The Ukrainian Tax System: Why and How It Should Be Reformed? Part II

This article continues a series of blogs on the issues of the Ukrainian tax system by Vladimir Dubrovskiy. It argues that unlike in many other countries, the bulk of tax avoidance/evasion in Ukraine occurs in large and extra large business


This article continues a series of blogs on the issues of the Ukrainian tax system by Vladimir Dubrovskiy. It argues that unlike in many other countries, the bulk of tax avoidance/evasion in Ukraine occurs in large and extra large business. So, for a number of reasons, contrary to the current government’s approach, this problem should be addressed first by accomplishing a fundamental reform of the general tax system, while any necessary changes to simplified taxation should be subdued and come next. Read the first part here.

Rampant tax avoidance/Evasion: hunt a big fish first

In the first article in this series, I tried to provide a general overview of the current Ukrainian tax system with the focus on its institutional problems. Now, let us tackle more technical issues. Taxes exist for providing revenues to the State budget. Thus, rampant tax avoidance/evasion means that a tax system fails to perform its main duty. Tax avoidance is a symptom of serious problems with taxation system rather than the problem itself. Thus, to reduce tax avoidance/evasion, the fundamental flaws in the tax system should be addressed. And taking into account the limited capacities of the Ukrainian government to address these flaws, they should be addressed by order of importance: from the violations committed by extra large business – to the ones of individual entrepreneurs. However, currently much more effort is concentrated around the simplified taxation system rather than on nailing the big businesses – just as the Parkinson’s law of triviality predicts (“The time spent on any item of the agenda will be in inverse proportion to the sum [of money] involved”). This article explains why such an approach is counter-productive and should be reconsidered.

Fighting tax evasion will lower the burden on honest taxpayers

Enormous scale of “shadow economy” is the first thing that is glaring in the Ukrainian tax system. Estimates of informal economy vary from 30% to 50% of GDP, but the most reliable one is still “a hell of a lot”. This is the most evident fallacy of the current taxation system, although hardly the main one in terms of its effect on well-being: confiscatory and excessive taxation can be at least no less detrimental.

Some libertarians argue that this is rather good than bad, since the tax burden of about 40% of official GDP (including the payroll tax) is certainly unbearable for such a poor economy, especially taking into account remarkably low quality of government services and institutions. In a sense, rampant tax avoidance/evasion just de-facto corrects this enormous burden to more or less affordable 30% or so. Therefore, they say, it is vital for survival of the country’s economy that otherwise would be strangled by taxes. This is probably true, but the way it is being done is also harmful for the economy, at least because, as any kind of rent-seeking, it diverts time and effort of businessmen for devising innovations in tax avoidance rather than in technologies. Moreover, as any kind of an impracticable law, it helps nachal’niks (the bosses) in limiting access to lucrative economic opportunities and favors those having personal ties with authorities – thus, strengthens the Limited Access Order (LAO). This may be still better than being strangled by taxes, but it is a certainly poor solution.

The first best solution to this problem is, of course, to cut the budget expenditures – but, alas, there is not so much room for this. Unfortunately, now the majority of savings should be spent on defense and on servicing of the state debt that has more than doubled over the last year due to devaluation of Hryvnia. Contraction of the state should be set as a long-term goal, specifically, by establishing fiscal rules.

Yet, part of the tax burden that cannot be cut can still be spread more evenly by fighting evasion and avoidance while cutting rates or otherwise lowering nominal tax liabilities of the compliant payers so that overall tax burden remains the same – and this is an obvious second-best solution that can be implemented rather quickly (say, since the beginning of 2016). That is why fighting tax fraud is so critically important for growth, even letting alone usual considerations about tax justice.

“Shadow economy” in Ukraine: a special case

This idea is by mo means new. Nevertheless, numerous attempts of helping Ukraine in fighting tax avoidance/evasion did not yield any significant result. This failure can be largely attributed to habitual advisors’ focus on petty evasion (such as plumbers working for cash) and avoidance in small business as the most common cases of “shadow economy” known from the literature based on experience of other countries. However, unlike most of countries with similar GDP per capita, and even unlike most of more developed countries, Ukraine’s economy is remarkable (if not unique) with domination of large and extra large businesses, unprecedented for an economy not abundant with easily extractible natural resources.

