Robert Conrad: Tax Reform is not Simply Changing the Law

The review is a response to the article Tax Reform – What’s On the Table written by Pavlo Kukhta, member of the Editorial Board of iMoRe


Robert Conrad from Duke University admits that radical tax reform in the Ukrainian context means broadening the tax base and eliminating the gross inefficiencies present in the current system. Tax reform is not easy and there are no simple answers if for no other reason than the government must collect revenue from those who do not want to pay.  Thus, it is essential that constraints be recognized in a transparent manner and that radical reform follows an orderly transition through time.

It is a pleasure to comment on “Tax Reform: What’s on the Table?”. I found the review most helpful and recommend that it be read anyone considering the issues surrounding tax reform in Ukraine. As a U.S.-trained economist who has worked on tax policy around the world, I would like to use the paper as a starting point for a more general discussion of options for Ukrainian tax reform.

Impetus for Tax Reform

The author notes that tax reform should concentrate on:

  • De-shadowing the economy
  • Making taxation more uniform
  • Lowering the effective rate of labor taxation
  • Improving the administration of taxes and making it less onerous and
  • Fixing the “rules of the game,” including a moratorium on changes to the Tax Code

I will comment on some of these points below, but believe two objectives should be added. First, any changes in the tax system should be fiscally sustainable. After all, the purpose of the tax system is to generate sufficient resources for the public sector to finance government operations. Most would agree that the Government’s share of the economy needs to decline through privatization, deregulation, and other reforms. We might debate the appropriate level of government activity for Ukraine, but we know that any decline in the relative role of government in the Ukrainian economy will take time. Thus, it is essential that tax reform be able to finance reasonable expenditures now and accommodate other reforms through time. Internationally, sustainability is necessary now in order to demonstrate Ukraine’s resolve and hopefully attract external finance; more importantly, sustainability is necessary domestically to demonstrate to Ukrainians that their Government can act in a responsible manner, provide important government services, and finance necessary reforms.

In order to be sustainable, a tax reform will have to be acceptable to the majority of the public. There is no such thing as a simple tax system because no one wants to pay taxes and most people, including me, will take any cost effective legal, and sometimes illegal, means to reduce taxes to a minimum. It is clear that the current tax system lacks public support, but Ukraine’s recent history has demonstrated that quick fixes and gimmicks, such as the small business tax system, have only eroded public confidence further. Thus, realism and honesty need to be hallmarks of this reform if it is to be a success. The public has to be realistic. Some people who now pay little or nothing will simply have to pay relatively more tax. In addition, the Government needs to be honest about the reform and should not market quick fixes to what is by its very nature a complex process in the design and administration of tax systems.

Second, the reform should have a reasonably progressive impact. Those at the lower end of the income distribution should see some real reduction in their tax burdens. Of course, one method is to redesign the personal income tax exemptions so that workers at the low end of the distribution, as well as entrepreneurs running truly small businesses, pay less, or nothing. An additional way to achieve this result is to broaden the base of the VAT and to increase excise taxes. Lower-income people eat at home, produce their own food, and provide home medical care among other economic activities for which there are substitutes in the market; in short, much of their consumption is beyond the scope of the VAT. The VAT is limited to market-based modern sector activities, however. Thus, by definition, a broad-based VAT is progressive because the proportion of consumption purchased in formal markets in any time period generally increases with income.

Expensing, The Estonian Model for Corporate Income Taxation, and Standard Income Accounting

  • Expensing

The author suggests that expensing fixed assets might be a simplification and a viable alternative to more standard income accounting for the profits tax. I believe that expensing is neither simple nor even viable in the Ukrainian context. In order to be economically neutral, full expensing of assets must be accompanied by: limiting interest deductions to zero (otherwise, expensing combined with interest deductions can lead to double deductions, which in turn will yield negative effective taxes), no inventory accounting, no receivables or payables, and unlimited loss carry-forwards (adjusted for inflation); in other words, full cash flow accounting. Simply allowing expensing while leaving the other parts of the profits tax system in place will result in negative effective taxes, the way economists measure effective tax rates. That is to say, the government will be providing a tax subsidy to capital and therefore will be using the tax system to discriminate against labor.

