Author: Serhiy Verlanov
Unbalanced income taxation that may already be called traditional or the one “developed historically” constitutes the source of injustice in the Ukrainian tax system.
If the structure of revenues from end tax-payers is analyzed carefully, it will appear that revenues coming from individuals (individual income tax), military tax, value-added tax (VAT) as well as single tax of which local budget is the recipient) prevail over the revenues coming from legal entities (profit tax, rent, excise tax, environmental taxes). Besides that, individuals pay more diligently and in a more predictable way.
The current status of the Ukrainian tax legislation also points to the clearly manifested imbalance.
On the one hand, we have a poorly developed system of declaration and tax rebates for individuals. Thus, in most cases individuals in Ukraine declare only income (and even this is done by the tax agent – mainly, the employer). The concept of tax costs for individuals is so far not there (that could be the costs of acquisition of the first housing or a certain amount of costs paid for all types of insurance). Instead, the current tax rebate system is small and too complex to be applied in practice (education, some healthcare costs, mortgage crediting, voluntary life insurance), therefore, too few people use it.
On the other hand – legal entities have a well-developed, though rather complicated legislation, lobbying mechanisms for advocating their interests and legitimately reducing their costs .
So far one should not be looking for quick recipes to improve this complex situation. Any sporadic measures torn away from the overall picture will obviously evoke dissatisfaction in the society and will be perceived as “attacks” coming from the state. But still, let us try to outline the core measures that will enable to overcome budget gaps that are just accumulating from day to day (in addition to risks) as well as to collect taxes in the current conditions of the Ukrainian economy.
Ukraine has some 42 mln. individuals who are tax-payers. This figure includes those earning their money abroad since none of them has been removed from tax accounting, so they keep being our tax residents.
The tax imbalance primarily lies in the income tax for individuals. Thus, “active” income is taxable at the rate of 18% + 1.5% of military tax. If salary makes 15 or more minimum salaries, single social fee is also to be paid.
“Passive” income, that is dividends, are taxable at the rate of 5% + 1.5% of military tax. Foreign dividends are taxable at the rate of 9% + 1.5% of military tax. This is a very loyal approach. But that is not yet it. Over the recent two years the income obtained from domestic government loan bonds (ОVDP), have not been taxable at all.
Each ОVDP holder who pays 0% correlates with tens of thousands of individuals getting income below the average salary in Ukraine. The imbalance is obvious, and this issue needs to be settled immediately.
However, it should borne in mind that this issue cannot be settled just through reduced tax load on the labour remuneration fund, since that will mean losses for the revenue part of the budget. Thus, the decision to reduce single social fee from 33-36% to 22% has not reached its goal: it did not take citizens’ income out of shadow economy, and even led to increased deficit of the Pension Fund (though, for justice’s sake, it should be pointed out that it would have to be financed additionally even if there was no tax rate decrease).
Thus, any talks about tax reduction collapse facing the argument of the need to finance state-financed workers and pensioners as well as to pay external debts. Unlike Kazakhstan, Norway, Russia, or Saudi Arabia, with their state or private monopolies of natural resources that generate a large number of budget revenues, Ukraine mainly enjoys the classical structure of budget revenues, the lion’s share of which consists of consumption taxes and income taxes.
I suggest adjusting this imbalance in the way that has long been discussed by the Government and experts, however, has recently retreated to the periphery for different reasons. I mean introduction of the progressive taxation scale, for example, from 10% to 25% depending on income, as well as introduction of tax rebates that would meet today’s requirements.
The lower threshold of taxation rate would be used for minimum salary taxation. Everything below the minimum salary would not be taxable at all, in case that is the only source of income. The employer would just have to pay the single social fee.
The average salary would be taxable at the rate of 15-17%. The upper threshold – 25% – could be applied to super income. If we address the European experience, we may consider the possibility of introducing an additional tax load at the rate of 3-5% for the so-called delta, that is if the super income exceeds a certain threshold. For example, in England this threshold makes £150 thousand, In any case, social justice would not be affected by this move.
Restoration of the discussion about the progressive taxation scale has never been so much relevant due to the voluntary declaration campaign that is going on now. Since September 1, 2022 the tax authorities will already be able to trace individual spending using some indirect methods, and no decision-makers are concealing this any longer. Starting with that day, it will not be possible to buy something without showing your income, therefore more income will be fiscalized than now.
The system could be balanced through the introduction of the household (family) income declaration and, respectively, tax rebates for individuals. Ukraine, definitely, is not yet ready for such a system, but we have to develop it by providing more opportunities for tax-payers. This is a rather complex mechanism, therefore, the level of institutional capacity of fiscal authorities must also be high.
