The financial firepower of the International Monetary Fund and other supranational organizations that have poured billions of dollars into Ukraine has had an impressive impact on the state of the country’s economy.
Real wages are now up nearly 15 percent since the 2014 Russian annexation of Crimea and the ousting of the Viktor Yanukovich regime, which triggered a severe economic crisis. The currency has remained stable now for over two years and the economy is growing again. However, positive macroeconomic statistics in the country have been closely correlated to net inflows of international financial support. Perhaps it is unsurprising that the flow of positive figures has slowed with the flow of such support. The IMF has recently revised Ukraine’s 2019 gross domestic product growth forecast down from 4 percent to 3.3 percent and its current account deficit is expected to widen faster than previously thought.
There is no doubt that real progress has been made in reforming the economy since 2014, with more transparent government tenders, automated value-added tax refunds reducing the prevalence of illegal value-added avoidance schemes and friendlier traffic police (not as trivial as it might sound).
Statistics for the first quarter of 2018 from the Ministry of Economic Development and Trade suggest that the shadow economy in Ukraine had receded from 37 percent to 33 percent of GDP when compared to the same period of 2017. This appears to suggest the shadow economy, in fact, grew by 2 percent of GDP during the first quarter of 2018 since statistics released by the same ministry in June this year reported the shadow economy had fallen to 31 percent of GDP by the end of 2017.
In any case, the situation is far better than it was in 2015 as over $10 billion has been added to the white economy. However, the shadow economy remains stubbornly high with some estimates as high as 47 percent when calculated using “consumer spending-retail turnover”. This leaves around $50 billion circling in the economy without a trace. While such a large amount of cash in the economy is unaccounted for, corrupt officials will continue to evade punishment and competition will remain in check. Let us not forget that despite the substantial investment into the National Anticorruption Bureau of Ukraine (NABU), not a single high profile corrupt official has been jailed.
As certain sources of corrupt revenue disappear, entrepreneurial law enforcement officers and public officials turn their attention to new opportunities that are not on the international radar. For example, official production of vodka in 2017 was less than half of what it was in 2013 (excluding Crimea and occupied territories). Claims that this is a victory in the fight against alcoholism are convenient, but patently false. Many bazaars and kiosks will happily sell you a professionally manufactured bottle of vodka for less than half the tax payable on such a bottle. The tax “saving” enjoyed by this black market each year is at least $320 million.
Other officials have discovered that the coffee market is a decent source of rent. A large amount of instant coffee is imported into Ukraine at prices two to three times below its market value (at $3-$3.50/kilogram). This coffee is then put in counterfeit branded packets and sold around the country. Ukraine’s law enforcement services have plenty of evidence of this phenomenon submitted by white market participants. However, so far the tens of millions of dollars disappearing in the form of customs revenue is proving too tempting for anything to be done about the problem. So why rely on law enforcement to solve the issue when economic structural reform can take the matter out of their hands?
It is impossible to root out corruption when a large shadow economy dominates a country’s landscape. However, the reverse is also true: it is impossible to engage in corruption in a country that does not have a shadow economy. If there weren’t billions of hidden dollars flowing through the economy how would the police be paid not to notice the vast availability of excise-free vodka or counterfeit coffee? Perhaps they could start taking Mastercard or Visa?
It is time to rethink Ukraine’s anticorruption strategy and adopt preventive measures rather than treating the effects of corruption ex-post facto. For this, resources need to be more aggressively redirected towards eradicating the shadow economy. The greatest driver of liquidity in the shadow economy is the payment of salaries in envelopes. If this driver is removed then the value of physical cash when compared to cash in the banking system will be reduced. With time more and more cash will be declared and its supply in the shadow economy will fall sharply.
So how might this be done?
It is my impression that most people prefer to be paid officially; however, many businesses and employees struggle to agree who should bear the cost of taxes, which amount to over 50 percent of a net salary. That is a very obvious obstacle to whitening the economy. I have always been perplexed by the lack of a progressive tax system in Ukraine. In fact, I would say the tax system is the opposite of progressive: a unified social tax of 22 percent is not charged after a salary reaches Hr 55,000 per month.
The point of a progressive tax system is that it ensures low earners are not disproportionately burdened with financing the State. I conducted a small experiment to consider what a Ukrainian progressive tax system might look like. Initially, I made a series of assumptions based on data available from the World Bank, IMF and the Ministry of Economic Development and Trade of Ukraine to map out the distribution of earnings by working population decile. Next I considered the impact of establishing a flat 10 percent employer social security contribution (instead of the existing 22 percent) and create stratified tax bands for each decile, according to which the poorest two deciles of the population would pay no income tax, the top two deciles would pay 18-20 percent and everybody else would pay between 6 percent and 10 percent, instead of a flat 19.5 percent today (including the 1.5 percent military charge).
The result of such a system, in the event the that the population accepted this social contract with the government and stopped receiving salaries in envelopes, would be an increase in tax revenues of approximately $3.5 billion. However, the potential downside is that, if the population does not change the way it receives its salaries, then the budget would stand to lose as much as $10 billion. On the face of it, these scenarios may lead one to conclude that the status quo is safest. However, a longer-term view should take into consideration the effects such a system would have beyond the government’s tax revenues. Should such a system be successful, $50 billion would move out of the shadow economy. Starved of oxygen, the flame of corruption would finally go out.
