Ukraine Needs a Radical but Sensible Tax Reform

At present, the government’s proposal at a radically changed tax policy is the main issue of economic discussion. This proposal is basically right and deserves all support. The fundamental problem with Ukraine’s public finance is that public expenditures have persistently been far too large. In 2014, Ukraine had public expenditures of 53% of GDP, while successful fast-growing countries in the neighborhood (Lithuania, Latvia, Slovakia, Bulgaria and Romania) had public expenditures of about 35% of GDP, which should the Ukraine’s target.

Ukraine can moderate its public expenditures eliminating energy subsidies of 10% of GDP and halving the cost of public pensions from 16% of GDP to a normal 8% of GDP. But before public expenditures are cut, taxes cannot be reduced, because the result would only be another financial crisis. The IMF assesses the reduction of Ukraine’s public expenditures in 2015 to 48% of GDP, but it should be decreased further to 40% of GDP in the short term.

For 2015, the IMF assesses Ukraine’s state revenues at 41% of GDP, which should be sufficient. The main concerns about Ukraine’s tax system are a vast underground economy, massive tax evasion, cumbersome taxation practices, unjust tax burdens, and outright criminalization of the tax administration.

Two taxes dominate Ukraine’s state revenues. The “unified social security contribution” or payroll tax of 41%, which contributes 14% of GDP. In the European Union, the corresponding average rate is 36% of the payroll, and in the United States 15%. The value-added tax (VAT) together with excise taxes yields 14% of GDP. The nearly flat personal income tax gives 5% of GDP, and the corporate profit tax 4% of GDP. Foreign trade taxes contribute barely 1% of GDP. Nontax revenues, mainly dividends from state companies and privatization revenues, add 5.5% of GDP.

The aims of tax reform in Ukraine are pretty obvious. The first goal must be fiscal, to gather revenues that approximately equal expenditures. Otherwise the country will be thrown into another financial crisis. Second, the tax system should be simplified and decriminalized. The number of taxes should be reduced and tax administration legalized. Third, the various tax rates should be evened out and loopholes abolished. In particular, the taxes on labor and most of all the payroll taxes should be reduced. As a consequence, taxpayers would spend less time and effort on tax payments and audits. The general trend in taxation is to move taxation from production, that is, labor and capital, to consumption.

The current government proposal makes perfect sense: The four major taxes would all be 20%. The greatest and most important change is to reduce the payroll tax or “unified social security contribution” from 41% of the payroll to 20%. This tax is unsustainably high and it is a major cause of the small official labor force and the sizable shadow economy. This cut would greatly facilitate the collection of the unified social tax and make sure that Ukrainians by and large benefit frorm social insurance. This is the most vital change bringing out people from the underground economy.

A decade ago, Ukraine introduced a flat personal income tax of 15%, but Yanukovych abandoned it by adding a higher rate of 17%. It makes sense for Ukraine to return to a flat personal income tax, but it needs to be 20% of the income to secure sufficient state revenue. About half of the post-communist countries have flat personal income taxes, and as one of the more corrupt countries Ukraine needs such a tax until it has succeeded to clean up its corruption. In Russia, the introduction of a flat income tax in 2001 led to a sharp increase in those tax revenues, as has generally been the case.

Yanukovych’s Tax Code of 2010 legislated a gradual reduction of the corporate profit rate from 25% to 16%. Few countries collect as large a share of GDP in corporate profit taxes as Ukraine, 4% of GDP in 2013, while the EU countries on average obtain 2.5% of GDP in corporate profit taxes. Even so, the largest private Ukrainian companies tend to minimize their profit taxes through transfer pricing to off-shore tax havens. These sizable revenues reflect Ukraine’s truly severe collection practices for medium-sized companies, which have greatly impeded entrepreneurship. A further reduction of the corporate profit tax would be desirable, whereas multiple loopholes need to be eliminated. Yet, it would be unfair to tax salaries more than corporate profits.

Value-added tax (VAT) has been controversial all along in Ukraine. The general impression is that VAT is subject to massive evasion and fraud. Yet Ukraine’s revenues from VAT are very substantial. While the EU average is revenues of 7% of GDP from VAT, Ukraine obtains 10% of GDP. There is no realistic alternative to the VAT. The Ukrainian government recognizes this and therefore focuses on improving the administration of VAT, while opposition parties intermittently call for its replacement with a sales tax. A great advantage with the VAT is that even politically influential enterprises are forced to pay it.

So far, the Ukrainian government proposal for tax reform makes perfect sense, so why are people up in arms. There are essentially three arguments against this excellent tax reform proposal.

First, since 1998 Ukraine has had a very favorable simplified taxation for single entrepreneurs. I proposed it once upon a time together with Yuri Yekhanurov and Serhiy Tihipko. It has allowed small entrepreneurs to pay either a small lump sum tax or a low turnover tax. This sector of micro enterprises expanded rapidly to millions of people. The current tax proposal would rein in the simplified taxation so that it would not apply to highly-earning professionals as is actually the case today. This makes perfect sense to all but these individuals who now protest loudly.

The other community that complains consists of farmers, because Ukraine’s agriculture benefits from very mild taxation, which has rightly aroused a great deal of controversy with the IMF. All agricultural enterprises regardless of size have been subject to a land tax of up to 1% of the assessed value of the land, but usually this tax has been minimal. For Ukraine’s millions of poor agricultural producers this makes sense because they have a small family plot and in hard times they live on subsistence farming. Ukraine’s many large agro-holdings of up to 500,000 hectares are quite a different matter. They are often large integrated companies with non-agricultural enterprises as well but they pay the very low agricultural tax for all their activities, and they have also been relieved of VAT. They should be subject to ordinary taxation with full bookkeeping.

Finally, we encounter the non-economic arguments – that all taxes should be lower and nobody should really pay. Curiously, these views are put forward by the same people who argue that gas tariffs for households should be cut by half and pensions indexed fully to inflation. This is sheer populism that can do nothing but break the state budget and destabilize the country’s economy and politics. Only an enemy of Ukraine could make such statements in public, so it is quite amazing that they are made in public.