Maksym Bugriy 7.01.2015 RKK/ICDS (RAHVUSVAHELINE KAITSEUURINGUTE KESKUS)
Ukraine’s Parliament (the Verkhovna Rada) ended 2014 by adopting a set of laws aimed at reform, notably the 2015 state budget. These laws could set the country on a firm course of Westernization, making it possible for Ukraine to repeat the reform success stories of the former Soviet republics Estonia, Latvia, and Lithuania. Yet, public view of the government performance so far was fairly critical. Since improving state finances would lead to social spending cuts, then the risk of political instability increases. The government is walking a fine line in its effort to balance political support in the short term and the need for long-term political reform.
The 2015 state budget law approved by the Verkhovna Rada on December 29 proposed a new budgetary system to replace the previous arbitrary (and therefore more liable to corruption) mechanism according to which the central government in Kyiv redistributed consolidated budget expenditures among Ukrainian provinces. This new mechanism, which will remains to be clearly defined, will potentially help to improve economic grounds some provinces dependent on subsidies provided by Kyiv authorities. Indeed, the administration of former President Viktor Yanukovych lavished social spending on his home region of Donetsk in 2011-2012; the reduction in spending after fall 2012 Verkhovna Rada elections led to discontent of certain categories of Donbas residents, which later served as one of the key domestic factors encouraging support for the Russia-led insurgency. According to the Verkhovna Rada Speaker Volodymyr Hroisman, by September 2015 President Poroshenko will propose amendments to the Constitution that would replace the existing system of province (oblast) administrations directly appointed by the president with a more decentralized setup; Ukraine’s regional governance system would then resemble the Polish system, in which a governor appointed by the prime minister handles central government functions in each region, while an elected regional assembly and its executive handle regional budgetary and other policy aspects.
The tax reform bill that was approved by the Verkhovna Rada alongside the State Budget Law includes some favorable measures for businesses, such as a reduction in the number of separate taxes from 22 to nine, a one-time tax amnesty for individuals, and a considerable reduction in the corporate social tax rate from the current 41% to 16.4% percent. Yet, questions are raised regarding the implementation of some of these initiatives. According to an Estonian manager of a multinational company in Ukraine, a business may be entitled to reduce its social contributions only if it increases salaries by 30 percent – and for cost-sensitive companies paying low salaries this will immediately lead to an increase in tax burden compared to the current system. While this government initiative leads to longer-term advantages for businesses, there is also a risk that the government might undo these favorable changes in the long term.
Other initiatives that seems like attempts to introduce wealth taxes include a levy on new cars with an engine size over 3 liters as well as a new real estate tax on larger apartments and houses. However, these fiscal measures seem to be targeted foremost at increasing tax collection and the tax rates are not based on the market value of the assets, but on physical measures, such as engine volume and house area.
No wonder the Ukrainian authorities’ budget and tax reform initiatives have encountered criticism from some economists. An editorial by the Vox Ukraine group of economists argues that ’’The proposed package of budget and tax laws is based on [a] wrong ideology: more government, more taxes. Ukraine’s state is inefficient, incompetent, and corrupt, but it places itself at the center of the economy. The government wants again to expand its role [as well as its], controlling and administrative functions’’. Likewise, the Russian economist Andrei Illarionov contends that the authorities should more radically reduce government spending, minimize the budget deficit, and begin reforms to the state natural gas company Naftohaz and to the pension system.
The Verkhovna Rada had to adopt the budget law and tax bills has by the end of 2014 in order to facilitate the disbursement of the next tranche of the IMF financing that is so crucial in helping to alleviate Ukraine’s economic crisis. The slowdown of international demand for Ukraine’s mining and metals exports and the impact of the armed conflict in the east led last year to a fall in GDP of about 7.5 percent, according to estimates by the National Bank of Ukraine. Meanwhile, the inability of the government to borrow on international capital markets since 2013, combined with the impact of existing commitments to service past debts (including those of Naftohaz) has placed the country on the brink of a balance of payments crisis.
The hryvnia, Ukraine’s currency, has fallen from 8.5 to 16.5 to the dollar, raising the specter of sovereign default. Andrei Illarionov estimated that Ukraine’s central bank reserves could decline to around $5 billion by the end of January 2015 at the current spending rate; by the end of November 2014, total reserves stood at twice that amount. Also according to Illarionov, Ukraine’s sovereign debt to GDP ratio could exceed the 60% threshold, potentially triggering a Russian call option on $3 billion of private debt issued in December 2013.
Thus, the Ukrainian authorities have a difficult challenge to streamline state finances via cutting public spending, while at the same time increasing expenditures on defense and security. The new budget provides for a substantial increase in military spending – funding for the Ministry of Defense surged by 157 percent, albeit in hryvnia terms. While only a 28 percent increase in euro terms, it is still a significant increase given that most Ukrainian military procurement is local. Despite the recent formal renunciation of its unaligned foreign policy in favor of the objectives of EU integration and meeting NATO standards, Ukraine still has virtually no military allies. Thus, this growth in military expenditure—particularly the eight-fold increase (in local-currency terms) in weapons procurement—represents a considerable deterrence-building effort against further Russian military moves.
The social spending sphere is the important source of risk for a government struggling to ensure social cohesion. Even despite the increase in defense spending, the largest single share of the state budget (17 percent) is devoted to pensions. Moreover, while the budget cuts subsidies for Naftohaz by 71 percent, the government is yet to bring the natural gas prices for households to a market level—although further price increases are planned in 2015. These issues are sensitive for national security—given that subversion and destabilization rather than all-out war are becoming the prevailing Russian tactics toward Ukraine.
While duly criticizing the government and watching its commitment to reforms, it is important to realize that its strategy and performance are largely a result both of a consensus among political elites as well as o citizens’ expectations. At this stage of economic reforms, the post-Maidan government whose core officials have been in charge of the country for ten months now, desperately needs to demonstrate ’’quick wins“ to the Ukrainian people. Yet it is probably wary of risks that the still-weakened state institutions might be shaken if it raises household natural gas prices, increases the retirement age, or even simply lays off redundant public servants and workers of unprofitable state companies. It is important however that Western support continue to be available to Ukraine in these difficult times, given that Ukraine’s success is becoming even more important for the Euro-Atlantic community.
Ukraine Balances between Reforms and Stability