Political, Economic And Institutional Aspects Of Making Cuts To The Ukrainian Budget

It seems like there are no further arguments needed to be advanced for the urgent necessity of cutting budgetary expenditures: obviously, considering the severity of the external threats the country faces, if we do not cope with this issue Ukraine can simply disappear altogether – writes Vladimir Dubrovskiy in his column for VoxUkraine.org. So if we want to save our country and at the same time the inheritance of the Revolution of Dignity, we have to consider a number of political, economic and institutional factors that are usually underestimated by both the government and the IMF.

It seems like there are no further arguments needed to be advanced for the urgent necessity of cutting budgetary expenditures: obviously, considering the severity of the external threats the country faces, if we do not cope with this issue Ukraine can simply disappear altogether. However, budget cuts in and of themselves are not a solution because if they are carried out incorrectly – whether that means mechanically or by the standard recipes worked out for different types of countries, then the results will miss the mark by a considerable degree. So if we want to save our country and at the same time the inheritance of the Revolution of Dignity, we have to consider a number of political, economic and institutional factors that are usually underestimated by both the government and the IMF.

1. Characteristics of a fiscal crisis in transition countries

The budget deficit in countries where, like in Ukraine, a “limited access social order” (hereafter, LAO) dominates (North, Weingast and Wallis’s terminology) or “extractive institutions” (the term employed by Acemoglu and Robinson), have a very different nature when compared to developed countries with “open access order” (hereafter, OAOOAO)”. The latter mainly suffers from an oversized “social state”, while the first suffer from the excessive and irresponsible national resources’ appropriation by “the ruling coalitions”. Usually, the fiscal crisis in these countries is created by such factors as:

• a short term horizon;
• lack of coordination within the elite (“the tragedy of the commons ”);
• an excessive need for a “peace purchase” for the ruling coalition’s stabilization (according to the LAO logics)
• or simply excessive reckless greed and a lack of intellect, as in the case of Yanukovych and his partners.

Accordingly, effective recipes for overcoming a fiscal crisis by LAO, first of all, require that limitation on the elite’s ability to acquire rents are imposed – or, in other words, systemic reforms . By systemic reforms we mean limiting opportunities for rent seeking for a narrow groups of interests such as for industry and regional clans, individual “oligarchs” and so on. Such reforms lead to a restriction of potential sources for rents, the gradual narrowing of rent-oriented sectors, thereby reducing the impact of these respective groups – and this is one of the likely mechanisms for LAO’s destruction and a prerequisite step in order to begin the transition to OAO.

The crisis of 1998-99 in Ukraine was caused mostly by a lack of coordination which was manifested outwardly in a lenient policy of “soft budget constraints” and through an extensive use of bartering and mutual settlements on accounts. After the 1998 crisis, a political reaction was delayed for a year due to the presidential election (where there was a very real threat that the Communists could return to office), but having won, a Cabinet led by Yushchenko was appointed – the first reformist government in the history of Ukraine.

The reforms successfully implemented thus far have destroyed the most harmful ‘schemes’ in the economy, and created a basis not only for stabilizing the nation’s public finances, but also for economic growth. Subsequently, businesses’ resources and efforts were partially reoriented from rent seeking to productive activity.

The main lesson which should be learned from this experience is that the opportunities for cutting budget expenditures can be found far from textbook prescriptions that are primarily based on developed countries’ own experiences. It is necessary to note that despite the pervasive initial level of fear, the social sphere only benefited from these reforms, and Yushchenko with Tymoshenko gained political capital, which then allowed them to win the Orange Revolution.

Unfortunately, despite many setbacks and the furious criticism leveled at it, the IMF continues to counsel countries to carry out some “belt tightening” by means of reduced social expenditures herein paying insufficient attention to the budget deficit’s nature and the general dominant social order existing within the country. Governments in countries with “extractive” institutions readily accept such an approach because it does not destroy their means of pumping out rents to be secured by elites.

However, the IMF is partially right at the present moment in its diagnosis of Ukraine’s budgetary woes, because over the past 16 years that have followed the aforementioned crisis, the country has managed to take the long road towards creating a bloated welfare state. It can be partially explained by the nation’s Soviet heritage, but other similar countries, including some in South America, also traditionally suffer from both of these ailments. Countries in transition are especially prone to having a large fiscal deficit due to two factors, both of which play an important role in Ukraine.

