Ukraine
Selected Issues

This Selected Issues paper examines the main factors explaining Ukraine’s growth performance so far, assesses whether the recent recovery is sustainable, and provides a quantitative analysis of long-term growth prospects. It finds that the recent recovery is not yet self-sustaining and estimates that long-term per capita GDP growth of 4–5 percent per year would be possible only if structural reforms are accelerated. The paper also discusses how the shadow economy has been measured in Ukraine and compares the results with studies of other transition economies.

Abstract

This Selected Issues paper examines the main factors explaining Ukraine’s growth performance so far, assesses whether the recent recovery is sustainable, and provides a quantitative analysis of long-term growth prospects. It finds that the recent recovery is not yet self-sustaining and estimates that long-term per capita GDP growth of 4–5 percent per year would be possible only if structural reforms are accelerated. The paper also discusses how the shadow economy has been measured in Ukraine and compares the results with studies of other transition economies.

I. long-term growth prospects1

1. This chapter examines the main factors explaining Ukraine’s growth performance so far, assesses whether the recent recovery is sustainable, and provides a quantitative analysis of long-term growth prospects. It finds that the recent recovery is not yet self sustaining and estimates that long-run per capita GDP growth on the order of 4–5 percent per year would be possible only if structural reforms are accelerated.

A. Ukraine’s Growth Experience So Far

2. The period following independence was characterized by a deep protracted fall in output. Over the 1990s, real GDP fell by approximately 55 percent on a cumulative basis. Ukraine suffered the largest cumulative decline in output among the transition countries, only surpassed by Georgia, Moldova and Tajikistan (Figure 1). As of 2002, Ukraine’s per capita income was well below other transition economies and slightly below the CIS average (Figure 2)2. Several factors contributed to this development:

  • Unfavorable initial conditions: Ukraine inherited a highly industrialized economy, heavily reliant on subsidies and excessively dependent on energy. Industry (mainly steel, chemicals, shipbuilding, coal, machine tools and weaponry) made up a relatively large share of output, amounting to close to 50 percent of output at the onset of the transition process. As a result of the loss of traditional markets, manufacturing output fell sharply, declining by over 60 percent in the first 5 years of transition. It also fell markedly as a share of GDP (Figure 3).

  • Uneven macroeconomic management: Prudent macroeconomic policies were not consistently pursued during the first decade of transition, prolonging the output decline. After initial progress reducing inflation and stabilizing the exchange rate, the macroeconomic performance deteriorated. The combination of policy slippages and adverse external shocks culminated in a financial crisis in 1998/99. An attempt to defend the exchange rate proved futile, and the currency depreciated sharply from September 1998 through December 1999.

  • Piecemeal reforms: While good progress was made early on with trade and price liberalization, progress in deeper institutional reforms lagged behind. This compares with the experience of other CIS countries, but significantly lags progress made in more advanced transition countries. Improvements were made in the regulatory and legal environment of the financial sector. While progress was made in privatization, greater advances were made in small-scale privatization than large-scale privatization. Little progress was made in improving governance and in enterprise restructuring3 (Figures 4 and 5).

Figure 1.
Figure 1.

Real GDP Index in Transition Economies, 1991–2002 (1991=100)

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: Fund staff estimate.
Figure 2.
Figure 2.

Per Capita Income of Ukraine and Others, 2002 1/

(In U.S. dollars)

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source. WEO.1/ GDP on a purchasing power parity basis for 2002 divided by population.
Figure 3.
Figure 3.

Ukraine: Share of GDP, 1991–2002

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.
Figure 4.
Figure 4.

Reform Progress in Transition Countries, 2002

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: EBRD Transition Report, 2002.Note: “+” and “−” ratings are treated by adding 0.3 and subtracting 0.3 from the full value. Minimum indicator 1 and maximum score 4.3.1/Central Europe and Baltics countries.
Figure 5.
Figure 5.

Average Transition Indicators, 1991–2002 1/

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: EBRD.1/ The index scores progress in transition on a scale from 1 to 4, with 1 meaning no reforms and 4 meaning full transition to a market economy.

3. The economic recovery started in late 1999. In 2001, growth reached 9 percent, and then slowed to below 5 percent in 2002, in line with other countries in the region (Figure 6). Growth has been largely export led (Figure 7). Russia provided an important engine for Ukraine’s export growth in 2000. Since then there is evidence that Ukraine has been able to reorient its exports away from CIS countries, with exports of oil and machinery gaining at the expense of traditional sectors, such as metals and chemicals. Consumer spending strengthened in 2001–02, fueled by higher real wages. Import substitution also appears to have played a role, reflected in strong growth in sectors that normally sell to the domestic market such as food products. Several key factors appeared to play a role in the economic recovery4:

  • Macroeconomic stabilization: Prudent fiscal and monetary policies since end-1999 ensured a stable environment and helped to increase confidence in the domestic economy. This was reflected in rapid remonetization and the reduction in nonmonetary transactions. The fiscal position improved significantly, even registering a small surplus in 2002.5 At the same time, inflation was brought down to very low levels.

  • Excess capacity combined with low real wages; Given the large decline in output compared to other transition countries, it is possible that there was an overshoot relative to productive potential.6 In addition, declines in real wages through 1999, including the sharp deprecation of the currency during 1998–99, finally made unused capacity profitable and helped competitiveness. While real wage growth has picked up significantly since then, the level of wages remains low relative to other countries (Figures 8).

  • External factors: Exports rebounded in 2000, reflecting strong demand from Russia—Ukraine’s largest trading partner—which provided a ready market for exports in traditional sectors (Table 1). In addition, financial flows from Russia, including transfers and investment in Ukrainian oil refineries, supported the recovery.

  • Reforms in several key areas: Progress was made in land reform in the agricultural sector. Since 2000, the government began leasing communal properties in the agricultural sector to individuals which contributed to higher output in the sector. Increased cash collections in the energy sector and the elimination of offsets and promissory notes in the fiscal area enhanced the remonetization process. There is also some evidence of learning about marketing in traditional industries. For instance, Ukrainian producers were able to reorient their exports to other countries, including Asia in 2002, as anti-dumping measures imposed by some trading partners threatened metals exports.7

Figure 6.
Figure 6.

Figure 6 GDP Growth in Ukraine and Others. 1999–2002

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Sources: Fund staff estimates; and WEO.
Figure 7.
Figure 7.

Ukraine: Contributions to GDP Growth by Expenditure Category, 1999–2002

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Sources: Ukrainian authorities, and Fund staff estimates.
Figure 8.
Figure 8.

Ukraine: Average Wages Relative to Russia, CIS, Baltics, 2002

(U.S. dollars per month)

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.
Table 1.

Russia’s Role in Ukraine’s Recovery

(in percent)

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Source: Fund staff estimates.

B. Is the Recovery Sustainable?

4. On the supply side, there is still significant excess capacity. As a result, the factors of production are not yet fully utilized, suggesting that the recovery may continue for a while longer using the existing capital stock. Unemployment remains relatively high and output remains well below its level at the beginning of the transition process, in contrast to many other transition countries.8 There is some evidence of gains in productivity in the manufacturing sector, and low relative wages could preserve competitiveness for a while. Productive capacity has also increased in the agricultural sector, due to land reform. However, its steep decline in earlier years suggests that it too has unused capacity.

