Russia’s Economic Gambit: Kremlin Proposes Historic VAT Increase as War Costs Mount

Russia’s finance ministry announced Wednesday its proposal to raise the value-added tax rate to 22% from 20% beginning in 2026, marking a desperate attempt to finance military expenditures as the war in Ukraine enters its fourth year. The tax increase represents the most significant fiscal adjustment since the conflict began, exposing the mounting financial pressure on Moscow’s war machine despite earlier promises by President Vladimir Putin to avoid major tax hikes.

The proposed VAT increase, coupled with additional levies on gambling businesses and other sectors, signals a fundamental shift in Russia’s fiscal strategy as traditional revenue streams from energy exports continue to weaken under the weight of international sanctions and volatile global commodity prices. The announcement comes as Russia’s budget deficit has already exceeded its full-year target, reaching 4.88 trillion rubles in just seven months of 2025.

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Fiscal Crisis Deepens Despite Economic Resilience Claims

The reality behind Russia’s fiscal position starkly contradicts the Kremlin’s public narrative of economic stability. By May 2025, the federal budget had reached a deficit of 3.4 trillion rubles, representing nearly 90% of the revised 3.8 trillion ruble target for the entire year. This fiscal deterioration accelerated dramatically, with July alone adding another 1.19 trillion rubles to the shortfall.

The proposed VAT increase is not merely a revenue-raising measure but a critical lifeline for a budget under severe strain. VAT accounted for 37% of federal revenue in 2024, making it the backbone of Russian government financing. According to economic analyses, increasing the VAT rate by two percentage points could potentially halve the projected 2026 deficit, providing crucial breathing room for continued military spending.

Russia’s National Welfare Fund, the country’s primary fiscal buffer, has been depleted to dangerous levels. The liquid portion dropped to 2.8 trillion rubles by May, representing a 71% decline from pre-war levels and marking the first time that liquid assets fell below the expected budget deficit. This depletion has forced the government to rely heavily on domestic debt issuance, with Russian banks serving as the primary buyers after foreign investors exited the market.

Military Spending Dominates Budget Priorities

The finance ministry’s statement explicitly linked the tax increases to military needs, emphasizing the “strategic priority to provide financial support for the country’s defence and security needs and social support for families of participants in the special military operation.” This candid acknowledgment reveals how deeply the war has transformed Russia’s fiscal priorities.

Defense and security spending now exceeds 8% of GDP and accounts for 40% of total federal expenditure, reaching levels not seen since the Soviet Union’s Cold War era. Between January and May 2025, military and security spending consumed over 5.2 trillion rubles, representing a 33% increase from the previous year and highlighting the unsustainable trajectory of war financing.

The scale of Russia’s military expenditure is staggering. Intelligence estimates suggest Russia spends approximately $857 million daily on the war, with monthly expenditures reaching $25.7 billion. Since the full-scale invasion began in 2022, total military spending has approached $1 trillion, representing 13.1% of Russia’s GDP or 68% of the total federal budget.

Economic Contradictions and Structural Weaknesses

Despite claims of economic resilience, Russia faces mounting structural challenges that the proposed tax increases alone cannot resolve. Industrial factories are operating at only 81% capacity, with widespread labor shortages caused by military conscription and emigration of skilled workers opposing the war.

The Russian economy has effectively split into two parallel systems: a militarized sector that enjoys government subsidies and preferential treatment, and a civilian economy struggling under the weight of high inflation, expensive credit, and resource constraints. This dual-track system has created a “war boom” in defense industries while constraining growth in other sectors.

Inflation remains persistently high at over 8%, with perceived inflation among consumers reaching 16-21% according to various surveys, far exceeding official statistics. The Central Bank’s attempts to combat inflation through interest rate increases to 21% have primarily impacted the civilian sector, while military industries remain insulated from monetary policy constraints through government subsidies.

Energy Revenue Decline and Sanctions Impact

The proposed tax increases become more critical when viewed against the backdrop of declining energy revenues, historically Russia’s primary source of budget income. Oil and gas revenues are expected to drop to 8.32 trillion rubles in 2025, representing a nearly 25% decrease from earlier projections.

This decline reflects the combined impact of international sanctions, reduced global energy demand, and Moscow’s struggle to maintain pre-war export levels through alternative channels. The government has cut its average oil price assumption to $56 per barrel from $69.70, acknowledging the reality of constrained market access and price pressures.

The energy revenue decline has forced a fundamental restructuring of Russia’s fiscal model. Where oil and gas exports once provided the primary funding for government operations, tax revenues from domestic economic activity must now fill the gap. This shift places additional pressure on an economy already strained by war demands and international isolation.

