The MinFin’s proposal for the tax reform doesn’t help to escape the economic trap. It even does not try to address any of major issues of the Ukrainian tax system, while the most dramatic change suggested by the Ministry – cut of the payroll tax rate (“single social contribution”) is already stipulated by acting legislation. Actually, the laws of 28.12.2014, in which it was stipulated, have more right to be called a “tax reform” than current proposal – although, of course, they were not a reform either.
The discussion initiated by VoxUkraine is extremely useful because, among other good things, it demonstrates how far from the Ukrainian realities are some distinguished foreign experts. The problem is that these experts are supposed to advise to the Ukrainian government and – even more important – to the international donors and creditors on which it now heavily depends. I already tried to fill this gap by a series of articles (see here, here and here), and promise to continue. Unfortunately, this has made no effect so far, as the Ministry of Finance already came up with a proposal that has little to do with genuine reform (defined as altering the very nature of relationships between the involved parties and solve the major problems). Instead, the government for the third time (after 2005 and 2010) tries to outfox the public by the same trick: “Oh, do you really want tax reform? OK, we will “reform” (= emasculate or eliminate) simplified taxation. Oh, you do not want reform any more? OK, it’s up to you” – and the conditions for entrepreneurship remain the same or worsen. Alas, some distinguished colleagues in fact support this trick by praising the government for technical improvements and applauding to crackdown on simplified taxation. But this is a road to nowhere.
A Trap to Escape
In fact, strategically the main problem is that the Ukrainian economy is in a trap.
Normally [1], there is quite a strong cross-county correlation between the quality of governance, size of the government (in terms of the GDP share collected in tax revenues), and the social benefits it provides. The demand for the latter is, in turn, related not only to the paternalistic expectations or “habits” like free education and healthcare, but also on objective social and demographic factors like ageing, transition from extended to nuclear family etc. – but, again, normally all of them also develop along with institutions and welfare. For instance, industrialization destroys the patrimonial family relationships that secure some subsistence for old or disabled people – but, at the same time, dramatically increases welfare, and better living standards that it brings result in ageing; meanwhile industrialization is, in turn – again, normally – eventually based on the development of modern state governance and market institutions. As a result, an aged population rarely combines with poor market institutions and governance.
Respectively, the “size” of government varies tremendously across the World, with modest (although statistically significant) negative impact on long-term growth rates – although, it may be still a matter of causality. But the real picture is more complex. There are more or less economically viable countries with low taxes, poor institutions and low social support. The governments in these countries fail to collect much money in revenues, or do not even try to, in such a way de-facto compensating for weak institutions. It is OK, since the taxpayers there get “a value for money”, namely a tax burden that corresponds to the quality of institutions and does not really impede growth. On the other extreme there are “Nordic” countries with high taxes, excellent institutions and high social support that are also viable because there taxpayers also get “value for money” – much more value for much more money. And they are rich enough, so low growth rates do not frustrate their citizens.
If taxpayers get more for the same money, then a country has a good chance to become a “tiger”. It happens if the population is young and mostly healthy; the people are not used to “free lunches”, while, at the same time, governance is relatively good and market institutions are strong enough compared to “third-World” peers. Alas, such outliers are rare and they quickly disappear by joining the upper end of the spectrum. More often, low ability to collect taxes further undermines governments’ capacity to provide public goods, and this is a trap into which many developing countries fall. However, this is not the case of Ukraine. The problem we face is of a completely different sort. Due to Ukraine`s unnatural historical path, our country became an outlier on the opposite side of the spectrum than the “tigers”.
On the one hand, Ukraine suffers from extremely poor governance and market institutions. This includes, although is not limited to, rampant and systemic corruption that not only imposes a very high “bribe tax” on business but also distorts competition (and, respectively, the competitive selection) and incurs substantial social losses. Besides, the government fails to provide public goods of sufficient quality (and quantity) – just look at the court system. On the other hand, Ukraine already has an aged population with quite high (even by European standards) expectations of social standards, public goods, and “free lunches”.
Furthermore, it has to fight a war against one of the strongest world superpowers – which means not only high military expenditures but also a necessity to satisfy paternalists at least to the level that would not allow Russian agents to spark an uprising. The latter factors mean that the tax burden cannot be lowered to the level that corresponds to actual quality of institutions, and it cannot be reduced quickly; while the former means that high taxes are unbearable for the economy. Therefore, the country will never start growing strongly unless governance dramatically improves. But this is an extremely problematic and long-term process. And, moreover, corruption can never be overcome by “brute force”, only by dramatic elimination of relevant vulnerabilities. High taxes are among the factors that magnify or even create corruption vulnerabilities, so they actually prevent improvements in this core issue.