First, large segments of the population that require resource redistribution may press the state, by their de facto political power, to introduce certain democratic institutions (Acemohlu and Robinson, 2006). But the endowment of them with de jure political power fits into the LAO system: these are simply the subsequent causal agents of peace, which can be restrained by privileges based on redistribution, while not betraying the fundamental principles of the prevailing social order – that is to say, without providing access to political and economic opportunities. This approach has to be set aside until the point when when these privileges begin to threaten fiscal stability on a larger scale and/or when a certain opening up of opportunities (for example, market trade) appears cheaper for the elite, at least in the short-term. These difficult decisions, however, are taken by a ruling coalition only under the pressure of a fiscal crisis.

At that stage of social development, when a country already has formal democratic institutions, a certain level of social capital, but has not yet moved to an OAO (partially because the population chiefly perceives economic activity as “a zero-sum game”, and consider resource redistribution to be its primary interest and/or goal, rather than the granting of access through equal opportunity) fiscal crises are inevitable and frequent. They are an integral part of the transformation process, one of its most important mechanisms.

Second, at the transitional stages such as those exhibited in “fragile” and “developed” LAs, the players’ ability to coordinate is more problematic when compared to “basic” LAO, where it is concentrated in the hands of the state, and OAO, where the established rules are valid. On the other hand, a basic LAO is likely to be successfully preserved mainly in resource-rich countries because it is better able to solve the natural rent distribution problem, and the presence of a strong fiscal base makes the market-style reforms unnecessary for the authorities.

In spite of these factors, the struggle against running a fiscal deficit in a transitional country is complicated when one compares both “basic” LAO and OAO.

Indeed, it is a struggle on two fronts. It requires extraordinary political artistry on the part of the reformers when deciding on whom they can rely on politically – be it on “oligarchs” or on the broader public – in every given situation. Or, perhaps is it better to adopt a package of reforms that will leave all parties unsatisfied as a result of compromise, but unsatisfied in equal measure?

However, from a political and economic point of view the choice is obvious – favor a policy that primarily limits small groups’ privileges. If it is aimed at OAO’s promotion, it is tantamount to a sin not to use the opportunity that a fiscal crisis provides. Instead, an attack on a bloated social safety net, although it may be more effective in the short-term as it coincides with the desire of elites to strengthen their extractive institutions, is counterproductive in the long run, because instead of moving forward it helps to hold a country in a zone of danger. Additionally, it undermines progress towards developing democracy, as the promoters of the unpopular reforms are very likely to be removed from power after the elections or even massive riots. Therefore, the temptation to be congratulatory with a dictatorship (which is supposedly necessary to carry out unpopular reforms) grows.

Everything though has been listed above, it does not mean, of course, that a bloated social safety net is a “sacred cow” that cannot be touched. But one should (and must) tackle them only after a firm reduction of elites’ privileges. One should start not with wages and pensions, and not even with healthcare service privileges, but with those whom have real sources of tangible wealth. This is especially true when one considers that the Ukrainian people rose up against the latter.

2. Give consideration to political (in)stability and external (in)security

Unlike the typical successful “belt-tightening” examples that are carted around, Ukraine is quite unstable now, which is, moreover, a process that is being driven by external forces. It is a significant, and no less dangerous, mistake to just look at the processes at the level of formal political events. If we make such a mistake, it would have to be done in the event that an exceptional society will be able to consolidate itself around reformers which will in turn allow for painful reforms to be carried out with ease. First of all, the political timetables are themselves very ambiguous, and second, they only superficially reflect the complex and multi-vector social processes taking place. Taking Putin’s impact on current events into account, one can be almost certain that he will do his best to help generate protest and a revanchist mood, provoke and support economic protest actions financially and organizationally through his agents and demonstrate that the “belt-tightening” policy’s realization will be at the expense of the public, making it a threat to national security.

Sociologists and political scientists can speak at greater depth on this topic. I would like to cite just a few facts.

