Which taxes can Ukraine afford without suffocating itself?
By Mykhailo Kukhar, IMF Group Ukraine
What do we think about Ukraine’s tax system? It’s awful! What do we think about its pension system? It’s horribly unfair! Have I guessed your answers correctly? No polls or surveys needed. There are too few respondents with a different opinion to take them into account — they are just beyond the margin of error.
Guess what? This is not only our opinion. You can ask citizens of any country on the European, North or South American continents the same two questions. The answers will be the same. That’s why such polls are not held at all.
Governments act as they please, trying to find a reasonable balance between a tax rate that cannot be too high and social payments (including pensions). Of course, every government would like to raise the latter as high as possible for the electorate, btut this would be achieved at the expense of business and people who are employed.
The issue we are referring to is crucial for the economic agenda of elections in all developed democratic states. This has been the case during the entire post-war period. It’s only Ukrainian politicians who have been using the people’s economic ignorance en masse over the course of the country’s 25 years of independence. They promise shamelessly to cut taxes and raise pensions (social payments).
One cannot fool anyone with such tales in the West. Democrats in America, members of the Labor party in Great Britain and other left-oriented politicians, such as the socialists in France and other European countries, admit honestly that in order to raise welfare payments to the poor and unemployed by a certain per cent, they would have to raise taxes by certain amount. This would be the price for fulfilling their preelection promises.
Republicans, the Tories and other right-oriented politicians need to be reminded that business and the employed part of the population are able to handle the tax burden only up to a certain point. Beyond that point, business loses investment instruments and moves manufacturing facilities abroad. If our country does not want to lose the international competition at all levels and therefore aggravate unemployment, we need to cut certain taxes correspondingly. Yes, for that purpose we would have to cut certain social payments programs which can be identified as irrelevant or redundant. This is the price Ukraine must pay to survive in the modern world, right-wing politicians say.
Eventually, everything revolves around the parties arguing about the so-called fiscal percent of GDP — the share of the national income that the government will take from employed citizens and businesses in the form of taxes before reallocating the funds via the budget in a manner that it considers appropriate.
No wonder the fiscal percent of GDP issue (i.e. the share of budget or state expenditures comprising GDP) is one of the most studied in modern macroeconomics. Thousands of research papers are dedicated to this issue, including at least three Nobel Prize winning works. Top economists at international organizations publish their analytical reports devoted to the experience of different countries on this problem and cite the most efficient models.
This global problem, just as any other similar one, doesn’t have a simple solution. It’s controversial, just as the argument between the interests of the labor and the capital is in political science. In economics, fiscal percent of GDP actually reflects the same thing.
The modern world can be roughly divided into four groups of countries, based on the burden taxes have on their economies. We can briefly describe their basic characteristics and objective development patterns. I would suggest focusing on the two most recent decades: from 1991 to 2012. This encompasses our country’s existence as a new economic actor on the world stage, as well as the period that established the world order in economics and politics — the hegemony of the U.S., an expanding China and the two world financial crises (1997–1998 and 2007–2008). Respectively, we have two continuous eight-year-long economic growth cycles, which even out statistical fluctuations and can provide us with a generally clear and accurate picture of what’s going on.
The European Union
Let’s start with the euro zone. The EU as we know it, with its monetary union, emerged only in 2000. However, the tax and budget systems of the member states have evolved towards its current state during the whole period of their post-war history. Strictly speaking, since 1992 (Treaty of Maastricht that introduced unified and universal criteria for the external debt size, for the budget deficit, exchange rate and inflation) they have virtually been implementing a coordinated macroeconomic policy.
Average fiscal percent of GDP for the group of countries known as EU-27 was 38% in 1991. By 2000, the indicator exceeded 41%, and during the entire following decade, up until the last year, it decreased to 38.8%. The drop is an illusion, however, because the majority of euro zone countries have forgotten the “Maastricht stability criteria” after the 2008 crisis. Instead of the maximum budget deficit of 3% from the country’s GDP, EU states have state expenditures which exceed current profits by 7%, or even 10% of their GDP. Without much ado concerning Brussels, these countries finance their deficits without slightest problems by accumulating debt with borrowed funds and drawing the excess 10% of GDP from investing into their own economies. By the end of the second decade of the greatest economic experiment in modern history, EU governments take away every other euro earned by business entities and use it to maintain the previously mentioned world’s highest system of social standards characteristic for this group of countries.