Let us address international experience, for instance, German experience. There are eight statuses (“classes”) of the individual-tax-payer, calculated depending on the number of family members, costs, etc. (the eighth status – the fewest number of taxes, the first one – the largest number of taxes).
In Germany there is a standard of own real estate repairing and maintenance cost, that may be referred to household costs. In some EU countries e-car acquisition is stimulated through deduction of income taxes for individuals.
About two million sole proprietors were registered in Ukraine as of January 2022.
Simplified taxation system (so far there are four groups) is attractive due to administration simplicity and absence of physical contact with tax authorities and other bodies, which is highly important. Since, to be frank, nobody derives pleasure in any country of the world from communicating with tax officers. This can be more or less painful for the nervous system, but is never a pleasant thing to do.
The so-called simplified system is a part of the long-term social contract introduced in the period of Leonid Kuchma’s Presidency (1994–2005). The state “does not see” the entrepreneur until he reaches a certain threshold. In response, it expects from him if not loyalty then at least tacit consent with its policy. So far the simplified system is more of a social issue, hence, it is highly sensitive to any changes.
The “simplified” system has led to the situation when a whole range of state systems (healthcare system, education, pre-school education system, elderly people care system) have a business alternate. The systems are funded from the state budget, while the business alternates earn money by providing respective services. And that is inefficient spending of the tax-payers’ costs.
The configuration of the current “simplified” system is absolutely distorted and asymmetric as compared to the general taxation system, this having a negative effect on fiscal payback.
So far we don’t know how to find a way out of this situation and to solve the problem of quality and reasonable tax costs. This field should further be fiscalized, in particular, VAT payment for education and healthcare services should be introduced at some points.
Over the past 2.5 years two basic things have happened in the “simplified” system: 1) increase in the limits, this running counter to the statement on restriction of this taxation form application; 2) introduction of the payment transaction registrars (PTR).
How should specific groups of the simplified taxation system be developed in the mid-term prospect? The 1st group – no changes. The 2nd group – to carry out fiscalization. The group consists by 70-80% of trade. Unfortunately, large networks use it for minimizing their tax commitments, replacing sole proprietors when they reach certain limits. Certainly, after fiscalization it is necessary to keep doing analytical work in this direction, differentiating networks from small-sized business.
Business of the 3rd group of the simplified taxation system may further be regulated according to two alternative scenarios. The first one is DIIA.CITY “for everyone”, that presupposes a 5% rate of individual income tax. The second way is increased rate, for instance, up to 10% (this corresponding to the lower threshold in the progressive taxation scale), with some part redirected (for example, a half) to the general state budget fund. If this became reality, any discussions related to the “simplified” system reform would be exhausted.
There also exists a drastic limit-reduction option. If we take the average salary of 15 thousand UAH, it can make some 300-400 thousand UAH a year. Besides that, the permitted number of hired staff can be reduced, or it may generally be prohibited to hire staff and to provide services to legal entities.
Most probably, the simplified system will keep evolving, it will not be changed drastically since the issue is really socially sensitive.
Along with that, the construct of a self-employed person (category of payers-representatives of individual professions) needs to be developed, in order to bridge the gap in the regulation of sole proprietor and self-employed person taxation.
In Ukraine as of December 2021 there were about 1.4 mln. legal entities of which only 260 thousand (220–230 thousands of active ones) were VAT payers.
Quick fiscal result is possible only while working with legal entities, since they generate 90% of profits in Ukraine and, correspondingly, show 90% of fiscal payback.
The main problem of the corporate sector that makes it so much ambiguous from the fiscal point of view is its segmentation by taxation modes (“single tax payers” of all groups, non-payers of VAT, etc.), which leads to artificial fragmentation of business groups. This leads to the absence of due corporatization of small- and middle-sized business, which is one of the factors for a more dynamic growth of Ukraine’s GDP.
How critical is the issue of corporate tax rates? In fact, that is a taboo topic – since there prevails the view that taxes should only be going down. The problem of corporate tax rate affects any political administration, makes its actions less flexible, limits the range of tools to be used for solving these or other issues.
Global experience shows that this problem is not critical in case of “poor” administration in fiscal authorities. When the administrator is strong, rate increase leads to the respective fiscal effect. Everybody knowns what the costs of business, business model are. If a corporate tax rate makes 18% and the company pays 100 mln. UAH, including a certain profit tax amount, for example, 20 mln. UAH, will the increase by 1 percentage point lead to the increase in the revenues from all taxes, or will it just change the internal distribution between different types of taxes, while the total amount will remain the same - 100 mln. UAH?