5. Gross fixed investment has yet to play a major role in sustaining growth (see paragraph 13 below). Gross fixed investment growth was slower on average that output growth over 2000–02. The relatively low level of investment is not due to a lack of domestic savings. In Ukraine’s case, the domestic savings ratio is significantly larger than the investment ratio, as reflected in the large current account surplus and low FDI. It contrasts sharply with the experience of the Central and Eastern European and Baltic countries, where investment exceeded domestic savings and was partially financed by foreign capital during the period 1995–2000. It also differs from investment performance of the newly industrialized Asian countries during their rapid growth period, when the average investment-to-GDP ratio was much higher than in Ukraine (Figure 9).

Figure 9.
Figure 9.

Savings-Investment Balance, 2000–02 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: WEO.1/ Averages For 2000–2002 except Central and Eastern Europe where the average is for 1995–2000 and Newly Industralized Asian Countries where the average is for 1986–95.

6. The lack of well-functioning institutions pose significant obstacles to new businesses and investment. The recent business investment survey conducted by the EBRD and World Bank suggests that after taking into account the improvement in macroeconomic conditions, the business environment has worsened in Ukraine.9 Small and medium-sized enterprises cite a lack of access to finance and policy instability as key factors inhibiting their development.10 FDI is discouraged by an incoherent, ineffective and nontransparent legal system. Moreover, frequent legislative, regulatory modifications contribute to a discretionary and unpredictable investment climate. At the same time, tax exemptions and quasi-fiscal activities in the energy sector that largely benefit the traditional sectors have created an uneven playing field for small and medium-sized businesses11 (Figures 10 and 11).

Figure 10.
Figure 10.

Qualitative Reform in Business Environment, 2002

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: EBRD Transition Report, 2002, Business and Enterprises Performance Survey, 2002.Note: Ratings are from 1–4 with 1 indicating no obstacles and 4 indicating major obstacles.1/Central Europe and Baltics countries.
Figure 11.
Figure 11.

Cumulative Foreign Direct Investment in Transition Economies, 1990–2002

(US$ per capita)

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: WEO.

7. Experience suggests that new small and medium-sized firms are key to growth in the more successful transition countries.12 New enterprises tend to be more cost efficient and demand oriented. They have an advantage in that they can freely develop new market opportunities in contrast to existing enterprises which may be encumbered by past business decisions, such as product lines, investment and location. They also tend to be more responsive and flexible to changes in the markets and more competitive due to small size and close relationship between ownership and managerial control.

8. In Ukraine, the performance of private startups has been more successful than other types of enterprises. Value added is higher in private start-ups compared with privatized and state-owned enterprises. Most of these enterprises are small (less than 50 employees). The number of SMEs rose significantly, by some 10 percent in 2000. These firms were mainly in the agricultural sector reflecting the transformation of collective farms to private farms; but there were also new firms in transport and property sectors. In addition, small businesses taxes, introduced in 1999, provide substantial tax relief to qualifying businesses, on account of high eligibility thresholds.

9. Even though Ukraine’s economic situation has improved, significant vulnerabilities remain. These include the risks of a sharp downturn in the external environment and a possible loss of confidence that could limit the opportunity to borrow on international capital markets. This might result in a liquidity crunch as occurred in 1998–99. Rapid remonetization has also fueled very high credit growth in the banking sector that is increasing credit risk. Quasi-fiscal activities in the energy sector and arrears could undermine progress in budget consolidation.

C. Quantitative Assessment of Long-Run Prospects

10. A number of recent studies have analyzed growth prospects for the transition countries. Earlier work was based on the hypothesis of growth convergence, where poorer countries “catch up” with more advanced countries based on their investment rates in human and physical capital (Levine and Renelt, 1992). More recent work has tried to take into account the impact of institutional quality, as well as measurement problems relating to human capital and the hidden economy, and the initial scope for catch-up (Crafts and Kaiser, 2001). Table 2 below compares growth projections from 3 different equations. The first two equations (LR1, LR2) are based on the Levine-Renelt growth equation and are estimated over the period 1960–1989 and 1960–1999, respectively. The third equation (CK) includes an indicator of institutional quality: the rule of law indicator developed by staff at the World Bank.

Table 2.

Per capita Income Growth Projections 1/

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Sources: Crafts and Kaiser, 2001; and Fund staff estimates.

Projections based on 1998 data, except Ukraine where both 1998 and 2000 data are shown.

11. Ukraine’s per capita income growth projections are in the range of 2-5½ percent per year (Table 2), depending on the model used and the sample period.13 The significant range reflects the sensitivity of these estimates to the period of estimation as well as the institutional quality indicator. The higher growth projections in the LR1 model reflect in part an earlier estimation period, which yielded a higher coefficient on investment and also increased the effect of the “catch up” variable. The CK model yields the lowest growth projections as it tries to capture the generally weak institutional framework of the transition countries through the rule of law indicator. The growth projections for Ukraine compare with a projected range of 2.8–5.5 percent average growth in the EU accession countries among the transition countries and an average of 2.2–5.1 percent for CIS. The effect of 2000 data on the projections is small mainly because the investment ratio changed little relative to 1998.

12. The growth projections suggest that investment-oriented reforms and significant improvements in institutional quality are needed to sustain high rates of growth. This is particularly evident when institutional quality is factored into the growth equation (CK), given Ukraine’s relatively low ranking on the rule of law indicator and the large positive coefficient (1.06) for the indicator of rule of law in the CK equation (see Figure 12). Thus, if Ukraine were to achieve an improvement in the rule of law indicator of 0.5 (still below the Baltics), per capita income growth could increase by an additional ½ percentage point.

Figure 12.
Figure 12.

Rule of Law Indicators, 2001

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: “Governance Matters II: updated Indicators for 2000–01” by Daniel Kaufmann, Aart Kraay and Pablo Zoido-Lobaton, Jan 2002.

13. The literature on transition countries suggests that macroeconomic stabilization and structural reform are key to economic growth. Havrylyshyn (2001) summarizes the five key points that emerge from recent studies on the determinants of growth.14 First, stabilization, especially the control of inflation, is a necessary first step before sustainable growth can occur. Second, while stabilization is a necessary condition, many of the studies identify structural reform (or market liberalization) as the most important factor. Third, initial conditions (e.g., overindustrialization and price distortions) and other factors specific to countries have some impact on growth. Fourth, institutions matter and increasingly over time. Fifth, the studies found that traditional factor inputs do not explain growth over time and across countries. Investment ratios have little or no explanatory power, in fact empirical evidence suggests that investment tends to increase only after growth has begun to recover. Efficiency gains appear to be the main source of initial growth. Aggregate investment becomes increasingly critical in sustaining growth as the recovery proceeds.

