Russia's small businesses cry foul over war economy tax hikes

By Nika Khutsieva and Darya Korsunskaya

MOSCOW (Reuters) -Russia's new wave of tax hikes, designed to mobilise state finances as the war in Ukraine grinds on, is set to hit one in 10 small business owners, many of whom say they will have no choice but to shut down or move into the shadow economy.

Russia has been gradually raising domestic taxes since 2023, the second year of the war, including personal income and corporate profit taxes, to keep up with military spending, now at its highest level since the Cold War.

The new tax regime, including a measure to cut the annual revenue threshold for VAT tax breaks for small businesses to 10 million roubles ($123,000) from 60 million roubles, is set to take effect in 2026, pending approval by parliament.

"This is a shock for all small businesses," said Sergei Borisov, head of the Opora small businesses lobby, one of several groups that wrote a letter last week to speakers of both parliamentary chambers in an attempt to stop the initiative.

Under the tax proposals, businesses with annual revenues of between 10 and 250 million roubles, currently exempt from paying VAT, will have to pay VAT of up to 5% and will need to hire accountants to handle their tax affairs.

Opora says the measure will affect 700,000 entrepreneurs or one tenth of the entire entrepreneurial class. A third of the 11,000 business owners polled by Opora said they will be ready to close down, and a similar share said they may have to move into the informal economy and stop paying tax altogether.

"For years, we operated under the simplified tax system, which was clear and convenient. Now our costs will go up, and we don't know how we will survive," said Sergei Pakhomov, who manages a grocery shop in central Moscow.

SMALL BUSINESSES ARE A BIG EMPLOYER

The measure comes on top of a proposal to raise the general VAT rate to 22% from 20%, expected to generate about 1 trillion roubles to help fund military spending and curb a swelling budget deficit.

Small and medium-sized businesses account for more than a fifth of Russia's gross domestic product, according to the latest available data from the Economy Ministry, and employ 31 million people, about 40% of the total workforce.

Russia defines small and medium-sized companies as those employing up to 250 people and generating up to 2 billion roubles in annual revenue. The government expects to raise 200 billion roubles ($2.5 billion) from the measures.

But Opora has calculated that additional costs for businesses would amount to as much as 420 billion roubles ($5.2 billion), double the amount of extra budget revenues. The lobby groups have proposed setting the threshold for VAT payments at 30 million roubles, rather than the 10 million roubles proposed.

"While not disputing the undeniable need to increase federal budget revenues to ensure national defence and security, it is important to note the extremely negative consequences for microbusiness sector," the lobby groups said in the letter.

Faced with criticism, Finance Minister Anton Siluanov said in parliament on Wednesday that he was ready to adjust the proposal but did not give details.

'TAKE MONEY FROM THE BIG SHARKS'

The sector has benefited from substantial state support in the form of tax breaks, loan and office lease subsidies, and startup grants that helped small firms survive the COVID-19 pandemic and adapt to the economic fallout of the war.

The finance ministry said the reforms will curb fraudulent schemes in which larger businesses split into smaller units to pay less tax, arguing that at a lower threshold such breakups would no longer make economic sense.

But small business owners said they would be the ones hit hardest.

"Take money from the big sharks, not from us little ones. I'm kind of in shock. They are already squeezing the life out of us," said Irina Pankratova, who runs the Artel tailor shop in Moscow.

Jewelry designer Anna Slavutina, who started her business in 2003 and now owns three shops with her husband Alexei Filimonov, said one of their two stores in St. Petersburg has been running at a loss for the past year.

"Our customers there are asking us whether we are going to close. What can I tell them? We will see," Slavutina said, adding that if they do shut down, the state would lose tax.

TAX SPIRAL

Slavutina's warning is echoed by T-Bank's chief economist Sofya Donets, who predicts the tax reform is likely to push the budget into a "tax spiral," in which the planned increase in revenues is offset by a shrinking tax base.

"It's all going to be an experiment on living people. I think we will see more business closures, not in the form of bankruptcies, but more like 'to hell with it all' voluntary shutdowns,” Donets said.

Donets and other economists argue that this year's hikes in corporate profit and personal income taxes have so far failed to deliver the expected budget revenues, suggesting the government could face a similar trap in 2026.

Small businesses may struggle to pass on the tax increase to consumers next year due to slowing demand, high competition, and rising input costs, economists say. Many may also consider going underground.

"They won't collect much money from this, but we could end up with a flood of social problems. For a cow to give a lot of milk, it needs to be given all the conditions for a good graze on a green meadow,” said economist Evgeny Kogan.

(Additional reporting by Elena Fabrichnaya; Writing by Gleb Bryanski; editing by Guy Faulconbridge and Ros Russell)