Ukraine: Technical Assistance Report-Reducing Social Security Contributions and Improving the Corporate and Small Business Tax System
Author: International Monetary Fund. Fiscal Affairs Dept.
Publication Date:
08 Feb 2016
eISBN:
9781498315906
ISBN:
9781498315906
Language:
English
Keywords:
ISCR; CR; excise tax; SSC rate; tax burden; single tax; tax rate; SSC reform; tax liability; SSC base; SSC rate cut; SSC payment
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This paper discusses four key issues, which are closely connected, on tax policy in Ukraine. These issues are social security contribution (SSC), the simplified tax regime for small taxpayers, the corporate profit tax, and excise tax. Ukraine's SSC rates are very high, which are associated with an oversized informal sector that erodes the tax base, while the simplified tax regime for small taxpayers provides inordinate benefits that weaken the tax system and is prone to abuse. Corporate profit tax revenue has declined to its lowest level since 2006 and is now well below the regional average. Excise taxes have become an important revenue source, but remain low by international standards.

Abstract

This paper discusses four key issues, which are closely connected, on tax policy in Ukraine. These issues are social security contribution (SSC), the simplified tax regime for small taxpayers, the corporate profit tax, and excise tax. Ukraine's SSC rates are very high, which are associated with an oversized informal sector that erodes the tax base, while the simplified tax regime for small taxpayers provides inordinate benefits that weaken the tax system and is prone to abuse. Corporate profit tax revenue has declined to its lowest level since 2006 and is now well below the regional average. Excise taxes have become an important revenue source, but remain low by international standards.

I. Introduction

1. This report discuses four topics on tax policy in Ukraine. Two of them are currently being intensively debated among policymakers and stakeholders, namely, Social Security Contributions (SSC) and the simplified tax regime for small taxpayers, which are closely related, and the Corporate Profit Tax (CPT) and excises, which need attention as well. These issues are discussed in the same order in the four Chapters that comprise this report.

2. These four topics are closely connected. Ukraine has very high SSC rates, which are associated with an oversized informal sector that erodes the tax base. The simplified tax regime for small taxpayers provides inordinate benefits which weakens the tax system and is prone to abuse. The difficulties of the social security system cannot be understood without examining the special regime used by the self-employed under the single tax regime for small taxpayers. Lowering SSC rates is a starting point to resolving the problem, but this should be a revenue neutral initiative—for which the report discusses different options. Specifically, Chapter II reviews the policy debate on SSC; Chapter III looks in detail at the simplified tax regime for small businesses; Chapter IV explores the fiscal space in excises and, finally, Chapter V discusses improvements to the CPT.

II. Social Security Contributions

A. Background

3. There is consensus in Ukraine that the Social Security System needs reforming. It runs with a large public deficit (over 5 percent of GDP – see Tables 1 and 2) despite very high contribution rates. At the same time, high informality rates imply that the coverage is poor and that both employers and employees have a strong incentive to opt out of the system. Also, the system is further weakened by generous and sometimes lax regulations governing the self-employed. The government of Ukraine is considering different options to simplify the system, strengthening its finances and simultaneously lowering contribution rates. This Chapter of the report discusses these options.

Table 1.

Ukraine: Social Funds Operations

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Sources: Ukrainian authorities and IMF staff estimates.
Table 2.

Pension Fund of Ukraine Operations, 2007-15

article image
Sources: Ukrainian authorities; and IMF staff estimates.

Previous FAD recommendations

4. A previous FAD tax policy mission report1 pointed out that Social SSC in Ukraine are high for international standards. At approximately 40 percent of the wage base, they are above all countries in the OECD. At the same time, it argued that it was reasonable to assume that this high tax burden on labor was associated with a large informal sector. Indeed, informality in Ukraine is very large, one of the highest in the world.2 The system is also complex, with nearly 70 different rates depending on the production activity risk class.

5. The recommendation in that report was to reduce the average SSC rate, possibly by as much as 40 percent, to 25 percent of the wage bill. This represented a smaller reduction than proposed by some participants in the policy debate in Ukraine at the time, but it would have implied limiting the amount of revenues surrendered to a level which could be compensated for the most part with a more progressive personal income tax (PIT) structure. The overall strategy recommended in that report was to shift the tax burden away from average income employees towards higher income individuals, expanding the base of property taxes, higher marginal rates in the PIT, and eliminating exemptions and privileged tax regimes, such as the Flat Agricultural Tax (FAT).3

The policy challenges ahead

6. Ukrainian authorities share the concern about high SSC and informality. These impose a high cost on a reduced base of taxpayers while limiting the delivery of mandated social benefits. FAD’s recommended strategy, however, was not adopted. The legislation was changed to reduce SSC rates (though not the number of rates), albeit no consensus has been found on how to mitigate the impact on revenues. In the last semester alone the strategy in this regard has changed directions a number of times, as reflected by Rada amendments to proposed and approved bills (see Box1). The discussion on SSC reform continues among stakeholders, led by the Ministry of Finance and its ad hoc advisory bodies.4

7. The status quo is not tenable. The law as it stands today mandates a reduction in SSC rates without taking into account some vital contextual facts: the social security funds in Ukraine are already deep in deficit; the budget in fiscal year 2016 will face some additional pressure because some one-off revenue raising measures in 2015 are not renewable5; and supply side effects of lower rates are not sufficiently dependable to be the cornerstone of a prudent tax policy. Given these constraining elements, reforming SSC needs to be at least revenue neutral in a static sense. Hoping that an uncompensated drop in SSC will move the Ukrainian economy along the lower half of a Laffer curve and solve public revenue shortages is a heroic assumption and should not be the basis for tax policy in Ukraine at this point (positive dynamic effects may be factored in when, and whether, they materialize in the medium-term).

Recommendations

  • Reduce the number of risk based SSC rates to a handful.

  • Reduction of SSC rates should be revenue neutral.

  • Revenue neutrality should not account for dynamic effects of SSC reduction

B. Deficits in social security funds

8. Four different social benefits are financed with SSC: unemployment insurance, temporary disability, accident insurance and pensions. Pensions are by far the most important of these benefits; revenues of the pension fund are about eight times the other three put together (see Table 1). The pension system has operated with a very significant deficit for a long time. Although this deficit has diminished over time (from 7 percent of GDP in 2009 to 5 percent in 2104), the projected deficit for 2015 (3.9 percent of GDP) is still a matter of concern. Also, the other funds for the first time are projected to add 1.4 percent of GDP to that deficit in 2015.