14. The growth accounting framework suggests that achieving per capita growth on the order of 4–5 percent per year would require significant reforms (Table 3). In this approach, long-term growth is decomposed into contributions from labor, capital and total factor productivity (TFP) growth. The shares of labor and capital are based on the Cobb-Douglas production function, with elasticities for capital and labor with respect to output equal to 0.3 and 0.7, respectively. This framework implies that long-term growth in Ukraine will largely depend on gains in investment and TFP growth, given the constraints posed by the demographic projections. While it may be possible to raise the contribution of labor through higher labor participation rates or by raising the effective contribution of labor15 through learning by doing, these factors may not be sufficient to offset the decline in the working age population. Thus achieving per capita growth of 4–5 percent would require reform measures to strengthen property rights and governance and raise investment. TFP growth would also be expected to be connected with increased FDI and improved institutional quality. Rough calculations for the transition countries suggest that TFP on average grew by 1.4 percent over the period 1995–2001, with Ukraine experiencing negative growth. For comparison, the Baltic countries had average TFP growth of 3 percent over this period and China had estimated TFP growth of 4 percent.16

Table 3.

Ukraine: Growth Accounting Framework 1/

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Source: Fund start estimates.

The growth accounting framework is based on a Cobb-Douglas production function: d Q = .3*d K + .7*d L, where d Q is the change in output, d K is the change in the capital stock and d L is the change in labor. The residual of the estimated change in output from the Cobb-Douglas production function is total factor productivity (TFP). The capital/output ratio is assumed to be 1.5 percent and depreciation is assumed to be 5 percent. Investment to GDP ratio for 2002 was estimated to be 20.1 percent.

D. Summary and Conclusions

15. Ukraine’s recovery is not self-sustaining. Unused capacity seems to be playing a significant role in the recovery, reflecting the large initial drop in output during the 1990s. Competitiveness is currently supported by relatively low wages. However, a poor investment climate is contributing to low investment, including FDI, compared to more successful transition economies. While it maybe possible to extend the recovery for several more years, sustained long-run growth will require increases in investment and productivity, as wages rise and the capital stock ages and deteriorates further.

16. Long-run per capita growth on the order of 4–5 percent per year would be possible, if structural reforms are accelerated. This would imply catching up to the poorest EU country in about 50 years.17 Ukraine’s business climate poses a significant bottleneck to investment and is poor in relation to other transition countries. Per capita growth above 4–5 percent might be possible, but this would require radical reforms.

17. To achieve sustainable growth, Ukraine needs to advance on reforms to improve the business climate. Significant increases in investment and productivity will be needed to sustain growth, as wages increase and the capital stock deteriorates, Ukraine’s demographics and the weak institutional environment are likely to constrain long-run growth. Even so, Ukraine has the potential to attract significant FDI, if measures are taken to improve the business climate, given its proximity to EU accession countries, large resource endowment, relatively low wages, and its sizeable internal market. A long-run rate of real per capita GDP growth on the order of 4–5 percent would compare favorably with the experience of some of the more successful transition countries, such as Hungary and Poland, where per capita GDP growth averaged 5 percent, in the eight years following recovery.

18. The reform agenda for sustainable growth over the medium term might include measures to:

  • Encourage a level playing field for business by eliminating tax exemptions and privileges; abolishing the use of Free Economic Zones; and eliminating VAT refund arrears.

  • Measures to hold public institutions accountable; strengthen the judiciary and the enforcement of contracts; and strengthen corporate governance, including through the use of international accounting standards and financial disclosure.

  • Reduce regulatory obstacles that impede trade, business formation, and restructuring. This should include efforts to reduce licensing and registration fees and strengthen the implementation of bankruptcy procedures for banks and other enterprises,

  • Energy sector reform is needed to ensure that resources are allocated efficiently. In particular, quasi-fiscal operations should be reduced, including through tariff reform and resolving electricity sector debts of the state-owned oblenergos.

  • Continue with privatization under open and transparent procedures. Establish an appropriate regulatory framework for the telecom sector and reduce the number of enterprises that are excluded from privatization. Continue with titling of land and development of a land cadastre to facilitate land ownership and its use as collateral for loans.

  • Strengthen bank capitalization and banking supervision. Improve access to credit by SMEs, including by strengthening creditor rights.

II. Measuring Ukraine’s Shadow Economy18

19. This chapter discusses how the shadow economy has been measured in Ukraine and compares the results with studies of other transition economies. It also analyzes recent economic developments and indicators in Ukraine, with a view to assess the size of the shadow economy.19

A. Statistical Estimates of Ukraine’s Shadow Economy

20. Gathering information on the shadow economy is important for the conduct of economic policy. The existence of a large informal economy may increase the risk of policy mistakes based on distorted data. Moreover, information on the shadow economy is important if the aim is to reduce such economic activities, which can inhibit competition and discourage foreign investment. Firms operating in the shadow economy may lose services related to banking and in other sectors, and their workers may have limited access to the social safety net services.20

21. Like most other transition economies, Ukraine has faced the challenge of reorienting its statistics from the so-called system of material production to the system of national accounts. The process was made more difficult by transition-related structural changes in the economy, most notably deregulation and privatization. These developments affected statistical observations, data collection, and the recording of activities in the enterprise and household sectors. The most notable effect was that the number of economic units increased. The task of collecting data of these new (often small) enterprises has been a challenge and statistical agencies in many transition economies had to make drastic changes in their work methods.

22. Ukraine’s statistical authorities have started to impute informal activities in their recorded GDP data. The State Statistic Committee (SSC) has developed a comprehensive framework for estimating the size of the shadow economy and has included estimates for the shadow economy in their GDP statistics starting in 1995. The total adjustment has amounted on average to 20 percent of GDP, including about 15 percent for household activities and 5 percent for enterprises (Figure 13). The biggest contributions to this estimate are from agriculture (almost half), followed by trade and industry.21, 22

Figure 13.
Figure 13.

Ukraine: Shares of the Legal and Shadow Economy Recorded by Official Statistics, 1997–2002

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: Ukraine Research Institute of Statistics.

23. The applied methodology may leave a part of the informal economy unaccounted for, especially activities by large enterprises. Industry, dominated by large industrial companies, makes up 40 percent of Ukraine’s GDP, compared to only 12–13 percent for agriculture. Anecdotal reports of asset stripping and other illegitimate activities in the industrial sector suggest that the shadow economy is not limited to small businesses.23 According to Dean (2002), the comparison with other transition economies also suggests that the structure of Ukraine’s adjustments to the official GDP overweight agriculture. Even a small change in the adjustor for industry would be significant; increasing the share of the industrial sector from the current 5 percent to 10 percent would raise Ukraine’s officially reported GDP by 2–3 percent, or Hrv 5–6 billion.

24. A detailed research project on the shadow economy is being implemented. The existing analytical framework applied by the SSC has been supported analytically by its research arm, the Research Institute of Statistics (RIS). By adjusting internationally accepted methodologies for regional specifics, the techniques applied by the RIS include financial, monetary (Guttmann’s method), electricity consumption, and incomes and expenses based methods. The institute has also initiated an analysis of aerospace photographs for assessing unreported activities in the agriculture, evaluating the size and quality of crops.