I am aware of only one country (Timor-Leste) that allows such accounting for large enterprise taxes and unlike Ukraine, Timor-Leste is a poor, but resource rich, country with a small population. Even that country, however, is about to change its rules after finding the system difficult to administer. This system is administratively cumbersome because of all of the incentives created by cash accounting relative to accrual systems. For instance, auditors have to verify both that a sale was made and that the sale was paid with cash in the current period. Thus, there are two pieces of paper to audit, as opposed to one. This is true because, in at least one variant of the cash flow tax, loan proceeds and capital repayments are not taken into account because interest is not deducted. Thus, it is possible for a company to sell goods to another company and have the purchasing company “loan” the selling company cash. The purchasing company can then write-off the loan as a bad debt so that the selling company has no taxable income and the purchasing company can take the full deduction. Absent audits and matching, at least on a selective basis, this is one of several methods to game the system. In addition, there are all of the common games that are played with a cash basis system, such as accelerating purchases and delaying receipts in order to reduce the base, in some cases below zero in order to create unlimited loss carryforwards. In short, expensing is neither a simplification nor administratively simple.

  • The Estonian Model

The Estonian profits tax has been proposed as an alternative to the more standard corporate tax. Under this system, there is no corporate tax per se; the tax is imposed only at the time dividends are distributed. The author does not note, however, that this system is one of a number of options available to eliminate the double taxation of corporate income. It is true there may be an incentive to retain earnings in an entity, but that is not the economic objective served by the Estonian system. Thus, the system should be judged, I believe, relative to its economic objective (taxing corporate income only once) and the Estonian models fails any reasonable test.

First, shareholders are wealthier when a corporation in which they own shares makes a profit. That is, the time to impose tax is when the income accrues because that is the time when shareholders become wealthier. Paying dividends is only one manifestation of the shareholder’s increase in wealth. If the shareholders leave their increase in wealth within the firm for reinvestment in that firm then the deferral of taxes, at the choice of the taxpayer, is an interest-free loan from the government to the corporation and its shareholders. Such a loan should be part of any tax – expenditure budget and in the case of Ukraine should increase the deficit because that interest-free loan must be financed. In addition, shareholders do not use dividends simply to increase consumption. Dividends can be a source of funds for investments in other profitable opportunities. A tax on distributions, again at the choice of the shareholder, creates a type of lock-in effect which may lead to inefficient investments.

There is an old saying among tax experts that “a tax deferred is a tax avoided” and this raises a second administrative issue. I believe that the Estonian system is as complicated to administer, if not more complicated, relative to any reasonable standard corporate profits tax. This is because there are many more ways than dividend payments to get money out of the corporation to shareholders. The author correctly notes that one means to transfer income to shareholders is to pad corporate deductions with personal expenses, but that is only one method to transfer price. There are many potential transfer pricing abuses common among related parties. For instance, shareholders could loan funds to the corporation and get paid interest instead of taxable dividends. Thus, if the Estonian tax administration is doing a reasonable job, standard intensive audits must be a normal part of its activities; in effect, there should be no difference in administration relative to a standard corporate tax. In addition, pressure is now placed on defining dividends because that action (as opposed to other distributions such as repayments of capital or loans repayments) are the source of the tax on capital.

Finally, foreign investment is completely exempt from the Estonian tax because dividends paid to foreign persons are exempt [1]. Thus, the Estonian system explicitly discriminates against domestic labor and capital by exempting such foreign investment. This treatment provides an additional incentive to abuse the system. For instance, an Estonian resident might establish a holding company in the Netherlands (which should be designated as a tax haven in my view) and the Netherlands holding company can then make investments in Estonia free from the tax on dividends.