As for Ukraine, we can say the fiscal percent of GDP for the euro zone at the level of 50% is the highest index of joint business and citizen taxation, not only in modern history, but since ancient times and the start of written economic history.
A number of researchers interpret the notion of “fiscal percent of GDP” more broadly, calculating it not only as an inevitable extraction of money from the economy and into the budget and the state pension fund. These economists are absolutely correct to include allocations to private and corporate pension funds and payments, which have been made as obligatory as taxes, and also mandatory medical insurance paid by employees or enterprises. If you use this method to draw up the calculation of money extracted from the economy and put into the budget and other social funds, you would wind up with “Swedish socialism.” The level of fiscal percent of GDP in Sweden itself, Finland, Netherlands and Denmark averages from 60% to 70%.
Economic growth in the euro zone was an average of 1.7% from 1991 to 2012. Since the creation of the EU, this rate has averaged 1.1% (2000–2012).
The United States
The second group is represented by one country only — the U.S. that is itself a huge economic conglomerate accounting for a quarter of the world’s entire economy.
Despite world hegemony and corresponding military expenditures (the largest in the world — exceeding joint military expenditures of all other countries in 2008), the U.S. has one of world’s best systems of education, healthcare and social welfare. Of course one might argue whether the US healthcare system is good, compared to ones in the EU. In my opinion, it is definitely inferior to the German and the Swiss ones, but at the same time is undoubtedly better than the British and the Spanish ones. But no one, even skeptics, will say that the U.S. social welfare system is far worse than in EU member states. However, the fiscal percent of GDP in the U.S. is only half of what it is in Europe! We have to admit that within the last two decades it increased from 25% to 31% of the GDP (including the 34% peak of 2007–2008). Still, 70 cents from each U.S. dollar earned by an business or individual stays with that business or individual (until recently, the amount was 75 cents)! According to liberal economic theory, a businessman who earns money knows better than anyone else the most effective way to invest those 70–75 cents.
In exchange, the economy has consistently thanked U.S. financial authorities with 5% to 7% economic growth during growth cycles. During economic slumps, GDP drops have not exceed 0.5%. Europe, on the other hand, with its pattern of withdrawing from 50% to 60% of money for the budget, has not boasted such growth rates for more than two decades, although the economic situation has changed on numerous occasions (mostly, for the better).
“The Arabic economic world”
The third group of countries would be difficult for Ukraine to emulate. These are Middle East and Persian Gulf countries. They are very unequal, with differing income levels and crude oil export incomes comprising their GDP. However, these countries are important for us as a model for analysis.
Therefore, we will agree to call them “the Arabic economic world”. Unlike the notorious “Russian world,” this is truly a “world,” one related with common socio-cultural characteristics and an amazingly similar economic structures, with taxation based partly on religious doctrine. For example, Arabic banks have no right to lend money with an interest rate and must not repossess the borrower in case if project financed goes bankrupt. However, they have the right to lay claim to a share of profit. That’s why Arabic banks represent a highly complicated system of joint-stock companies with elaborate corporate rights. Roughly speaking, everyone is connected to everybody else through small, but still common, business bonds.
The second significant characteristic of this economic system is, of course, commitment export profits from hydrocarbon sales. This system includes Iran and Iraq. Libya prior to the overthrow of Kadhafi mostly exported processed petrochemicals, thus providing USD 700 dollar salaries and welfare payments for its scarce population. The system also includes the most highly developed country in the region — the United Arab Emirates, which, using oil dollars as a trampoline, has built modern production facilities, technical parks and logistics centers. Nowadays, its share of crude oil export counts for less than 5% of its GDP.
Their experience is not exactly applicable to Ukraine. We will never have so much oil. However, their example is interesting for us as just another group of countries with an inventive type of business-state relation. Revenues are generally drawn due to state’s ownership of extractive industries and the accompanying infrastructure, e.g. pipelines, oil refineries, seashore terminals, cargo carriers. Surplus profit of extracting monopolies is distributed often by means of direct equal sponsorship of the population (namely, in the UAE and Lybia during Kadhafi’s Jamahiriya, each citizen received a bank account opened at his name at birth, and part of the oil export profit was allocated to that account).
