Compromise appears likelier on tax code, 2016 budget

Ukraine’s state budget next year may amount to only $38 billion. For perspective, that is less than half of the municipal budget of New York City, with eight million residents, compared to Ukraine’s 43 million people.

But viewed another way, the spending represents 40 percent of the official gross domestic product of $94 billion expected in 2016. So political battles over taxes and public spending are fierce.

But as this week wore on, President Petro Poroshenko and Prime Minister Arseniy Yatsenyuk appeared to throw their political weight behind much of the blueprint outlined by Finance Minister Natalie Jaresko, who found areas of compromise with a rival plan touted in parliament.

She will not be celebrating, however, until the proposed tax code changes and 2016 budget get approved by parliament and are signed into law, hopefully by year’s end.

“I can say that I feel better,” Jaresko said in a Dec. 7 interview, when she walked the Kyiv Post through some of the highlights of the Finance Ministry’s tax-and-budget strategy. “I can’t say I will feel good until it’s adopted and it’s done.”

The atmosphere for an agreement is much improved since the beginning of December, when some politicians in Ukraine were chafing at International Monetary Fund requirements for unlocking a third loan tranche of $1.7 billion, which in turn would qualify Ukraine for another $2.3 billion in Western assistance.

Among the many IMF requirements is a fiscal deficit of no more than 3.7 percent of GDP. Some politicians led by lawmaker Nina Yuzhanina, chairperson of parliament’s tax committee, were proposing tax and budget changes that would create a much larger deficit, with a gap of some $8.3 billion, forcing draconian spending cuts to meet IMF requirements.

Jaresko’s plan, by contrast, would require finding cuts of only $2.5 billion, which she says she has identified.

Finance Minister Natalie Jaresko delivers a public account of her performance for the year in Kyiv on Dec. 9. (Ukrafoto)

For the moment, anyway, Jaresko and that rest of the political camp that favors staying within the IMF program – and the international lender’s restrictions – appear to be winning out.

“For 23 years, this country has started IMF programs and walked way, detoured, decided they couldn’t or didn’t want to continue,” Jaresko said. “That has hurt us tremendously in terms of credibility and reputation internationally. It is not just the financial part of the IMF, it’s the reputational. To attract foreign investment, being in the program is important. It’s a seal of good housekeeping.”

Ukraine has achieved macroeconomic stability this year – stabilized the hryvnia, built up hard-currency reserves to $13 billion and closed 62 of the worst banks – but the gains are fragile, Jaresko said.

Kyiv is unable to finance larger deficits on its own and needs to build up its reserves closer to $20 billion, or enough to cover four months of imports.

Tax, revenue highlights

While some in business contend it’s too late to make changes starting in 2016, Jaresko disagrees, saying the measures she has outlined will cut tax rates, broaden the tax base, simplify payments and reduce abuses by “demilitarizing” a tax collection branch that will lose 17,500 employees by year’s end.

“We made changes to our tax reform without changing the philosophy, which remains the same: a fiscally sustainable tax reform which reduces the largest burden on business, reduces the payroll tax by over half and reduces the burden of tax administration on taxpayers. In the end, the goal is to broaden the tax base, cut out privileges, cuts out exceptions and reduces the number of individual favors so that we can, over time, de-shadow the economy.”

The biggest change will be the sharp cut in payroll taxes, now at an exorbitant 49.7 percent from the employer and 3.6 percent from the employee. Jaresko proposes a reduction to 20 percent for employers, with no contribution required of employees.

In the short run, Jaresko said the change will cost the state budget Hr 100 billion.

In the long run, however, the aim is to start eliminating the 50 percent of the economy that is in the shadows.

Many employers now simply don’t declare their employees or underreport their employees’ incomes to avoid taxes.

Additionally, the government has given employers legal ways to reduce taxes by creating special, lower taxed classifications of labor – such as the private entrepreneur, which is taxed at a much lower rate.

Ukraine’s state-owned oil and gas behemoth Naftogaz has historically been a collosal drain on Ukraine’s budget. By eliminating murky intermediary companies and raising natural gas prices, Kyiv is expected to entirely eliminate the firm’s deficit next year. (Source: Finance Ministry of Ukraine)

Personal income and corporate tax rates are slated to be reduced to 18 percent each next year.

As for value-added tax, historically a source of fraud and abuse in Ukraine, Jaresko said the nation is moving fully to electronic, automatic VAT refunds. Ukraine now already requires companies to pay VAT up front, as part of the drive to eliminate fictitious claims for refunds. The general VAT rate is 20 percent. But some industries have an exemption – the agricultural sector is one – while others have a favored lower rate, such as 7 percent for pharmaceuticals. Jaresko wants to eventually eliminate the disparities in rates.

