Ukraine Raises Taxes on Citizens, Dealing a Painful Blow to the Economy

Source: Ekonomichna pravda.

After over two years of resistance against Russia’s full-scale invasion, the Ukrainian government is set to raise taxes on its citizens. This painful and unpopular measure is intended to mobilise the country’s internal resources amidst declining support from international partners.

While there is no official data on the change in rates, we propose considering the optimal tax increase strategy for Ukraine.

Yuriy Gaidai, senior economist at the Centre for Economic Strategy

First, let’s define the need. A conservative estimate would be the $5 billion recently mentioned by Minister of Finance Serhiy Marchenko. This gap is caused by the delay in military aid, which forced the government to exceed the budgeted defence expenditures.

At least the same amount will be needed to carry out this year’s mobilisation to replace at least some of those defending the country for over two years and in case of further intensification of military actions (defence or offence).

These funds were not anticipated, as last year’s baseline assumption when developing the 2024 budget was a decrease in the intensity of hostilities in the second half of this year following a successful counteroffensive.

What taxes could be raised?

It’s been reported that the government is contemplating raising the rates of value-added tax (VAT) and military levy. This could mean an increase by 3.0 percentage points to 23% and the latter by 3.5 percentage points to 5%.

According to our estimates, such an increase in the VAT rate would generate an additional UAH 93 billion in annual revenues for the state budget. However, this comes at the cost of suppressed consumer demand, direct inflationary pressure, and increased attractiveness of ‘export’ schemes with tax credit (having zero VAT liabilities, some exporters will overstate the volume of goods purchased with VAT to get a refund).

There is also discussion of introducing a 5% military levy(on income) for taxpayers on the third group of the single tax, potentially generating an additional 33 billion UAH for the state annually. But only in theory.

In practice, however, doubling the single tax rate (5%—current rate and 5%—proposed military levy) would reduce the number of taxpayers.

This reduction would occur not only due to a shift into the shadow economy but also as businesses move to the second group or the general tax system in cases where the key factor is the tax burden rather than the administration cost. A 10% turnover tax is comparable to and often exceeds, what entrepreneurs on the general tax system pay.

We expect that after introducing the 5% military levy, only the professional services segment, some IT sole proprietorships, those providing other business services, and some ‘smuggling’ trade will remain in the third group of the single tax system payers. Essentially, engaged in high-margin activities, on which increasing the tax burden is justified under current circumstances.

Increasing the military levy for employed workers could generate an additional 90 billion UAH annually. This unpleasant measure aligns with the wartime concept that “you either fight or work for the defence.”

In addition, an increase in excise taxes on motor fuels will raise UAH 20 billion this year (and UAH 60 billion in 2025).

Therefore, the proposed initiatives ‘add up’ to UAH 240-250 billion per annum (UAH 60-70 billion by the end of 2024 if introduced in August-September). While these revenues are critically needed, they will come at a cost to the economy.

Are There Alternatives?

It is impossible to avoid raising taxes in these circumstances. President Volodymyr Zelenskyy and his financial team must nevertheless make this unpopular decision. However, if implemented in combination, some steps would reduce the budget gap and the need for tax increases, even without systemic changes.

What are the criteria for choosing specific budget-filling instruments besides minimising market distortions and damage to economic activity?

Firstly, the fairness of the burden increases. While fairness is a subjective and difficult-to-measure concept, it is a crucial factor for maintaining unity within the state and support for the government. That is why, for example, the hryvnia emission and the accompanying inflation are instruments of the ‘last resort’, as the ‘inflation tax’ disproportionately affects low-income Ukrainians.

The second is the ease of tax collection, the ratio of administration costs to revenues, and, on the other hand, the ease of tax evasion and shadowing. This, in particular, is a reasoning against raising corporate income tax, which will push businesses to use a wide range of tax base erosion tools.

The (un)legality of such methods and additional charges can only be established through a tax audit, which is time-consuming and costly.

However, the government is quite effective in collecting indirect taxes. Today, 43% of these revenues come from value-added tax and almost 10% from excise taxes.

Besides, VAT and excise taxes are consumption taxes. It is obvious that the low-income will be impacted by their increase. Yet, low-earners spend a larger share of their income on consumption in the informal sector. With increasing incomes, the share of ‘white’ consumption is growing—wealthy people tend to buy more food in supermarkets rather than at markets and spend more money on fuel in networks that do not evade taxes.

Therefore, the increase in consumption taxes is progressive – the effective tax rate, i.e. the share of taxes in expenditures, is higher for wealthier households.

Raising the VAT rate is a reasonably good tool for increasing budget revenues. What else can be done to reduce the budget gap with minimal damage to the economy?

On the revenue side, there is an urgent need for a strict restriction against obvious tax evasion schemes, primarily those involving excisable goods and grey imports. The first steps have already been taken and are yielding results (excise tax revenues in April increased by 19% compared to March), but with proper work by customs officers, tax authorities, and law enforcement, it is possible to reduce annual budget losses by UAH 50-60 billion.

Another UAH 10 billion are losses from the gambling industry’s evasion of personal income tax and military levy on winnings. The critical solutions here are the introduction of an online monitoring system and restrictions on p2p transfers (the latter will also make other tax evasion schemes more difficult).

Accelerating the tobacco excises increase schedule for one year and cancelling incentives for electric vehicles  imports (especially given the energy situation) could generate an additional UAH 10 billion.

It is also reasonable to extend the military levy to ‘premium consumption’, first of all, to jewellery, exempt from the pension tax, and cars above a specified value and real estate.

Finally, suppose the current monetary policy design is maintained. In that case, it is reasonable to retain the 50% income tax rate for banks, as they now earn money not from entrepreneurial talent and lending to the economy but from the state’s liquidity preservation.

On the expenditure side, it is finally time to conduct a functional spending review. Expenditure reviews, previously performed in the form of cargo-cult and bureaucratic excuses, should first cover the functionality of the largest ministries and result in the implementation of the programme-based approach. The objectives and indicators of budget programmes should be under the actual goals and available wartime resources. 

According to our estimates, a ‘soft’ spending cut could save UAH 45-50 billion, primarily in higher education and healthcare.

These steps will require responsibility and political will, but they could significantly reduce the budget gap and the need for tax increases.