In the the majority of these countries there is no income tax and small business taxation whatsoever. Traditional Muslim family customs is a substitute for pensions and welfare systems and no one is motivated to conceal their incomes. This allows small businesses to develop at unprecedented rates, with no restrictions and barriers at all. The moderate 10% to 15% income taxes for larger non-state companies, coupled with lease incomes, fill up the budget within necessary limits sufficient to finance the army and modern healthcare systems. If it hadn’t been for the extraordinary, unprecedented population increase in these countries, they would have no unemployment at all and solved their social problems decades ago.
The average fiscal percent of GDP of this group of countries is about 33% at the expense of a high ratio of the state sector, according to IMF statistics. Tax burdens do not exceed 17% of GDP (from 12% to 27%). The average rate of economic growth is more than 4.7% annually (I shall not provide a precise calculated index, because the picture is largely distorted by the statistics of the enormous economic breakdowns in a number of Northern African countries after the notorious “Arab spring” events). If it hadn’t been for the problem of unemployment caused by overpopulation, there might have been no “Arab Spring.”
China and the “Asian tigers”
The fourth group of countries comprises China and other “Asian tigers”. This is a number of states each of which deserves a close analysis. South Korea, Hong Kong and Singapore developed earlier than the others. China, Vietnam and Myanmar followed, chasing their competitors with a lag of two to three decades and currently have reached the peak of their growth rates. All of these countries share a similar recipe for success. Manufacturing outsourcing at the expense of cheap labor, making themselves the most attractive countries for investment, plus centralized (and often oppressive) country management based on long-term planning. They provide a safe haven for financial capital, as well as homeland tycoon capital, and offer cheap manufacturing, allowing them to flood Western markets with their own brands. No one could assume in the late 1990s that “Siemens mobile” would be purchased by Chinese funds, while the main rival for “Apple” in Europe and America would be not even a Japanese but a Korean brand — “Samsung.”
During the early stages of accelerated development (as a rule, we are talking about the first two decades when we refer to the “Asian tigers”), there wasn’t even a slightest hint of social welfare (China managed to prosper during the 1990s and the 2000s with no pension fund whatsoever). This is why fiscal percent of GDP in this group of countries did not exceed 10%, as a rule (until lately, China had this index at 8%).
Namely this region managed to achieve outstanding results in terms of economic growth. GDP growth rates of the “Asian tigers” has been 8% to 10% to 12% annually, virtually doubling each 10 to 15 years and decreasing by 4% to 5% in the years of crisis. Growth rates of 4% to 5% are peak growth rates for EU member states, but are characteristic not only for China but for the majority of the region’s countries with aforementioned fiscal percent GDP ratio.
The “Asian tigers” phenomenon is a subject of lengthy and exciting discussions. So are the economies of the Arabic world, but I would like to stop here on purpose. I want to draw an important line and finally speak about the tendency that I hope is already obvious: The higher fiscal percent of GDP is, the slower the economy grows. Should fiscal percent of GDP be too high (almost 50% or more), it’s just a matter of time when the your country begins to:
- age slowly and brings those growth rate figures to a zero;
- lose all companies and manufacturers that can be possibly lost due to high taxes;
- accumulate debts, as the Greeks or the Swedish did, to feed those who are left;
- and, finally, you are swept away completely by swarms of immigrants, or, even worse, your country is compelled to announce default.
Ukraine: a brief overview of the taxation history
Some 25 years ago, a new country appeared on the economic map of the world. It had no currency and no army, let alone a taxation system. To be precise, Ukraine had a certain taxation system that it inherited from the USSR’s last pre-perestroika government. But tax rates and tax revenue plans were made redundant from 1991 to 1993 because of raging hyperinflation. Only by the year 1995, having created the basic infrastructure for money emission and circulation, did Ukraine manage to achieve basic financial stability in terms of the exchange rates and price inflation.
During these first five years Ukraine’s independence six prime ministers and National Bank of Ukraine chiefs battled permanent crises while building a new financial system.
If any of these officials understood or had knowledge of the aforementioned models, Ukraine could have availed itself of a historical chance to choose its taxation model independently and to incorporate the very best elements found in the East and in the West.