According to the Wealth-X And UBS Billionaire Census 2013, by that year 18 Ukrainian billionaires amassed total wealth constituting 28% of the country’s GDP [1]  – compared to 12% in the USA [2].  The most, if not all, of them are “oligarchs” benefiting from close ties with state officials and using them, among other things, for tax evasion. Hence, the XXL-size business is likely to be the main sector of the unofficial economy in Ukraine in absolute values: although the respective firms operate legally, just concealing some portions of their profits, the very scale of their operations makes these activities much more important than any kind of violations committed by small business.

At the same time, the approach to taxation usual for developed countries, where the most of taxes are levied on middle-class people, cannot work in Ukraine (as well as in many other developing countries) simply because this middle class is much too tiny to feed the state. In Ukraine the middle class is predominantly associated with small and micro business – unlike, say, in Russia where these are mostly highly-paid employees of giant companies. Value added of small business and individual entrepreneurs in 2013 constituted just 15.7% of totall value added created by all enterprises [3]. So, can one imagine them paying the major share of taxes, letting alone that small business is normally considered as a source of jobs rather than of the budget revenues?

Moreover, in Ukraine attempts of putting tax burden on the middle class are perceived even more unfair than in the developed countries due to enormous inequality mentioned above. This exacerbates administrative difficulties, high corruption, lack of tax culture (and overall trust in the government) and other problems that make taxing small and micro business so difficult. Indeed, there is no alternative to devising a way of taxing the rich – if not the incomes and consumption of ultra-rich people (this is hardly realistic, however cynical it sounds), then their sources of incomes.  But the government officials often connected with the oligarchs (or intimidated by them) gladly supports the advisors’ misperceptions that drive their efforts away from this. As a result, big companies actually bear disproportionally low share of the tax burden compared to their share in GDP: 1% of the turnover paid in taxes reportedly used to be informal “norm” for the oligarchs – most often in exchange for direct subsidies and/or other privileges that exceed the respective amounts by far. Here the most of the “shadow economy” can be found.

Tax evasion trough “tax havens” and “tax laundries” is many times higher than through simplified taxation

Instead, a surface observer immediately picks out simplified taxation as the one that provides “evident” opportunities for tax avoidance – for instance, simply because it is possible to buy goods and services without a receipt. But what seems to be obvious is not necessarily true: it took almost twenty centuries for the people to grasp that it is not the Sun that goes around the Earth, but the opposite. Obviously, simplified taxation system is used (or, rather, abused) by larger businesses for tax evasion. But, according to available facts discussed below, any measures addressing simplified taxation can have at best marginal effect on the problem of the giant shadow economy, since the respective abuses are much smaller than two other, much more important, ways of minimizing the tax liabilities: tax havens and a special “tax laundry” industry.

For sufficiently large businesses that play such an enormously high role in the country’s economy, using tax havens is a preferable way of tax optimization due to its relative safety: nothing illegal, according to the Ukrainian law. No surprise, Ukraine is in top-20 countries that use (or, rather, abuse) tax havens. To the extent the available estimates are reliable [4], total stock of capital drained to the tax havens amounted to about 170 billions USD for 1994-2010, or 10-15 billions USD annually. One can just imagine the turnovers of this industry… But nobody actually dares to investigate these issues in greater details because it is much too dangerous. What is, however, evident – they cannot be boiled down to just transfer pricing or just capital transfers, especially if only direct deals with counterparts registered in “havens” are considered. The schemes designed by the best consultants are far more sophisticated.

More risky but sometimes still convenient alternative available also for smaller businesses is using the specific “tax laundry” industry that offers avoidance of all kinds of taxes including the VAT. This industry emerged back in 1990s when the payroll tax was 52% and an upper marginal rate for the personal income tax was as high as 90%. Then it has got its own momentum, including sunk cost – such as investment into patronage, devising sophisticated schemes, links to customers etc. Now only some extraordinary efforts can possibly extinct this practice.