I believe that the Estonian model should not be given any serious consideration in Ukraine given the overt discrimination against its own citizens, the administrative burden, and potential for abuse created by the system. This is particularly true when one notes that Estonia has a population of only about 1.35 million people, which is less than 3% of Ukraine’s population, and has per capita GDP almost three times Ukraine’s measured in purchasing power parity terms [2]. Even if the Estonian model is acceptable for in that context, there is no reason to be believe that the system is appropriate for Ukraine.

Modify the Current System

I believe the most effective way to reform the corporate tax is to modify the existing structure by:

  • Eliminating most, if not all, tax incentives, tax holidays, and other discriminatory aspects from the corporate tax;
  • Reducing the options under the corporate tax so that there is one reasonably clear set of rules; and
  • Integrating the corporate tax so that corporate income is not taxed twice.

Broadening the tax base is by far the best method to reduce rates to a minimum. Currently, Ukraine begins the computation of corporate income using net income as measured by international accounting standards. This provision was enacted supposedly to simplify the system, but ironically it has increased complexity for two reasons. First, adjustments to accounts to derive taxable income are inevitable because of differences in depreciation, loss carryforward rules, transfer pricing, and other issues. Second, there are optional methods for computing certain revenues and expenses under international accounting standards. In addition, international accounting standards might dictate the use of one particular method for computing particular items such as foreign exchange gains and losses. The fact that the accounting profession has accepted one out of many potential rules should not relieve a government of its responsibility to evaluate the policy and revenue implications of using that rule for tax purposes. Any option may have different policy implications for a particular country and the government needs to make a clear, transparent decision about what is the most practical and neutral method to employ given the perspective of that country, and through time.

One benefit of the Estonian system is that there is only one tax on corporate income, although with an effective rate lower than the statutory 20%. There are other methods, however, to ensure that double taxation is eliminated. I believe that it is important to eliminate the double taxation while ensuring that capital income is taxed at least once. Such an outcome is not generally possible with the Estonian system or in cases where dividends are exempt from tax while maintaining the corporate tax. The reason for the latter is that in order to have full taxation of corporate income with a dividend exemption, the base of the corporate income tax cannot have loss carryforwards or any deviations from economic concepts, an objective that is impossible as a practical matter. There are methods, however, to ensure that the dividends distributed to shareholders are fully taxed at the statutory corporate rate and Ukraine should choose the most cost effective method. Such a change cannot be accomplished this year, I believe, but should be part of the overall program for reform within the next two years.

  • Reduce the Tax on Formal Sector Wages

There is appeal to merging the social tax and personal income tax (PIT) into one tax on the income from labor services. In order for this to be successfully implemented, however, a number of issues must be resolved. First, there needs to be a clear separation between the tax collected and the allocation of that tax revenue between general revenue and the Social Funds. While mechanical as an accounting matter, it is necessary to increase public awareness of the separation between total revenue and the allocation of that revenue. There is not a trust fund for pensions in Ukraine and all pensions must be paid out of current revenue. Absent a fully-funded pension system, the allocation of certain taxes to the Social Funds, as is current practice, is merely an accounting entry with no economic substance. This is true because a deficit in the Social Funds must be compensated by either general revenue or reduced retirees’ benefits. The former result simply implies that the consolidated Government deficit is not affected, while the latter may, and probably should, be socially unacceptable. Both pensioners and contributors need to understand this point because current pensioners contributed to the funds during their working lives in anticipation that they would receive a basic pension. In addition, allocating a portion of the revenue to the Social Funds probably is reasonable because there will be a clearly identified revenue source which can be used once pension reform begins in earnest.

The allocation of personal income tax revenue to general revenue also has ramifications because currently the wage tax is allocated to subnational governments. I believe allocating one portion of the personal income tax (the wage tax) to local governments is a serious policy mistake because it is important for taxpayers to understand that the Government is moving toward a more comprehensive income tax by integrating the corporate tax with the personal tax and using various withholding methods on interest income and other types of income. Thus, it is better in my view to pool all income taxes (corporate, wage tax, and various withholding taxes) with the VAT and other revenue sources. Then a portion of pooled revenues can be allocated to subnational governments. This approach would increase transparency and perhaps achieve better results with respect to the fiscal capacity of subnational governments. Subnational governments should also have their own revenue sources, the property tax in particular.