But, of course, nothing like that happened. We just copied the “European model,” assuming it was the best possible example on the planet.
If someone had got up and exclaimed then that the EU is the oldest and least effective fiscal model, that it is an outdated concept in the macroeconomic theory and that it had reached its potential a long time ago and is stagnating slowly, that person would have been just laughed at. The credibility of such statements, I dare say, is not obvious for most readers. Although the idea of “the thing of yesterday,” “the ceiling,” or “the stagnation” is, in fact, the quintessence of most recent articles written by leading economic theorists in the European press.
In retrospect, we feel even more hurt that we hadn’t used this chance, because it represented a rare opportunity to radically build the outstanding and effective macroeconomic models of an entire country. During the first half of the 1990s, we had a tabula rasa for a country!
The average pension was equivalent to USD 5. Salaries in the industrial sector were equivalent to USD 10. Fiscal percent of GDP until the year 1995 (when hundreds-plus inflation rates were finally curbed) could not be measured adequately. But, as far as we can judge, it was from 20% to 25% of GDP — together with the State Pension Fund. Taking into account that the country had a stable six-month-long pension payment debt up until 1999, it’s quite possible that the tax burden on the country’s economy did not exceed 20%.
However, as we all remember, this had absolutely no stimulating influence on the economy. In a country where the exchange rate was only occasionally stable and a year with an inflation rate of less than 30% was considered a success, the economy shrank steadily from 1991 to 1999, having lost almost 60% of its GDP since the collapse of the USSR.
That’s why during the first two five-year periods of its modern history, Ukraine had an income tax differentiated to a rate of from 30% to 90%, depending on the economic sector. — a tax that has been universally avoided since it was implemented — and a profit tax for citizens with a progressive scale of up to 40%. The maximum rate applied to individuals earning more than USD 700. If it was still in place today, the middle class would be obliged to pay the maximum rate …
The 1990s was spent experimenting. Officials kept either adjusting the Pension Fund (with its permanent deficit) to the budget or unlinking the two. The introduction the 38.5% payment rate to the Pension Fund in 1998 and other social welfare structures pushed Ukrainians in the shadow economy. They stayed in that shadow, despite the unified plain income tax rate of 13%. We just copied the corresponding project from the Russian Federation, which, having faced similar problems in 1998, at least spent some time on macroeconomic planning.
The very first year fiscal percent of GDP in our national billing system was actually calculated was 1996. It was then state expenditures of the consolidated budget and the pension fund accounted for 37% of GDP. Since then, it has been growing steadily, experiencing a slight decrease only in 2002–2003, until reaching 48% in 2012. (On the Ministry of Statistics official web page, you will find a smaller value, but the author made his own calculations based on public data on the expenditures from local and central budgets, the pension and other social welfare funds). The same year, the European Statistics office reported their 38.8% of weighted average of tax over GPD burden in EU-27 countries. Taking into account the fact that they traditionally do not include obligatory pension fund payments into the tax burden index (from 9% to 12% of GDP), Ukraine has already achieved the average European 50%, or we are at least a couple percentage points away from our “perfect picture.” But this is irrelevant, because it’s tragic. Two decades ago, we had a choice, but we pushed ourselves in exactly that group of countries that have no potential for swift economic growth.
Ukraine: Asking the obvious questions
I’ll try to give you the most based figures illustrating the current situation vis a vis fiscal percent of GDP, which, recalculated according to the current hryvnia to USD exchange rate, is approximately USD 176 billion. It has more than doubled within the last two decades.
The official average salary, according to officials statistics, exceeded USD 400 (or equivalent) last month. The “unofficial” salary figure is even higher. Official salaries in Kyiv are already reaching USD 700 in Kyiv. It was USD 10 per month in 1991. Nine years later it was USD 120 per month. Calculate for yourself how much it increased in dollars during the last two decades. Undoubtedly, skeptics will remind us of the “dollar inflation” phenomenon, but even they are unlikely to say USD purchasing power fell by 2000%.
That’s why I dare mention (quite fairly) that none of those “Asian tigers” displayed comparable growth rates in such short periods of time — I mean the income of the population. For example, it took the Chinese juggernaut more than two decades to build up average salary levels from USD 7 to USD 130 per month.
