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Energy Insights: Energy News: The most important foreign news story this week was about Russian tax policy

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The most important foreign news story this week was about Russian tax policy



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It's been a busy week for foreign news editors: the ISIS attack in Brussels, President Obama's trips to Cuba and Argentina, North Korea's ballistic rocket test, Europe's new refugee policy, presidential candidate speeches to AIPAC, and, now, an airstrike killing ISIS's second-in-command.

For all these important stories, though, the most consequential development in international affairs this week may have come, believe it or not, in a proposed change to Russian tax policy.

Bear with me.

According to the New York Times, Russian leaders, as they struggle to keep their country's economy afloat, are considering something drastic: a major new tax on the oil industry.

This has been debated for some time, but if it now goes through, it would be a major and long-term blow to Russia's economy, one so severe that it would have potentially sweeping implications for the future of Russia itself, and thus the future of a world in which Russia has become increasingly active.

To understand how an oil tax could be this consequential, and why Moscow is considering it anyway, it helps to look at the numbers.

When oil was selling for $100 a barrel, about $74 of that went to the state in taxes, according to the Times's analysis. Oil companies also spend about $15 a barrel on production and shipping, leaving oil companies with about $11 a barrel in profit.

Now, oil is selling at $35 a barrel, and taxes only take $17 a barrel. Subtracting the cost of production and shipping, oil companies only take $3 a barrel in profit.

Russia's government relies overwhelmingly on oil and gas taxes, which fund about half of its national budget. Half! So with those oil taxes falling from $74 to $17 per barrel, that's been catastrophic for the Russian economy, to the point that some analysts fear political instability. So you can see why many in the Russian government are pushing for higher taxes on oil revenue.

But Russian oil firms also saw their profits drop from $11 to $3 per barrel. While we think of oil companies as taking profits just to shower on themselves and indeed, there is some of that they also spend heavily on finding and developing new oil sources. That means exploration as well as developing the technology for new extraction methods, such as shale or deep sea wells. All of that is expensive, and made in investments that take years or decades to pay dividends.

Here's where the possible new tax comes in: It would target Russian oil firm money used for developing new oil sources. In the short term, this would boost tax revenue. But it also would make it much harder for Russian oil firms to develop new oil sources. Over time, as current oil wells dry up, new ones would not come online to replace them.

The Times's Andrew Kramer calls this "the oil industry equivalent of eating the seed corn." He cites a Russian energy ministry report predicting that by 2035, Russian oil output would be cut in half. In other words, even if oil prices go back up, Russian oil output will decline so drastically that its economy might never recover.

Kramer points out that we've seen this movie before in the late 1980s, when declining oil prices devastated the Soviet economy so severely that the Kremlin, then as perhaps now, felt it had no choice but to respond by taking drastic amounts of cash out of the oil industry:

It would not be the first time oil entered a spiral of declining volumes and rising demands from the state. Short of cash in an oil price downturn in the late Soviet period, the Kremlin squeezed the oil industry. It was deprived of capital, at the time, for such things as imported machines.

Output in what is today the Russian Federation fell to about 8.8 barrels in 1991 from about 11 million barrels a day in 1988, according to "Collapse of an Empire: Lessons for Modern Russia," by a former prime minister, Yegor T. Gaidar, who argued that oil prices and not the arms race with the United States ended the Soviet Union.

Of course, today's Russia is not the 1980s Soviet Union, and I'm not sure we're at a point where the Russian political system is at serious risk of again collapsing under economic strains.

But the potential consequences here of Russia so cannibalizing its own oil industry that its current economic decline becomes more or less permanent are really difficult to overstate.

Sooner or later, the Kremlin would have to do one of two things (or even both): cutting back the Russian military, which is wildly expensive but gives Moscow the geopolitical muscle it believes is so crucial, or cutting back already weak social services, which does risk political instability.

The Russian state, as it currently exists, is not quite as precarious as the late-1980s Soviet Union, but it's pretty precarious, and what stability it has is expensive. Vladimir Putin maintains power through a combination of popular and elite support; the elites support him in part because he keeps them rich and powerful, and the public supports him because he delivers (they feel) stability and protection.

He also keeps the Russian state together in part by giving vast amounts of government money to regional governments in Russia's territory in the Caucasus, such as Chechnya, preventing those regions from rebelling or attempting to break away, as they have in the past.

All of those things cost money: The elites are accustomed to Versailles-level wealth, the public relies on large (but rapidly shrinking) social services to keep their communities from completely collapsing as the economy shrinks, and everyone believes they need the powerful Russian military to defend from terrorists and from a West that is seen as bent on Russia's destruction. (This military and its assertiveness abroad also promote nationalism, which is another way of buying internal stability.)

If this oil tax goes through and Moscow may feel it has no choice, simply to survive year to year and the Russian economy declines long term as a result, then this status quo simply can't last.

In this scenario, there are a few possible worst-case outcomes:

1) Russia, which currently has some of the highest military spending (as a portion of GDP) in the world, will have to cut back, and will cease to be one of the world's leading military powers. Its economy is currently smaller than Brazil's or Italy's, and could become nearer to that of Canada or Australia. As a result, Russia will accept having military power commensurate with its economy and, while it will retain a nuclear deterrent, will cease to be a global military power, and thus will cease to hold such sway over Eastern Europe, Central Asia, and (to a lesser extent) the Middle East.

2) Or, rather than accepting a reduced role for itself in the world and in Europe, it could do what declining powers often do, which is seek to make up for weakness by becoming more provocative or aggressive. This would introduce even greater instability and risk for conflict in Eastern Europe and elsewhere on the Russian periphery, which is already high.

3) Russia's elites, its public, or both will suffer economic setbacks severe enough to worsen political instability, with unknowable but surely dire consequences. Modern Russia has experienced repeated periods of political instability, at times violent, amid economic decline.

4) Russia will stop buying off client rulers in Chechnya or other Caucasus states, risking a return to separatism and possibly violence there.

This is all necessarily speculative, and it's also meant to articulate the most extreme plausible outcomes; you should not take this as an absolute prediction of things to come, which are impossible to predict.

The point is that both the Russian political system and Russian global power, as they currently exist, are already more than a little precarious. They're built, to a very large degree, on a foundation of oil revenue. And that foundation may be slipping away, possibly over a period that could last decades.

You'll notice that while some of these outcomes could be considered good news for the world and some of them bad news certainly, many Eastern Europeans would be happy to see Russian military power decline all of them are bad news for ordinary Russians, who've already suffered plenty since the end of the Cold War but seem bound, in just about any scenario, to suffer more.

What happened in Brussels is important, of course primarily for the victims but also for the sustainability of an open Europe. Obama's trips to Latin America are accelerating a trend toward ending once-severe hostility within the Western Hemisphere. North Korea's rocket tests illustrate the country's continued threat to Northeast Asian stability.

All of these events matter a great deal. But what is happening in Russia, though it may not appear it at first glance, is an inflection point in a trend that has been building for years the decline of Russia as a great power and that in the past three years has proven its potentially global consequences over and over. We can't know for sure how those consequences will play out in the coming decades, but it's a safe bet they will be very, very significant.

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