9. SSC have been the most important and dependable source of tax revenues. For most years SSC have been larger than revenues from all income taxes (CIT + PIT) or from indirect taxes (VAT + excises). Up until the beginning of the conflict in the East, SSC also showed a more stable growth trend than other taxes, though insufficient to close the expenditure gap (see Fig. 1).

Figure 1.
Figure 1.

Ukraine: Tax Revenues as percentage of GDP, 2003-2014

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

10. Adjusting for Crimea and conflict-affected regions, SSC revenues in 2015 have not underperformed. With these adjustments revenues in fact have risen 7 percent compared to the same period in 2014 (see Fig. 2). So, SSC continue to be a fundamental source of revenues for the budget.

Figure 2.
Figure 2.

Ukraine: Monthly SSC Revenues – excluding Crimea

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

Sources: Ukrainian authorities and IMF staff estimates.

C. SSC reform: recent changes in the law and new proposals

The initial proposal by the Ukrainian government

11. In December 2014 the government of Ukraine proposed to the Rada a graduated reduction in the SSC for employees with an income above 2 MW. The fall in revenues from the proposed rate reduction would have been partially compensated by: a) imposing a minimum base of one monthly MW on employees working less than 40 hours per month, i.e. having all part-timers paying SSC as if they were fully-employed and b) raising significantly the cap on SSC (see Box 1). According to mission calculations, the (static) cost of this initiative would have been UAH 17.5 billion (1.2 percent of GDP).6

The first reform adopted by the Rada

12. The reform proposed by the government was not adopted. Instead, the Rada voted for a conditioned reduction in SSC rates for 2015, followed by a smaller but unconditioned decrease in 2016, without increasing the income cap, nor keeping a high rate for individuals with income below two minimum wages. As approved, the 2015 reduction of 60 percent in the SSC rate would apply only if employers increased the payroll base of the tax sufficiently to compensate for it (combining new employment and increased wages). The cut in SSC rates was thus conceived as providing an incentive for employers to “de-shadow” their informal payroll and expand the base sufficiently so that net revenues would not be affected. For 2016 the bill authorized a 40 percent cut in SSC rates without conditions.

13. Some employers did apply the reduced SSC rates in 2015. According to SFS, 7,000 employers applied the reduced SSC rate for 2015, covering almost 700,000 employees. This is not insignificant, but it is uncertain how companies complied with the conditions to apply the reduced SSC rate, whether (and how much) the payroll increased from legalizing wages previously paid underground or from increased employment that would have occurred anyway, or from wage inflation, or from company mergers, or any combination of the above.

14. It is difficult to discern why employers would actually opt for this scheme. It offered no reduction in their total tax bill, the only potential benefit would be regularizing past underground payments. However, there is no amnesty associated with this initiative, nor a credible (and imminent) threat that the law would be enforced to collect past due SSC. Remaining in the informal economy appears to be still be the safest option. Also, no conditions apply for 2016; it might seem preferable to taxpayers to wait a year to enjoy the benefit of the SSC cut.

The reform amended

15. In March 2015 the Rada scrapped the previous text of the law and lightened conditions to apply reduced SSC rates. Also, it would allow each company to adjust down its SSC rate according to the increase in the wage base it paid in 2015 as compared to 2014, without exceeding a reduction of 40 percent. The SSC rate reduction for 2016 remained unchanged, that is, without conditions or other compensating measures.

16. In May 2015 the Rada initiated discussions to amend the bill approved in March. A new initiative (originating on the legislative floor) was approved eliminating all conditions to decrease the SSC rate in 2015, and allowed an immediate reduction to 60 percent (lowering the current rate from 40 to 15 percent in 2015), with no compensating measures to recoup the revenues at stake.7 The implicit argument is that a drastic cut is what it takes to provide a sufficient incentive for employers to formalize the wage bill that they pay underground. The risk is that formalization does not happen in any significant degree, or not sufficiently to compensate the cut, with severe effects on the budget. The bill was vetoed by the President in July.

Amendments to the SSC reform, 2014 -2015

I. Initial proposal submitted to Rada in December 2014

  • For wages below 1 MW (part-timers) the assessment base is 1 MW

  • For wages up to 2 MW the current (40 percent average) rate applies.

  • For wages exceeding 2 MW the SSC would be reduced to a marginal rate of 26 percent for 2015, 21 percent for 2016 and 16 percent for 2017.

II. The proposal adopted by Rada on December 28, 2014

In 2015 SSC may be reduced by a coefficient of 0.4 if the following conditions are concurrently met:

  • (i) The SSC base exceeds the average monthly base in 2014 by at least 2.5 times;

  • (ii) The average wage is higher by at least 30 percent compared with 2014;

  • (iii) The average payment per individual insured is at least UAH 700;

  • (iv) The company average wage is at least three minimum wages.

For 2016 on the reducing coefficient is set at 0.6 without conditions.

III. The proposal adopted by Rada on March 2, 2015

  • Taxpayers can pay a lower SSC rate in 2015 if:

    • (i) The 2104 monthly SSC base per employee increases 20 percent;

    • (ii) The average SSC payment per employee is no less than 2014 average;

    • (iii) Number of employees does not exceed 200 percent the 2014 average.

  • The reduction in SSC rates will be set for each company and calculated as the ratio of average monthly salary in 2014 and the current reporting month salary. However, the reduction cannot be more than 0.4.

  • The reducing coefficient from January 1, 2016 will be set at 0.6 without conditions.

IV. The proposal voted in Rada May19, 2015

  • SSC are lowered using a 0.4 reduction coefficient beginning current year and no conditions apply.

  • The President vetoed this bill in July, 2015

Discussion in the Task Force

17. Discussions on SSC are ongoing and the policy aims remain unsettled. Different stakeholders have presented new proposals to the Task Force on Tax Reform which advises the MoF. One proposal which has gained some traction is merging SSC and the “Military Tax” 8 with the PIT at a flat 29 percent rate (higher than the current top marginal rate). Revenues would be allocated according to some proportion to the general budget and to funding social security benefits. The idea is that current SSC and Military Tax would be grossed-up to wages to increase the base of the new “combined” PIT. The PIT rate would then decrease gradually to ultimately 20 percent by 2018.

