Sequester and Balancing. How the 2019 Budget Is Performing

“The government has enough funds for social security expenses and peak loan payments this autumn,” says the Ministry of Finance of Ukraine. “The budget might need a sequester, while significant spending on debt repayment and service are limiting the government’s ability to finance the budget deficit,” claims the National Bank of Ukraine.  These two statements made by the ministry and the regulator contradict each other. However, both of them are true in their own way. 

The budget situation is extremely complicated. Macroeconomic conditions are straying further from the forecasts with each month. 

Economic growth slowed early this year significantly undermining budget performance in some areas. The situation quickly changed in the second quarter when the GDP growth increased to record-breaking 4,6% year-on-year. This happened due to a seasonal upswing in agriculture, an increase of 10,3% in retail sales in January-June and banking sector’s profits.

“Growth of 4,6% surpassed all of our expectations. NBU has forecast it will be 3%. This increase was quite unusual and we need to understand whether the rate will remain the same in the next six months to make any estimations of how it will influence the budget revenue. Banks’ profits, bumper harvest and growing retail sales had an effect on GDP, but a rate of 4,6% seems too high for the third and the fourth quarters at the moment,” Deputy Governor of the National Bank of Ukraine Dmytro Sologub told VoxUkraine. 

Budget revenues are influenced both by several new negative factors and by strengthening of some of the old ones. As a result, fiscal risks are growing and budget spending performance in certain areas is delayed. However, so far the government has been able to keep the situation under control, with social expenses that are the most important ones for the public being performed on time. Loan payments have also been made on schedule.

VoxUkraine studied what the budget situation really is and whether a sequester might be needed this year.

Revenues

The state budget’s general fund has received 94% of the planned revenues (Table 1).

National budget revenues in January-June 2019, UAH bn

Revenues from personal income tax and corporate income tax overperformed by 5%. The major reasons for that are an increase in minimum wages and an improvement in corporate performance. 

VAT. Revenues from VAT both on imports and Ukraine-made goods are lower than planned, 88% and 78% respectively. 

As far as goods made in Ukraine are considered, according to the Ministry of Finance, this underperformance was caused by an increase in VAT refunds for exporters. Meanwhile, VAT on imports was influenced by several factors: the appreciation of Ukrainian hryvnia, lower import growth rates and prolongation of additional tax breaks for import of solar panels, wind turbines and electric cars. Another negative factor was the decision of Russia to limit the export of Russian coal, gasoline, diesel, oil and liquefied natural gas to Ukraine by making it necessary for exporters to obtain export licenses for these goods starting from June 1, 2019. According to the State Fiscal Service, import of these goods from Russia decreased in June by 15% year-on-year value-wise.

Excise Taxes. Excise taxes on cigarettes and tobacco products were increased starting from July 1. This change mitigated the consequences of a number of problems on the tobacco market but was unable to compensate for them fully. As a result, excise taxes provided only 76% of the planned revenues. The problems undermining the tobacco excise tax revenues and creating a hole in the budget are supplies stockpiled before the excise tax increase, counterfeiting and smuggling. According to the research by Kantar Ukraine, Ukraine’s national budget will lose UAH 4,64 bn of taxes in 2019 to illegal tobacco goods trade, or about 0,5% of total planned tax revenues and 3,5% of planned revenues from excise taxes.

Natural resources consumption tax. Revenues from natural resources consumption tax have been underperforming recently. The national budget started this year with a revenue shortage of UAH 0,8 bn, with most of it being caused by the fact that UkrGasVydobuvannya made advance payments last year, but in the first six months the shortage increased by more than 150% to UAH 2,1 bn. According to official data, the main reasons for this change were a decrease in natural gas imports and reduction of its price for electricity producers to UAH 5964,3 per 1000 m3 (compared to the planned price of UAH 6869). However, in relative terms, the shortage of natural resources consumption tax revenue is a lot less dire than the underperformance of excise tax and VAT revenues.