Finally, there are some conceptual and practical issues with how to merge the social tax with the PIT to form one single tax. This issue arises because most of the social tax is imposed on employers and is not transparently understood to be a tax borne by labor. Thus, merger of the social taxes and PIT will involve an adjustment in tax-inclusive wages, combined with what will appear to be an increase in the tax burden on employees. That is, quoted wages will have to increase while at least part, if not all, of the increase will be taken back immediately in combined taxes. While purely mechanical, the change will require increased public understanding in order to be successful. In addition, there will be issues about who benefits from any tax rate reductions if rates change at the same time merger is implemented. In the short run, a reduction in social tax rates with no merger of the rates will generally mean increased after-tax cash flows for employers, while a reduction in PIT rates, again with no merger, will increase after-tax incomes for individuals. If rates are combined into one structure and overall rates are reduced, there is the additional issue of who will get the initial benefit from rate reductions. The state could try to force employers to increase employees’ wages by the amount of the total tax reduction (keeping employers’ short term wage bill constant), or employers might be allowed to keep the entire reduction (in effect keeping net of tax wages paid to employees constant), again in the short run. While the longer-term effect on wages will be determined by market dynamics, the short-term allocation of gains and losses may affect the acceptability of the merged tax, again if the combined rate is reduced. In addition, some incentives may be created by the merger that need to be examined before simply making such a change by administrative fiat. For instance, employers might have an incentive to delay hiring until the rates are reduced, or even to fire existing personnel and rehire them at an adjusted wage after the merger of the rates is completed.

In summary, while the conceptual combination of rates has much economic appeal and, I believe, should be an objective of the reform, care should be taken to implement the proposal successfully and with minimum disruption to either local finance or the labor markets.

  • De-Shadow the Economy

One of the reasons offered for reducing the combined tax on labor is that such a change will reduce the benefit of paying wages in the shadow economy. This is certainly true, but there should be no expectation that such a cost reduction will change the nature of the shadow economy for at least three reasons. First, at current levels of compliance, either the probability of getting caught paying shadow wages is relatively low or the cost of bribing a tax official is sufficiently low relative to the cost of compliance. Thus, a decrease in the cost of taxation should not be expected to bring people out of the shadow economy in any numbers. That is, if the probability of being caught is low, then lowering the tax without changing honest administration may not reduce the net benefits of staying in the shadow economy enough to induce compliance. Second, those who are not complying now and who would otherwise comply may choose to stay in the shadow out of concerns about the past. Once registered and current on their obligations, there is nothing to keep honest administrators from accessing back taxes plus penalties and interest for evading taxes in the past. One solution to this problem is to grant an amnesty for those who comply going forward. Amnesties generally do not work, however, because those who have complied feel discriminated against because they complied, while those who evaded get off for free unless there is a change in expectations about administration. In addition, there may be no incentive to take advantage of an amnesty if a taxpayer can stay in the shadow and pay little or nothing with confidence that they will not be caught. Third, I believe that there will be little incentive for lower- and middle-income workers to come out of the shadow because of the overt discrimination created by the current small and medium size business regime; an issue to which I now turn.

