The Political-Economic And Institutional Issues Of The Ukrainian Tax System. Part III

This article is the third part in the series of posts devoted to Ukraine’s tax system


This article is the third part in the series of posts devoted to Ukraine’s tax system. The first article provided a general overview of the country’s tax system while the second explained that tax evasion should be fought with a top-down approach. This article argues that the main purpose of tax reform should be to limit the discretion of tax authorities by simplifying the tax code as much as possible.

In the cult novel and movie “Hard to be a God” a genius inventor in a medieval society is upset with the way his contemporaries use his devises. For instance, a meat chopper he designed in order to help people with dental problems is used instead as a torture tool. This is a perfect parable illustrating the fate of seemingly modern tax institutions in contemporary Ukraine.

From the institutional and political-economic viewpoint, Ukraine belongs to the countries with “limited access social order (LAO)” according to the North, Weingast and Wallis [1] taxonomy; or to those one with “extractive institutions”, according to the one of Acemoglu and Robinson [2]. The former means that modern institutions are likely to be perverted in such a way that allows using them in order to limit access to the lucrative economic and political opportunities. The latter means that they are likely to be abused whenever possible for extracting rents for the “elites” instead of creating public goods. Both describe tax system in Ukraine.

Moreover, the tax system is perhaps the focal point of both phenomena in Ukraine. First, unlike other regulations it affects every entrepreneur (or would-be entrepreneur).

Secondly, it is exactly about extraction of resources. Historically taxes emerged as a typical extractive institution, since they primarily were spent for enrichment of the elites. The latter are interested in sharing their loot for public goods only to the extent that maximizes their long-term gains [3]. Although in the formally modern states taxes are collected only for public goods and social purposes, under domination of extractive institutions they are being stolen, and not only at the stage of public procurement, but at the very stage of tax revenues collection.

Thirdly, and the most importantly, taxation (especially the one of net corporate income) is inherently discretionary. This discretion may be not so disastrous under an “open access social order” (OAO, as opposite to LAO) dominantly present in developed countries (or, maybe, even in some other LAO countries where access is limited by other means, such as explicit legal restrictions or statute privileges). But in Ukraine it meets a deep-rooted historical tradition  inherited from the Russian Empire where the authorities for centuries used to rule (precisely speaking – to exercise vaguely limited personal discretionary power) through selective implementation of impracticable laws (the tradition sometimes called a “blackmailing state” [4], “soft rule of law” [5] or “soft legal constraint”). This is a way the LAO exists in formally modern institutions. This problem goes far beyond taxation: among other things, a free entrepreneurship potential in Ukraine is constrained mainly because discretionary enforcement of impracticable norms allows public officials (“nachal’niks”) to effectively subdue and select entrepreneurs, settle the winners and mow the markets for them by driving out their competitors. Therefore, what the economists use to treat as under performing governance and outrageous violation of market fairness is OK for the Ukrainian authorities – and taxation is the most pronounced illustration of the case.

How a meat chopper became a torture tool: the case of State Tax Administration

Let’s consider the State Tax Administration (STA, now State Fiscal Service, SFS), which was created in 1996-1997 as a discretionary punitive tool in the hands of then President Kuchma rather than as a normal fiscal institution. First, the STA was responsible to him directly, which looks quite strange for a fiscal authority. Second, until the early 2000’s the STA paid bonuses to inspectors for fines imposed on taxpayers as a result of an inspection. Third, tax evasion for an amount of a couple of average monthly salaries was made subject to criminal prosecution and could lead to jail time. Last but not least, Kuchma put Nikolay Azarov in charge of the STA. Azarov, who became infamous later as Yanukovich’s Prime Minister, did not understand the concept of a market economy, and with such little knowledge of taxation that he sincerely considered VAT refund to exporters as a privilege; instead, he was personally always loyal to his chief and ready to attack any business any time.

Although later on the above mentioned provisions were altered [6], and Azarov formally moved to other positions (and after Maidan left the country), the institutional memory persists. Moreover, the tax authorities as well as the Ministry of Finance stubbornly oppose any attempt to limit the inspectors’ discretion. Instead, they try to boost it (along with the inspector’s authority) whenever these government bodies are allowed to draft the legislation, as in 2010 or 2014. It is quite natural given that the above-described system of relationships provide them with little or no incentive to streamline the law or otherwise eliminate discretion inherited in it: even apart from other possible interests, they simply have little idea how they can collect revenues without blackmailing firms.

