Budget Declaration. Second Attempt

The Budget Declaration serves to ensure transparent fiscal policy and predictable financing for various sectors in line with the medium-term budget deficit targets. This, in turn, should contribute to the sustainability of public finances, and hence to economic stability and development.

But will this document help improve the quality of the national budgetary planning? What are the strengths and weaknesses of the first Budget Declaration approved by the Government?

What is the Budget Declaration, and why is it needed?

The Budget Declaration is a strategic document outlining the Government’s consolidated approach to fiscal policy for the next 3 (in some countries – 5) years. The document should determine the fiscal policy both in terms of revenues and spending.     

Adopting the medium-term Budget Declaration is in line with international best practice in public finance management that is widely used in other countries (even though the documents can have different names, e.g. New Zealand‘s Budget Policy Statement and South Africa‘s Medium Term Budget Policy Statement).  

Ukraine’s  Budget Declaration for 2022-2024 is the first officially approved attempt to implement such an approach. However, it is the second attempt to draw up such a declaration based on the new legislation on medium-term budgetary frameworks passed in December 2018. The first Declaration was produced by the Ministry of Finance under Oksana Markarova in 2019, but it was not approved by the Volodymyr Groysman government due to political reasons (a new president was elected, there were negotiations to form a new government and discussions to call an early parliamentary election).      

In 2020, the Government refused to prepare the Budget Declaration amid uncertainty over the COVID-19 pandemic. However, the incumbent Government’s second attempt was more successful. On May 14, the Ministry of Finance submitted the Declaration to the Government, which then approved it on May 31.

Clash of the forecasts

Already after adopting the Declaration, the Ministry of Economy made public the government-approved Forecast of Economic and Social Development of Ukraine for 2022-2024, based on which the Declaration was drawn up. This reverse sequence of the Government’s actions directly affected the preparation of the document – between the Declaration’s being submitted to the Cabinet of Ministers and being made public, GDP forecast for 2022-2024 was updated (with budget revenue figures remaining the same). 

One probable reason for this is the divergent views of the Ministry of Finance and the Ministry of Economy of how fast the minimum wage should increase. 

The Declaration is based on the assumption that in 2022, the minimum wage will be UAH 6,500 from January 1 and UAH 6,700 from October 1. Thus, the weighted average minimum wage will be UAH 6,550. However, according to the Ministry of Economy’s comments to the draft Declaration contained in the accompanying documents, the Ministry’s macro forecast, on which the Declaration was based, had initially estimated an increase in the weighted average minimum wage of UAH 6,700 in 2022. Thus, budget revenue estimates in the Declaration were actually based on a higher minimum wage, while spending was based on its lower level. Such inconsistencies could lead to a hidden budget deficit. 

Accordingly, the macro forecast that served as a basis for the draft Declaration had to be revisited at the last moment, which was reflected in GDP forecasts.

What’s in the Declaration?

The Declaration is reminiscent of the traditional “explanatory note” accompanying each draft state budget law for the next year. Much of the document describes the macroeconomic environment, key macro forecast figures and budgetary performance. But, unlike annual budgets, this document deals with a three-year budgetary planning cycle.   

It is a document of nearly 170 pages, of which about 50 are a textual description of the Government’s budgetary policy for the next three years. The remaining pages are given to appendices that define the Government’s policy objectives and key performance measures for these targets, as well as maximum spending for each budget manager. 

In line with best international practice, the Ministry of Finance also included in the Budget Declaration the so-called “fiscal space”, i.e. a budget reserve to ensure the state’s ability to withstand fiscal risks (a possible unforeseen decrease in revenues or an increase in spending not included in the Declaration), which can be allotted closer to the beginning of the new fiscal year.

Specifically, the “fiscal space” is UAH 24.6 billion for 2022, UAH 24.7 billion for 2023; and UAH 48.9 billion for 2024 (this does not include an additional UAH 34 billion, which can be available to the Government in the event of additional tax initiatives). These funds will be allocated during the preparation of the law on the state budget for the relevant year – primarily for planned capital expenditures, public administration reform, etc.

We saw several problems in the Declaration. 

Possible tax changes

The first problem is the approach to defining the tax base. One of the Declaration’s tasks is to give taxpayers an understanding of medium-term taxation. This requires that the Government form and coordinate, at all levels, a consolidated approach to defining taxation rules.

However, according to the Declaration, the budgets’ revenue base rests on the current tax rates (excluding the tax on tobacco products), in particular, on the current extraction rates for oil, gas condensate, iron ore and natural gas. Also, the budget was based on the assumption of “no indexation of tax rates defined in absolute terms”, as well as excise, environmental taxes and rent. 

Assessing the financial resource of the 2022-2024 budgets, only the following significant tax changes are taken into account:

• indexing normative monetary valuation of agricultural lands, from 2024;          
• applying regular rates until 2023 instead of preferential rates for production from new wells operating since January 1, 2018.          

According to the Declaration, the lack of indexation of tax rates in absolute terms, as well as lower contributions to the budget from the National Bank will reduce the level of redistribution of GDP through the state budget from 22.5% of GDP in 2022 to 21.6% in 2024.