Currently, she said, roughly 1,700 companies pay most of the taxes in Ukraine. Those who pay their taxes honestly, she said, are at a competitive disadvantage to the tax dodgers. One of the biggest tax evaders is the state-owned Ukrnafta oil business, which owes the government nearly $500 million in taxes and dividends.

Oligarchs and monopolists have long been criticized for avoiding taxes through transfer-pricing schemes that essentially underreport the value of transactions in Ukraine while profits are taken in offshore, low-tax jurisdictions.

The overall goal, Jaresko said, is tax fairness and justice, which was “a very important part of” the EuroMaidan Revolution that drove ex-President Viktor Yanukovych from power on Feb. 21, 2014.
“People want justice in the tax system,” she said. “There’s constant criticism for oligarchs or exceptions for different industries that are oligarch-owned.”

Jaresko said, however, that lower rates and simplified taxes alone won’t spur voluntary compliance on the scale that Ukraine’s budget needs.

The aversion to paying taxes is historic, since the Soviet Union didn’t have taxes. In independent Ukraine, people simply didn’t trust the government to spend their tax money properly.
Fundamental changes in attitudes and increased rates of voluntary compliance will depend on government performance, Jaresko said.

“No matter how much you reduce taxes, some of this will remain until we are providing public services again – until roads are fixed, schools are fixed, when they don’t have to make separate private payments for diplomas or medical services,” she said.

On the revenue side, Jaresko favors a reversal in the 2009 legal ban on gambling to increase revenue. She said the re-establishment should be done according to best international practices. Some of the favored proposals in parliament would exclusively benefit luxury hotels as venues for casinos. Such a move could bring in more than $200 million in additional government revenue next year.

She also said that Ukraine’s government will also force royalty payments on the nation’s largely unregulated amber mining business. Additionally, she said that, until more than 1,800 state-owned enterprises can be privatized, the state will also force them to pay higher dividends.

Additionally, Jaresko’s proposed budget counts on $1.4 billion in frozen Yanukovych assets to help fund the military and capital expenses. A “special confiscation” law needs to be passed by parliament, however, before Prosecutor General Viktor Shokin will act, Jaresko said.

Social security, defense, education and debt service are likely to be the four largest categories of budget expenditures in 2016.

Property taxes will be increased for luxury apartments, based on size, with some of the largest paying $1,000 a year for homes larger than 300 square meters. Another $1,000 tax will be imposed on luxury automobiles. Jaresko said fraud prevents Ukraine from imposing property taxes based on assessed market value, the way it’s done in Western democracies.

Additionally, an exemption for property taxes on commercial buildings has been removed, Jaresko said, giving municipalities the potential to tax such properties and possibly reduce the number of vacant ones by discouraging owners from letting them sit empty.

Budget highlights

One of the biggest boosts to Ukraine’s fiscal health is the elimination of the government subsidy to state-owned Naftogaz, the energy giant that has sucked as much as $10 billion in subsidies from taxpayers as recently as 2012. Next year, Naftogaz is not expected to have a deficit.

A move towards market pricing of gas consumption and the elimination of energy-trading intermediaries is credited with the financial turnaround. Before, insiders made fortunes in cashing in the sale of natural gas sold at market prices while purchased at much lower regulated prices.

While clearly a financial boon to the state, Ukraine’s government will spend more than $1 billion on subsidies to compensate the nation’s poorest 4.3 million households for the utility price hikes.

Ukraine’s budget is dominated by three key areas – spending on military and law enforcement, pension payments and debt servicing.

It’s very difficult to find savings in any of those areas. With Russia’s war against Ukraine, the nation has committed to defense and security spending of 5 percent of GDP – some Hr 113 billion, or $4.8 billion.

In hryvnia terms, Ukraine’s gross domestic product keeps rising. But in dollar terms, it has droped from $183 million in 2013 to less than $94 billion expected next year.

In rough terms, 24 percent of the budget goes to pensions and the “social safety” net, another 15 percent to education, 13 percent to defense and security, 13 percent to debt servicing and another 13 percent to “economic activity,” including transportation. Smaller amounts go to government salaries and cultural programs.

Pensions are already paltry, roughly $70 a month on average, so those payments cannot be reduced. However, Jaresko said that social benefits can be means-tested to help against fraud. She also said that government investigators have discovered fraudulent payments that have been stopped.

Changing the way services are delivered is another way of saving money. For example, hospital budgets have been set based on the number of beds rather than services delivered, creating enormous waste and distortion.

Decentralization of spending and tax authority should also yield savings as local communities decide which schools and hospitals to keep open and which ones to close.