, there is a good chance that these people will start protest voting if not a protest movement. 

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