25. According to an unofficial and preliminary report of the RIS, the share of the shadow economy may be twice as large as in official estimates.24 This estimate of the shadow economy would imply an upward adjustment of GDP by almost 25 percent (see Figure 14).25

Figure 14.
Figure 14.

Ukraine: Shares of the Observed and Unobserved Shadow Economy, 1999–2002

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: Ukraine Research Institute of Statistics.

B. Evidence on the Size of the Shadow Economy

26. A cross-country comparison of key indicators lends some support to the hypothesis that the size of the shadow economy and therefore nominal GDP is underestimated in Ukraine. In particular, in terms of tax collections and monetization, as measured in ratios to official GDP, Ukraine is not far off more advanced transition economies in Central and Eastern Europe (CEE) and the Baltics (Tables 4 and 5). This stands in sharp contrast to Ukraine’s relatively low level of per capita GDP (Table 6) and wages (Table 7). For instance, tax revenue as a share of GDP increased to over 30 percent in 2002 is line with the average level in the CEE and Baltic countries, countries which are reportedly five times richer in terms of per capita GDP and wages. Broad money as a share of GDP is also relatively high. While anecdotal evidence suggests that Ukraine’s banking sector is less developed than Lithuania’s,26 both countries had about the same broad money-to-GDP ratio in 2002. It is also difficult to explain the high level of international trade relative to GDP in Ukraine, given its large size (Table 8).

Table 4.

General Government Tax-to-GDP Ratios in Transition Economies, 1997–2002 1/2/

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Sources; GFS and IMF staff estimates.

Includes taxes collected by central and local governments.

Unweighted averages for CIS, Baltics and CEE countries.

Table 5.

Broad Money to GDP Ratios in Economies of Transition, 1997–2002

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Source: IFS.

Includes foreign currency deposits.

Unweighted averages for CIS, Baltics and CEE countries.

Table 6.

Per Capita GDP in Economies of Transition, 1997–2002 (In U.S. dollars) 1/

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Source: WEO.

Unweighted averages for CIS, Baltics and CEE countries.

Table 7.

Average Wages in CIS and Baltics, 1997–2002 1/

(In U.S. dollars)

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Source: EU2 Centralized Database.

Unweighted averages for CIS and Baltics.

Table 8.

Exports and Imports to GDP in Economies of Transition, 1997–2002

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Source: WEO.

Population (most recent available estimates, in millions).

27. Cross-country comparisons of the shadow economy suggest that Ukraine’s unofficial economy is much larger than estimated by the official statistics. In a number of studies, Ukraine has the largest share of unofficial economy among the largest in the CIS, Baltics, and Central and Eastern European countries. Since 1995, the estimates from various studies on the size of the shadow economy have been in the range of 50–120 percent of GDP.27 As in most transition economies, the share of the unreported economy has been increasing in late 1990s. In a comprehensive cross-country study, Schneider28 finds that the share of Ukraine’s informal economy reached 51 percent of official GDP on average for 2000–01. As shown in Table 9, this is well above the unweighted averages of the group of the CIS and Baltics (45 percent), and the Central and Eastern European countries (29 percent). Based on most recent data, Dzvinka29 finds that the share of Ukraine’s shadow economy may have risen from 52 percent in 2000 to 60 percent at end-2001.

Table 9.

A Comparison of the Shadow Economy Relative lo Official GDP, 1994–2001 1/

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Sources: Schneider (2002), Eilat and Zinnes (2002), Johnson et al (1997).

Electricity method is used in Schneider (2002) Johnson et al; Eilat, Zinnes use modified total-electricity approach.

OECD data are based on 2001–02.

C. Recent Trends

28. There is no conclusive evidence on the dynamics of the shadow economy. The above discussion indicates that the shadow economy and official GDP are most likely significantly underestimated. It is less clear whether the share of the shadow economy has been fluctuating or remained constant as implied by the SSC estimates included in the official GDP series. While the cross-country literature discussed above generally finds an increase in the shadow economy in recent years, other indicators suggest that the shadow economy may be in decline. There are also some indications that economic activities may move in and out of the shadow economy, distorting the official GDP growth rates.

29. The most common proxies for assessing the shadow economy have stabilized or declined (Table 10). Non-monetary transactions have decreased significantly. The gradual decline in unemployment and stable labor force participation also point to a retrenchment of the shadow economy. The role of cash, widely used in unofficial economy, has also declined relative to bank transactions, though the evidence is not conclusive without data on foreign currency in circulation.

Table 10.

Ukraine: Selected Economic Indicators, 1997–2002 (In percent)

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Sources: Ukraine State Statistics Committee. Ukraine Research Institute of Statistics and Staff estimates and projections.

RIS estimates are based on 9 months.

30. Large fluctuations in economic growth rates give conflicting signals. Recent trends in a number of economic indicators have diverged significantly from the official GDP growth rates (Figure 15). Following a buoyant 20 percent increase in 2001, nominal GDP growth slowed down considerably in 2002, to only 8 percent. This contrasts with continued high growth rates for wages (21 percent), taxes (21 percent), bank loans (51 percent) and private deposits (70 percent). Although structural reforms may have contributed to remonetization and improvements in tax collection, the size of the divergences suggests that the shadow economy may have grown more rapidly than official GDP, especially in 2002.

Figure 15.
Figure 15.

Ukraine: Selected Economic Indicators, 1997–2002

(percentage changes)

Citation: IMF Staff Country Reports 2003, 173; 10.5089/9781451838992.002.A001

Source: Fund Staff estimates and projections.1/ Bank credits are mostly short-term, minimizing lag effects.

D. Conclusions

31. The discussion suggests that Ukraine’s GDP may be significantly underestimated. Based on existing studies, the total economic activity not captured in the official statistics was probably at least Hrv 50 billion in 2002, or 23 percent of the official GDP. The evidence on the dynamics of the shadow economy is less clear cut.

32. The possible underestimation of GDP has implications for economic policy. For instance, the discussions on current tax reforms may be affected by the tax-to-GDP ratio, which would be lower if the estimate of the shadow economy is increased. In addition, a large unofficial economy also implies that movements in and out of informal activities may have macroeconomic implications. Monetary policy could be affected by large fluctuations in money demand, and the execution of fiscal policy could be hindered since an increase of the shadow economy can unexpectedly shrink the tax base. To the extent that the shadow economy is not captured by statistics, it may well distort the official growth rates, although it is not clear whether this has been the case in recent years.

33. Structural reforms will be important in reducing the shadow economy. To discourage informal activities and encourage growth, the government intends, inter alia, to reduce tax rates and provide tax amnesties for the return of illegally expatriated funds. However, recent literature suggests that institutional reforms could be more important than tax rate changes. Regulatory discretion and corruption are key determinants of underground activity in Ukraine, implying the need to enhance transparency and strengthen governance in public and private institutions.

III. Tax Reform in Ukraine30

34. This chapter studies taxation issues in Ukraine with a special focus on tax revenue structure and the nature and revenue costs of tax preferences. Section A discusses recent trends of Ukraine’s tax system. Section B discusses the role of the tax revenue mix and draws lessons from comparisons with other transition economies. Section C evaluates tax preferences and possible options for their rationalization and other base-broadening measures. Section D provides some conclusions.