It will be up to economic historians to explain Ukraine’s fantastic growth rates from 2000 to 2008. The country’s GDP grew by from 7% to 12% annually, matching China’s growth rates overthe same period. But China demonstrated these rates with a a fiscal percent GDP rate of 8%. Ukraine, on the other hand, entered the so-called “golden 2000s” with a cumulative tax burden of 40% (a figure comparable to the European one), finishing the period with an even more “European” rate of 48%.
The GDP of no other country grew so fast as Ukraine’s. Even oil-rich Russia and Kazakhstan, which had similar and even larger growth rates in the 2000s, posted 33% and 25% fiscal percent to GDP rates, respectively. So why have politicians not praised Ukraine’s economic growth?
The answer may seem paradoxical: Entire sectors of Ukraine’s economy were (and remain) internal offshore zones, at least according to European standards.
Ukrainian politicians often use the term “shadow economy” when asked to explain the phenomenon. I have always found it hard to imagine how some kind of a metallurgical plant secretly produces each second ton of output, takes it abroad illegally and in some manner and sells it for cash. Or how a supermarket manages to sell every second package of sausages without using a cash machine.
That’s why I have never trusted such exaggerated labels. A plant, as well as a supermarket, can easily save money on taxes in Ukraine. Any business school graduate can show them how.
I will describe just the three primary “offshore holes” in our tax legislation. European investors (who complain at all business associations about the adversities of doing business in Ukraine) have been immensely thrilled about making use of them for the past 15 years.
The first “offshore hole” was small business. The opportunity to pay while you are paying a unified tax rate (1.4% to 6% from the income) is unprecedented, and not only for Europe. Offshore tax rates are even more onerous.
The “nirvana” for small businesses did not end there. If your private enterprise or LLC is was within the general taxation system, you paid 7% for encashment (since 2010, the rates increased to 13%) and you could forget about VAT and corporate taxes forever. That’s why, despite the usual “ritual curses” directed at every government from small business owners, large number of private café networks or shops almost doubled annually in large cities. The main problem was market over saturation and competition, not the visits tax service paid you.
The second “offshore hole” was agriculture. In order to “support the national manufacturer,” Ukraine’s agricultural sphere was the only one allowed at the end of 1990s to buy agricultural produce “for cash,” without reporting turnover to the tax service and banking system. They could abstain from paying VAT, as well. They faced a challenging situation — “reviving” the Ukrainian village! After all, at what cost do small and middle-sized farming enterprises engage in commerce without registering a commercial entity? I think that if you offered such conditions to French or Polish farmers they would immediately refuse those infamous EU agricultural subsidies in favor of Ukraine’s “tax paradise.”
The third tax hole was transfer fee pricing. Ukraine’s parliament went through the motions addressing the issue in 2013. The U.S. and EU had filled gaps in their tax legislation a decade earlier. In Ukraine, you could still legally sell products to your own offshore company from your own enterprise almost at a loss for yourself, even if the delivery was made within the country and not for export. Taking 35% annual interest rate loans from your own offshore company in euros or in dollars in order to repatriate profits to some island with profit tax rates ranging from 0% to 5% … No problem, taxes.
By the way, this scheme works for exporting raw materials from mining and raw material processing complexes. However, for exporting high-maintenance products like metallurgical ones, it is virtually useless.
Small businesses and agrarians did not pay taxes, while metallurgists optimized theirs. Let all the others pay!
For state enterprises — such as NaftoGaz and UkrTeleCom — the picture was clear and transparent. Just take a look at books of the two organizations (open-source data): from 70% to 80% of the money went to pay taxes! Into the budget! All the energy companies did that. How can you hide electricity bills? The machine building industry paid taxes in full. They paid VAT, profit taxes and salary-related taxes. Generally, all large enterprises (with a hundred or, even more, thousand employees), made all the necessary salary-related payments, including those to the Pension Fund. You could not distribute salaries “in an envelope” to thousands of employees. It’s was not even even worth trying.
Which leads us to the following conclusion: A country with a cumulative taxation rate of from 40% to 50% of GDP could not have achieved 10% growth for an entire decade! This has never happened throughout the entire economic history of the world. For an econometrician, the scale reached by Ukraine’s shadow economy represented the nation’s economic growth!
