Ukraine Needs a Smaller and More Humane State

Ukraine is a corrupt state which has among the highest public expenditures in Europe. This situation is aggravated by the fact that Ukraine cannot finance its giant public expenses. Anders Åslund explains what should be done to clean up this mess and achieve economic growth.

Ukraine needs a smaller and better state that delivers more welfare to its citizens and costs them less. In particular, the state must not cause the citizen so much hardship. In 2014, the International Monetary Fund (IMF) assessed Ukraine’s public expenditures at 53 percent of gross domestic product (GDP), while the successful countries in this region have public expenditures of around 35 percent of GDP, for example, Lithuania, Latvia, Slovakia and Bulgaria.

The other states have grown nicely and now have a GDP per capita that is much higher than Ukraine’s, sometimes up to three times (Poland and Estonia), while Ukraine’s GDP per capita has tragically fallen by one quarter since 1990 according to World Bank statistics¹. Clearly, Ukraine is on the wrong track, and its excessive public expenditures are a prime issue.

Nobody questions the need for a state in modern society. It is needed for the defense of its citizens, the provision of law and order, infrastructure, healthcare, education, pensions and some social benefits. But this does by no means imply that a bigger state is better. The United States has public expenditures of about 35 percent of GDP, while in wealthy and well-organized Singapore public expenditures constitute only 25 percent of GDP.

Many “services” states may offer are not desired. The traditional feudal state offered many privileges to the lords, such as the right to decide over their employees, monopolies and subsidies, not to mention the right to judge their subordinates in their own feudal courts. The Ukrainian oligarchic state has many similarities with the feudal state. The courts work to the benefit of the wealthy and well-connected rather than defending the population with the rule of law.

The modern social welfare state has encountered another problem. A majority of the population has repeatedly voted to transfer a substantial share of the wealth of the entrepreneurs and successful to themselves. Money goes around through high taxation of the wealthy to the majority. In the Scandinavian countries this has functioned without much corruption, but growth slowed down because of the high tax burden and limited incentives to work. Therefore, these countries have sharply curtailed both public expenditures and taxes in the last two decades. In Ukraine, the situation is even worse. The oligarchs have enriched themselves with state subsidies, notably in the energy sector.

Ukraine has ended up in the worst of all worlds. First of all, it has among the highest public expenditures in Europe, competing with France, Sweden and Denmark. Second, it has one of the most corrupt states in Europe, so it does not even offer the most elementary public services such as law and order, not to mention good education and healthcare. Third, its high public expenditures have forced the country to impose the highest taxes in the region, which further aggravate corruption and hinder growth and entrepreneurship. Finally, Ukraine cannot finance its giant public expenditures, but goes from one fiscal crisis to the other, now enjoying its tenth IMF program in just over two decades.

This cannot continue. Ukraine must start cutting its public expenditures drastically, from 53 percent of GDP to 35 percent of GDP, if it aspires to become a normal market economy that can grow.

In comparison with other countries, Ukraine stands out for two forms of public expenditures. One is energy subsidies that accounted for 10 percent of GDP in 2014. A normal market economy should have no energy subsidies, so this is harmful waste that should be eliminated as soon as possible.

The other is pensions that peaked at 18 percent of GDP under President Yanukovych, which is more than twice as much as the European average. If the energy subsidies are eliminated, and the pension expenditures halved as share of GDP, Ukraine’s public expenditures would decline to 34 percent of GDP and the proportions of state expenses would look normal. Ukraine does not need to cut expenditures on education, health care or road construction, though the whole state should be made more productive and efficient.

Technically, the easiest task is to abolish energy subsidies. Most of these subsidies are price differentials between very low consumer prices and high import prices for gas from Russia. In 2013, the Ukrainian state paid its own state producers of gas $50 per 1,000 cubic meters, while Gazprom charged about $400 per cubic meters. Needless to say, much of the domestically produced gas was diverged to the private market to the great benefit of some who were close to President Yanukovych. This cannot be stopped through more effective policing because the gains from these rents are too high. They will only end up with somebody else.

If all energy prices are unified at the market level or the marginal price level, no more energy subsidies are needed. All other postcommunist countries have done so, but Ukraine has continued to nurture its energy traders, most recently Dmytro Firtash and Sergey Kurchenko. Such public expenditures make no sense whatsoever and should be abolished as soon as possible. On April 1, the current Ukrainian government took a great step in that direction raising all energy prices to at least half their cost. It would have been desirable to take them further, but the IMF assessment is that this will reduce energy subsidies by 6 percent of GDP. In addition, the lower international energy prices should shave off another 2 percent of GDP of the energy subsidies leaving only 2 percent of GDP.  Then, the government can afford to compensate the poorest third of the population fully in cash to the cost of 2 percent of GDP.

To reduce the excessive cost of pensions is more complicated and demands more time. To begin with “special pensions” to the old Nomenklatura should be abolished or at least sharply scaled down. Many Ukrainians benefit from early pensions that should be tightened up. Most European countries have a retirement age of 67. If Ukraine insists on the current very low retirement ages of 57 for women and 60 for men, most pensions will go to relatively young people who still work and not to the poor and sick. In the longer run, Ukraine needs to adopt a pension reform that offers a minimum pension for all, but then offers higher pensions for most based on private savings. This would also enliven the morbid Ukrainian financial markets and encourage savings for investment. At present, Ukrainian pensions are falling sharply, but they do so because of the absence of indexing in the face of high inflation. The cost of pensions has to be reduced, but this is the most socially unjust way of doing so.

The conclusions are plain and clear. Ukraine needs to sharply reduce its public expenditures in the next few years in order to achieve economic growth. The first and biggest step is to abolish energy subsidies of 10 percent of GDP. The second big step is to trim the pension costs over a few years by 9 percent of GDP. No dramatic costs cuts are required in other areas.

Notes