A convincing victory at the elections was won by “pro-Maidan” politicians and political forces. However, not long after the presidential elections, the President lost more than half of the public’s trust, and parliamentary elections showed a record low turnout – which means that the majority of voters did not find worthy representatives among the political forces made available to them.

One should not rely on the victory of the Revolution of Dignity as an established fact because still 30% of respondents ( in a poll done by the Democratic Initiatives Fund) consider it to be a coup d’etat. Even those people who have personally defended the nation’s independence have no common solid ideological views regarding the “pro-Maidan” politicians, much less economic reforms. In fact, the revolution is still ongoing. The government is not sufficiently reputable to support the politics of both a reasonable segment of society and the more radical and/or regular representatives of Maidan. The system of governance has been destroyed, it is largely filled with ineffective, corrupt and unpatriotic bureaucrats and staff members, sometimes even with outright saboteurs in their ranks, as well as the presence of either Putin’s or Yanukovych’s agents. Under these conditions, widespread public discontent can be a threat to national security.

The announcement for raising tariffs on public utilities announced on 27.03.2014 greatly helped the local clans and Russian secret services to bolster the separatist mood in the Donbas because they received a very strong, especially at the local level, argument against the new government in Kiev. It is not by accident that a new wave of separatism began shortly after the tariff’s escalation was made public (on 06.04.2014). The author warned about the high likelihood of such events back in March (Popular Reformist Practice: Recipes for the IMF, Mirror of the Week, Ukraine, №8, March 6, 2014), based on the same logic. Unfortunately, these predictions have come true. It is highly likely that Putin is waiting for an opportunity to take advantage of events that will unfold during the next round of “belt tightening”.

One should consider inclusion as a characteristic of Ukrainian political culture – unlike, for example, Georgian or Russian political culture. On the one hand, it clearly stifles radical reforms. But, on the other hand, until recently this inclusiveness itself allowed Ukraine to implement reforms and develop while avoiding heated violent conflict – despite geopolitical and mental divisions and other external factors, which did their best to push it towards that end. The breach of this tradition was mainly caused by the recent revolution. So even with the slightest possibility of reforms being enacted – including budget cuts – they should be done in a manner that provides as much support and involvement of the general public. It should be noted that thanks to the outcomes of the Arab Spring, of all countries, Tunisia has achieved the greatest success with this inclusive approaches. As for the current attempts to impose those tax and budgetary ‘innovations’ on society which were mainly directed against the interests of ordinary citizens, and the way itself in which they were made – without a public debate (except for a few “notes” in dubious Internet publications), without the possibility of any detailed elaboration by the deputies and experts, etc. – is unacceptable and contradicts the principles of democracy in a general way, but also in an inclusive political culture in particular. This, by the way, was a typical practice of the Yanukovych regime.

When the heterogeneity of society takes the place of the “fairness” of a reform, it gains special importance. But it is well known that protests, as a rule, are usually not driven by despair from intolerable living conditions, but rather by expressions of injustice (in the sense in which the participants understand it to be so). In Ukraine this means that any benefits and social safety net reductions for the general populace – including those that are truly unfair – should be preceded by much deeper and firmer reductions in formal and informal privileges of the “oligarchs” of various levels and as well as fighting corruption. And both actions should be well communicated to the public and felt at a household level.

For example, the rise in tariffs for public utilities should at least be accompanied by a drastic change in their governing settlement rules. This would entail a transition to a marginal rate system calculated without any consideration of technological losses with a meter’s installation. On the other side, there should be a reform that would lead to the total annihilation of schemes of theft in this arena together with the criminal prosecution of their executors and beneficiaries.

3. Consider the real institutional government and state capacity in general

Usually the recipes for fiscal deficit reduction implicitly provide that the government has an effective (though often excessive) bureaucracy at its disposal that is able to implement the necessary reforms. In Ukraine we can hardly assume that the aforementioned conditions are present. Therefore, on an instrumental level, the reforms should be designed and based on the realities on the ground. In practice this means setting up mechanisms able to work in the absence of bureaucracy in the classical sense as defined by Weber.