Special firms, usually patronized by tax authorities and/or law enforcement officers, cash the money transferred onto their accounts allegedly for various services or as royalties, interest etc. for just 5-10% of turnover. They use short-living fake firms, specialized banks, etc., which, however, can be uncovered by modern investigating techniques. But under a systemic corruption inherent to Ukraine it only means that they should have to share their profits with potential investigators, especially at the top level. The Revolution of Dignity gave a unique chance to at least partly uncover the scale of “tax laundries”: according to the post-revolutionary estimates of Ukrainian tax authorities, their total turnover in 2013 amounted to about UAH 300 bln. (near $37 bln. at that time), which makes it approximately as large a loophole in the Ukrainian tax system as the operations with tax havens described above [5].

Summing up, both tax havens and “tax laundries” are roughly of the same scale of a few dozens of billions of USD – totaling to about 20-30% of the official GDP or over a half of Ukrainian shadow economy.

A “petty” shadow economy (like plumbers or baby sitters working for cash) is incomparable in scale with these abuses, and so is the misuse of simplified taxation. The turnover of “tax laundries” quoted above exceeds the total reported (hereafter if not specially noted – by State Statistics Service) turnover of all entities that use simplified taxation [6], and total reported turnover of all individual entrepreneurs. Similarly, even a million (about 10% of total private sector employment) of illegally working individuals each earning about an average salary can have a total income of a few dozens of billions UAH. Also, there are some companies that pay their workers as individual entrepreneurs thus avoiding the payroll and income taxes. Note, however, that in such a way they cannot avoid the VAT (unlike at the “tax laundries”). And the total turnover of all payers of this unified tax eligible to sell to legal persons and having no employees (therefore potentially able to cash money for their business clients) amounted to about 41 bln.UAH in the same year 2013. All of these and other abuses of same kind taken together will hardly reach 10% of the official GDP, which is not so bad even for an OECD country. However, these abuses are easier to see, especially because – unlike quite exotic “tax laundry industry” – they appear exactly where a surface observer with the experience of “other countries” glances first.

A sequence that matters: a political-economic and institutional analysis

Therefore, from a purely fiscal viewpoint all “socially sensible” problems with simplified taxation and petty shadow economy are of secondary importance compared to large-scale “industrialized” tax evasion. They should be, of course, also fought – but not as a first step, for at least two reasons.

Firstly, there is a rather trivial managerial consideration: it makes little sense to design a terrace before designing a building. Furthermore, in this case nobody can predict which problems the tax reform will solve, and which kinds of them it will create. Small and micro business (particularly, the one eligible for simplified taxation) is still a small portion of the whole economy, so logically the reform of a special regime for it should be subdued to the general reform. This means also, among other things, that it should be done after the main reform, not before  it.

 The second reason is more complex but also more important. From the institutional perspective, Ukraine still lives according to the social covenant of “corruption consensus” under which the “big guys” and the “small guys” mutually forgive each others’ abuses. This is, of course, a “bad equilibrium”. But the only sustainable and relatively safe, evolutionary, way of escaping it is dismantling of this social covenant “top-down” and by no means vice versa (here the parable with dismantling a building works perfectly).  These two ways cannot be applied simultaneously, although in a long run they complement each other.

With respect to particular case of a “shadow economy” it means that mass petty abuses should be, as a rule, addressed after the ones committed by large business.

Coming back to fiscal approach one can see that such a sequence is also more efficient given the actual political-economic constrains. Since petty tax abuses are fiscally much less important compared to the ones of the large business, then cracking on the former will have (and has always had when it happened) at best a marginal effect on budget revenues. It is much more efficient to focus instead on the large “beasts” as long as they are abundant: if a meat is viewed as a purpose, hunting a bison makes much more sense than hunting mice, of course if the respective technology already exists (as in this case). At the same time, it is politically impossible to hit “big” and “small” guys simultaneously. Whatever strong and important the international donors and creditors are, they still cannot establish an occupation administration, thus the government has to rely on some social groups inside the country.