  • Reform the SME system

The author to the paper under review correctly highlights most issues about the small and medium (SME) business regime. One issue that is missed, however, is the horizontal and vertical inequity created by the discriminatory small and medium size business policy. For example, consider the Tier I classification. An entrepreneur, however defined, is eligible to pay a small fixed fee in lieu of taxes if their turnover is less than 300,000 UAH per annum. This value is more than three times annual per capita Ukrainian income. Even if net cash flow from legitimate trading is relatively low, say only 50% of current turnover, the effective tax is still low relative to a wage earner in similar circumstances. For instance, if a trader has turnover of 300,000 UAH and net cash flow of 120,000 UAH, the tax could be as low as 10% of a monthly minimum wage; meanwhile, an employee making 10,000 UAH per month would pay 15% on wages above one-half the minimum wage, plus almost 40% in Social Tax. The problem is worse for workers in Tier III. Consider a self-employed professional (a doctor, a lawyer, a computer programmer, an economist, an accountant, or other professional) making 10,000,000 UAH per annum, most of which is net income. Such an individual pays 40,000 UAH in tax (4% effective rate) per annum. If that same individual were an employee, he or she would pay in excess of 125,000 UAH in personal income tax, in addition to the Social Tax. Such discrimination is blatant and workers who would otherwise be employed may be mad as a result. They and their employers may express their anger by staying in the shadow, and for good reason. There is no reason to comply with a system that is so unfair and where high-income individuals, as well as entities that split into smaller entities in order to be defined as a group of small enterprises, can escape most taxation either because of their political influence or simple lack of broad public awareness.

It has been claimed that this system was established because it is supposed to be a simplified system, but such schemes are not simple. For instance, all tiers, except the agricultural tax, have qualifications based on turnover. Of course, accounts must be maintained to verify turnover and legitimate tax administrators should have every right to audit those accounts. Thus, by design and legislative intent, books of account, at least with respect to turnover, are required to qualify for special status. In addition, purchases of most inputs should be subject to VAT and thus purchasers who are small businesses should get receipts. Finally, people in Tiers II and III may have employees. Thus, there should be formal records of employee withholding and gross compensation.

There appears to a myth around the world, including Ukraine, about small business. A small business is viewed as a small seller or trader, perhaps without assets, who is somehow barely making ends meet and who cannot manage to maintain basic accounts. That image, however, is not realistic in Ukraine, where the literacy rate is greater than 90% and accountants, lawyers, doctors, and other professionals are both educated and have significant incomes. For some reason the argument is that the Government should reduce the tax burden on such individuals because they are incapable of determining whether they have more cash at the end of the day than they did at the beginning. For these and other reasons, I believe that true tax reform cannot occur until the small and medium business tax is curtailed. It is simply a matter of both common sense and fairness. As noted, part of the reform should include the requirement that simple cash accounts be maintained and, if necessary, the government should offer free training to those who are really not capable of writing down the difference between the cash balance at the end of the day and the beginning of the day. If such actions are taken, then there needs to be a transition to the new rule because there will be a significant increase in the tax burden of those in the affected group. These taxpayers were not doing anything illegal because the law explicitly encouraged such behavior. Accordingly, those in the affected group should be allowed to adjust to the changed rules via a phased transition.

  • Broaden the VAT Base and Issue Refunds

The author correctly notes, in my view, the problems with VAT, including the need to broaden the base and the need to issue refunds rapidly (at least to a group of approved VAT taxpayers). The author notes the need to report only net VAT as government revenue, perhaps by the use of a special account. The failure to promptly refund VAT is one problem Ukraine shares with almost all transition economies, and I have recommended the use of such accounts, admittedly with mixed success, in other countries. It is essential that such an account be published and that values are reported in a transparent manner. As well, there should be independent audits of this account in order to ensure the integrity of the system. Regardless of the method selected, it is important that the Government demonstrate that it can obey its own laws by granting refunds.


Radical tax reform is needed in Ukraine, but radical in the Ukrainian context means broadening the tax base and eliminating the gross inefficiencies present in the current system. Such reforms take time, and thus I believe that the author’s suggestion that the tax laws be fixed for a certain time period is both unrealistic and ill advised. Tax reform must be phased to be successful. Administrative improvements and attacking corruption are necessary elements that require time to be implemented effectively. In addition, tax reform is not simply changing the law. The law will be imperfect, and there will need to be regulations, much public education, and phasing because the Government, like all economic agents, has scarce resources and cannot do everything at once. In addition, public participation will be necessary in order to clarify regulations and implementation plans. Democratic participation requires time to listen, to exchange views, and to seek transparent means to implement reform.