A. Trends in Ukraine’s Tax System

35. Ukraine’s tax system performed poorly in recent years, in terms of revenue, economic efficiency, and social equity. Taxes as a ratio of GDP fell by 6 percentage points of GDP between 1998 and 2001, before rebounding in 2002. Despite some positive tax changes, the economic efficiency of the tax system has been hampered by the lack of adjustment of specific excise rates for inflation, the introduction of poorly designed tax incentives, and the steady decline of VAT revenue. The accumulation of large VAT refund arrears in recent years also contributed to increase efficiency costs. The social equity effects of the tax system have likely deteriorated mainly as a result of the absence of adjustment of the personal income tax thresholds for inflation.

36. Ukraine places a higher tax burden on labor than on consumption and capital. In 2002, labor taxes represented 45 percent of total tax revenue, consumption taxes 32 percent, and capital taxes 22 percent (Table 11). Payroll taxes alone, levied at a total rate of about 40 percent, raised close to 30 percent of total tax revenue in 2002, compared to only 20 percent for the VAT. Non-tax revenue has remained consistently strong, contributing 14 percent of total government revenue in 2002. This reflects the extensive role of government in the economy. Fees collected by government agencies for providing services, mainly in the social sectors, amounted to 3 percent of GDP in 2002. The large size of the public sector is also reflected in capital and property revenue, which was 1 percent of GDP in the same year.

Table 11.

Ukraine: Consolidated Government Revenue 1997–2002

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Source: Ministry of Finance.

Depreciation deduction, fixed agriculture tax.

Temporary excise surcharges (tobacco and alcohol products), tax on jewelry and cell phones, and taxes on foreign exchange and real estate transactions; these taxes are earmarked to the pension fund.

Vehicle tax, road tax, and taxes for innovation fund.

State duties, taxes for energy stabilization fund, and some local taxes.

37. The tax burden declined steadily in the aftermath of the 1998/99 financial crisis. The revenue decline was driven by the erosion of revenues of the enterprise profit tax and the VAT. Tax administration weaknesses, amplified by frequent tax amnesties and a proliferation of tax exemptions, and the fast changing economic environment were the main underlying factors. The decline in profit tax revenue has been uniform across former Soviet countries. Ebrill and Havrylyshyn (1999) explain that it reflects falling profitability, common administrative difficulties, and the removal of Soviet-era type taxes (such as excess wage taxes). The fall of VAT revenue seems, however, more peculiar to Ukraine and mainly reflects administrative inefficiencies, extensive noncompliance in unreformed economic sectors such as energy, and base contraction as a result of the introduction of simplified tax regimes (see below). The rapid expansion of exports and, to a lesser extent, investment may have induced a natural reduction in the VAT base, but these effects remain limited (see World Bank 2002)

38. Tax revenue recovered remarkably In 2002, partly as a result of improved tax administration. Indirect tax revenues were boosted without any changes in rates, by requiring more systematically the payment of VAT and excises on imports at the border. The use of 90-day promissory notes for paying the VAT on imports was significantly restricted, leaving this option only for producers directly importing their production inputs. In the same vein, the authorities started to require the payment of excises on energy goods used in tolling arrangement (such as Russian gas refined in Ukraine then re-exported). Another positive VAT administration change was to require customs certification at the border to clear VAT refunds. In addition, most tax preferences for imports of foreign joint ventures (e.g. import duties and VAT exemptions) were discontinued during the year, following protracted legal proceedings.

39. The 2002 rebound in tax revenue was also underpinned by a steady increase in personal income tax and payroll tax revenues since 1999. The income tax increase has been highly regressive because it has partly resulted from the non-indexation of the nontaxable threshold and income brackets. Payroll tax revenue has recovered from the loss caused by the 1999 rate reduction, due to rapid wage increases and improved compliance, following the clearance of pension arrears and implementation of individual contribution accounts.

40. Earlier tax reforms focused on the VAT and reducing the payroll tax rate. Positive changes were made to the structure of the VAT, by shifting to the destination principle (1997) and extending the use of accrual accounting to the energy sector (1999–2001). The elimination of a 12 percent payroll tax earmarked for the Chernobyl fund was also an important step (1998–1999).

41. The authorities are working on comprehensive tax reforms that should produce a unified Tax Code. Legal amendments were passed in late 2002 that change the structure of the enterprise profit tax (see Box 1). In addition, excise tax rates for petroleum products were unified and the administration of alcohol excise taxes was improved. A draft personal income tax law was approved in the second reading in March 2003. This law would establish a 13 percent flat tax as in Russia. The authorities also plan to reform the VAT law with a view to overhaul administration procedures (such as registering and refund release processes), reduce exemptions, and reduce the rate (currently 20 percent).

Enterprise Profit Tax Reform in 2002

Parliament passed amendments to the profit tax law in late 2002.

The structure of the tax was changed:

  • the standard rate is to be reduced from 30 to 25 percent starting in 2004;

  • a fourth category of depreciable assets for computer and IT equipment is created and depreciation rates for existing categories are all increased by 60 percent starting in 2004;

  • length limitations for loss carry-forwards were suppressed;

  • freight services provided by nonresident companies are now subject to taxation; and

  • insurance service taxation was upgraded;

  • the taxation of insurance activities and financial leasing was upgraded, including by fine-tuning the definition of taxable transactions.

Measures were taken to address tax avoidance:

  • the tax administration was given powers to verify prices underlying tax liabilities using fully defined methods; and

  • economic tests were introduced for deductions associated with payments to taxpayers enjoying tax breaks or non-resident status and the write-off of bad debts.

Administration was simplified by setting the tax on an annual basis.

B. Macroeconomic Aspects of Tax Reform

42. The economic effects of tax reform depend on the resulting tax burden and tax structure. Economic theory points to the importance of the impact of taxes on capital accumulation but with ambiguous predictions, made more uncertain by country idiosyncrasies. International comparisons are therefore a useful guide for tax reform deliberations.

Level and Composition of Tax Revenue

43. Efficiency and equity considerations do not provide unequivocal prescriptions for the level of tax revenue or the tax mix. In theory, the tax-to-GDP ratio should reflect the efficiency of public spending and the tax mix should take into account the effects of taxes on physical and human capital accumulation and labor supply. The conventional belief is that taxing income entails a higher efficiency cost than taxing consumption. Income tax, containing elements of both labor tax and capital tax, reduces the taxpayer’s ability to save. Taxing consumption, while discouraging labor for leisure, is in theory neutral on growth because it does not affect the relative price of future consumption. These results are however not robust and the impact of taxes on human capital should be taken into account. For instance, Tanzi and Zee (1996) explain that growth-depressing effects of a tax on physical capital can be offset by faster human capital accumulation.

44. The scope for tax reforms may be limited by country-specific constraints. For Ukraine, a large share of agriculture in total output (11 percent to 12 percent), a large informal economy, and the fast growth of small business establishments may limit the scope for assessing high tax rates or relying on certain modern taxes, such as personal income taxes and, to a lesser extent, value-added taxes. Other constraints stem from limited tax administration capacities and political set-ups often less amenable to rational tax policy than in advanced economies.