18. Merging SSC with PIT entails some important risks for revenues. The proposal now under review by the MoF considers different mechanisms to compensate for the loss of revenue that the 29 percent PIT rate on a grossed-up base would imply with respect to the current system. However, these compensators rely heavily on the assumption that employers will legalize a wage bill now paid underground and in taxing persons that qualify for a simplified regime for small taxpayers (see Chapter III) at a much higher rate. These are uncertain assumptions, which are not fully consistent: on the one hand it is expected that employers are very sensitive to a lower SSC rate, bringing a shadow payroll into the open, while on the other small taxpayers are expected to be very unresponsive to higher taxes, not migrating their activity to the shadow economy (estimations discussed in Section H of this Chapter).

19. Ukraine has no fiscal space for a SSC reform that loses revenues. A gradual reduction in SSC rates is justified as an element in a more comprehensive effort to combat informality—an effort that needs to encompass reforming labor regulations, rationalizing social security benefits and improving administrative efficiency. Any upfront reduction in revenues from lower SSC rates must be fully compensated by other revenue increasing measures from no uncertain sources.

Simultaneous changes in the PIT

20. The December 2014 tax reform increased the top marginal PIT rate to 20 percent, shortly followed by pushback to shrink the tax base. The increase in the top rate is a step towards a more progressive scheme, although FAD’s recommendation was also to include an additional income bracket at 25 percent. However, an initiative presented to the Rada in May 2015 aimed at reversing course by increasing the lower bound of the income bracket to which the 20 percent rate applies, from 10 minimum subsistence wages (MSW) to 17 MSW.9 Thus, all individuals with an income between 10 and 17 MW would pay only 15 percent, obtaining a tax cut as compared to the situation prior to the December 2104 reform, when they paid a 17 percent tax.10 Though the bill was vetoed by the President in July, it is indicative that there is still strong support for a quasi-flat tax structure in the PIT.

Recommendations

  • Overturn the uncompensated SSC rate reduction coefficient of 0.6 projected for 2016.

  • Reductions in SSC rates must be fully compensated by additional tax revenues.

  • Do not include in expected revenues possible effects from reducing the informal economy.

  • Do not decrease the base of the top marginal rate in the PIT.

D. Pensions and welfare through the social security system

21. Traditionally social security systems have both a pension component and a welfare safety net for the old aged. The second ingredient makes social security a distinct operation from a pure (even if government run) pension plan. The safety net provides a subsidy to a population in need, financed by high income social security contributors and all taxpayers (from the general fiscal budget), in varying proportions, depending on the deficit of the social security system.

22. Social security in Ukraine, as in much of the world, is a defined benefit system financed through as ‘pay as you go’ scheme. This means that the government acquires the obligation to pay retirees a specified benefit funded with SSC from current taxpayers, supplemented with revenues from other taxes as the system may require. The benefits are normally (above a certain level of income) a declining function of contributions, which will provide during retirement a replacement ratio of the salary earned at time of retirement. Thus, the pension element of social security is correlated (up to a certain point) with contributions into the system; welfare payments are not, they constitute a minimum pension which has not been sufficiently funded with the contributions of the beneficiary.

23. A declining population in Ukraine has weakened the financial health of its social security system. Population in Ukraine has actually declined in the last decade (from 51.6 million in 1993 to 44.6 million in 2015) at the same time as it has aged.11 The combination of a shrinking labor force with a fast ageing population inevitably leads to a higher tax burden and a higher incentive not to work or to do so in the informal sector. Thus, Ukraine faces the challenge of a dwindling payroll tax base already subject to a very high tax rate, generating an incentive for a growing informal sector that deprives the social security system from further funds. Inevitably, social security benefits must be financed increasingly from the general budget.

24. Active coverage, defined as participation of workers in mandated pension schemes, is also reduced with growing informality. Traditional social security systems rely on formal employment to fund and deliver benefits, that is, on employers to withhold payroll taxes and on employees’ payroll contribution to select beneficiaries and determine the amount of pension benefits. The growth of informality necessarily leads to a larger number of persons dropping out of the system, with no safety net in old age. When governments respond to this problem by implementing non-contributory benefits and special regimes for the self-employed, the social security system adds a welfare component financed from general funds.12 This is potentially a vicious circle rendering informality a more attractive option for employment and a strong disruptor of the traditional social security system.13

25. The question arises why a separate social security system for employees in the formal sector should be kept at all. Benefits could be entirely financed from the budget, finding possibly a more efficient instrument to obtain revenues to do it, eliminating the payroll tax. In a way, keeping separate general government accounting to fund social security benefits is a financial fiction in that whichever reserves may be accumulated in the specific funds, usually, these are lent to the government to finance its current expenditure. The social security funds typically cannot invest their resources in any other vehicle than government treasury bills or their equivalent.

26. The legal commitment however is very important. A pay-as-you-go social security system is an intergenerational contract, a constitutional commitment, which the upcoming generation will contribute to finance the retirement of the current contributing cohort, in the same way as with the current generation of retired people. The fact that their contributions formally go into a committed social security fund fulfills that condition. So, regardless of how the revenues are collected, a separate accounting is needed so that social security entitlements are not negotiated and voted every year in the budget process.

27. To the extent that a pension is provided through the social security system, the payroll will continue to be a relevant element of the system. Since pensions are necessarily a percentage of the taxpayers’ labor income, and benefits generally a function of contributions, regardless of how the revenue is obtained, the social security authority has to keep a record of the (monthly) payroll of each taxpayer in order to determine their individual pension, and safeguard their entitlement, even if payroll is not the direct base of the tax. So, even if payroll taxes are substituted by other taxes in order to fund social security benefits, the payroll would continue to be an anchor of a pension system. Where social security only provides a uniform and universal stipend to all individuals above a certain age, the payroll becomes irrelevant and the system is simplified, but at the expense of delivering pensions as traditionally understood. Which model to follow, or which mix between both models to adopt, is a matter of social choice. As long as pensions are one of the main benefits of the social security system, there is a limit to how much taxation can be simplified in order to fund it.

Recommendation

  • Consider fully funding pensions from the budget only when reviewing comprehensively the social security system and its pension benefits

E. The continuing allure of a flat PIT

28. Ukraine introduced a flat tax in 2004, with single rate at 15 percent on income of all individuals. This became a popular strategy in a number of Eastern European countries at the time. As recent as 2011 Ukraine introduced a second marginal rate of 17 percent for higher income individuals, but few actually paid this top rate (212,416 individuals – 1.3 percent of total PIT payers). So, for all practical purposes, the regime continued to be very close to a flat tax until the current year, when the top rate was increased to 20 percent. But there is a strong push to return to the flat tax, to replace the current PIT, the SSC and the Military Tax.

