The State Does Not Have an Ethical Right to Tax (True) Small Private Entrepreneurs

Ukrainian tax authorities treat business and entrepreneurs as enemies who cannot be trusted to pay their taxes and must be policed

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Authors:

There is one particular bizarre feature in the Ukrainian tax code. There are two ways to tax labor income. First, there is a simplified tax system that has low marginal income and social security tax rates (e.g., 5% income tax under some conditions instead of 18% income tax). Second, there is a full tax system where the tax rates are much higher.

The simplified tax system is intended for entrepreneurs whose total annual revenue is relatively small (under 5 mln UAH, which is approximately equal to 185 K USD at the beginning of 2017). The idea is to encourage entrepreneurship by minimizing tax and administration burden for small businesses. Unfortunately, the simplified tax system has been abused. There exist enterprises (e.g., retail chains) or even industries (e.g., IT) where thousands of de facto full time employees of a large business are remunerated for their services as private entrepreneurs. The system of simplified taxation is a loophole that is used en masse by businesses in Ukraine.

The response of the government, the policy analysts, and the international agencies such as the IMF has been to push for minimizing the difference in tax rates between the two regimes as well as better administration of taxes so that this loophole is eventually closed. The business community, some experts and politicians pushed back, stalling, e.g., the tax reform in the fall of 2015 [1].

In this piece, we argue that the approach to close the loophole is ineffective and conceptually flawed. Furthermore, we suggest that the real problem lies elsewhere, in the philosophy of tax administration. Today, Ukrainian tax authorities treat business and entrepreneurs as enemies who cannot be trusted to pay their taxes and must be policed. Consistent with this ideology, business activity is subject to comprehensive regulation and even the simplified taxation status or registering for independent work (e.g. attorneys and notaries) cannot be obtained without a daunting amount of paperwork. Furthermore, all digressions and violations are to be punished and there is no forgiveness.

We see a fundamental problem with this approach.

Today, the Ukrainian state does not guarantee the welfare of its citizens. First, Ukraine has moved away from being a paternalistic state [2]. Second, the government does not have resources to provide its citizens with a high standard of living.

But since no government in the last 25 years has been able to fulfill its obligations to take care of its citizens, the state must admit this and at least leave the citizens the opportunity to provide for themselves.

This implies that individuals and small businesses should not be subject to any tax or related paperwork if their per capita income is below a sufficiently high amount (e.g., two minimal wages per month).[3] Specifically, the state should abandon any requirement for the registration of private entrepreneurs and set the tax rates at zero for small revenues. It also should reverse the recent legislation that imposed a fixed tax on dormant private entrepreneurs.

In our opinion, the state’s obligation to provide minimal standard of living to those who can earn it independently supersedes the state’s right to tax everyone. Similarly, fighting abuse of simplified tax system does not justify the cost of imposing additional fees and barriers on real small entrepreneurs. In other words, as the state does not provide adequate minimal standard of living, it forfeits its ethical right to tax those who can earn this standard independently[4]. Of course, the state can and should tax those who earn above this standard.

How can we minimize the abuse of the simplified tax system by big businesses? There are two approaches.

First, the state can impose requirements on the entrepreneur to demonstrate that s/he is not an employee of a big business, or prove that the source of income fall within the allowed categories. This approach imposes costs on those who do not abuse the system and is not ethically justified. It also does not work.

The second approach is to have the state verify whether payments made to individuals by big businesses qualify as remuneration to private entrepreneurs. This is costly for the state and some of this cost may be transferred onto the big businesses [5]. But this is a fairer allocation of the burden of tax administration.

The point that Ukraine authorities have lost the ethical right to be tough on tax optimization and evasion applies more broadly. The state has failed to provide a business friendly climate in which companies and private entrepreneurs can thrive. The business in Ukraine exists often not because of the state but in spite of it. Yet, the government relies on business and the taxes it pays to provide the society with some public good and social safety. So, Ukraine tax authorities should respect business. Protection of business and helping it grow must become the first and the foremost priority, while tax administration can move, for the time being of the economic crisis, to the back seat.

We would like to conclude with a caveat. We do not advocate forgiving abuse of tax law by the big corporations that occasionally avoid paying taxes using political connections and highly skilled lawyers. No, those corporations should bear the largest burden of taxation and the state should see to it. Our theme is that the state can and should help small businesses and individuals to survive in the current weak economic environment by minimizing tax and administrative burden even if it means facing the risk of abuse by larger businesses.

Notes:

[1] For more discussion about the history of taxes in Ukraine see, for example, https://voxukraine.org/en/tax-reform-in-ukraine-or-how-to-accomplish-the-impossible/ and the linked articlets in Ukrainian and Russian https://www.rbc.ua/rus/news/yuzhanina-kompromisse-minfinom-voprose-nalogovoy-1449507705.html, http://forbes.net.ua/nation/1404254-liberalnye-nalogi-vr-protiv-minfina, http://biz.liga.net/all/all/stati/3141503-pomeryalis-reformami-sravnenie-nalogovykh-reform-minfina-i-rady.htm

[2] One might argue though that Ukraine has never been a true paternalistic state, just talk.

[3] The Ukrainian legislation imposes a substantive paperwork burden on an entrepreneur who would like to qualify for the simplified tax system or pay tax under general rules. At the same time, this paperwork can be and is done by big companies with respect to their full time employees. Thus, this barrier is frivolous and futile.

[4] Currently, the tax exemption for individual income is very low (UAH 689 for 2016 and UAH 800 for 2017) and applies only to income received as official salary. Thus, people making some small money on an irregular basis cannot use even this small benefit. Instead, they simply refuse to report and pay taxes on the money they make.

[5] For example, the state might set up a system in which every individual on all of its income automatically qualifies for the simplified tax system but is required to submit a tax declaration in the end of the year. Furthermore, the businesses are required to submit information to the tax authorities about any individual who is paid (a significant) amount of money during the year. Tax authorities then can crosscheck income declared by individuals against income reports submitted by companies and investigate suspicious cases. This will require a non-corrupt and competent tax authorities that can track down ghost individuals who receive payments by organization but do not submit income declarations or pay taxes.

 


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The authors do not work for, consult to, own shares in or receive funding from any company or organization that would benefit from this article, and have no relevant affiliations