Brian Levy distinguishes “less developed” countries into two broad categories, depending on which successful state components are prevailing: a centralized bureaucracy or checks and balances. According to historians, Ukraine historically belonged to the second category, so the bureaucratic institutions themselves have never been very strong. The colonial inheritance further continued to weaken them in at least three directions.a)

   a)The Russian (Moscow) tradition is to deny the possibility of checks and balances being established as such, which prevents mobilization; instead it relies on a “line of command”. That is, according to Levy’s classification it belongs to the opposite category. Therefore, the imposition of the “line of command” during colonial times undermined the actual ability of the Ukrainian state to function and its continued attempts of its recovery throughout its independence: even the quite sincere intentions of statesmen of the Soviet school to build an effective state only made the situation worse.

   b) Ukrainian executive power has successfully adopted an erroneous tradition from its Russian counterpart, according to which a government official becomes a sovereign “chief” by allowing a selective, at his own discretion, application of the law. A selective punishment is especially dangerous for the violation of non-executive laws (ambiguous; inconsistent ones which contradict one another; over-burdensome and/or restrictive laws which are contrary to available public and/or technical opportunities, or those that leave the final decision to the executor’s discretion, etc.).

This procedure fundamentally distorts “bureaucrats” incentives: from those officials who had originally aimed to serve their communities, they turn into these so-called chiefs – with an inherently granted unchecked level of power; the opportunities for corrupt income acquisition due to this overlap of power are the motivating factor behind official bonuses; the relations within the state apparatus gain quasi-market features (an “administrative market” is formed), and risk becomes a norm of life. Finally, this work becomes attractive to unscrupulous, risk-averse people who are professionally unsuitable to be bureaucrats in the classical definition of the word. This is what a considerable, if not overwhelming, part of the Ukrainian state apparatus consists of – individuals that keep up direct contact with specific people, exercise oversight, make deals with public procurement etc.

   c) For a number of reasons, Russia has served as a metropolis during the whole history of government in Ukraine, a role which had it pursuing a policy of deliberately depriving Ukraine of a national elite, be it by the extermination of the unsubdued or through enticing the rest of them into the imperial ruling class. In addition, the ethnic and linguistic proximity provided Ukrainians with excellent career opportunities in the metropolis. Therefore, in particular, the quality of personnel in the Ukrainian state apparatus lags far behind, even when taking into consideration countries with generally lower levels of education and creativity.

It is necessary to add that getting rid of the control of the Communist Party, the state apparatus was in a situation which Alexander Paskhaver figuratively calls “a horse which threw off its rider.” This has led to the proliferation of unnecessary and burdensome control and other bribery functions on the backdrop of a decline in others, and a trend of generally inflating the bureaucracy’s numbers. After all, it formed an independent and highly influential interest group, so potent that even a brilliant representative like Mykola Azarov was able to lead the government.

This quality of public administration imposes rather strong restrictions on the effectiveness of reforms, and also leads to the necessity of utilizing creative approaches and tools of reform. In particular, it is about creating and using mechanisms based on checks and balances; the broad involvement of civil society; a gradual removal of the bureaucracy from reforms and development, particularly in decision-making, etc. Reform policy should be framed in the laws of direct action to prevent their distortion and emasculation by means of regulations. In addition, they should be very simple, to avoid even the slightest level of discretion or ambiguities and other opportunities for arbitrary interpretation. To that end, flexibility and sophistication have to be sacrificed.

Interim conclusions

So, the budget of Ukraine currently suffers from both massive embezzlement and tax evasion by small groups of people (which is characteristic of countries with extractive institutions), and from bloated social and pseudo-social obligations. It is difficult to say which of these problems is currently predominant – this merits its own study – but at least it is clear that they are of the same order of magnitude. For political and economic reasons, budget-saving measures should be directed primarily against the interests of narrow groups, based on the support of the broader public and civil society and, hopefully, foreign donors. Only after considerable progress in this direction is made can we begin “tightening the belt” in the realms of social spending and pseudo-social safety nets, such as energy subsidies and poorly targeted social assistance programs. These reform policy instruments should take into account the existing governance problems described above. Under these conditions, the current crisis may yet become a great chance for systemic reforms that have failed to occur in the last 15 years.