29. The major appeal of the flat tax was its apparent simplicity and promised (up to a certain point) increase in supply of labor and thus tax revenues. The simplicity of a flat tax system can easily be exaggerated, however. The increased difficulty of administering a tax system with three rates rather than one is practically immaterial. The real complexities in the tax system lie in how the base of the tax is determined: multiple options, exemptions, special regimes, ambiguous language, undefined concepts, inconsistent rules and many other intricacies are usually the culprit of a very complex tax system. The Ukraine is no exemption.

30. Studies have shown that the expectation of higher revenues from introducing a flat tax is not strongly backed by empirical evidence. Most countries that introduced the flat tax did not see a major employment surge and suffered a revenue loss. Where tax revenues increased, a wider package of measures had been introduced together with the flat tax, so that the revenue increase could not directly be imputed to the flat tax. As pointed out in M. Keen et. al. (2007), “Except in Russia, the second wave of low-rate flat tax reforms have been associated with a reduction in revenue from the PIT: behavioral responses may have mitigated the revenue loss, but in no case has there has appeared to have been a Laffer effect: these reforms have not set off effects strong enough for them to pay for themselves. And in Russia, there is little evidence that the strong revenue performance after the reform was due to the flat tax itself: rather it appears to have reflected wider macroeconomic recovery.”14

31. Distributional aspects of a flat tax are also a concern. The introduction of flat tax systems can have serious drawbacks on income distribution. The effect can be particularly severe for middle classes, while favoring the richest income brackets.15 Thus, countries with a relatively equitable distribution of income, such as the Ukraine,16 stand to suffer the most adverse distributional effects from introducing a flat tax.17

32. Slovakia, one of the signature flat tax countries, re-introduced a progressive income tax system in 2013. Although the flat tax was one of the measures which contributed to a strong economic performance after 2004 (although difficult to impute to the flat tax specifically), low levels of tax revenues and poor level of tax compliance, among other problems, led the government to discard the flat tax. It is particularly noteworthy how revenues declined as a percentage of GDP, from 39.6 percent in 1995 to 29.6 percent in 2013.18

33. The introduction of the flat tax in Ukraine more than a decade ago served to signal a fundamental commitment to transition towards a market economy. This was probably a very relevant message in 2004, but times have changed and public policy in Ukraine today needs to emphasize its commitment to prudent fiscal management and to a more efficient and fairer tax system. A flat tax does not clearly serve this purpose now; much less if it hopes to maintain tax revenues thanks to dynamic supply side effects. FAD’s basic recommendation in its March 2015 report was to gradually reduce SSC only if a fully compensating strategy was adopted with a more progressive tax system. The mission finds no fundamental reason to believe that the flat tax option would be preferable.

Recommendation

  • Do not overstate the simplification benefits of a flat tax system; keep a progressive structure for PIT.

F. SSC rates and formal employment

Pros and cons of payroll taxes

34. Payroll taxes often represent a high and un-graduated tax wedge for low income workers. Contrary to typical PIT structures, payroll taxes, as the Ukrainian SSC, tax wages at the same rate starting form the first unit of earnings. PIT often exempts an initial low income bracket and graduates the tax burden as income increases. Thus, the PIT provides for a relatively smooth transition into tax-paying employment (aside from facilitating redistributive policies). SSC normally have the opposite pattern, imposing a proportionally high burden on lower income as the contribution is capped at some multiple of the minimum wage; the reason being that benefits are also capped and contributions are kept largely proportional to the benefits. It is generally accepted that such tax structure is a strong incentive to work in the informal sector, especially if social security benefits are not highly valued.

35. The growth of the payroll may at times lag behind nominal GDP. Real wages may grow slower during certain periods of the business cycle. For example, increasing unemployment and stagnating nominal wages led to payroll growth well below the inflation rate during the first half of 2015 (se Fig. 3).

Figure 3.
Figure 3.

Ukraine: Average Wages and Inflation

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

Sources: Ukrainian authorities; and IMF staff estimates.

36. On the other hand, payroll taxes have a wide and more stable base. SSC in Ukraine collect more than double the revenue of the PIT (11.8 percent of GDP versus 4.8 percent in 2014). This is because all wage-earners are subject to SCC, with no exemptions, loopholes, deductions or special regimes (there is no “social tax deduction” as in PIT). The payroll is also a more stable tax base than profits over the economic cycle, which is a desirable feature considering that SSC fund entitlements are thus protected from budgetary adjustments.

SSC rates and informality in OECD countries: empirical evidence

37. The correlation between SSC rates and informality is not so straightforward. Although an inverse relationship between SSC rates and formal employment stands as a general principle, empirically it is harder to verify. Fig. 4 shows little correlation between SSC rates and informality in OECD countries (correlation coefficient for sample = .25)19.

Figure 4.
Figure 4.

Social Security Contribution Rates and informality

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

38. Cutting SSC rates is not strictly associated with declining informality. About half of OECD countries between 2007 and 2012 reduced SSC rates, while the other half increase them, but—as shown in Fig. 5 and 6—both groups of countries experienced an almost equivalent reduction in informality.

Figure 5.
Figure 5.

Changes in SSC rates and informality

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

Figure 6.
Figure 6.

Change in tax wedge and informality

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

Labor regulations

39. Other factors may have a stronger impact on informality. The decision to employ formally or underground takes into account the full cost of a labor contracts, of which SSC are only a part. Inflexible labor regulations, high severance payments, collective bargaining, to cite a few examples, may be sufficiently costly to cancel the effect from a change in SSC rates.

40. Informality is a multivariate problem and relying solely on reducing SSC rates to combat it risks having little effect. 20 Ukraine may have to revise its labor regulations in order to make more decisive inroads in diminishing the underground economy. Although Ukraine follows fairly closely the pattern in the eastern European region, it is not competitive according to international standards. As shown in Table 3, rigidity in hours worked together with difficulty in redundancy are relatively high and may be an obstacle to reducing informality.

Table 3.

Comparative Labor Regulations: Rigidity in Hours/Difficulty in Redundancy

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Source: World Bank Doing Business: Labor Market Regulationhttp://www.doingbusiness.org/data/exploretopics/labor-market-regulation

Minimum payroll tax base

41. Low income earners are more prone to participate in the informal economy. Some international evidence indicates that individuals that are most likely to participate in the underground economy are students (typically part-timers), welfare recipients and low income workers,21 who transit more easily from the formal to the informal sector (and back). Imposing a relatively higher tax burden on them can make the informal sector more attractive. A higher burden can be imposed by introducing a minimum payroll base higher than actual earnings of low-income wage earners.