45. Against these uncertainties, international comparisons can help identify appropriate directions for tax reforms. Tanzi and Zee (2000) find that economic development leads to both higher tax revenue levels and a shift in the composition of tax revenue from consumption to income taxes, from trade taxes to taxes on domestic goods and services, and from corporate to personal income. The propensity of developing countries to rely more on consumption taxes seems robust through time, with consumption taxes yielding about twice as much revenue as income taxes. This presumably reflects both difficulties to administer efficiently personal income taxes and the need to encourage capital accumulation. The reliance on capital taxation is also increasingly limited by the liberalization of capital movements.

Tax Structure Comparisons

46. Transition countries have followed different reform paths. In terms used by Aslund (2001), central European countries opted for systems reminiscent of socially-oriented market economies common in western European and Scandinavian countries. These tax system are characterized by high tax ratios, high VAT and payroll taxes, progressive income tax rates, and low profit taxes and import tariffs. In turn, the Baltic countries pioneered more liberal and simple tax systems, imposing a lower tax burden and with VAT as the main tax, high flat income taxes, and low taxes on payroll, profits, property, and foreign trade. Recent reforms in Russia were a step in that direction. More simple tax systems were adopted by countries like Georgia, Kazakshtan, and the Kyrgyz Republic in the mid-1990s. In the aftermath of major revenue collapse, Georgia adopted a system with the same rate for the enterprise profit rate, the personal income tax (top rate), and the VAT, and low social security taxes. However, reforms in those countries were often hampered by the reintroduction of tax exemptions, thus limiting any dramatic revenue improvement.

47. Tax system comparisons of Ukraine with other transition economies indicate the following (Tables 12 and 13):

  • Ukraine’s tax-to-GDP ratio is not excessively high, but this is primarily due to low tax productivity. The tax-to-GDP ratio may be lower than shown in Table 12, taking into account that GDP may be significantly underestimated (see Chapter 2). The productivity31 of Ukraine’s main taxes is relatively low, reflecting narrow bases, numerous tax preferences, and extensive tax evasion.

  • Ukraine relies more heavily on profit and income taxes than other countries. It has the highest profit tax rate and collects more revenue from the personal income tax than other CIS and central European countries. The taxation of gas transit and significant natural resource taxes32 are also factors behind the predominance of direct taxes.

  • Payroll taxes are generally more significant in GDP terms than in other CIS and Baltic countries (with the highest tax rate), but are lower than in central Europe. Combined with high profit and personal income taxes, this contributes to high proportion of direct taxes in tax revenue.

  • Ukraine’s indirect taxes perform poorly as a percentage of both GDP and tax revenue. This reflects very low productivity of the VAT and the erosion of excise tax revenue due to insufficient adjustments for inflation. The VAT problem looks particularly serious. After adjusting for overdue VAT refunds, the net VAT revenue is only 5 ½ percent of GDP. All countries except Georgia and Kazakhstan raise more VAT revenue by at least 1 ½ percent of GDP, often with lower rates.

Table 12.

Tax Revenue Composition (for Consolidated General Government)

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Source: IMF Country Documents, GPS revenue statistics, OECD Revenue Statistics (2002).

Includes taxes on mineral and natural resource extraction

Preliminary data.

Unweighted average fur EU15.

Table 13.

Basic Tax Rates of Selected Countries

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Source: IMF country documents.

Tax levied only on distributed profits.

As a percentage of per capita GDP.

48. Ukraine’s tax system has become more distorted than the norm in transition economies. Labor and physical capital are heavily taxed while consumption taxes produce relatively low revenue. Moreover, high tax rates are made necessary by narrow tax bases. Such patterns are likely to undermine medium-term economic growth. Country comparisons show that there is scope for tax reforms that would shift the tax burden from income taxes, comprising capital and labor taxes, to consumption taxes. The center of such reforms should be the VAT, whose underperformance has been pronounced. Adjustments in excise rates (mostly specific) may also be considered in conjunction with rates in neighboring countries and the strengthening of their administration. The revenue brought by such reforms would be available to finance uniform reductions for income taxes.

C. Tax Preferences

49. From a microeconomic perspective, the main source of tax distortions in Ukraine is the combination of narrow tax bases and high rates. Narrow bases are explained by weaknesses in tax administration, multiple tax exemptions and privileges, and simplified tax regimes conducive to tax avoidance. This section focuses on tax policy explanations.

Main Characteristics

50. Tax preferences are widespread and significant, with overall costs in 2003 projected at 3½ percent of GDP. The main non-standard tax preferences (excluding on personal income taxes and import duties) are estimated at 3 percent of GDP, a reduction of 2¾ percentage points of GDP since 1998 (Table 14). This reduction was driven by the discontinuation in 2000 of VAT zero-ratings for energy products and VAT exemptions for imported goods seen as “critical” for domestic production. The costs of VAT exemptions peaked again in 2002, owing to the growing economic significance of exemptions for pharmaceutical products and for publishing and printing industries. The temporary suspension of exemptions for publishing and printing industries is expected to reverse this trend in 2003. Profit tax incentives have been relatively volatile, reaching over 1 ½ percent of GDP in 2000 and falling to ¼ percent of GDP in 2003 thanks to the termination of tax breaks for the metallurgy and investment deductions for the metallurgy, mining and chemical industries as well as the temporary suspension of tax credits for military housing.

Table 14.

Ukraine: Costs of the Main Tax Exemptions, 1998–2003 1/ (la percent of GDP)

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Source: Ministry of Finance.

Covers the main non-standard tax exemptions and some standard VAT exemptions. Excludes Personal Income Tax and Import duties preferences.

51. Focusing on non-standard tax preferences, recent inventories conducted by the State Tax Administration enable us to distinguish seven broad categories (Table 15):

  • Tax incentives for agriculture: The agricultural sector receives large subsidies from special VAT regimes and the zero-rating of dairy products and meat (¾ percent of GDP). Under these regimes, agricultural producers both retain the 20 percent VAT on their sales (including exports) and are eligible for tax refunds on their production inputs.

  • Tax incentives supporting specific domestic industries: Schemes include import duties exemptions, VAT exemptions or zero-ratings, and sometimes profit tax exemptions or accelerated depreciation for industries like ship- and aircraft-building, airspace industries, and automobile industries. Excise tax rates discriminate between imported and domestically produced automobiles and some alcoholic beverages. Incentives provided to the construction sector, in the form of VAT exemptions for newly built housing, is the largest incentive in this category.

  • Some 11 free economic zones and 66 priority development zones covering 10 percent of Ukraine’s territory: These are aimed at attracting foreign investment and fostering regional development. Preferential tax treatments generally consist of five-year exemptions from import duties and VAT for imports of equipment and raw materials and a reduced profit tax rate, either an unlimited 20 percent or a three-year full holiday followed by a three-year fifty percent tax break. Several zones also provide exemptions from payroll contributions to the unemployment fund and the land tax for periods no longer than five years. From a governance perspective, local authorities have significant discretion for the granting and administration of tax breaks within general frameworks established by parliament, especially in approving individual investment projects.

