Tax Reform in the Light of Macroeconomic Stability: the NBU Perspective

If Ukraine opts for populism in the tax reform issue, this can prevent it from achieving a more important objective: the balanced state budget. Ukraine should ensure that the state budget deficit in 2016 does not exceed 3.75% of its GDP to continue its cooperation with the IMF and other foreign donors. The tax reform options proposed today need to be more clearly prioritized. First of all, the emphasis should be put on improving the quality of tax administration and implementing structural reforms aimed at improving the business climate.

Recently, tax reform has become one of the most discussed topics in the Ukrainian political and expert circles. Should the NBU stay away from this debate?

The National Bank of Ukraine has repeatedly stated its objectives, which are: reducing inflation by the end of the next year to 12% and by 2019 to 5%, and keeping it at this level thereafter. For that end, the central bank is ready for a major change in its approaches to implementing the monetary policy aimed at introducing inflation targeting (IT) regime by the end of 2016 (Monetary Policy Guidelines for 2016-2020). At the same time, the NBU’s ability to ensure price stability is immensely tied to the country’s stable fiscal position, which should also be one of the objectives of the tax reform.

The liason here is quite simple. If public finances are unbalanced, this directly or indirectly affects the efficiency of the central bank’s monetary policy. The worst form of the domination of fiscal policy over the monetary one is a situation where the government can only accommodate its budget deficit by means of monetization. Typically, this results in accelerated inflation.

Interestingly, this relationship also works in the opposite direction. Empirical studies confirm that introduction of the inflation targeting (IT) regime usually results in increased fiscal stability, as it disciplines the governments. After introduction of the IT regime, governments can no longer rely on the funding provided by their central banks. However, reforms in the monetary and fiscal areas should go hand in hand.

In general, it would be difficult to imagine the successful implementation of the NBU’s objectives without the public finance reform. One of the reasons is the fact that the NBU will no longer be able to support the state budget with its profits. The NBU funds allocated to the state budget in 2015 exceeded UAH60 bn, which equals to about 12% of budget revenues. However, next year this figure will be considerably lower. On the whole, the central bank’s profit from its operations aimed at maintaining price and financial stability should not be considered as a stable source of revenue for public coffers.

The Budget Threat

Unfortunately, Ukraine’s much needed reform of its public finance, including tax reform, today is often interpreted incorrectly, becoming a target for speculation. The need to mitigate the tax burden on businesses that, according to many experts, seriously hampers the economic development of the country provides the basis for a variety of populist tax reform concepts that disregard other important aspects of the reform. These concepts insist on the primary importance of cardinal tax cuts, arguing that such an approach would provide for a significant deshadowing of the economy and help increase the tax assessment base. But the chance of this actually happening is insignificant, and cannot be relied upon to reform the public finance. The results of such “reform” could become a Pyrrhic victory for the country.

If Ukraine opts for populism in the tax reform issue, this can prevent it from achieving a more important objective: the balanced state budget. Ukraine should ensure that the state budget deficit in 2016 does not exceed 3.75% of its GDP to continue its cooperation with the IMF and other foreign donors. In the medium term, primary surplus of the general government sector should reach 1.6% of GDP. This is not only the goal of the government, but also Ukraine’s commitments set out in the Memorandum of Economic and Financial Policies signed with the International Monetary Fund. Given that relying on the alternative sources of external funding is not an option, terminating the cooperation with the IMF is fraught with the deterioration of the macroeconomic situation.

Accordingly, the future tax reform should provide for the compensation of reduced budget revenues in order to achieve the fiscal policy parameters stated above. Otherwise, such reform would result in a significantly increased budget deficit. According to some estimates, the maximum negative impact of the tax reform could reach 10% of GDP, or about UAH$200 bn. This could greatly affect the country’s public finance that is already in a bad shape.

The negative consequences for the country could increase manifold in case of termination of the support for Ukraine by the IMF, which is unlikely to cooperate with a country that does not fulfill its commitments. Ukraine’s cooperation programs with other foreign and international lenders are also “tied” to the success of its cooperation with the IMF, so Ukraine is risking financial isolation.

We can recall that some countries, such as Slovakia and Georgia, took a chance to “play roulette,” that is, dramatically lowered tax rates and achieved success, despite the IMF stand. However, there are two very important differences between the situation in Ukraine and in those countries. Firstly, for them the IMF was rather a foreign advisor than a lender of last resort. Secondly, what is most important, is that in both Slovakia and Georgia, tax reform was a part of large-scale structural transformations. So tax cuts were just a part of the overall package of reforms that included tax reform.

Reformist Support

The success of the tax reform is based on the comprehensive approach. Obviously, the economy needs to be stimulated by reducing tax rates. This primarily applies to reducing the unified social contribution (USC) rate, which in Ukraine is disproportionately high (see Table).

The “fiscal maneuver” required to reduce the tax burden should be achieved by renouncing some of the functions of the state incompatible with market economy. This would reduce the share of GDP redistributed by the government, which in Ukraine is clearly overstated.

On the other hand, tax liberalization will not work unless it is accompanied by other reforms needed to improve business climate and ensure stable growth of the economy. For example, in Georgia, the reduction of the tax burden was accompanied by revolutionary reforms of the judicial and law enforcement systems aimed at eliminating corruption, including that of fiscal authorities, protecting the legitimate rights and interests of bona fide taxpayers, and ensuring the unavoidability of punishment for tax crimes.

Such activities contribute to building trust in public authorities and to the deshаdowing of businesses. The increased ratio of the “risk of sanctions for tax dodging” to “cost of paying taxes” is also important. After all, in Georgia even delivery boys of online stores never forget to carry portable cash registers. Are they such good citizens? Or maybe it is just cheaper to pay taxes than fines?

When there are no incentives to pay taxes, even a radical reduction in tax rates will not move businesses out of the shadow. Moreover, given the dramatically low level of trust in public authorities and the unsatisfactory pace of structural reforms, the entrepreneurs are not likely to hurry with legalizing their activities due to the fear that the government might not stick to its promises and increase again the tax burden.

Besides, today’s discussion on tax rates is only limited to a few taxes (USC, VAT, and income tax). However, the taxation of passive income slipped out of sight of experts and politicians. For example, the NBU believes that taxation of income on individuals’ deposits at the level of 20% is too high and slows down the return of depositors to the banking system, despite its gradual purging. This, in turn, would have a negative impact on the banks’ credit activities. Therefore, we propose to reduce this rate to 15% and increase the rates of taxes on other types of passive income to compensate for the negative effect of reducing the tax on individuals’ deposit income.

Summary and Suggestions

The tax reform options proposed today need to be more clearly prioritized. First of all, the emphasis should be put on improving the quality of tax administration and implementing structural reforms aimed at improving the business climate.

Therefore, given the lack of prospects for a quick deshadowing of the economy and the weak fiscal position of the state, a radical reduction of tax rates should not be introduced in an emergency mode, less than two months before the beginning of the new fiscal period. The issues pertaining to cutting the rates of underlying taxes, improving their management and finding compensations on the expenditure side of the budget need to be discussed in detail first at the expert level, and then in the Parliament. Only after that should the modified tax system become the basis for budgeting, and not only for the budget of 2017, but also for the three-year budget plan, which is an important factor for improving the quality of the medium-term budget planning.

Therefore, the National Bank is looking forward to a responsible tax reform that would, on the one hand, improve the business environment in Ukraine and prepare the ground for the economic growth, and on the other hand, ensure the country’s fiscal and macro-financial stability.