Enterprise profit tax:  the essence of discretion

At the operational level, taxation of corporate net incomes by the “Enterprise Profit Tax” (EPT) is at the core of this repressive tax system because it inherently allows a high degree of discretion. Since the rules are opaque, cumbersome and often contradictory, an inspector can easily find reason to penalize a firm or its top management. For instance, the issue of tax deduction for materials damaged during the production process, which requires proper qualification of such materials as recyclable or non-recyclable waste, avoidable or unavoidable waste, within the established limits or not, rejected products or wasted materials and depending on respective qualification, a tax deduction may be allowed in full or within the established limits or not allowed at all. It also concerns other dual-purpose cost and payroll-related expenses. Such kinds of things provide an inspector with de facto power to make decisions that can have serious consequences to the returns from a business and its competitiveness, not to mention a possible criminal liability of the CEOs. In other words, they make an inspector a nachal’nik over a firm.

But perhaps all we need to do is simplify the  law? Unfortunately, in spite of its seeming theoretical simplicity and clearness, in practice there is no way to make corporate income taxation simple and straightforward thus eliminating personal discretion. The very economic nature of net profit as a margin between revenues and business costs makes it notoriously vulnerable to manipulation. In countries with strong corporate governance culture and well-developed financial system, a firm normally has an incentive to declare its profits, or even to overstate them in order to raise its stock market value (and small and medium firms that are not publicly traded are subject to strict control procedures so that expected benefit of tax evasion for them is lower than expected cost of punishment). Otherwise, the business would like to conceal profits in order to minimize or avoid taxation. The government, of course, does not like this: it creates sophisticated and cumbersome norms in order to limit tax evasion, and sends inspectors to perform tax audits uncover profits and punish violators.

This largely increases compliance cost and diverts time and effort of businessmen from developing their business to inventing ways to minimize tax bills. The government tries to figure out and close the newly discovered loopholes, and businesses, in turn, find even more creative ways to circumvent the law. As a result, the law has to be amended (“updated”) each time a new issue is discovered, so it becomes increasingly complex and unstable – therefore, the firms should spend more and more for accounting, but still always remain at risk to be caught on some (even occasional) error, just like a driver on a road with frequently updated road signs.

Moreover, even if the EPT law is simple and stable, the criteria for its enforcement are inherently vague and cumbersome. Take, for instance, the criterion on connection of any transaction with the business activity of the taxpayer. A tax inspector may consider a separate transaction as ‘loss-making’ and, as such, not related to the business activity of the taxpayer, therefore not eligible for tax deduction. It concerns, for example, the sale of goods with a discount, so-called advertising sales, other marketing and advertising activities which are always under scrutiny [7]. Thus, the judgment remains largely at the discretion of an inspector, or, at best, it can be disputed only by an expert through a court. In this situation, it is easier for a firm to pay a bribe (taking into account that in Ukraine the whole tax system is corrupt, the expected punishment for bribing a tax inspector is very low) than to conquer an unfair decision of an inspector afterwards.

At this point one should take into account that for a Ukrainian “to bribe a tax inspector” does not sound as terrible as it does in the most of – at least Northern and Western – European countries. For historical reasons, an average Ukrainian is much more prone to corruption, and changing this attitude is neither quick, nor an easy task. From the economic viewpoint, the fact that a tax inspector’s discretionary decision affects business returns means that she possesses (or rather extracts) some de facto informal property rights over a firm. The symmetry of property rights requires that she also possesses a respective share in the returns too – which means that discretion is indispensable from corruption. As Robert Klitgaard put it in his famous formula, “corruption equals monopoly plus discretion minus accountability”. Since the monopoly is inherent in a fiscal service, and weak institutions cannot outbalance discretion with sufficiently high accountability even if it is stipulated in the law, corruption flourishes. Therefore, in order to reduce it, the laws should first of all minimize the discretion opportunities. From this viewpoint, Ukraine cannot afford having a corporate income tax (the one calculated as certain share of [specified] revenues reduced by [allowed] business cost) at least because, on the one hand, it cannot be properly collected in a corrupt-prone environment (as is the case with direct taxes under weak institutions all over the world), and, on the other hand high discretion inherited in it instantly begets corruption as described above.