  • Tax exemptions aimed at supporting innovation, research, and education. These are mainly VAT exemptions for research and development activities, academic and domestically-produced books, as well as peripheral services used by education institutions (e.g., catering).

  • Tax exemptions with social policy purposes: These include VAT exemptions for medical products and transportation services, or profit tax and VAT exemptions granted to enterprises with disabled employees.

  • Highly preferential simplified tax regimes, established in 1999: Though the purpose of small business tax regimes (not quantified in Table 15) is usually administrative simplification, Ukraine’s simplified regimes provide substantial tax relief to qualifying businesses, on account of high eligibility thresholds (in terms of turnover and numbers of employees) and the substitution of a moderate proportional turnover tax or a fixed tax for most standard taxes including social security contributions and the VAT.33 The agricultural sector also enjoys an extremely generous simplified regime, which consist of a proportional tax on arable land and planting fields. This single tax replaces all the main taxes except the VAT.

Table 15.

Ukraine: Inventory of Tax Expenditures, 2001–2003

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Sources: Ministry of Finance, Ministry of Economy, and Fund staff estimates.

Excludes exemptions allowed by foreign treaties and standard exemptions such as exemptions for non-profit organizations’s incomes.

Excludes exemptions for financial transactions, exemptions stipulated by foreign treaties, exemptions for education and healthcare, and exemptions for government services.

Cost Effectiveness

52. Tax incentives aimed at promoting industrial development and attracting foreign investment in Ukraine are poorly designed. As explained in Zee et al. (2002), indirect tax incentives are often not economically justified34 and prone to abuse, and should be limited to export-oriented activities. Ukraine has relied heavily on domestic zero-ratings and import duties exemptions to support non-export related activities, including in free economic zones. Free economic zones pose further problems. Leakages of goods from these zones into the domestic market have reportedly been extensive, owing to weak administrative controls. In particular, large quantities of commodities unrelated to the implementation of investment projects (e.g. meat and other food products) have been imported into economic zones. Contrary to best international practice, enterprises operating within these zones usually benefit from profit tax breaks. This has attracted activities unrelated to exports and introduced more opportunities for tax avoidance, notably through transfer pricing.35 Moreover, such tax breaks are known to be less efficient than other forms of direct tax incentives, including investment allowances or accelerated depreciation.

53. Tax exemptions with social purposes are poorly targeted. As a general rule, VAT exemptions aimed at reducing prices of basic consumption needs are an inefficient way for assisting poor households, and income-targeted subsidies should be relied upon instead. VAT exemptions for pharmaceutical products are however found in other countries as a means to subsidize access to basic drugs. Countries usually have public health insurance systems that cover the costs of basic drugs (essentially prescription drugs), which makes the issue of VAT coverage irrelevant. In Ukraine (where there is currently no health insurance system) efforts should similarly focus on restraining these VAT exemptions to core medical supplies, covering drugs that would normally be classified as prescription drugs and a small number of other highly cost-effective drugs.

54. Simplified tax regimes and extensive tax exemptions have undermined the tax system. Simplified tax regimes have contributed to tax base erosion by providing tax relief to small to medium-sized businesses and altered the tax system’s neutrality with clear incentives for businesses above the threshold to split into smaller units. More generally, the prevention of abuses and leakages linked to exemptions is likely to absorb a substantial amount of quality administrative resources. The diversion of these scarce resources may contribute to weaken tax collection as a whole.

55. Numerous exemptions are especially damaging for the integrity of the VAT. Exemptions introduce cascading and distort producer and consumer prices, thus defeating the purpose of the VAT as a neutral consumption tax. Exemptions weaken the VAT’s feature of self-policy, adding to administrative costs.36 Moreover, multiple zero-ratings and other special treatments undermine directly the VAT refund process. The special VAT regime for agriculture permits refunds without matching VAT payments to the budget. The recent decision to zero-rate domestic sales of imported natural gas is bound to complicate the matter further, by creating possible leakages in the VAT chain.

Reform Challenges

56. Reforms should focus on the elimination of tax incentives, starting with indirect tax incentives. Simplified tax regimes should be unified into a single regime, based on the VAT threshold and producing broadly the same tax burden as the standard profit tax. There is ample scope for streamlining socially-motivated VAT exemptions without affecting the poorest households, though this might require compensation through existing income-targeted social benefits.

57. Ukraine’s taxation of agriculture should be brought closer to best international practice. Jt is currently the most nontransparent and preferential system among CIS and Baltic countries (see Box 2). The first-best policy would be for the agricultural sector to be taxed at the standard VAT rate, as is the case in several countries (including Chile, Denmark, New Zealand, Finland, and the United-Kingdom). Given possible collection difficulties, a higher tax free threshold may be needed to ensure that collection exceed administrative costs. A second-best approach would be to exempt the sector from VAT as a means of eliminating the effective subsidy as VAT refunds would thus not accrue.

58. The base for the personal income tax should be broadened. Besides suppressing occupation-based exemptions,37 the definition of taxable income should be extended. In particular, the definition of income does not include explicitly (i) additional benefits such as employer-provided housing and the provision of discounted goods to employees; (ii) income from the sale of immovable property and certain financial assets such as company shares; (iii) amounts received by individuals engaged in agricultural or construction works in the countryside of a temporary basis; and (iv) interest income derived from bank deposits. As importantly, legal and administrative loopholes in personal income taxation need to be tackled. The investment income earned by foreign corporations that are controlled by residents of Ukraine is generally not included in the income of owners as the income is earned.38 In the same vein, wages and salary paid to non-residents for employment or services performed in Ukraine may not be taxed if paid outside Ukraine. This reflects the absence of specific rules for determining the source of income. Base-broadening efforts should also focus on simplifying the current system of social deductions and allowances. Many of those deductions seem questionable or uncontrollable from a tax administration point of view. Base-broadening focusing on these reform aspects would significantly improve both the efficiency and equity of the tax system.

VAT Treatment of Agriculture in CIS and Baltic Countries

Estonia, Georgia, and the Kyrgyz Republic tax the entire agricultural sector at the standard VAT rate (18 percent, 20 percent, and 20 percent respectively). Georgia grants exemptions for various imports including pedigree animals, planting stocks, and pesticides.

Russia assigns a reduced VAT rate (10 percent) to a selection of agricultural products including dairy products, meat, fish, salt, sugar, vegetables and bread, and taxes other agricultural products at the standard rate (20 percent).

Belarus and Moldova tax the entire agriculture at reduced rates (10 percent and 5 percent, respectively). Belarus zero-rates and Moldova has exemptions for selected products.

Lithuania and Latvia assign lower flat-rate schemes to small farmers (6 percent and 12 percent, respectively) and tax other agricultural producers at the standard rate (18 percent). These flat-tax schemes, equivalent to “exemption with credits” for purchasers of agricultural goods, are in line with the sixth European Directive.

Armenia, Azerbaijan, and Turkmenistan exempt the entire agricultural sector.