At the same time, Parliament is currently considering amendments to the TCU submitted by the Government, including those contained in the National Economic Strategy until 2030 approved in March 2020, as well as other initiatives submitted by MPs. If adopted, these changes carry significant implications for future tax revenues.

It is stated in the Declaration that the Government proposes to Parliament a number of changes to tax legislation that, starting from 2022, will increase budget revenues by about UAH 34.1 billion, in addition to the resource already provided for in the Declaration. These are the following changes:

• indexing excise tax rates on alcoholic beverages, environmental taxes and rent in absolute values;          
• prohibiting public sector enterprises from independently forming reserves for future spending and doubtful debts;          
• increasing the pre-tax financial result of state-owned enterprises in the amount of the non-refundable assistance provided to related parties;          
• restricting the transfer of losses of previous periods to 50%, for large taxpayers;          
• restricting budget VAT refunds for intermediary payers in case of purchasing/importing goods to be supplied on the territory of Ukraine;          
• abolishing VAT exemptions for taxpayers selling housing on the secondary market;          
• restricting tax invoices drawn up more than 6 months from the date of the transaction from being included in the tax credit;
• introducing a minimum tax liability for 1 hectare of agricultural land;          
• introducing an electronic tax audit.            

The Declaration thus does not provide a final understanding of what the Government’s tax policy will be and what financial resources it will have.

This caution is understandable as other tax changes under active discussion in Parliament could lead to a decrease in tax revenue. These are primarily the proposal to extend the VAT rate of 14% to a number of socially important products; new tax benefits to support scientific and technical activities (exemption from VAT for state research institutions and higher education institutions importing equipment for their needs) and the catering industries (reduction of VAT rate to 7% on transactions in the restaurant business and catering services).

Spending is not prioritized

Another significant problem is the lack of a unified stance of the members of the Government on the expenditure budget, which is evident both from the number of various government bodies’ comments and complaints that the Ministry of Finance did not include all their proposals in the document, and from the amount of budget requests sent by the Ministries.

Preparing a Budget Declaration is a non-trivial task for the Ministry of Finance. After all, it needs to get government bodies accustomed to the fact that budget resources are scarce, and that each Ministry needs to plan its spending in advance based on an understanding of policy priorities.

The task is complicated by the fact that the Government needs to reduce the state budget deficit to ensure the country’s financial stability. There are plans to reduce it from 5.5% of GDP for 2021 to 2.7% of GDP at the end of 2024, i.e. by more than half. 

This means a significant slowdown in spending compared to what the Government has become “used to” over the COVID-19 period of 2020-2021. Specifically, according to the document, spending should grow by an average of 6.5 percent annually in the next three years, while projected revenue will grow by an average of 9.8 percent. 

To achieve this goal, the Government must clearly prioritize its spending. However, it failed to do so. So as before, many budget managers will additionally receive a little bit from the budget pie as before. 

The Budget Declaration does not contain a list of national priorities. It has 5-10 paths of action in each area under the Government’s care. Such a list is largely in line with the Government’s earlier plans (see the Box). 

However, the Government’s budgetary constraint we talked about earlier is noticeable almost everywhere in the Declaration. For example, the Government maintains the current level of state support in absolute terms for some industries. This means that it will decrease as a share of the budgetary expenditure.

For example, the Ministry of Finance foresees an annual increase in the minimum wage and subsistence level, but it will be slower than the Ministry of Economy’s macroeconomic forecast estimates. After an increase in the minimum wage to UAH 6,500 from December 1, 2021, the next 3% increase to UAH 6,700 is planned for October 1, 2022. From January 1, 2023, the minimum wage will increase by 7% (to UAH 7,176), and from January 1, 2024, by nearly 7%, to UAH 7,665.  

The subsistence level will increase at a rate exceeding the forecast inflation rate for 2022-2024 by 2 percentage points. Specifically, the subsistence level for able-bodied individuals is defined as follows:

• UAH 2,481  from January 1, 2022    
• UAH 2,600  from July 1, 2022
• UAH 2,684  from December 1, 2022

It is easy to predict that a moderate increase in these indicators will arouse considerable criticism of the document. But the Ministry of Finance should be paid a compliment for doing it in order to curb the budget deficit.

At the same time, the Government promises to reform the system of social supports and pension provision, which will make it possible to move from “passively adapting social policy to the country’s limited financial and material resources” to provide truly effective support to those who need it. However, there is no detail of this approach in the document.

The Government also plans on increasing (again, without details) the motivation of those receiving benefits and housing subsidies to economically use housing and communal services and implement energy efficiency measures.

The Government also has plans to change its approach to the formation of the wage and the amount of remuneration for public sector, government agency and court employees, and to untie their salaries from the subsistence level for able-bodied persons. 

It will be recalled that the size of more than 150 different types of payments from (and to) the budget depending on the subsistence level is a considerable issue for the budget today. Therefore, each step towards increasing this indicator means an additional increase in spending on a wide range of budget payments.