Mathematically, it would be easy to build a model and show the average figures, as well as the turning points of the admissible tax burden with maximum growth indicators during the 20th century in various countries. But the first book that the author of this article decided to publish with his own name is called “Popular Macroeconomics.”
So let me share the conclusion I drew from my calculations …
Ukraine’s actual fiscal percent of GDP is twice less than the official one. It is between 25% and 30% of the country’s gross income — twice less than in Europe and approximately on par with the U.S. That’s why an economic growth rate of 5% during a growth period cycle is possible and normal for us.
There is one caveat. Ths indicator differs in various spheres and clusters of our economy — from 7% to 70%! It destroys some and pushes others offshore.
I don’t know what percentage of the economy is in the shadow sector. I also have no idea how large the shadow economy salaries are. But, as an economist, I can give provide the formulas necessary to calculate them.
According to official statistics, citizens monthly deposit from USD 500 to USD 900 million in banks. It’s been this way for the last three years. If you trust official data on the salaries and incomes of the population, it turns out that citizens bring every fourth hryvnia he earns to the bank. Do you personally know anyone who would put a quarter of his monthly salary in the bank because there’s nothing to spend it on? That’s absurd. I would trust this statistic if it were at least every tenth hryvnia.
So, we should assume the income of the population does not constitute 32% of GDP. We would have to start looking for the “lost” 30% to 40% of GDP, searching for unregistered incomes in the national accounting system. This would account for a tremendous amount of money.
Even economics students are aware that at the beginning of the 20th century, John Maynard Keynes set forth a system of formulas to build his national accounts system and unite all the economic indicators into one chart. The purpose was so country officials could not claim inflation did not exceed 3% when, in fact, it was 30%. But if another eight economic indicators are awry, it becomes obvious to all how poorly “the sleeve is attached to the jacket.”
The opposition claims that government lies and inflation is not 3% but 30%, but let me repeat once again, any economics student can check the calculations. There is a direct correlation between sales of goods and services with internal demand and consumption levels. One can understand who is “lying” by just jotting down two or three equations on a napkin.
In fact, Keynes’ verifying equations have been a constant headache for Ukraine’s Economy Ministry for the last 15 years. Ukraine habitually reports discrepancies in macroeconomic statistics and it has been necessary to match, “reconcile” and draw it all together on a permanent basis.
Take, for example, the period following the economic downturn in 2009. Ukraine’s economy grew for two and a half years, but started slowing down in the second half of 2012. GDP growth was from 3% to 4% and retail goods turnover increased from 12% to 24% annually. In three years, Ukraine achieved more than UAH 220 billion of unrecorded sales growth! Any economist will tell you this is either unrecorded growth or unaccounted inflation.
Because internal consumption is a part of the GDP, it cannot grow by itself. It either grows together with the GDP or its ratio within the GDP structure grows. However, the structure did not alter dramatically. Inflation can be easily cross-checked using monetary indicators.
The unrecorded and officially unaccounted part of Ukraine’s economy accounted for 15% of Ukraine’s GDP over three years. The country’s population joyfully spent those unaccounted-for USD billions to build summer cottage houses, buy food, et cetera. That’s the story of Ukraine’s economic statistics.
So, what should we do with our our 50% fiscal percent of GDP (for someone it’s 7%, for someone else it’s 70%, while the actual figure is 25%)? Shall we raise it?
It should not be increased under any circumstances. Maybe there is reserve capacity to raise it. But how do we know? What if these small businesses close as a result and several hundred thousand unemployed people take to the streets? It’s high time for someone to lower taxes and introduce fringe benefits. For whom and in what amounts?
You can determine this by looking at the simple chart called “Economic sectors, growth and declines.” It is available for free and updated quarterly on the Ukrainian government’s statistics committee website . It’s not your “average” figure of 3%–4% of GDP. It illustrates very clearly who should pay less in taxes and for which sector they should have been lowered a long time ago.
As Ukraine lowers tax rates, government must at the same time demonstrate the political will to at least support entities providing for the country’s welfare. We must remember the budget is constantly short on money and will need trimming. As soon as you take an unbiased look at it, you will be enlightened. After all, Ukraine’s “poor government” spends SO much money on it. But that’s a another story.
Mykhailo Kukhar, IMF group of Ukraine