Budget revenue shortage would be bigger if not for the National Bank. It was able to “fix” the revenue situation by transferring UAH 64,9 bn of its 2018 profits to the state budget. This sum is 17,3 bn larger than was planned initially and is the result of an improvement in the financial performance of Ukrainian banks in 2018.

Corporate income tax provided UAH 23,3 bn for the budget, though it is only 64% of the planned amount. According to the Ministry of Finance, in June and July, Naftogaz fulfilled its obligations and transferred UAH 12,3 bn to the budget. At the same time, Centrenergo and Tubroatom provided only UAH 195 mn and UAH 265 mn respectively, failing to pay the second half of expected dividends. Meanwhile, Ukrnafta paid no dividends at all.

Spending

Average national budget’s general fund spending performance level is 91% (Table 2).

Social expenses. Spending on pensions peaked in the first six months of 2019 due to an indexation of pensions, an increase in military pensions and one-time payments for select categories of pensioners in March and April. All of these took place during the presidential elections, even though they were not necessarily included in the initial budget. 

According to the Ministry of Finance, the 2019 budget included UAH 20 bn to be used on indexation of pensions starting from March 1, 2019, and UAH 5,5 bn to be used on military pensions readjustment.

However, the Pension Fund needed UAH 30 bn more than planned due to additional payments and selective pension rises. As a result, the government was forced to update the Pension Fund budget, with national budget spending on pensions being increased as well. 

Spending on subsidies was lower than planned in the first six months of 2019, only 90% of the plan, mainly due to the reduction in the number of people receiving subsidies in the first half of the 2018/2019 heating season.

Spending on defence and security is performing well, as usual (Table 3). Ministries of defence and internal affairs used 91% of their budgets, while the Security Service of Ukraine and the General Prosecutor’s Office received 95% and 92% of the planned funds respectively. 

Education and Healthcare. Subventions on education and healthcare, as well as the New Ukrainian School programme were financed almost fully. These expenses are politically and socially important since they are used to fund education and healthcare reforms. 

However, there are expenses in these areas that received no funding this year.

For instance, the Presidential Fund for the Support of Educational and Scientific Programs for the Youth was never launched. Creation of this fund was initiated by Petro Poroshenko in November 2018 when the budget bill was being prepared for the second reading. Many experts and MPs questioned the idea of creating a new fund with a budget of UAH 1 bn at the time since it was unclear how these funds were supposed to be distributed. No specifics have emerged since then.

Expenses on economic activities were financed differently depending on the activity. Expenses on roads received only 8% of planned funding in the first quarter, but in the second quarter the funding level increased to 65%. One of the reasons for that is the road maintenance cycle: no works are usually done in winter and early spring. 

Expenses on supporting the agricultural sector are also underperforming. Animal husbandry support programme and agricultural loans cheapening programme received 64% and 74% of funding respectively, but that does not mean they were underfunded since both programmes draw funds unevenly throughout the year and depend on the behaviour and needs of agricultural companies. 

Energy sector funding performed a lot worse. Mine liquidation programme received only 44% of planned funds. Novovolynska mine was more fortunate: Ministry of Finance transferred 83% of planned funds to support its operations.

Transfers to local governments and regional development funding. The government was able to find funds to finance social subventions on healthcare, education and social subsidies, with these areas receiving 90% or more of planned funding. However, development spending had been performing a lot worse. 

There are two main sources of funding for regional development, State Regional Development Fund and the subvention for regional social and economic development.

SRDF funding has been underperforming this year: it received only UAH 226 mn (8,7% of planned funding). 

However, judging by the State Treasury Service data, there have been no problems with the subvention for regional social and economic development in the first six months of 2019. The government has distributed funds and reviewed the distribution in January and June and recipients have received the funds. Unfortunately, the situation changed in July.

On July 10, the government approved the distribution of UAH 2,5 bn as a part of the subvention. “UAH 1,4 bn are to be distributed to small towns that will use these funds to improve their educational and utility infrastructure in order to prepare for the next phase of the administrative and territorial reform. However, it’s been a month since the recipients were supposed to receive these funds,” says Oleksandr Slobozhan, Executive Director of the Association of Ukrainian Cities. 