42. In Ukraine the SSC burden on part-timers was increased. In the March 2015 reform a minimum SSC base for part-timers was adopted equaling to one monthly minimum wage. The initiative hopes to clamp down on full-time employees who declare earnings for less than 40 hours of work per month. This may actually drive them further into the shadow economy, with an undetermined net effect on revenues.22 On the other hand, the reform does not affect unregistered payments (“brown envelopes”) of higher income individuals. Expected revenue gains from this minimum wage base on part-timers could be illusory.

Other determinants of informality

Access to financial services

43. It has been pointed out in the literature that a large and persistent informal sector is closely related to low levels of income. Often very low income individuals or businesses are formally classified in a category that has no tax obligations—although they are not illegal but rather “outsiders”.23 For example, in some countries businesses with up to five employees may have no obligation of enrolling their employees in the social security system. Any specific variable that hampers the growth of these businesses would enhance informality, while SSC rates would in fact be irrelevant. Access to financial services, for example, has a stronger empirical correlation with informality than SSC rates have, as shown in Fig. 7.

Figure 7.
Figure 7.

Financial Deeping and Informality

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

44. Tangible benefits obtained from social security are a strong incentive in favor of formal employment. Although pensions may often be the more costly benefit, health services for the contributing population may have a greater appeal, as individuals (especially young people) may place a heavy discount on pension benefits. For example, a recent study in Uruguay showed that extending health benefits to dependent children of private sector salaried workers had a significant effect on informality rates.24

Some administration issues

45. Complex administrative procedures can go a long way in explaining informality. The challenges with SSC are quite unique in that they involve more than one authority. In Ukraine the SFS is responsible for collecting SSC, but not for enforcing all other rules concerning compliance with social security regulations. This requires non-trivial inter-institutional coordination and well-defined division of responsibilities.

46. There are limitations to enforcement. Employers have the obligation to register their employees and a registration card needs to be issued to the employee (procedure now temporarily suspended), registration records must be kept at a central office which may be a different place than that where workers perform their job. Thus, an onsite inspection may find that no worker has a registration card, no records held either, but this in itself would not constitute a violation of any labor regulation. In fact, it is only since January 2015 that registration of employees is required before they start work.

47. The cash problem. Unreported wages cannot be deducted for CIT purposes, so avoiding SSC poses a problem for employers who do not have large earnings in cash which they can keep unregistered. Thus, employers need to present false invoices to make up for the wage bill paid in cash. The most likely supplier of such invoices (at a price) is a business that is rich in cash from non-legal origins and that needs to launder its earnings. However, the SFS has limited powers to investigate the financial transactions of this type of companies because of very strict bank secrecy laws. The SFS can obtain bank statements only with a court order and the information so obtained is restricted generally to general account balances. A decisive push against an expanding informal sector would require softening bank secrecy laws, for example, requiring only the intermediation of the central bank to obtain the information. To the extent that Ukraine signs on to ongoing international efforts to expand bilateral and multilateral exchange of information for tax purposes, it will also have to ensure that it has access to such information—including bank account information—for the purpose of sharing it with partner countries.

Recommendations

  • Keep SSC as a separate payroll tax.

  • Develop a comprehensive, inter-institutional strategy to combat informality.

  • Do not increase presumptive taxation on low income earners

  • Relax bank secrecy regulations for tax purposes

  • Continue to seek technical assistance on tax administration related to SSC

G. The social security regime for the self-employed

48. The social security regime for the self-employed represents a serious flaw in the system. Informality is not the only way employers can avoid SSC payments. Hiring workers as if they were self-employed is another way, with the advantage of legal coverage. The key problem lies with individuals who have their own business (sole proprietors) who are excluded from PIT under the Single Tax (ST) regime, which provides for a minimal SSC. Table 4 below shows the SSC rates for different types of business establishments.

Table 4.

Ukraine: Social Security Contribution Rates

article image

Depending on the class of professional hazard

If monthly income is less than one minimum wage the base of SSC is one MW.

49. The general principle is that for sole proprietors profits are the SSC base. There are two types of self-employed individuals who are employed under civil law contracts: service providers and individual entrepreneurs or sole proprietors. Service providers are treated for tax purposes as employees; those who contract them withhold under general PIT and SSC rules and rates.25 SSC is due on their profits, subject to a minimum. Sole proprietors are treated differently, and the specific rules depend on whether they are registered for ST for tax purposes. If they pay PIT under the general regime, the only condition is that the payments must not be less than one minimum wage per quarter, even when they show losses (if they have no income then there is no SSC obligation). Whether the correct amount was paid is left to SFS audit and enforcement.

50. Sole proprietors who register under the simplified (ST) regime enjoy a privileged regime. Specifically, they contribute at the rate of 34.7 percent of one MW, regardless of the income earned. A higher payment would be entirely voluntary and presumably motivated by greater social security benefits. The generalized perception is that hardly anybody does so. The minimum quota applies even if no income is earned. This regime is cheaper for anyone earning more than a minimum wage. Evidently, the incentive is to hire workers as sole proprietors under the ST regime. Private sector representatives admit that this is a common practice.

51. Sole proprietors may be salaried employees for all practical purposes, except for their formal contract with their employers. However, the Labor Code does not have a sufficiently clear definition of what constitutes an employee, so that workers can be classified as sole proprietors even if they work under similar conditions and circumstances as regular employees.26 Nor is it clear that the inspectors of the Ministry of Social Policy have the authority to re-characterize contracts into labor contracts to trigger a collection procedure for SSC past due.

52. The current preferential SSC rate for sole proprietors results in unequal treatment of similar labor services and results in revenue loss for the budget. The revenue loss of reduced SSC payments by sole proprietors may be as high as UAH 3.85 billion (0.25 percent of GDP) in 2014. This revenue estimate is based on Group 2 and 3 sole proprietors who are under the ST regime. There are 905,195 sole proprietors in these two groups accounting for 80 percent of the population of individuals in the ST regime. Requiring them to pay SSC similar to other labor providers would enable equal treatment of similar service and improve the revenues of the social security system. It is unknown how many of these sole proprietors are legitimate entrepreneurs who under the general system would still have the opportunity to pay based on one MSW per month. We assume conservatively one half of the taxpayers in this group would continue to pay on the basis on one MSW. The ST regime—including its revenue implications—are discussed in detail in Chapter III below.