In this sense two examples are highly illustrative: amber mining (1) and gambling (2).
1. In 2021 the revenues from amber mining were expected to make 369.2 mln. UAH. While the revenues to the state budget made only 5.6 mln. UAH, that is 1.5 % of the expected amount. This points to either absence of the market as such, or to the problems of fiscalization in the industry.
The fact that the market still does exist is confirmed by the availability of numerous amber mines in Zhytomyr and Rivne regions, hence, it’s all about the tax gap. And here we should get clear and analyze: either the fiscalization mechanism is difficult, or the regulator works not in the best way possible, or there is corruption in place.
2. In 2021 gambling business intended to collect 10 bln. UAH, but as the result seven times less came to the state budget. Similar questions arise.
One more example is agricultural industry that has been sharing the first and second places with metallurgists over the recent years in terms of their contribution to the country’s GDP and currency proceeds. At the same time, its representatives are mainly within the 4th simplified taxation group. Companies pay by the size of lands leased by them. Tax load in this industry for all tax-payers is about 0.1% of profit tax, which is unreasonably too little.
Thus, any sectoral regulation should be preceded by the research of market elasticity and possible tax gaps, and only then draft laws on changes in corporate taxation shall be passed, with due account of the opinion of the representatives of the industries. It does not matter whether it’s about metallurgy, tobacco, or telecom.
Thus, as the result of the reform, the lease fee shall be brought into conformity with the market price of raw materials and products. The same refers to corporate tax for agricultural producers. Ukraine depends on the global situation with prices, so this also needs to be taken into account.
There has also come the need to increase environmental taxes. In the nearest future export-oriented Ukrainian business may be affected by the so-called “carbon” taxes that will make about $400 mln. Probably, it would be better to pay carbon tax in Ukraine than while exporting.
VAT is one of the taxes most difficult to regulate globally, particularly in Ukraine. That does not add ease to doing business and does not contribute to GDP growth in Ukraine.
The main problem is a rather unexpected for business blockade of tax invoices, regulated by Resolution of the Cabinet of Ministers No. 1165 as of December 11, 2019. Unfortunately, no amendments have been introduced to it over two years (with the latest amendments made in February 2020), and that is a problem since business that does not work in good faith gets quickly adjusted to restrictions.
The Resolution contains a rather tedious and bureaucratic unblocking procedure: long court litigations and complexity of decision enforcement. Even if you win the case related to tax invoice unblocking, you will still have to go through ten circles of hell to get it registered, and it’s not yet clear whether you will. Besides that, corruption component is present in the process. In most cases it is related to the activities of the unblocking commission.
Thus, for business that is a VAT payer there exist higher legal risks. Accusations of economic crimes may reach you regardless of your actions and motifs. And this is one of the most serious obstacles on the way of foreign capital to Ukraine.
The following problems arise in tax administration:
- Ambiguous interpretation of the norms of the law, differences in judicial practices. Depending on the circumstances, a tax body may pass mutually exclusive decisions in similar situations. The same can be said about court.
- Complex and inconvenient IT solutions, in particular, interfaces. Currently they do not stand any criticism, moreover, if we take into account the scope of money spent on these objectives over the recent two years. Of interest seems to be the idea of assigning the task of tax interface development to the “Diia” team. As the result, there could appear a specialized “Diia.Taxes” application.
- Inefficiency and outdatedness of the awareness-raising work, lack of initiative among performers.
Ways of reforms
- Digitalization of all processes. The overwhelming part of business entities may well forget their way to the tax inspection. Communication must be taking place via the e-cabinet with automatic algorithms only, in most cases. That is the only way towards significant administration improvements in Ukraine.
- VAT. Introduction of the prior consent concept: all documents are uploaded to the e-cabinet prior to the tax invoice registration. In his turn, the administrator is to study those documents. Certainly, after primary study of the work of business, most typical operations will further on be performed automatically.
Prior consent shall be the guarantee of tax invoice registration, it already cannot be blocked, all the questions must be asked beforehand. Right, that will make administrative process more complicated, but in general Ukrainian business would not object, moreover, taking into account current realia. For example, Italy, with so many fraudulent actions with VAT, took this path – relative slowing down of the commercial civil circulation, – but, as the result, the issue was, in fact, removed from the agenda .
It seems to also be promising to introduce a penalty for the state for non-registration of tax invoices – by analogy to VAT reimbursed not in due time.
