Ukraine Lowers Ambitions on Tax Income – End of Discussion?

Almost three years into Russia’s war in Ukraine, state budgets and funding for Ukraine’s defense have come under increasing strain. The West has delayed ammunition and financial aid due to political backlashes and the slow pace of decision-making. In the face of continued Russian aggression and North Korean soldiers now bolstering Russia’s offensive drive, it is clear that Ukraine must rely on its own resources as much as possible.

Ukraine spent $121 billion on defense in 2023, according to state budget statistics on OpenBudget. Germany, by comparison, spent $67 billion in the same year, according to the Stockholm International Peace Research Institute report.

The key difference is that Germany has the resources. According to its 2024 census, Germany’s population is 84 million compared with Ukraine’s 31 million in controlled territories, according to the National Demographic Strategy. And Germany’s overall tax revenue amounted to €916 billion ($989 billion) by the end of 2023, according to German statistics.

Ukraine may need the same amount, if not more. The obvious first step to getting there is raising taxes. On July 18, Ukraine’s Ministry of Finance submitted a bill following consultation with business leaders, but its ambitions have been dramatically cut.

The first draft of the long-awaited bill aimed as high as raising Hr.125 billion ($3 billion) of new tax income by the end of 2024. But the pressure from Ukraine’s enterprises and cuts made by lawmakers has left Ukraine with merely Hr. 21 billion ($512 million) in tax income for this year – 83% less than originally planned.

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The squeeze happened following lawmakers’ amendments. So, what went wrong?

Income tax and military levy have become key tools

To raise money for defense, the new tax bill will see Ukrainian employees paying 5% military levy from their salaries – formerly 1.5%.

Sole Proprietors operating what is called a FOP in Ukraine, previously had taxes from their revenues only, or taxes tied to the minimum wage, depending on the tax group chosen. The new bill will force them to pay the military levy as well.

The bill also imposes advance tax payments from gas, diesel and LNG sellers, with companies selling fuel on a business-to-customer (B2C) basis expected to pay taxes from profits upfront. 

A windfall tax of 50% will also be imposed on banks for the year 2024, and a corporate tax of 25% for non-banking financial institutions (excluding insurers).

Military levy in the left corner, VAT on the right

A huge part of the debate between all stakeholders is focused on which major tax to increase – the military levy or Value Added Tax (VAT).

The military levy was created to allocate cash for the Armed Forces of Ukraine (AFU), first imposed after Russia’s annexation of Crimea and invasion of the Donbas in 2014.

The tax is paid from employees’ salaries – this decreases net profits of the business, but also decreases consumption and inflation. This is a pressing issue for Ukraine as inflation hit 8.6% in September and is forecast to reach 9.7% in the first quarter of 2025.

But the same design has a flaw – conscientious employees and enterprises will pay it, but the shadow economy will typically evade it.

Such a tax move risks expanding the shadow economy, according to Oleksandra Betliy, an analyst at The Institute for Economic Research and Policy Consulting (IER). A compromise might be to increase the military levy to 3% rather than 5%, for instance, whilst keeping the proposed change for Sole Proprietors to pay the military levy.

Raising VAT is seen as an alternative to amending the military levy, since it is a taxation on final consumption from both the official and shadow parts of the economy, Yurii Gaidai, an economist at the Centre of Economic Strategy wrote on Facebook.

“Smugglers, embezzlers, crypto scammers… and shop owners selling smuggled Polish milk or Italian sausages buy goods with VAT and excise taxes added,” he wrote.

The Ministry of Finance did not support the VAT increase due to its potential inflationary effect, according to Gaidai, quoting Deputy Finance Minister Iryna Vorobei.

A Kyiv Post source participating in discussions about the new tax law also said that the idea of raising VAT was not supported by the presidents’ office, with experts vaguely informed about the plan from lawmakers representing the president's party.

“They don’t like inflation, but how are we supposed to finance our defense?” the source said, disagreeing with the arguments.

Inflation fears have some truth to them. An official familiar with the tax discussions who asked to remain anonymous told Kyiv Post:

“VAT is an indirect tax that influences the price directly, so the military levy is less inflationary. VAT is indeed paid by those who consume rather than earn. We counted that a 1% percent increase in VAT adds about 0.7-0.8% to inflation.”

VAT increases are understood to push inflation upwards for the first 12 months before the impact eases. But there are risks:

“It’s one thing when you have higher inflation for a year due to a VAT increase. But what if inflation increases due to higher demand and higher wages, forming an inflationary spiral?” Kyiv Post’s source questioned.

The VAT option, of course, has the advantage of being collected from everyone.

“The vulnerable will always pay military levy, but entrepreneurs and shadow economy actors won’t pay it – a VAT increase would force them to do so,” the source added.

Following discussions, lawmakers chose to increase military levy.

Acknowledging the pros and cons of both options, the president's party lawmaker Danylo Hetmanstev told Kyiv Post that “drawbacks from the VAT increase were more convincing.”

Banks and more taxes

Parliamentarians have suggested a windfall tax on the banks – something neither the Ministry of Finance, Ukraine’s central bank, nor the National Bank of Ukraine (NBU), liked the idea of.

The NBU warned that such a move risks jeopardizing the bank’s revenues as the banking sector is one of few Ukrainian industries with stable income despite the war and losses.

But there may not be bank revenues at all if there is insufficient money to effectively defend Ukraine.

“It will damage the long-term investment climate in the banking sector, but we should ensure financing of defense and security in the short run,” Betliy told Kyiv Post.

These measures have left Ukraine with roughly Hr. 21 billion ($512 million) of tax income in 2024 and an expected Hr.140 billion ($3 million) in 2025.

Despite the modest amount of tax income forecast and criticism the moves have garnered, the tax bill was still signed by the parliamentary speaker and – at the time of writing – is at the final stage awaiting President Volodymyr Zelensky’s signature before coming into force. 

A need for future tax rises is a possibility should the war suddenly require more cash.

“We may need to increase VAT, only if budget spending increases before we approve the state budget for 2025, according to the minister of finance,” Hetmantsev told Kyiv Post. 

It is probably better not to have “a next time”, but rather increase the necessary tax rates while the opportunity is here, Betliy told Kyiv Post.

“You cannot change rates all the time,” she concluded.