Recommendations

  • Eliminate preferential SSC treatment for sole proprietors under the ST regime.

  • Legally define the concept of employee to include those formally under contract as sole proprietors but de facto working under the same conditions as employees and make these liable to general SSC rates.

H. Revenue effects of proposed SSC reforms

Revenue effects of reducing the SSC contribution rate

53. This section provides estimates of the amendments to the SSC and some alternative scenarios. Table 5 shows the current distribution of wages and salaries of the employed population and their incomes and SSC payments for 2014. The current average SSC rate is 41 percent and contributions are capped at 17 MSW. Out of 13.87 million taxpayers 87 percent earn less than UAH 5,000 per month. Those earning less than UAH 5,000 pay 61 percent of the SSC.

Table 5.

Ukraine: Distribution of Income and SSC Payments, 2014

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Source: State Fiscal Services of Ukraine IMF FAD staff calculations.

54. SSC rates were reduced by 60 percent in 2015, subject to conditions, and will be reduced unconditionally to 40 percent of the old rate in 2016. Although the MoF has some partial data on taxpayers applying the beneficial SSC rate for the first half of 2105, it is not possible to establish employers’ actual response in formalizing their payroll. It is therefore difficult to estimate the net aggregate revenue effect of the reduction in SSC for the whole year. The consequences of SSC reform in 2016 is easy to estimate, as there is no conditionality on reducing rates: next year losses in SSC revenues (using 2014 figures) would be UAH 70.8 billion (4.5 percent of GDP), as shown in Table 6.27

Table 6.

Ukraine: Revenue Impact of Changes to the SSC Rates, 2014

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55. Reducing SSC lowers deductible labor cost for employers. This in turn would increase taxable profits and thus mitigate to some extent the fall in payroll taxes. If this effect was entirely translated in higher CPT, the negative impact of SSC cuts for 2016 could be reduced to 3.9 percent of GDP, still a very significant impact to public finances. However, this offsets is unlikely to materialize fully because of large Advance Corporate Tax refund arrears and corporate loss-carry forwards.

56. The need for compensating tax revenues could be reduced with alternative rate reduction scenarios. Table 6 indicates revenue losses and fiscal compensation required at more moderate levels of SSC rate cuts (to 30 or 28 percent) and raising the cap to 25 MSW. Financing requirement in these cases would respectively be 2.9 percent and 3.5 percent of GDP.28 Introducing a second SSC rate at 5 percent on individuals earning over UAH 30,000 per month generates an additional but small amount of additional SSC revenue.

Revenue effects of merging the SSC and PIT system into a flat PIT

57. A proposal combining the SSC with the PIT is under consideration at the Task Force for Tax Reform. The key features of the proposal are: (1) replacement of the SSC, Military Tax and the PIT by a flat 29 percent PIT rate; (2) gross up of the wage bill by the amount of SSC and the Military Tax. The re-arrangement of the tax basis with the new rate would cost initially UAH 75.2 billion in tax revenues29 (see Table 7). Supporters of this plan propose mitigating this initial impact by substantially increasing the tax burden on taxpayers that benefit today from the ST regime for small taxpayers, decreasing net wages of public employees and with an estimated increase in revenues from formalizing the underground economy.

Table 7.

Ukraine: Revenue Effect of Merging the SSC and the PIT Systems with a Single PIT

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58. The proposal would also tax at a much higher rate the income of persons benefiting from the ST. The plan would impose a 20 percent rate on gross income across the board to taxpayers in Groups 2 and 3, both to legal persons and individuals. According to MoF calculations (and roughly confirmed by the mission with SFS data) this would generate close to UAH 22 billion, reducing the short-fall from UAH75.2 to UAH53.1 billion (3.4 percent of GDP) (see Table 7).

59. As proposed, taxation of small taxpayers would still be a distinct regime. It would be a different regime than the CPT and the PIT, since individuals earning a salary would not have the benefit of the ‘social tax deduction’ or the lower 15 percent marginal PIT rate, and sole entrepreneurs and legal persons would not be allowed to deduct expenses. Under these assumptions the initial effect of combining the three taxes into a single flat 29 percent tax would be mitigated to a net UAH 53.1 billion revenue loss (Table 7).

60. Increased revenues from taxing ST taxpayers may be overestimated, however. A 20 percent tax rate on turnover compares unfavorably to CPT (18 percent on net income), so it could be expected that these taxpayers would switch over. Legitimate individual sole proprietors could also deduct their expenses in the regular PIT regime and pay a lower rate too if their income is under than 10 MW, which is the case with over 60 percent of the individual taxpayers in Groups 2 and 3of the ST regime. Also, the increase in the tax burden on this group of individuals may lead many into the informal sector, eroding even further the gain in tax base assumed in the proposal.

61. The proposal changes the distribution of the current combined tax burden of SSC and PIT. Taxing a gross-up wage at 29 percent flat tax would have a progressive effect on the present system, which relies on high SSC rates on low income individuals. The new rate, as proposed, would increase the tax burden of high-income individuals who would no longer be protected by the cap on SSC. The opposite would occur with the lower income individuals, as they would be relieved of the full weight of SSC. As shown in Table 8, the breakpoint is UAH 50,000 per month. Individuals earning above this income level would stay in the old system. This alone represents an under-estimation of the proposal’s effect on the public deficit of about UAH 0.5 billion. The progressivity of the proposal is also lost so long the new system is optional.

Table 8.

Ukraine: Distributional Impact of a flat 29 percent PIT Rate, 2014

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Source: IMF FAD staff calculations.

62. The revenue shortfall would be remedied by government payroll savings and attracting people to the formal sector. A key feature of the proposal is that it envisages very significant savings in net government expenditure. Savings would come from a drastic reduction in the net payment to all public employees because government employees would not get their wages grossed up with the elimination of SSC, but they would still have to pay a 29 percent PIT rate. For them the PIT tax burden almost doubles, with no increase in wages. The rest of the change in tax bases is a wash for the government. Of course, the new system would have to be compulsory for them in order to obtain such savings. The mission cannot estimate how much tax revenues could increase from a shift of informal activities into a legal sector with a lesser tax burden. It was argued above that empirical evidence in this regard is mixed and results quite uncertain.

