Key Issues of the Acting Tax System

The existing tax system in Ukraine satisfies neither business, nor government. For the former, it is excessively burdensome; for the latter – it fails to secure stable revenues and imposes high administrative cost. From a macroeconomic viewpoint, the Ukrainian economy is suffering from a huge – comparing to the countries with a similar level of economic and institutional development – tax burden. It should be cut, but this cannot be achieved quickly enough to spur the economic growth that only can make such cuts politically sustainable. However, there are a number of other important issues that can be improved with feasible cuts of the overall tax burden.

• The tax burden per se is further exacerbated by high personal discretion in-built in the system.

Firstly, according to the famous Robert Klitgaard’s formula “corruption = discretion + monopoly – accountability”. Thus, given the remarkable institutional weakness of Ukraine, it imposes a huge “bribe tax” on the taxpayers. Recent poll of businesspeople confirms that the State Fiscal Service is an absolute leader in the corruption anti-rating, way ahead of everyone else. This tax can be and should be cut.

Secondly, discretion makes tax burden skewed: it is shifted onto the conscientious taxpayers and those who cannot defend themselves against the aggressive tax collection (first of all – the SMEs), while some other taxpayers (primarily, the “oligarchs”) enjoy actual tax privileges. It not only makes taxation utterly unfair, but turns it into the tool for raiding, suppressing the competitors, getting administrative (corruption) rents, etc. Thus, elimination of discretion can broaden the tax base, reduce the burden hold by compliant taxpayers and promote competition.

Note that the distortions possibly related to simplified taxation system (STS) for small business are much less important than the ones brought about by discretion due to miserable share of the STS users (1/16 of all private sector in terms of the volumes of sales). In the meantime, this arrangement plays a critically important social role, provides for a compromise de-shadowing of micro business, and shelters small entrepreneurs from discretion.

• Current tax mix is poorly suited to a corrupt country that badly needs to spur economic growth

In the total government revenues direct taxes (including the “single social contribution”, SSC) prevail over the indirect ones, meanwhile the property taxes are negligible, and the ones on mining are limited due to natural factors. At the same time, comparative studies demonstrate that direct taxes in corrupt countries are not collected effectively and further promote corruption; and that they are the most hindering for economic growth, while the property taxes are the least subversive. Besides, direct taxes have high elasticity, thus shifting the burden towards those that are harder to avoid or evade – VAT (under proper administration) and property taxes – shall eventually increase total revenues due to subsequent de-shadowing of income and salaries.

Therefore, Ukraine needs a comprehensive tax reform that would dramatically reduce the discretion, spread the tax burden more evenly among the business taxpayers (excluding small and micro business), and shift it from direct taxes, especially the ones on labor, towards business assets (property).

Key Goals for the Tax Reform

Such a reform can spur economic growth and make it sustainable through unleashing the entrepreneurship potential of the Ukrainian nation. On the structural level, the reform should speed up the Schumpeterian “creative destruction” by facilitating the development of new companies and sectors that use Ukraine’s competitive advantages (especially, in part of using human capital), at the expense of outdated ones.  To this end, the key goals of the reform are as follows:

1. to make the rules of the game in taxation equal, transparent, and non-arbitrary
2. to reduce the burden on the compliant taxpayers by redistributing the tax burden more evenly
3. to allow for abolishing the practice of imposing the plans of revenues collection
4. to cut down the overall expenditures (of the government and the companies) on administration, as well as other social losses
5. to considerably lower the level of corruption in the field of taxation

Together with the planned cut-down of ineffective government expenditures, it should create conditions for economic growth that would allow for further gradual reduction of the tax burden, therefore making growth self-sustainable. 

The reform should consist of two components: a fundamental change in the relations between the government and the taxpayers, which requires deep and radical legislative changes; and a comprehensive organizational reform of the tax service itself, with the human resources ‘reboot.’

Suggested Approaches

Taking into account the analysis conducted, the overall approach to the tax system reform should be based on the following mutually connected steps covering the tax structure reform and the ‘reboot’ of tax administration agencies.