Malicious spillovers of the corporate profit taxation in Ukraine

However, corruption is not the only problem that spills over from corporate profit taxation to the rest of the tax system.

Confiscatory taxation is the next one. The bad practice of setting plan targets on tax collection was condemned by all reformers and their advisers – nevertheless, it is still there. Why? Becausewhat else can a government do with a tax that is on the one hand easy to avoid or evade, but on the other hand there is often no clear criteria or the ways to prove such avoidance/evasion – or it is even legal. Especially given that in practice very few, if any, inspectors can resist the temptation of sharing under-payed tax with a firm instead of reporting a violation?

The best a government constrained by the rule of law can do in such circumstances is simply turn a blind eye to avoidance and praise any proceedings from this tax, however small. Cynical though it may sound, there is no way to make people pay in a lawful way. It is OK if this tax does not play any significant fiscal role since the bulk of revenues are being collected from individuals (employees or entrepreneurs). But this is not the case in Ukraine; and, no matter whether it is desirable or not, this cannot be changed in a foreseeable future. Then, a natural solution (especially in a country that used to live under central planning for seventy years) is to set a plan target on revenues and fines for the SFS. The latter, in turn, transmits these plans to inspectors, so they cannot so easily collude with a firm in tax avoidance/evasion any more, but have also to fulfill the plan targets. That is, the government rests with the confiscatory taxation with all its fallacies that spread to other taxes, mainly the VAT.

Even worse, there are no clear criteria for imputing a particular amount of EPT liabilities to a particular firm. Respectively, these plans become subject to discretion themselves, and in reality are set by negotiations just as their predecessors, production plans of Soviet times, did. As a result, in Ukraine the EPT is not a genuine corporate profit tax, but an arbitrarily levied duty subject to discretionary application and subsequent negotiations. For such a tax the rate does not matter at all, since the SFS squeezes it out by blackmailing the firms with punishment for inevitable, occasional or even fake violations; the firms try to negotiate using different means (including, but not limited to appealing to the law); and this whole non-transparent process has nothing to do with civilized practices of tax administration [8].

Last but not least, the Ukrainian EPT in its current form is effectively regressive. The higher a firm’s negotiating power, the less it usually pays in relative terms. In particular, huge companies owned by oligarchs used to pay symbolic corporate income taxes while successfully transferring their profits to tax havens and sometimes reinvesting them when necessary as fake FDIs stemming from Cyprus and Virgin Islands. Hence, the EPT helps to preserve highly skewed structure or property that, in turn, makes corporate tax in some form so vitally important.

The VAT makes up the next sad story. Of course, its administration is quite complex everywhere and the abuses are quite popular – so Ukraine is by no means unique in this respect. Still, it makes a special case. As long as plan targets on tax collections are set, they affect all kinds of taxes, including the VAT. But unlike profits, the value added is determined quite unequivocally. So, in order to fulfill the plan an inspector has to cherry-pick minor errors in order to claim tax invoices invalid and otherwise unfairly downsize the VAT credit. This too requires countless inspections along with all abuses they imply. On top of this, honest taxpayers suffer from the widespread bad tradition of kickbacks for the VAT refund (or selective refund to crony firms), most probably related to the above mentioned institutional memory of treatment of a refund as a privilege. Therefore, business people view VAT as the most problematic of all taxes in terms of administration, and even demand its removal. However, when doing this they fail to realize that the main abuses are rooted not in VAT own nature but rather in the SFS institutional memory and the discretion inherited from the EPT.

Last but not least: High payroll tax as an “impracticable norm”

The high payroll tax rate (“social contribution” [9]) is yet another selectively enforced impracticable norm. Of course, one can find a few countries where payroll tax is even higher. But only the ones famous for their institutional strength can afford this – which is by no means the case of Ukraine. For instance, the payers of high contributions to the Scandinavian pay-as-you-go pension systems have no doubt that they will receive generous pensions after retirement – and these pensions will be accurately set according to their contributions. In Ukraine the payers have little reason to trust the government that has no institutional continuity, so it can easily change the rules in the midst of a game, as it has already done many times. For demographic reasons, the whole pay-as-you-go system became unsustainable long ago but so far no Ukrainian government had the courage and/or institutional capacity to transfer it to a 2-3 level system. Currently, neither the employees see enough substantial benefits in being legally paid, nor the employers are willing to do so: a premium for avoidance of “social contributions” is much too high. Therefore, the majority of small and mid-sized firms (for larger companies this is more complicated) in some way avoid this tax and pay envelope wages. The punishment is, again, selective.