Institutional capacity of the tax service
The fiscal function is well-developed, if we take into account Ukrainian realia. In general, the tax inspection is coping rather well with the objectives set in this domain and fulfills the budget. This happens since there are very few new large foreign companies and significant capital investment in Ukraine. Business is mainly old, over many years of work it has learnt to work with the tax service, therefore there is less of the negative background than there used to be.
The analytical function is poorly developed. Over the period of my administration of the tax service (2019-2020) my team tried to develop this direction, invite the best experts, but when we left, this reform was cancelled, along with the list of staff members. Luckily, after Tetiana Kiriyenko became the acting head of the tax service (December 2021), the work of the Analysis Department was resumed.
The service function – below average, due to the IT component. E-services are outdated, but rather stable and resistant, in particular, to cyber threats. The point is that the tax service has got a separate e-system – its own servers and software, that is why it is easier to protect it than the databases of other central executive authorities.
The function of representation in courts – below average. So far about 50 thousand administrative proceedings are pending. Some two thousand staff members of the tax bodies across Ukraine are dealing with them – quite a number. Certainly, such number of disputes cannot stand any criticism and resembles spam, since the overwhelming majority of the documents are “copy-paste” of the inspection act developed in Kyiv and “sent” to the regions, telling the numbers of inspections and additional charges to be enforced.
At some point of time my team started fighting this shameful phenomenon, trying to settle problematic issues at the level of administrative appeal within the State Tax Service and thus give a signal to the middle and lower units of administrators concerning impermissibility of certain actions. This reform, however, was not accepted and, in fact, became toxic, since dispute settlement beyond courts in Ukraine is extremely dangerous and involves legal responsibility of the State Tax Service staff, up to criminal prosecution.
The law-enforcement function – poor level. This function still partially remains with the tax service. There used to be the Department of Tax Investigations, now there is the Department for Combating Money Laundering, having some law-enforcement features. It carries out primary analysis and hands over the materials to the law-enforcement agencies. The question is how far this function should be developed. I guess, it is necessary to find some balance in close cooperation with other bodies, in particular, with the newly established Bureau of Economic Security (BES). This body is not yet fully functioning, therefore, it is impossible so far to assess its institutional capacity, and it is also not clear what level of analytical activity the BES will show.
Ways to reform the tax service
It is primarily necessary to deviate from the paradigm of quick results, instead, in close cooperation with the Ministry of Finance mid-term and long-term planning of the activities of the tax service should be introduced, since it must aim at a specific deliverable (for instance, revenue increase).
Since 2014 two quality leaps have occurred in tax administration. The former is related to the introduction of automatic VAT refund and of the system aimed to counteract abuses in the field, – risk assessment criteria monitoring system (RACMS). This move immediately resulted in VAT collection increase by 30% and reduced the average refund time from over 180 days to 45, this influencing development of export-oriented business.
The other quality leap is related to the division of the fiscal service into the tax and customs ones. That resulted in the release of the capacity of those systems, certain competition between them, which finally gave a good result when “separately” stands for “better and more”.
The tax service must first of all be professional and depoliticized, since political influence on the administrators undermines institutional capacity. With this in view, it is necessary to restore the practice of open competitions and contracts, in particular, for top positions, as envisaged by the EU-Ukraine Association Agreement.
Taking into account Ukrainian realia, new laws are probably required – On the State Tax Service (STS) and On the State Customs Service (SCS), that would enhance their institutional capacity. There are several options here:
- To transform them into fiscal executive bodies with a special status (like the National Agency on Corruption Prevention), by involving international observers in the staff selection process. And their staff should be optimized in terms of structure and quantity.
- To leave everything as it is, but to establish a commission involving members of line international and all-Ukrainian public organizations that would elect the head and deputy heads as well as dismiss them on the basis of the fixed list of grounds.
- To make these bodies “super-political”, but only as far as one position is concerned – position of the head. To deviate from the “classical” division into political offices and professional civil service, to make these heads deputy ministers of finance – civil servants. In that way political cycle changes could be taken into account, and these actors would automatically resign when the Government is replaced.
In its activity the tax service should focus on tax-payers and develop its serviceability. As it has already been mentioned, tax-payers – 99% of individuals and 95% of legal entities – have to interact with the tax service online.
In any case, while we used to speak about the establishment of the tax service, further on we have to pay due attention to its institutional capacity building. That is a large-scale reform requiring significant time and effort: to be spent on its implementation, polishing and protection, including via international financial institutions.
 “War” rules of income taxation have increased the gap between taxation of individuals and corporate sector.