No country can have a moratorium on tax rules because economic circumstances change, new information is learned, experience is gained, and ambiguous rules are identified. The tax law, like all democratic institutions, is a type of organic body of law that must evolve through time in order to be effective. What taxpayers should expect is that the framework in which the tax law evolves is stable. That framework should be transparent, with corruption falling through time as expectations increase that taxpayers will be treated fairly if they comply in a reasonable manner.

In summary, Ukraine would benefit from establishing consistent expectations by following some simple rules:

  1. Gimmicks don’t work. Appealing notions like the Estonian model, broad rate cuts without compensating revenue increases, discriminatory policies, and tax amnesties generally do not work.
  2. Manage expectations, including the fact that tax reform must be coordinated with other economic reforms and that such reform is really part of a long-term learning process.
  3. Begin with what you have and broaden the base.
  4. Reduce the influence of politics in tax administration as much as possible. For instance, the head of the State Tax Service should be prohibited from asking questions about the audits of any person (legal or physical), except when investigating corruption on the part of the tax officials.
  5. Corruption takes two. Someone must be willing to pay a bribe to a corrupt tax official, and so it is important to ensure that there are inexpensive means for honest taxpayers to by-pass corrupt tax officials without fear of reprisals. In addition, it is important to protect honesty in the tax administration as much as possible. Part of this desired result can be achieved by depersonalizing the tax system as much as possible and part can be achieved by transparent administrative reform.

In short, there is no substitute for honesty and hard work. Tax reform is not easy and there are no simple answers if for no other reason than the government must collect revenue from those who do not want to pay. Thus, it is essential that constraints be recognized in a transparent manner and that radical reform follows an orderly transition through time.




Tax Reform Week

Tax Reform – What’s On the Table (Pavlo Kukhta, member of the Editorial Board of iMoRe)

Open Letter to the Expert Community and the Ministry of Finance of Ukraine from the VoxUkraine Group of Economists

Pavlo Sebastianovich: Medium and Small Businesses Displaced From the Legal Field of High Tax Rates (Pavlo Sebastianovich, Civic Platform “Nova Kraina”)

Vladimir Dubrovskiy: 1-2% of GDP in Additional Revenues as a Result of a Crackdown on Simplified Taxation are Unrealistic Figures (Vladimir Dubrovskiy, RPR expert)

Tetyana Prokopchuk: Business Believes that the Priority is to Simplify the Administration of Taxes (Tetyana Prokopchuk, Vice President of Policy of the American Chamber of Commerce in Ukraine)

Anna Derevyanko: Cosmetic Changes will not Work for the Society (Anna Derevyanko, Executive Director, European Business Association)

Ukraine Needs a Radical but Sensible Tax Reform (Anders Åslund, Senior fellow at the Atlantic Council in Washington and author of the book “Ukraine: What Went Wrong and How to Fix It”)

Roman Zharko: Core Problem of the Ukrainian Tax System is Practice of Discretionary Use of Fiscal Mechanism to Reach the Established Revenue Targets (Roman Zharko, PhD, Tax Manager, Baker Tilly)

Tax Reform in Ukraine: How to Accomplish the Impossible (Vladimir Dubrovskiy, expert of the RPR group)

Tax Reform in the Light of Macroeconomic Stability: the NBU Perspective (Dmytro Sologub, Deputy Governor at National Bank of Ukraine, and Serhiy Nikolaichuk, Director of monetary policy and economic analysis department at NBU)

Macroeconomic Implications of the Tax Reform (Yuriy Gorodnichenko, UC Berkeley, co-founder of VoxUkraine)

Tax Reform in Georgia: Lessons for Ukraine (Olena Bilan, Chief economist at Dragon Capital, member of the Editorial Board of VoxUkraine)


The author doesn`t 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