The proposed activities

1. The legal prohibition of any state support to business entities. Payments from the budget (state and local) to enterprises with any form of ownership should be strictly prohibited (programmed into the Treasury’s software) except for in the following instances:

• payments for public procurement (in certain circumstances – see Below.)
• VAT returns (after a relevant reform)
• investment in state-owned enterprises (a very narrow range defined by clear criteria, and completely controlled at the level of the actual budgetary unit). Procuring entities, which have the status of state-owned enterprises (Ukravtodor etc.) should be restructured as subunits of the relevant state authorities with the right to distribute the budget, or as ordinary contractors that perform public procurement in competition with others, including private structures, and are later on privatized.

The remaining types of covert aid (state guarantees, contributions to statutory funds, partial compensation of interest on loans, etc.) should be strictly prohibited. Social and quasi-social subsidies, if they are provided through subsidies to enterprises (including the subsidies to Naftogaz), should be forwarded directly to consumers on an individual basis.

For example, a consumer who wishes to receive a subsidy for gas, must provide documents proving the total volume of their consumption/usage and will qualify to automatically receive compensation at the first stage – even without means of testing the property. It can (and should) be introduced later, stage-by-stage, depending on the amount of gas consumed. The next step would be canceling subsidies for gas, while introducing an increase in aid to the poverty-stricken, and perhaps provide one-time assistance to help individuals to move to more affordable housing. It is also necessary to act accordingly with other types of energy subsidies. In this way, at the first stage it is possible to significantly reduce the cost of subsidies by (a) the total elimination of schemes of corruption in the resale of preferential gas; and (b) the voluntary elimination of subsidies from those inhabitants for whom the corresponding amount is not as important as seeking a refund. At the same time, this creates an incentive to install meters, and further on, energy savings, especially when the above-described “road map” has been properly delivered to consumers.

Thus, in contrast to the dominant approach today, it is possible to avoid the growth of dissent caused by the dissatisfaction of the general population, especially members of the public with a more paternalistic mindset, which is not classified as “poverty-stricken”.

Further steps are to reduce subsidies first and each time, gradually, touch on a small proportion of consumers; second, this reform will most likely take place against the backdrop of economic growth that will make them less noticeable in an environment of increasing revenues. In addition, the transition to controlling property, and especially a complete rejection of subsidies, should be accompanied by deep reforms in the public service sector that can significantly (in the case of central heating – up to two times) reduce the end-user prices by driving down instances of fraud and wasteful expenditures.

The more problematic side of this approach may be the technical ability to calculate and pay out subsidies to large numbers of individual consumers. The current system of paying housing subsidies cannot handle it because it is designed for providing service to considerably fewer people. Creating queues and other obstacles to get one’s hands on subsidies can be a tool of increasing the level of discontent. Also, the proposed mechanism itself, unfortunately, does not solve the problem of establishing high prices from monopolies for the sake of their corrupt enrichment by subsidies. It also does not take into account attempts at deliberately undermining the economy and national security of Ukraine (especially when one considers the origin of the owners of energy companies, regional gas etc.).

On a procedural level it is necessary to introduce a ban on raising questions about “state aid”. Officials who try to lobby for the interests of enterprises or industries should be immediately dismissed; Deputies, excluding those from political factions, bring their cause with them; lobbyists who “go from room to room” with a request – should be denied permits and any communication with them should lead to an anti-corruption investigation. It should be noted that the reorganization of the Cabinet under the premiership of Yushchenko greatly helped in overcoming interest lobbying and, therefore, the problem concerning shares of the State budget.

In general, the rejection of subsidizing business will cause fierce resistance from those who are fed by subsidies – in particular, the coal industry, agriculture, etc., especially those wutg parasitic structures that actually aggregate most of those subsidies. They will definitely try to gather up a group of dissatisfied and potentially vulnerable – individuals especially dependents of employees of the enterprises concerned – to take part in protests.

But:

(a) the potential number of protesters are much smaller than in the case of a general “belt tightening”;

(b) they are concentrated in certain areas which are predictable – so you can offer targeted compensation precisely to said vulnerable population, and to take increased security measures to prevent rolling protests organized by Russia’s secret services;

(c) in the case of agriculture, the main source of compensation has to come from the deregulation of the industry; in the case of coal – involving unemployed miners in road construction (especially in rural areas) all across Ukraine in shifts could be offered without reducing wages.