Is MinFin offering genuine reform?
Is MinFin’s proposal for tax reform a way out of this trap? No, because it even does not try to address any of the major issues of the Ukrainian tax system, while the most dramatic change suggested by the Ministry – cut in payroll tax rate (“single social contribution”) is already stipulated by acting legislation. Actually, the laws of 28.12.2014, in which it was stipulated, have more right to be called “tax reform” than current proposal – although, of course, they were not real reform either. So, what is the reason to applaud it? What exactly should “INSPIRE” (as put in the official presentation) in this proposal?
“Fairness”? This notion is so relative that it hardly serves as a solid criterion. Economic philosophers endlessly discuss whether it is fairer to tax incomes, consumption, opportunities… But all of this is loosely related to reality since in fact taxes are being collected in some “historical” way, and all that an economist can suggest is how to make them more efficient, less distorting (or, at least, distorting in a desirable direction) and overall less harmful for growth. However, surely the most unfair way of taxation is confiscation, when tax liabilities are subject to personal discretion – as is done in Ukraine. MinFin’s proposal does not alter this principle, it does not affect any of the current discretion opportunities. Moreover, it tries to expand this discretion by gradual elimination of simplified taxation.
Flat rates? Certainly these might be good – apart, perhaps, from VAT on essential medicines, which might harm or kill thousands of people who cannot afford necessary medical treatment even now, especially after Hryvnia devaluation. Also, a VAT on healthcare and education will further increase the gap between “free” types provided by the government and the types that people buy. Otherwise – yes, of course, the rates should be flat, at least because it saves time for accountants therefore improving the country’s position in the Doing Business rating. And that is, basically, it. Flat rates do not solve the problem of discretion (“unfair treatment”) that plagues all Ukrainian regulations, including tax , whereas it can make only marginal improvements in real business conditions.
Changes in the structure of taxes? Yes, in terms of long-awaited cut in the payroll tax the government is going in the right direction. However, this is not new, as said above. What should be decided now is a compensator that allows to sustain the fiscal balance irrespectively of this cut. The solutions proposed by MinFin further shift the tax burden towards households and the middle class; they do not show a way to tax the “oligarchs” (not as individuals, for it is hardly possible [2], but as beneficiaries of lofty rents), which would be a really a “fair” way to raise some money for the budget.
Maybe such a reform was good for Slovakia (from which it is copied), but who has proved that it is good for Ukraine? Does Ukraine now really have similar problems and opportunities as Slovakia did at the times when Mr.Mikloš introduced his reforms there? No, not at all. For instance, can one imagine the world`s largest automotive companies investing billions of Euros into Ukraine now? Alas, this is extremely unlikely to happen. Do we share a similar institutional and cultural background? No, only partly. First and foremost, unlike Ukraine, Slovakia never belonged to the Russian Empire, where the nachal’niks used to rule by selective enforcement of impracticable norms. Respectively, before Mr. Mikloš` reforms the main discussion in Slovakia was about progressive versus flat income taxes, and here the flat rate solved the problem. However, Ukraine already introduced a much lower flat rate nearly in the same years, with negligible effect. For foreign investors the main advantage of the Slovak reform was that they could save on lawyers and accountants due to the relative simplicity of the laws. Whereas in Ukraine now the main problem is that even good lawyers and accountants cannot protect investors from rampant blackmailing, extortion, and even raiding performed by tax officials or with their assistance. Unpredictable tax liabilities are a far more important problem than even tax rates, not to mention complexity of calculations due to difference in the rates, or high number of taxes. And so forth…
The blueprinted Slovak reforms do not even try to solve these problems. The only radical change proposed by the government is another crackdown on simplified taxation. This problem deserves a separate article that is underway. Here I just can remind that the share of respective taxpayers in the total sales of the Ukrainian private sector is just 6.6%. So, can an economist really think that any (subversive for taxpayers) manipulation of this share can spur economic growth, significantly increase budget revenues, or result in any substantial shrinking Ukraine’s 40% of economic output which remains in the unofficial economy? In other words, can it be a way out of the above-described trap? Unfortunately, not.
A Way Out
Still, there is an escape from this trap offered by a coalition of civil society organizations and individual experts.