Political Calculations and Public Resistance

President Putin’s earlier statements suggested openness to tax increases while attempting to provide historical justification. He noted that the United States had raised taxes on wealthy people during the Vietnam and Korean wars, drawing parallels between Russia’s current situation and American wartime fiscal policies.

However, the VAT increase will directly impact all consumers, not just wealthy individuals, creating potential for broader public discontent. Unlike targeted taxes on high earners or corporations, VAT increases affect basic goods and services, making the war’s costs more visible to ordinary Russians already struggling with inflation and economic uncertainty.

The greatest losers in Russia’s overheated economy are Putin’s core supporters: public sector workers, teachers, doctors, law enforcement personnel, and pensioners. Their wages and benefits are tied to official inflation rates of 9%, but real inflation for many households exceeds 20%, creating a growing gap between official statistics and lived experience.

International Context and Sanctions Effectiveness

The proposed VAT increase provides evidence of sanctions’ cumulative impact on Russia’s fiscal position, contradicting claims that economic measures have failed to constrain Moscow’s war capabilities. While Russia has demonstrated resilience in maintaining basic economic functions, the need for significant tax increases reveals underlying financial stress.

The ruble has lost more than half its value against major currencies since the invasion began, despite government intervention through mandatory foreign currency sales by exporters. Currency weakness has contributed to inflationary pressures while reducing the purchasing power of government revenues.

International financial isolation has limited Russia’s ability to access global capital markets, forcing reliance on domestic borrowing at increasingly expensive rates. The Central Bank has resorted to repo schemes several times to encourage banks to purchase government bonds, indicating strain in the domestic financing system.

Future Economic Outlook and Sustainability Questions

The VAT increase proposal represents a short-term solution to immediate fiscal pressures rather than a sustainable long-term strategy. Economic analysts warn of potential stagflation, combining high inflation with economic stagnation, as monetary and fiscal policies work at cross-purposes.

Russia’s economy is expected to grow by only 1.2-1.4% in 2025 according to World Bank projections, down from previous estimates of 2.5% made earlier in the year. This growth slowdown reduces the tax base precisely when government revenue needs are greatest, creating a challenging dynamic for fiscal planning.

The sustainability of current spending levels remains questionable. Manufacturing capacity in the defense sector depends heavily on Soviet-era stockpiles, which are being depleted at unsustainable rates. Maintaining current production levels will require significant new investments in manufacturing capacity, adding to fiscal pressures.

Broader Implications for Russian Society

Beyond immediate fiscal concerns, the VAT increase represents a broader shift of war costs to Russian society. The money supply has doubled since 2021, from 62 trillion rubles to 118 trillion rubles by March 2025, contributing to inflationary pressures that erode consumer purchasing power.

Income inequality has grown significantly during the war period. While defense sector wages have surged by 30-60% due to labor shortages, pensions average only $150-200 per month and public sector salaries lag behind inflation. This growing disparity creates social tensions that tax increases may exacerbate.

The proposed changes also reveal the limits of authoritarian economic management. While autocratic Russia can afford to spend 40% of its budget on the military compared to the prewar 14-16%, such allocations come at the expense of civilian needs and long-term economic development.

Looking Ahead: Critical Decision Points

The VAT proposal will be formally submitted to the State Duma as part of the 2026 budget package by September 29, with key components pre-approved by Putin and unlikely to face significant parliamentary modification. However, the broader economic challenges underlying the tax increase proposal will persist regardless of legislative outcomes.

Russian authorities face a fundamental choice: maintaining current military spending levels while accepting deeper economic distortions, or scaling back war efforts to preserve fiscal stability. The VAT increase represents an attempt to avoid this choice temporarily, but underlying resource constraints suggest such decisions cannot be postponed indefinitely.

The success of the VAT increase in addressing fiscal pressures will depend partly on implementation effectiveness and public acceptance. If tax evasion increases or consumer behavior shifts significantly in response to higher prices, projected revenue gains may fall short of expectations, requiring additional fiscal adjustments.

As Finance Minister Anton Siluanov emphasized that “everything that’s planned in the budget will be implemented regardless of external conditions”, the VAT increase proposal signals Moscow’s determination to maintain military spending despite mounting economic costs. However, analysts increasingly question whether such commitments remain sustainable as fiscal resources diminish and economic contradictions intensify.

The proposed tax increases, while significant in their immediate impact, may ultimately prove insufficient to resolve the fundamental tension between war financing and economic stability that has come to define Russia’s fiscal landscape in the fourth year of its Ukraine invasion.

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By: Montel Kamau

Serrari Financial Analyst

24th September, 2025