Ukraine keeps agricultural producers in the VAT system and allows them to retain the VAT on their sales for investment purposes. In addition, certain products including dairy products and meat, are zero-rated.

59. Further transparency efforts are necessary to overcome opposition to reform stemming from rent-seeking behavior. Those who capture rents in the form of tax incentives have an inherent interest to maintain the status quo. The tax incentive granting process should be made more transparent in all aspects including legal basis and economic consequences. The estimated revenue costs of tax incentives should be subject to public scrutiny in the budgetary process as tax expenditures. An increasing number of developing countries have established tax expenditure budgets that hold lawmakers accountable for the cost-effectiveness of granting tax incentives to achieve policy objectives. Transparency also requires to minimize public officials’ discretionary powers for granting tax incentives outside fully specified qualification criteria. In that regard, the accountability of local government officials managing special economic zones appears to have been particularly weak.

D. Conclusions

60. Ukraine has ample scope for improving its tax system and harmonizing it with neighboring countries. Based on other transition countries’ experience, reforms combining reductions in the rates of direct taxes with the rationalization of tax preferences and measures to broaden incomes captured by the tax net may imply only limited revenue costs. Maintaining current revenue levels and fully rebalancing the mix between direct and indirect taxes may however also require further adjustment in excise rates.

61. For tax reforms to be effective, tax administration will have to be strengthened. The main explanation for the steady erosion of VAT revenue between 1998 and 2001 and the factor behind its rebound in 2002 are mainly administrative. Despite improving revenue performance, the integrity of the VAT is also negatively affected by the inability of the tax authorities to remain current on legitimate refunds. Addressing these problems is as important as making the appropriate legal reforms.

IV. The Feasibility of Inflation Targeting In Ukraine39

62. This chapter examines the inflation targeting (IT) framework, including initial conditions, empirical work on the various types of inflation targeting, experiences of some transition countries, and practical implications for adopting IT in Ukraine. While Ukraine’s macroeconomic situation has improved, there are significant institutional shortcomings relative to countries that have adopted full-fledged IT regimes. This would make it difficult for Ukraine to adopt a full-fledged IT in the near future. With steps to strengthen the banking system and deepen financial markets, it may however be possible to adopt such a regime in the long term.

A. Background on the IT Framework

63. Under an inflation targeting framework, the central bank commits publicly to pursue a quantitative target for inflation as its primary objective. Its recent popularity stems in part from the drawbacks of other nominal anchors. For instance, in most developing countries the demand for money has been subject to strong fluctuations and structural breaks, which have made the relationship between monetary aggregates and the policy objective (a particular level of inflation or national income) unstable. These relationships have been particularly problematic in the face of free capital mobility and financial liberalization. In addition, some recent experiences with exchange rate rules (currency board, crawling peg) have proven to be very disruptive by limiting the authorities’ ability to respond to Teal shocks and increasing the damaging effects on the banking system, corporations, and government finances by reducing the need to hedge and risk of borrowing in foreign exchange.

64. In view of the difficulties with other nominal anchors, countries have increasingly turned to inflation targeting.40 Inflation targeting presents several advantages. It establishes price stability explicitly as the primary objective of monetary policy. It improves monetary policy transparency and accountability and hence credibility. It gives the central bank some flexibility in how it responds to economic shocks. It also allows for exchange rate flexibility which can help to absorb shocks.

65. There are drawbacks. The framework does not guarantee that the central bank will use the framework appropriately and the public must find the policy credible in order to bring about the desired impact on inflation expectations. Also, if the time horizon for targeting inflation is very short, there may be excessive fluctuations in the real exchange rate, output, and interest rates. A full-fledged IT framework requires relatively developed financial markets. In addition, there needs to be a proven instrument which can impact inflation so that the central bank can be reasonably confident about achieving a given inflation target. It is therefore difficult to implement in developing and transition countries with nascent financial markets and limited monetary instruments where transmission channels to inflation are not well understood.

66. Inflation targets are based on country-specific factors such as the degree of central bank credibility and the country’s vulnerability to shocks. Within the IT framework, there is flexibility as to what price index to use (the CPI or a core inflation index),41 whether there is a target range or point, and the target horizon, which can be set year-by-year (Poland) or a path can be announced several years in advance (Czech Republic). While the exchange rate is generally floating in IT regimes, it still needs to be taken into account in countries where there is a significant pass through to inflation.42 The ability to use an IT framework depends also on whether there is significant dollarization. If there is a large amount of transactions conducted in foreign currency, it may be difficult to have find an instrument that would impact inflation. If dollarization takes the form of asset substitution, then larger adjustments to interest rates would be required to affect inflation, given the need to compensate for the substitution effect of interest rate differentials on foreign versus local currency. See Box 3 for a discussion of recent experience in Hungary and Poland.

Experiences with IT in Hungary and Poland 1/

Both Hungary and Poland have full-fledged inflation targeting regimes. Hungary adopted an IT framework in June 2001, after the disinflation process had stalled under the previous narrow exchange rate band regime. In June 2001, all foreign currency restrictions were lifted and a change in the central bank law was adopted, which made price stability the primary objective of the National Bank of Hungary (NBH). The NBH announced that its medium-term objective was to bring inflation down to EMU-compatible levels by 2004/05 to qualify for the early adoption of the euro. The new framework met with much initial success. This was assisted by an appreciation of the forint following the widening of the exchange rate band, tightening of monetary conditions, and the guidance of inflation expectations afforded under the IT framework. The IT framework is formulated on the 12-month increase in end-of-year ‘headline’ inflation with a tolerance band of +/−1 percent. The target horizon is 1−1½ years. The NBH benchmark interest rate is used as the primary instrument for influencing inflation. However, there is still a great deal of uncertainty about the monetary policy transmission channel and the impact of interest rates is relatively weak. This mainly reflects the large share of enterprises which rely on external borrowing, so that interest rate transmission mainly affects households and small enterprises which have low debt levels. The exchange rate channel is the dominant channel for monetary policy transmission, but there is significant uncertainty about the extent of pass through. Supporting fiscal policies are essential to allow the NBH to make inflation and not the exchange rate its priority, including by keeping the current account within safe limits.

Poland formally adopted inflation targeting in 1999 to anchor its monetary policy. It targets the headline CPI and the inflation target is set by the central bank. Despite successful disinflation, the inflation targets have been missed repeatedly. Inflation exceeded the target in 1999–2000 and undershot the target in 2001. This reflected external shocks, technical factors, and an unfavorable policy mix. Technical factors that contributed to the misses were narrow bands, short time horizons, volatility of targeted inflation, and learning by doing process. The loosening of monetary policy in response to the Russia crisis and the subsequent tightening contributed to misses in both directions. Despite the misses, ‘inflation fighting credibility’ does not appear to have been compromised, although a loose fiscal and tight monetary policy have strained the IT regime. Low growth and high unemployment have increased tensions between the central bank and the government. To improve future performance, widening the band, relying on core inflation, introducing escape clauses, and lengthening time horizons are options that might help. An environment of political consensus and instrument independence is necessary in order to achieve low inflation goals of the central bank.

1/ Based on input from Nancy Wagner (IMF); Selected Issues for Poland, June