Firstly, the overall tax rate is not the only burden that the business has to bear. And even the compliance costs that MinFin’s “reform” promises to (marginally) cut fail to encompass the whole picture. They are important for micro business, but quickly fall with scale. But let us recall that Ukrainian businesses pay high “bribe taxes” [3]. Although, of course, this measure is very crude, and does not capture all the losses that corruption (namely, extortion) inflicts on society, several percent of a firm’s revenues frequently go to tax officials, at least in Ukraine. But there is a way to cut this figure dramatically. According to Robert Klitgaard, “corruption = discretion + monopoly – accountability”. Thus, by eliminating discretion one can dramatically cut the bribe tax, either converting it into budget revenues, or leaving it to business, or both – just as happened long ago when simplified taxation was introduced in Ukraine. In a way, the kind of relationships that already exist within 6.6% of the private sector should be spread to the other 93.4%, not vice versa.
Secondly, the composition of taxes matters. Economic theory suggests that lump-sum taxes (on imputed incomes, or property – as a proxy for one) are the least distorting ones, followed by indirect taxes, while direct ones are the most harmful. Empirical evidence supports this too. Hence, one can facilitate growth by simply reshuffling the same tax burden in favor of property taxes and indirect taxation. Moreover, other evidence suggests that it would also allow for some cutting of the rates, since in corrupt countries collection of the direct taxes is more problematic. By the same token, it means that such a reshuffling can help reduce corruption.
And, of course, last but not least, the budget should be cut – primarily by eliminating inefficiencies, corruption, subsidies etc.
All of the above is proposed in the concept prepared by civil society. Among other good things, it offers flat rates and abolishment of all privileges for industries (including agriculture). But it also offers some more, namely the “Hong Kong” version of tax on redistributed profits with possible losses more than compensated by property tax [4] deductible from the profit tax liabilities, a dramatic simplification for taxpayers, predictability of payments (and revenues), and so on. It is fiscally responsible (requires only modest budget cuts, 2-5% of GDP in the first year), and realistic in terms of revenues. In particular, we do not rely on any “de-shadowing” in our calculations. However, shifting the burden from an elastic tax base (salaries) to an inelastic one (property) should result in some “de-shadowing”, other things being equal, namely under a given expected cost of non-compliance. It is hard to grasp Prof. Conrad’s economic logic when he claims the opposite [5].
Yet, of course, there is no such thing as a good but simplistic tax system. For example, a single turnover tax that is offered by some domestic economists as a panacea does not work well in a market economy. Actually, the simplest tax law is a confiscatory one: “A King unilaterally and arbitrary decides on how much one should pay”, that’s it – but this is, of course, the most unfair and inefficient kind of a tax possible.
However, complexity in law or administration (which is inevitable for a good property tax) does not necessarily mean discretion or other corruption vulnerabilities. A good law is one written in understandable language, but large enough to close as many loopholes as possible. Moreover, complexity should not necessarily be brought to the interface where it complicates the user’s life, instead it can be moved inside the system. For instance, an extremely complex smartphone can be made as simple to use as a toy, so even a baby can play with it [6].This is exactly to what we aspire. And we do believe that such a tax system can become not just one of Ukraine’s competitive advantages, but also our way out of the above-described trap of society’s high paternalistic expectations despite the country’s fatally flawed tax system.
Notes
[1] There is a long-term academic discussion about these issues. A good survey available online is, for instance, here.
[2] Taxing personal incomes of the ultra-rich with progressive PIT is more or less effective only if they prefer to live and work in the same country. But even in the most comfortable countries it does not work well since a wealthy person can easily reside in a country with lower rates of this tax. So, in fact progressive income taxation shifts the burden on the middle class.
[3] Unfortunately, I failed to find any recent estimates.
[4] Unlike MinFin we are talking about a full-fledged tax primarily on commercial and industrial property, with no exemptions for commercial firms, and rates of about 2% of the imputed value of land with special coefficients for the share occupied with buildings and equipment and which account for their height. It should become an important source of budget revenues more than compensating for all past proceedings from corporate income tax. Details will follow.
[5] “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”.
[6] In the same way, the property tax that we propose (see endnote 3) is hard to calculate, but this will be done inside the tax service: the citizen will just have to pay a bill.
Tax Reform Week
Other articles:
Tax Reform – What’s On the Table (Pavlo Kukhta, member of the Editorial Board of iMoRe)
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)
Robert Conrad: Tax Reform is not Simply Changing the Law (Robert Conrad, Duke University)
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 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)
Attention
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