I. Other tax measures to compensate SSC reform

63. Reductions of the SSC rate within the existing tax structure could be explored. Previous FAD tax policy reports have suggested that a gradual reduction in SSC rate can be a way forward if reliable revenue sources can be found to compensate for it. The tax system would be less stressed if compensation would be limited, at least initially, to a reduction of SSC rates to 30 or 28 percent while increasing the cap significantly, for example to 25 MSW. Combining a SSC rate cut to 28 percent with such a cap would result in a revenue shortage of 3.5 percent of GDP, assuming no CPT offset due to lower SSC deduction by employers.

64. There could be sufficient fiscal space in indirect taxation and other components of the income tax to allow for a reduction in SSC rates. However, reforming the ST regime in particular has to be an integral part of this change in order to stop the erosion of the system though the self-employed. This is discussed in detail in Chapter III. Below we discuss different scenarios that may be considered to produce a revenue neutral tax package including a reduction in SSC rates.

VAT measures

65. The first choice for financing the revenue shortfall in SSC rate reduction by indirect taxation. These are the least distorting and more growth friendly taxes.30 Increasing the general VAT rate by one percentage point, for example, would generate about UAH 7 billion (0.4 percent of GDP). Increasing the preferential rate applied to pharmaceuticals (currently 7 percent) to the new general rate of 21 percent (comparable to neighboring countries) would increase revenues by about UAH 20.1 billion (1.3 percent of GDP).31 Additionally, if the government succeeds in eliminating the special VAT regime for the agriculture industry, a conservative estimate is that an additional 0.3 percent of GDP can be collected.32 Thus, VAT alone could provide a fiscal space of close to 2 percent of GDP.

Excise tax rate increases

66. Other than the excise on petroleum products, excise rates are relatively low. Detailed recommendations on increasing the excise revenues are described in Chapter IV. Therefore, these measures are not discussed here. Based on the recommendations in Chapter IV it is possible to increase tax revenues by 0.6 percent of GDP in 2016 (see Table 22 in Chapter IV).

Income taxes

Introduce a new PIT rate and bracket structure

67. There is less room to increase revenues from income taxes. Introducing a third bracket and a new marginal rate would improve the progressivity of the PIT system and raise some additional revenue. For example, a 25 percent rate applied to an income bracket above UAH 15,000, estimating only on the basis of wage income, would generate tax revenues around UAH 3.5 billion, or 0.2 percent of GDP (Table 9). However, the estimate is based on wage income only, which is more concentrated in the lower income brackets.33

Table 9.

Ukraine: Revenue Impact of a Change in PIT Structure, 2014

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Source: SFS of Ukraine data IMF FAD staff estimations.

68. Additional revenues can be expected from including the de facto employees into the PIT who are now in the ST regime as sole proprietors. It is difficult to estimate this effect because it is not known how many individuals in this group are in fact employees. In the extreme, where all individuals under this regime are considered employees, the 2014 income that would be shifted into PIT would amount to UAH 225.5 billion. At the average effective PIT rate of 13.4 percent this would yield an increase of UAH 32.6 billion in revenues. A more prudent estimate would assume no more than one half of that amount. This is a potential buffer to a SSC tax reform, but is intentionally not included in the set of possible compensating measures listed in Table 10.

Table 10.

Ukraine: Summary Revenue Effects of Tax Measures

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Source: IMF FAD staff calculations.

CPT measures

69. Revenue yield of CPT in Ukraine has been declining. This is discussed in Chapter V, which recommends a number of measures to tighten up the base of the tax. If these measures accompany an increase in the tax rate from 18 percent to 20 percent, revenues could be increased by around 0.3 percent of GDP. Moreover, to the extent that there are companies with no tax arrears or losses to carry forward, as explained before, SSC reduction will increase CPT revenues. However, this effect is not estimated.

Property taxes

70. The March 2015 FAD tax policy report demonstrated that there is scope to increase property taxation.34 This includes reducing exemptions in residential properties and motor vehicles. A circulation tax on luxury cars was introduced in 2014 at a rate UAH 25,000 per year, but it is applied to a small promotion of luxury cars. This can expand in line to what was recommended in that report.

Summary of measures

71. A summary tax revenue enhancing measures are provided in Table 10. The estimates are intended to provide possible revenue options in indirect taxes and profits taxation in order to compensate for the revenue losses from reducing the SSC. These estimates do not include revenues from rolling back the informal economy, from decreasing the net wages of the public sector or from incorporating individuals and legal persons from the ST regime to income tax regime. This shows that there is room for lowering SSC without taking unnecessary risks for the budget. The preferred menu of measures would emphasize indirect and property taxation.

Recommendations

  • Do not reduce SSC rate below 28 percent and increase the cap to 25 MSW.

  • Compensate reduction in SSC with a combination of the following measures:

    • Increase the VAT rate from 20 percent to 21 percent.

    • Eliminate the preferential VAT rate on pharmaceuticals.

    • Eliminate special regime for agriculture.

    • Increase excise tax rates as recommended in Chapter IV.

    • Increase the CPT rate from 18 percent to 20 percent.

    • Introduce a third PIT rate of 25 percent on incomes over UAH 15,000.

    • Eliminate concessional features of the ST regime as described in Chapter III.

III. Simplified Taxation regimes for small taxpayers

General design objectives of a simplified tax system

72. Most countries have special income tax and VAT schemes for small taxpayers. These schemes have two main—but related—objectives: (i) to reduce the cost of compliance for small taxpayers,35 and (ii) to allow tax authorities to concentrate on monitoring large and medium size enterprises. Small businesses are very heterogeneous across countries, so it is impossible to identify a single best practice model regime for all cases. Heterogeneity also exists within the same country, ranging from the subsistence economy, artisans and vendors, to small companies. Defining the ceiling below which entities are deemed ‘small’ for the purpose of these schemes varies, but generally it is a modest amount of turnover—which is generally considered to be the easiest proxy for size and/or capacity to comply with the tax system.

73. The objective of a simplified tax system is simplification, not to reduce the tax burden of small taxpayers.36 If taxpayers in the simplified tax system enjoy a substantially lower tax burden than those in the general tax regime, small taxpayers are not encouraged to transit to the general system. A lower tax burden also confers a competitive advantage compared to those businesses operating above the threshold. This can have very distortive effects, as taxpayers will have an incentive to manipulate their affairs to qualify for the lower tax burden, including by splitting up into several businesses that are ultimately controlled by the same person. Furthermore, the transition to the general system should be as smooth as possible so as not to involve steep increases in the total tax burden. Finally, a simplified tax system also facilitates voluntary compliance and could therefore help to reduce informality, but it is not the only tool to do so.