Intermediate implications: get rid of the EPT and other discretionary opportunities, then wipe out bad institutional memory

Therefore, a new genuinely modern and non-confiscatory tax system should eliminate discretionary opportunities to the maximal possible extent – primarily, the direct taxation of net corporate profit as a fiscally important tax. For all residual cases of discretion, the procedures and mechanisms should be designed in such a way that allows for maximum possible civil control and other kinds of checks and balances that bring accountability to the fiscal service and its officers. Flexibility, counter-cyclical properties, and even to some extent “fairness” in a sense of taxing true incomes, probably need to  be sacrificed in favor of  simplicity in order to  leave as little room for discretion as possible; otherwise the tax system will become even more unfair. Still, all of this does not mean that a new tax system should be “soft” on taxpayers – to the contrary, it should be merciless with non-compliant payers, whatever their reason. However, such a system should no longer allow abuses that  limit access to economic opportunities for all but certain (informally) privileged cronies. In this sense it would be much fairer than the current one.

At this point one can object that such a tax system cannot be created under the LAO, since it will be perverted in the same way that the current has been. Even if the EPT is abolished or reformed to the extent that eliminates its inherent fallacies (in the further articles I will explain a way to do this), its successor(s) could be perverted just as the VAT currently is – however low discretion would be inherent in it. A general answer is that such a reform should be accompanied by a “reset” of the SFS that should wipe out its destructive institutional memory.

The good news is that change is not impossible, in spite of all the skepticism towards Ukrainian institutions. Actually, the vast majority of domestic business entities already enjoy a tax system that works almost as it should, with negligible discretion and insignificant abuses within it – namely, simplified taxation. Of course, it is not without its own problems (especially on the nexus with the “general” tax system). However, the simplified taxation system shelters a few million  small entrepreneurs and their employees from pervasive discretion and personal power thus making them a sort of enclave of more or less free entrepreneurship within the LAO. From this viewpoint, this is no surprise that they played such a vital role in the Ukrainian Revolution. But the simplified taxation deserves a separate article that will come next.


1. Douglass C. North, John Joseph Wallis, and Barry R. Weingast. Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History. Cambridge University Press, 2009

2. Daron Acemoğlu, James A. Robinson. Why Nations Fail: The Origins of Power, Prosperity, and Poverty. Crown Publishers, 2012

3. Martin C. McGuire and Mancur Olson, Jr. The Economics of Autocracy and Majority Rule: The Invisible Hand and the Use of Force. Journal of Economic Literature Vol. 34, No. 1 (Mar., 1996), pp. 72-96

4.Keith A. Darden, “Blackmail as a Tool of State Domination: Ukraine Under Kuchma,” East European Constitutional Review 10, nos. 2/3 (spring/summer 2001): 67–71

5.Dubrovskiy, Vladimir, Towards Effective Anti-Corruption Strategies in Ukraine: Removing the Cornerstone Without Toppling the Building (March 1, 2006). CASE Network Studies and Analyses No. 322. Available at SSRN:

6.In 2012, STA was merged with customs service forming the Ministry of Revenues and Duties, that could control literally every enterprise in the country and the largest part of the government revenues. Currently, State Fiscal Service lost the ministry status, and there are plans to make it subordinate to the Ministry of Finance again (now it is subordinate to the Cabinet of Ministers).

7.These and other examples in this article are provided by Alexander Shemyatkin

8.Tax negotiations use to be part of normal practice in some countries. In several Swiss cantons corporate taxes are set individually. However, these examples are by no means instructive for Ukraine and other countries with weak institutions, since this way bears enormous corruption vulnerabilities and under the LAO is just perfect tool for personalization of relationships and merging of power with business.

9.It is not a tax from a legal viewpoint, since these contributions formally return to the payers (employees, for which their employers serve as agents) after retirement. However, in practice due to many factors the pensions are mostly detached from the contributions, the latter are also much too high while the pensions are low. In deed, the payers consider social contributions as a tax, and so does the government – it is collected by the tax service. For this reason we consider it as indispensable part of the tax system.


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