December 1, 2016
IIP, IIP Securities, International Investment Partners, Sergey Nosenko, Sergii Nosenko, VAT

The elimination of VAT as a key economic reform in Ukraine. The calculations of the IIP

When You buy any product in the USA, you pay a little bit more than indicated on the mark because the sales tax is added to the price at the moment of sale to the consumer. It’s simple: buy something — pay the tax. Sergii Nosenko, senior managing Director of international investment company International Investment Partners (IIP), explained his position on tax reform in Ukraine.

Sales tax in the USA goes directly to the local budgets, and therefore the level of prosperity of the cities depends on whether the government was able to create an attractive business climate. No one is going to put pressure on the business because it is a goose that lays the Golden eggs. One more important detail – enterprises in the USA, in order to sell their goods at retail (i.e., end consumers) do not pay any indirect taxes, only income tax. It is calculated and paid once a year.

EU countries have similar VAT taxes, but they don’t have such models of corruption as in Ukraine, and short-term lending by banks solves the problem of working capital leaching

VAT in Ukraine is included in the price of the product and it is 20%. In the USA the rate of sales tax varies from State to State but an average it is 8%. See the difference? You say that VAT is an indirect tax, and businesses are actually paying less because of the expenses, which reduce the tax base.

But this is only in theory. In practice, the VAT in our country is a major corruption sinecure. VAT forms for 34.1% of budget revenues of Ukraine and 8.9% of GDP. The tax goes directly to the central budget and regional authorities, in order to receive it into their budgets, have to go and cringe before “the king”.

Banks in Ukraine cannot credit VAT as it is in Europe, but the kickback to officials for VAT is in average 25% of the sum.

All export enterprises in Ukraine that give the country the inflow of foreign currency and generate a half of GDP are holding hostage by means of VAT. Analysts of investment company “IIP Securities” estimate that exporters lose from corruption in the sphere of VAT; it is about 20 billion UAH. of own funds in the year.

Most importers use the scheme for the formation of fictitious tax credit, which also involves the same tax, and only in these schemes, the annual budget of Ukraine loses about 28% of VAT receipts, which in absolute figures 2015 — around 70 billion UAH.

More active this works in the segment of imported final goods with high added value where the importer is a retail seller of: clothing, accessories, furniture, appliances, etc. From the 1.5 million self-employed persons in Ukraine, at least half are involved in such schemes.

It is by thinking in terms of industries or companies.

Speaking at the state level, corruption in VAT with it scales creates systemic economic failures. VAT is actually a mechanism for manual regulation of the economy, which can be used to create preferences to the same structures and actually destroy the competitors, which means that the competition is impossible, and “free market” is destroyed. Modern technological development of the market, attracting of international investment, new working places creation, income growth and welfare is impossible without competition.

If we rise one level higher — we can see that such economic model makes Ukraine backward, which means completely vulnerable to any external aggression, open for growth of radicalism in society (the poorer the people are, the less educated and more radical) and is in risk of absolute political power. We can rename streets or change the language of education in Ukrainian school — but without a steady economy Ukraine as a state and subject of international relations will not take place never.

What to do?

The main problem is not the VAT itself, but the large-scale corruption schemes in the fiscal service. We all understand that no new head of the tax service will not be able to change the situation inside — it is a culture that was formed over the years, and people go to work there in order to detect to the system. And it’s a completely different civil service — it is not to communicate with pensionaries in the regional social services office.

If we follow the way of police reform — which means, “to fire the old and to hire new one”, new one will quickly realize what is the gist of VAT and in a couple of years we get the same thing. Business cannot be interested in such system. We are interested only in the variant when none of bureaucrat will not have an access to the accounts or influence on them.

The problem should be solved systemically, the way when the return to the former position is impossible.

Analysts of “IIP Securities” have estimated the replacement of GST model to GDP model and assessed the benefits and harms that this model can bring to Ukraine.

As an alternative to VAT it is proposed to introduce a uniform indirect tax on consumption for all market participants regardless of the form of management.

This tax:

  • does not contradict the essence of the economic process
  • does not wash away the working capital at the stage of circulation of goods (added value)
  • eliminate the punitive function of the fiscal service
  • makes Ukrainian products more competitive on the world market, as VAT is excluded from the structure of export prices.

If we model a tax system in which tax on profits is 25%, and turnover tax for SPD — 2%, the rate of sales tax might be:

1 year (transitional) – 10%

2 year (adaptation) – 8%

3 years — differentiated in terms of regions on a scale from 5% to 10% with direct Deposit of tax in local budgets.


What are the risks?

Calculations show that in the first year of the reform, the shortfall in tax revenues (budget financing) will be 2.5-3.5% of GDP 9-11% of the expenditure budget, 12-17% of total tax revenues, which is about 55-70 bln. ($2-3 billion) in 2015 indicators

When the deficit will be covered by the issue of the national currency and when the foreign exchange part of state budget will be stabilized by means of gold reserves ($2 billion), inflation will be about 20% -25%, which is a valid indicator for the first, the most difficult transition year.


What will we get?

Only at the end of the first year (a difficult transition)

— unshadowing of the economy 5-10%

— formation of competitive environment, which will positively affect all markets

— significant improvement in the conditions and positions of export enterprises and service providers

—  improvement of the investment climate (dramatic)

—  growth in assets value, including one in privatization program.

During the second adaptation year Ukraine may receive up to 3% of GDP, unshadowing the economy in the range of 5-10%,  inflation in the range of 7-15%, as well as:

— stabilization of the macroeconomic indicators

— obtaining of the stabilization credit from the international funds (USD 2-4 billion)

— beginning of privatization by high-quality international investors

— start of direct foreign investment in the economy.

During the third year indicators of GDP growth and inflation would be the same, but it will be well visible the effect of unshadowing of the economy, privatization and investment, and, therefore, increase of incomes and improvement of living standards. The reduction of fiscal pressure and transparent taxation will allow to run a long-term program of modernization of the infrastructure and economy of Ukraine.

Replacement VAT for the sales tax will completely rebuild the tax system in Ukraine, will eliminate most of the tax holes and “gray” schemes. It will be like an earthquake in a particular State fiscal service, which would destroy the long-standing corruption scheme and will make the Ukrainian tax legislation simple for investors.

And finally — the foreign policy factor. How will the officials of the European Union react on the reform in the frames of existing international treaties and prospects of Ukraine in the context of integration with the EU?

The answer is simple — until Ukraine learns to consider its own sovereign interests, no one will consider with it. EU has a lot of its own, known to everybody, financial problems, and none of the partners can not force Ukraine to adhere outdated and inefficient economic and financial models.

Blog of Sergii Nosenko The elimination of VAT as a key economic reform in Ukraine. Calculations