It turned out that the funding delayed due to an official request of Andrii Bohdan, the Administration Head of the Office of the President of Ukraine, to freeze these resources until the new government is appointed. Cabinet of Minister received a letter with this request on July 23. Office of the President explained that the request was made due to the corruption risks connected to the distribution of regional development funding. 

“There have been numerous cases during the power transition periods when people involved with state governance as a part of the previous government created projects that used budget funds ineffectively and provided opportunities for exploitation of resources and other corruption risks,” said the Office of the President. It also added that representatives of the previous government understand that it will be impossible to arrange new corruption schemes with the new government and, therefore, are trying to create the conditions needed to exploit budget funding. “The President’s goal is to prevent such a situation,” says the official statement.

Meanwhile, mayors of several Ukrainian cities believe that this decision was based on political motives of the new team ahead of elections to local councils. 

Cabinet of Ministers has publicly declared that it is planning to ensure that development is funded, but currently this issue remains unsolved causing new conflicts.

Subvention for the maintenance of Kyiv’s Paton Bridge was also paused along with subventions for maintenance and construction of housing for orphans and disabled people, implementation of environment protection activities and a number of other projects.

What factors will influence budget performance

Macroeconomic forecast review. Budget performance depends on how accurate was the forecast used to plan the budget. If macroeconomic reality is different from the forecast the budget needs to be updated. This year started with an economic slowdown, but hryvnia significantly appreciated by summer. As a result, revenues from import taxes plummeted undermining the budget. 

Another reason to review the forecast is the preparation of the 2020 budget.

“The budget has to be based on the most accurate forecast possible. We definitely need to prevent the situation that arose in 2018 and especially in 2019 when both the average exchange rate and the year-end one provided in the forecast were constantly higher than the actual one (this is called forecast bias in statistics), leading to persistent underperformance of revenue areas that depend on the exchange rate. Therefore, we are waiting for a timely forecast review or a confirmation of the existing forecast,” wrote the Minister of Finance Oksana Markarova on Facebook.

Growth of revenues from unified social security contributions. There will be less need to pay increased pensions in the second half of the year since pensions will be raised only in December when the subsistence minimum will be increased. 

Potential lack of funds might be compensated by the fact that currently the Pension Fund’s own revenues are higher than planned. According to the official data, in January-July 2019 the Pension Fund received UAH 136,6 bn, UAH 8,9 bn more than planned. Ministry of Finance expects that there will be no need for additional resources if the Pension Fund’s revenues from unified social security contributions continue to be higher than planned. 

Previously additional pressure on budget spending was created by advance payment of January pensions in December, but in 2018 the government decided to discontinue this practice and pay January pensions in January. As a result, there are no plans to pay advance pensions this year.

Timely loans. Ministry of Finance often compensated the lack of funds from privatizations by borrowing. According to the ministry’s latest data, as of August 15, 2019, existing government loans amount to approx. UAH 316 bn (77,7% of the amount expected according to the reviewed yearly plan). 

Therefore, according to the budget, the government can borrow UAH 90,9 bn until the end of the year, including UAH 53,1 bn of internal loans and UAH 37,8 bn (approx. $1,4 bn) of external loans. The government is also expected to spend about UAH 52,4 bn and $3,4 bn on debt repayment and service. What is important, appreciation of hryvnia leads to a decrease in costs of debt repayment and service.

“Funds remaining on the single treasury account and the government’s foreign currency accounts will be enough to cover debt repayment and service spending in the next 2-3 months even without borrowing,” says the Ministry of Finance.

Solving the issue with regional development spending. Regional development had been underfunded for many years. It was always one of the first budget spending areas to suffer when the government needed to save funds, but regions still received funding, even though it was provided unevenly. For example, State Regional Development Fund projects received only 17% of funding as of August 2018, but by the end of the year funding level reached more than 60%. This year the situation is unusual due to the president’s stance on development funding. If “prevention of corruption risks” will end with a review of existing development projects and approval of new ones, Ukrainian cities might receive no funds this year at all. If this decision is made without corresponding changes to the budget, budget performance will suffer significantly.