Particularly, in this case in order to fight privileged “oligarchs” and grand corruption, a reformist government should lean upon the middle class, primarily small and micro entrepreneurs. They played a decisive role in the Orange Revolution and the Revolution of Dignity, in between they managed to organize their own Tax Maidan in 2010, and so far are the main social strata struggling for opportunities (as opposite to redistribution). There is no other way around: if the government relies on the recipients of social benefits and the emplyees, it would inevitably sink into populism; if it leans on the army and law enforcement bodies, then Ukraine should become an authoritarian police state. Or, most probably, a democratic government that simultaneously attempts on both large and small business will simply fail and get replaced by either the populists, or a dictatorship, or a populist dictator – in a shaky sociopolitical situation, as in contemporary Ukraine, this can happen very soon, long before its official tenure ends, and with unpredictable consequences. Therefore, losing political support of the middle class would be detrimental for the tasks that are far more important than even collection of a couple of billion UAH in budget revenues [7].

In light of this, persistent pointing at the abuses committed by and with the help of small business can be at least partly an incumbents’ diversionary tactics. Note that active assaults on simplified taxation and petty shadow economy always start whenever “big” evasion/avoidance (and related corruption) becomes under threat. By throwing this topic to the public the initiators create lots of buzz that helps them divert attention from more important things (recall the Parkinson’s law of triviality). Although the issues in question can hardly be called “trivial”, they attract disproportionally more time and effort that otherwise could be spend on curbing large-scale tax avoidance. Moreover, the civil society gets divided and misled: public anger diverts from an oligarch and a corrupt tax official to a small vendor that “also breaches the law”; the entrepreneurs that cannot use simplified taxation system (STS) mobilize against their peers allegedly enjoying better conditions due to it [8]; and whatever result of this internal fight perfectly fits a “big fish”.

Intermediate implications: reduce tax burden simultaneously with fighting evasion

The “general” tax system should be fundamentally reformed in order to (a) close the major loopholes and the very possibility to create the new ones, and (b) become fair and business-friendly, first of all non-discretional (see next article) before introducing any crackdowns against genuine abuses committed by small and micro business. At the same time, note that at least some of the reforms described in the further articles address many ways of tax avoidance/evasion at the same time – from transfer pricing in offshore trading with affiliated entities to a mid-sized shop that is “rented” by a few allegedly independent “individual entrepreneurs” from another individual entrepreneur.

Let me reiterate that every success in fighting tax evasion/avoidance (widening the base) should be necessarily accompanied by corresponding reduction in the tax rates, so the overall burden at least does not increase. Ukraine perhaps is the only example of such a poor and institutionally weak country with such a high nominal tax burden, and it will be strangled if this burden is imposed in full.

Still, as noted before, even this high tax burden is perceived as a less important impediment to business than tax administration. In other words, the way the taxes are administrated is more detrimental to average business than even 40% overall tax rate! And, as long as entrepreneurship is the only driver for economic growth in a market economy, this means that tax administration is one of the key impediments to growth in Ukraine. The next article looks at the roots of this problem.


Author’s calculation based on the WDI’s data on GDP

Note that in a richer country this share should be naturally higher just because of statistical effects

State Statistics Service data

James S. Henry. The Price of Offshore, Revisited – Tax Justice Network report, 2012, estimates total stock of money originated from Ukraine that were stored in tax havens as 166.8 billions for the period of 1994-2010, which is more than 10 billions a year. Note, however, that the flow could be even more intensive, and according to expert estimates it has intensified since 2010.

Unfortunately, this is the only year for which at least some official figures were reported

Hereafter – only groups from 1 to 3 of simplified taxation

see Political, Economic And Institutional Aspects Of Making Cuts To The Ukrainian Budget for more detailed analysis

Without mentioning, however, that unlike employees, individual entrepreneurs servicing legal entities have no guarantees, in particular they are not protected by the labor law and have to use their own working tools, etc.

VoxUkraine is a unique content worth reading. Subscribe to our e-mail newsletter, read us on Facebook and Twitter, see the latest video on YouTube.

Мы верим, что у слов есть сила, а идеи имеют определяющее влияние. VoxUkraine объединяет лучших экономистов и помогает им донести идеи до десятков тысяч соотечественников. Контент VoxUkraine бесплатный (и всегда будет бесплатным), мы не продаем рекламу, не занимаемся лоббизмом. Чтобы проводить больше исследований, создавать новые влиятельные проекты и публиковать много качественных статей нам нужны умные люди и деньги. Люди есть! Поддержать VoxUkraine. Вместе мы сделаем больше.


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