Desires beyond possibility 

The Ministry of Finance’s caution in planning the spending has already met with opposition from nearly every Ministry. According to the SCMU’s conclusions to the draft Budget Declaration, the budget managers asked the Ministry of Finance for the amount that is 60% more than the Government could afford, going far beyond the managers’ spending “limits”.

But is it about the Ministry of Finance or is it more about the adequacy of requests made by the government bodies? 

One of the key elements in preparing the Budget Declaration is informing the government agencies (main budget managers) about the so-called “budget ceilings”, i.e. the funding amounts that each of them can reasonably count on in the medium term in line with the budget capacity. 

Keeping within such “ceilings” is a powerful tool for training government officials to exercise restraint and prioritize spending. The Ministries need to decide on which spending areas are of more importance to them in order to allocate resources more rationally.

To this end, some countries even use punitive tools for those government agencies whose requests exceed the ceiling (Table 2).

Ukraine is still very far from such a consciousness of budget managers. How so? 

For starters, because some Ministries’ staff (and even their heads) still do not think in terms of policy-making, proposing that the Finance Ministry simply fund spending in the same way it has done for years (regardless of whether such spending is needed to meet their objectives or whether it is worth being funded at taxpayers’ expense).

Therefore, most government bodies propose that funding be allocated not to achieve specific objectives, but simply to support their own (often very outdated) infrastructure.

Secondly, even if some spending is indeed needed, there is almost always room for increasing its effectiveness through rightsizing, efficiency, digitization of processes, etc. Just like what any regular organization does in a limited budget situation. But the appendices to the Declaration show that such streamlining does not always take center stage for government officials. And the failed experience of conducting expenditure reviews shows that improving spending efficiency is not important for budget managers.

We estimate that less than half of the 55 budget managers (excluding 24 regional state administrations) who submitted their requests to the Budget Declaration plan their spending based on policy objectives. The others ask for money to keep going with the status quo. 

How should one plan expenditures?

How should that work? For example, the goal of the Ministry of Agrarian Policy and Food of Ukraine is to create conditions for food security and sustainable development of agriculture. Therefore, spending the stated amount of money could result in increasing the share of Ukrainian products in the domestic market, developing farming, etc. Instead, the Ministry of Agriculture states in the Budget Declaration that in order for this goal to be achieved, the share of household spending on groceries in the overall expenditure should remain stable at 60% over the next 3 years (!), whereas this figure is typical for poorer countries (it was 47% for Ukraine in 2019). 

One of the policy goals of the Ministry of Regional Development is to create and develop its own documentary and information resources, modern information and communication technologies, and a high-quality library service in order to enhance the scientific and technical sector capacity. But the performance indicator for this goal is “number of users of the State Scientific-Technical Library”, which according to the Ministry should see an annual increase of 115 people on average.

And it is clear from the policy objectives of the State Judicial Administration that there are no plans to increase the level of trust in the judiciary: it should remain at 40% over the next three years. And the share of unresolved cases should even increase to 80% (although there is hope that it is just an error made by those setting the goals). Instead, protecting the cases of the judges themselves is SJA’s number one concern (the level of enforcement of court decisions made in favor of the judges and court employees should be 100%), which once again underlines the need for judicial reform, where “being a judge” does not mean having advantages in exercising the right to a fair trial. 

And while some of these indicators help the Government keep track of what government agencies spend their money on, it in no way helps to understand whether such spending will contribute to a real change for the better in each of the policy objectives.

In addition, according to the appendices to the Declaration, government bodies often measure their own performance (requesting additional funding from the Ministry of Finance) based on such outdated and meaningless indicators as:

• number of incoming/outgoing calls of employees,       
• number of draft regulations drawn up,       
• number of management decisions made,       
• number of meetings/conferences held,       
• number of completed orders,       
• number of opinions on legislative acts provided, etc.

To remedy this problem and base budget spending on policy needs, rather than simply provide funding “because it’s always been this way”, the Ministry of Finance has been trying for years to launch “expenditure reviews” – an important tool for creating an effective budgetary planning system. The purpose of such reviews is to ensure a direct link between budgetary spending and achieving policy objectives.

But expenditure reviews are currently facing significant problems. The Government planned on carrying out expenditure reviews in 5 Ministries in 9 areas in 2019 and in 11 main budget managers and in 15 areas in 2020. But most of these reviews have not resulted in any action so far.

Conclusions

Despite all these shortcomings, we would like to congratulate the Cabinet of Ministers on adopting an important document – the medium-term Budget Declaration. It is always hard at the beginning, but it is important to start implementing best international practice in the field of public finance management.

In the years to come, we would like to see the goals being correctly defined by the budget managers, as well as a clear and predictable budget policy framework. The Government should also learn to identify several important development priorities for the country, to which additional funding should be directed in the first place, actively working in other areas to improve the efficiency of budgetary spending to achieve better results for the same money.

But already this year, the Government must show that the Budget Declaration is not a declarative document, but one of genuine importance. To this end, the draft State Budget for 2021 should be based on the policies and indicators contained in the Declaration. Any deviations will need to be justified in an explanatory note to the Budget.