Trust and rules are critically important for conducting economic activity. If Ukraine wants to succeed economically, and thus politically, the authorities should focus on increasing the security of property rights and minimizing the ability of the state agencies to void contracts that were concluded and executed in good faith.
After a severe contraction in 2014-2015, the Ukrainian economy is projected to grow about 1% this year. The government has achieved macroeconomic stabilization and we now should expect to see some economic recovery. This recovery, however, is likely to be weak because of the political instability and weak economic institutions.
The Importance of Economic Growth
Successful economic recovery and sustained growth are fundamental to the success of the reforms in Ukraine. Absent the economic prosperity, the Ukrainian public will become disillusioned with the government and the new political leaders who came to power in 2014-2015, setting the stage for the reversal of the power to the old pro-Yanukovich elites. We see some early indications of this process, with extremely low numbers of public support to the president and the (resigning) prime minister, and the on-going political crisis. The issue of economic growth is really the issue of national security and sovereignty of Ukraine.
Economic growth does not come from vacuum or goodwill of politicians. It requires secure property rights, functioning rule of law, enforceable contracts, and trust between businesses and between businesses and the government. Creating these preconditions requires coordinated and meticulous effort by the legislature, the executive, the judicial branches of power as well as by the media, the business community and the public at large. So far, the progress in Ukraine is limited: Heritage Foundation’s Index of Economic Freedom ranks Ukraine on the 162nd place out of 178 countries, with no notable progress achieved over the last two years.
Tax Authorities vs KyivStar
A case in point is the recent fine of 1 bln UAH imposed by the tax authorities on the leading telecom company KyivStar. According to an article in Liga, the KyivStar received over 4 bln UAH from the company Elbrus that acted as a retail distributor for sim-cards and cards that allow adding funds to the accounts of KyivStar clients. The company was connected to the previous president Viktor Yanukovych and telecom companies were pressured into using its service. Elbrus served as an intermediary between the KyivStar and the real distributors, charging a fee for its services.
In response to an investigation by the Prosecutor’s Office, the management of Elbrus refused to recognize their signatures on some of the documents related to the shipment of the cards from the KyivStar to Elbrus. According to the position of the Supreme Court, such a circumstance could be an evidence that the transaction was “fictitious”. If so, operations such as those of by the KyivStar with Elbrus could be found void. This allows for an interpretation by the tax authorities that the revenues received by the KyivStar from Elbrus are disconnected from the costs incurred by the KyivStar related to the goods shipped to Elbrus. As a result, the KyivStar is subject to taxation on this revenue, rather than profit, as well as a fine for allegedly evading taxes. However, the KyivStar has already paid the taxes on the profits received from these operations.
What is the connection with the economic growth?
The case of KyivStar is an example of a common practice when the courts and tax authorities consider business transactions “fictitious” and thus void on unconvincing grounds, including if a party to the contract refuses to recognize and acknowledge its signature on a contract or documents related to its execution.
This practice has several implications adversely affecting the ability of Ukrainian business to operate and grow. First, it makes contracts non-enforceable. If any party to a contract can at any time withdraw its signature to the relevant documents and the government agencies recognize such contracts as void, the contracts cease to be binding. Under this practice, any party can renegotiate a contract at any time under a threat of withdrawing its signatures. As a result, any investment becomes a risk since any return on the investment is subject to good will of the parties involved. Economists call this an environment with incomplete contracts and hold up, which leads to severe inefficiencies.
How and when are contracts enforced in other countries when a party to the contract denies its signature? The courts look at the body of evidence that proves that negotiations took place, were conducted in good faith, and that one or both of the parties implemented their obligations according to the contract. In other words, if there is clear evidence of negotiations, payments, delivery of goods, then the contract is considered to be valid and will be enforced.
In Ukraine this is not always the case. The further risk is a challenge of the transaction by tax authorities even where both parties are happy with the deal. Businesses rationally respond to this bad practice by increasing due diligence of their counterparties and contracting only with trusted partners. This is costly for at least two reasons. First, companies will have to spend more on legal and business keeping costs. Second, companies will avoid interacting with new partners, decreasing market competition and creating barriers to entry. This issue is particularly damaging for Ukraine. Currently, Ukraine is undergoing a recovery from a recession and simultaneously it is restructuring its business as it redirects its international trade from Russia to the EU and other countries. These processes unavoidably mean that businesses have to build new relationships with each other. If companies are afraid to engage with new partners, the recovery and transformation will be slow to non-existent.
This practice is also discriminatory against small businesses in a subtle way. Big businesses are better equipped to deal with the uncertainty of recognition and enforcement of the contracts by the state and the courts. There are economies of scale in hiring lawyers and maintaining large administrative departments that address these risks.
Finally, there is an issue of discretion of tax authorities in recognizing the contracts as void. Any discretion creates opportunities for corruption, where the tax authorities might be tempted to be harder on firms disloyal to them, the state, or the powerful politicians. Loyalty here can take multiple forms – from cash bribes to promises to stay out of competition in areas of interest to politicians with vested interests.
Conclusion
Trust and rules are critically important for conducting economic activity. If Ukraine wants to succeed economically, and thus politically, the authorities should focus on increasing the security of property rights and minimizing the ability of the state agencies to void contracts that were concluded and executed in good faith.
Legitimate businesses that are paying taxes should be cared for. It is important that the successful companies continue to operate and invest in the economy. Businesses should be taxed, but all businesses should be taxed according to the same rules and there should be no destruction of business by taxation. The discretion of tax authorities should be minimized to avoid opportunities for corruption.
Economic recovery is the issue of survival for Ukraine. Absent it, the public discontent will grow, plunging the country in a series of political crises. If Ukraine wants to grow its economy, it needs foreign investment, technology transfer, and entry of reputable and successful foreign companies operating according to best business practices. These will only happen if the business environment is sufficiently transparent, easy to navigate, and friendly to business. Most importantly, the rules should be fair and identical for everyone.