1. Corporate Income Tax (CIT): Fundamental reform that would turn it into the non-discretional business tax and allow for increase in tax revenue
2. VAT: the tax base and the principles of tax assessment remain the same, while its administration changes drastically
3. SSC: the tax is abolished. The loss of revenue is to be compensated by items 1-2, as well as slight increase of personal income tax, cut-down of budget expenditures in relative terms, increase of payment for the mineral resources use, excise duties, and property taxes, and perhaps by income from some other sources.
4. STS: remains intact with some possible corrections after the results of the main reform reveal the remaining problems and allow for some concessions
5. The fiscal service should be reformed simultaneously with the principles of its functioning; all parties of tax relations shall observe the law.

CIT

In line with the above-mentioned arguments, instead of the existing company income tax, the nonfinancial enterprises shall pay the tax on redistributed profits (RPT) without any control of expenditures, but with a lower threshold in the form of property tax (possibly, not only on estate property). To put it differently, a full-fledged property tax should be made deductible from the liabilities on the RPT.

Tax revenue will be secured by the lower threshold (property tax) in a form of differentiated land tax levied on imputed value. The latter should take into account the way of use (agriculture, urban territory, industrial/residential, developed) and location. Since this value is calculated impersonally, on the basis of a formula, it allows for zero discretion and negligible compliance cost – a taxpayer only pays a bill. A transparent mechanism of correction through an open bidding has been developed for the cases when the assessment of an object by the formula is unrealistically overstated.

In general, the reform should transform the corporate tax into a sort of ‘simplified tax’ with a minimum discretion, yet considerable revenue to partially compensate for the abolition of the single social contribution.

VAT

General characteristics of the administration reform:

1. To keep VAT as such (as opposed to the proposals to replace VAT with a sale tax or turnover tax).
2. To make arbitrary withdrawal of tax credit impossible.
3. To prohibit control over the connections between the business costs and the economic activity.
4. To provide automatic, not-discretionary, refund of VAT to the exporters and other taxpayers at a zero rate through setting up a separate VAT account at the State Treasury. Only a net VAT surplus will be wired to the budget.

Single Social Contribution

Abolition of the single social contribution needs a range of accompanying institutional actions such as liquidation of the Pension Fund of Ukraine as an independent fund and its merger with the state budget. This part of the reform requires at least partial compensators, as the loss of revenue from the largest tax cannot be covered by the reduction of expenditures, at any rate not in the short term. Main compensators should be as follows:

• improving VAT administration, considerably reducing the number of violations
• setting flat rate of PIT at 20% (as an option – keep a 10% SSC + 10% PIT)
• saving 6-8% of current expenditures of the budget and the Pension Fund by fighting embezzlement, abuses at the Pension Fund, ultimate abolishing enterprise subsidies, etc.
• increasing the revenue from excise duties and payments for the use of mineral resources
• increasing the revenue from a modified CIT as described above

If it is technically impossible to abolish the single social contribution altogether, it might be possible to introduce a combined tax (10+10), where the single social contribution shall be calculated on the basis of salary only.

Reform of the State Fiscal Service of Ukraine

The reform of the State Fiscal Service of Ukraine has the following goals:

1. To restore taxpayers’ trust in the controlling agencies.
2. To secure a situation when taxes are paid voluntarily by socially responsible business.
3. To transform the State Fiscal Service of Ukraine into a consultative and servicing agency.
4. To optimize and automate all the organizational processes of the State Fiscal Service of Ukraine.
5. To support the rights and legitimate interests of citizens in the sphere of taxation and customs procedures, to secure steadfast implementation of the Constitution of Ukraine.
6. To cut down the expenditures for the management of the Service back office and the governmental agencies subordinated to the Service.
7. To make Ukraine more attractive for investors and shape a favorable climate for business and economic development, to boost economic activity.

These goals shall be reached through a set of measures that are expected to improve the criteria of evaluating the functioning of the service, hold an effective personnel policy, clearly define the responsibility of the controlling agencies for their actions or passivity and decisions, impose public control over the functioning of the service, ensure its openness, and conduct an audit of all automated systems, as well as organizational and administrative documents.  

The personnel should be “reloaded” following the Georgian experience. However, it will bring expected results only in combination with dramatic reduction of the corruption opportunities and increasing responsibility for purely criminal violations, like creating and patronizing of the “tax laundries” or other kinds of abuses with the VAT.

 Download a presentation  Tax_Reform_UA

Coalition of authors-experts of the Tax Reform Group
of the Reanimation Package of Reforms