Justification: The main argument in favor of state aid to citizens (individuals) is that a person is born with the right to life and other inalienable rights, which in some interpretations consist also of economic and social rights – a minimum level of security, a certain level of education, basic healthcare, housing, etc. One can argue whether society should provide it to them, and if so, at what amount. But the undeniable fact is that business entities are organizations created by people to perform certain functions. They have natural rights, even the inherent right to life. And thus their receiving help from society is unnatural.

There are arguments for state aid to the so-called “points of growth”, “newborn branches, small business “green” technologies and other businesses. A review of their validity in general and in the specific case of Ukraine is beyond the scope of this article. But in a fiscal crisis, they do not matter, because the primary question is one of survival. On the one hand, Ukraine’s survival as an independent sovereign state, and, on the other – of millions of its citizens, who can prematurely expire due to a lack of available funds for physical survival and healthcare. Only after the resolution of these basic questions has been achieved can we start a public debate on any government support for business.

Support for enterprises, in its various forms, is an important source of corruption – directly or through the state covering the losses of state enterprises. Closing schemes of corruption one-by-one will take a long time, and will not necessarily lead to tangible results, in fact in many cases, it is likely that one scheme will just be replaced by another. By eliminating the main source of corruption, reformers will destroy all schemes simultaneously, and not provide it with the possibility of recovering. In addition, article by article spending cuts is inefficient from an operational point of view, because those who submit budgets are very good at hiding extra costs and fraudlent charges; and it is very, very difficult for a deputy to find them in the short amount of time available to them to review it. So, it is precisely for this reason that principle policy decisions are effective.

The approach should be equally just, severe and streamlined for all, especially in light of ongoing corrupt practices and the incompetence of the existing state apparatus. A “revision” of privileges and subsidies, which at best will lead to “old school” politics, will do nothing, because (a) the decision, again, will be made by an official; and (b) the criteria for dropping it cannot be written entirely objectively as the subject matter is highly complex and opaque

2. An introduction of full-value (in the original documents to the extent sufficient for an audit) online reporting on the implementation of the budgets of all levels (provided by the bill №0949), and on public procurement – and on the performance of government contracts. Enterprises implementing (the first stage – at least those who have received orders as unopposed) have thus given consent for the renunciation of trade secrets regarding the order. The same procedure should be further introduced into state enterprises, natural monopolies, and (if it was not possible to perform fully the previous section) for all enterprises which have privileges, receive governmental aid and/or have other benefits of a fiscal nature. Exceptions have to be made for defense contracts, but there must be other mechanisms of control. Also, it is not so important to monitor the procurement of exchanged goods if the contract price is tied to the current market and does not exceed it.

3. Deep tax reform (see the materials on Resuscitation Reform Package) among other things, it aims at preventing the abuse of VAT returns and ensures stable revenues to budgets at all levels.
4. The restitution of property taken by force, the revision of the results of privatization undertaken during the Yanukovych era and the potential prosecution of “oligarchs” who may be guilty of fomenting separatism and other treacherous These issues require further study. There is no doubt that restitution is reasonable, but there are still some unresolved legal issues primarily related to the subsequent resale (often fictitious) of this type of property due to whether or not it can now be owned by a real or formal “bona fide legal grantee”.
5. Radical (not 10% but at least twice as much) reduction in the state body apparatus by means of cutting off all unnecessary and corrupt functions. For example, as described on p. 1, the prohibition of legal person subventions with a deep deregulation means the complete dismantling of the possibility (and necessity) of entire ministries together with their regional offices, or at least reducing their staff by several dozen times over – to the extent required to perform the remaining necessary functions.

The performance evaluation of these actions can only be very approximate, since it is quite difficult to calculate the extent of abuse that will be excluded in such a way, and also thanks to the unprecedented radicalism of the proposed measures in terms of Ukraine. The estimated figures can be calculated by specialists from the relevant areas, but these assessments will still be based on assumptions. An intuitive assessment, to a considerable degree, would say that it would make up about UAH 100 billion of the economy.