74. Simplified systems should only apply to genuinely small taxpayers. The aim of these systems is to facilitate compliance of small businesses that lack the capacity to comply with all administrative and bookkeeping requirements that are mandatory for larger taxpayers. For this reason, most countries exclude from the simplified system legal entities, companies with more than a certain limited number—say five—employees, and entities engaged in certain activities such as financial intermediation, international trade (exporters and/or importers), or the production or provision of excisable goods or services. It may reasonably be presumed that such businesses are capable of keeping proper tax records and apply the general tax system.

75. A key consideration when designing a simplified system is to set a reasonable threshold. Three effects should be considered when setting the VAT registration threshold:37 increasing the VAT threshold (i) reduces administrative and compliance costs (effect 1), (ii) reduces tax collection (effect 2), and (iii) may affect efficiency to the extent that those outside the VAT net are conferred a tax benefit (effect 3). Thus, while a relatively high VAT threshold that leaves too many taxpayers outside the VAT system may facilitate control, it may come at a high cost in revenue and efficiency. On the other hand, a very low threshold might be efficient but will be very difficult to control in practice and impose an undue burden on the smallest businesses. The considerations for setting an appropriate ceiling for a simplified tax system are similar in these respects to those for setting the VAT threshold. Therefore—and also because this further simplifies the tax system as a whole—there are good arguments for setting the upper ceiling for the application of the simplified tax system at the same turnover level as the VAT threshold.

Current situation

76. Ukraine has effectively four different simplified tax regimes. Collectively these regimes are referred to as the Single Tax (“ST”).38 This terminology is somewhat misleading because between, and sometimes within, each of these regimes or “Groups” the applicable tax rates and bases vary, depending on the circumstances specific to the regime in question. The remainder of this section focuses on Groups 1 through 3. Group 4 consists of the farmers qualifying for a flat rate of tax based on land area—the former Fixed Agricultural Tax (FAT), which was discussed in detail in a previous FAD report.39

77. About 1.3 million taxpayers are currently registered for ST of which 1.14 million are individuals. The distribution of ST taxpayers and their tax liabilities are shown in Table 11. With more than 631,000 individuals Group 2 is by far the largest, followed by Group 3 (more than 274,000 individuals and almost 161,800 legal entities) and Group 1 (more than 234,200 individuals).

Table 11.

Ukraine: The ST Regime Taxpayers’ Income and Taxes, 2014

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Source: STS of Ukraine and IMF FAD calculations.

Features of ST system common to all groups

78. The ST regime has a range of common features common to all (or most) groups. These include that ST taxpayers:

  • May choose either for the normal (PIT, CPT, and in some cases VAT) tax regime or for the ST regime, and within the ST regime if they meet the criteria for more than one group they may choose for which Group to register (Article 291.3 TC);

  • Are excluded from engaging in specified activities, including gambling and lotteries; foreign exchange; manufacture and dealing in excisable goods; manufacture and dealing in precious metals and stones (except jewelry and household items); activities in the area of mineral resources; financial intermediation (except insurance agency) and other financial and insurance services; company management services; technical testing, analysis and auditing services; leasing of real estate (land, accommodation and non-residential property) (Article 295.1 TC);

  • May keep the following simplified books and accounts:

    • Sales registers for taxpayers of Groups 1 and 2, and individuals who are not VAT taxpayers of Group 3;

    • Income and expense statements for individual taxpayers of Group 3 who are VAT taxpayers; and

    • Simplified double-entry accounts for all legal persons of Group 3 (Articles 44.2 and 296.1 TC);

  • Generally have longer reporting (yearly reporting for Groups 1, 2 and 4 and quarterly for Group 3) and payment cycles (monthly for Groups 1 and 2 and quarterly for Groups 3 and 4) than taxpayers under the normal tax regime (Articles 294 and 295 TC);

  • Only pay 34.7% SSC on the MSW except for legal entities of Group 3;40 and

  • Are exempt from CPT, PIT, VAT (except for Group 3 taxpayers who choose to pay the lower 2% ST rate; see below), property tax and rental fee for water usage (Group 4 taxpayers) (Article 297.1 TC).

Group 1 (more than 234,200 individuals)

79. Group 1 is for individual entrepreneurs with turnover of not more than UAH 300,000. Entrepreneurs in this Group are not allowed to hire employees and must be engaged exclusively in retail trade, i.e. selling goods on market places or providing consumer services (Article 291.4, item (1) TC; A non-exhaustive list of consumer services is in Article 291.7). They are subject to a fixed rate of tax of up to 10% of the MSW for the income year (Article 293.2, item (1)).41

Group 2 (more than 631,000 individuals)

80. Group 2 is for individual entrepreneurs with turnover of not more than UAH 1,500,000 and not more than 10 employees. Entrepreneurs in this Group may provide consumer services as well as services to other ST taxpayers, be engaged in the production and/or sale of goods, and provide restaurant services (Article 291.4, item (2) TC). They are subject to a fixed rate of tax of up to 20% of the MSW for the income year (Article 293.2, item (2) TC).42

Group 3 (more than 435,800 of which more than 274,000 individuals)

81. Group 3 is for individual entrepreneurs or legal entities with turnover of not more than UAH 20 million. There is no limit to the number of employees that entrepreneurs or entities in this Group may hire, nor to the type of activities that they may carry out (other than the activities generally excluded from the ST regime; see above) (Article 291.4, item (3) TC). Taxpayers in Group 3 pay a proportionate tax rate of either 2% or 4% on their turnover, depending on whether or not they are registered for and pay VAT (Article 293.3 TC).

Analysis

The current regime remains overly complex and excessively concessional

82. While the December 2014 tax reform reduced the number of ST groups from six to four, this reform amounted to simplification in name only. First, rate and base variations remain between and within groups of ST taxpayers. Secondly, the aggregate number of ST taxpayers has remained constant,43 albeit that they are now classified into four instead of six groups—with former Groups 3, 4, 5 and 6 taxpayers now classified in the new Group 3, broadened to include both individuals and legal entities. Thirdly, the criteria for a taxpayer to qualify for a ST regime continue to be—depending on the circumstances—a combination of the taxpayer’s legal status, turnover, number of employees, and type of activities. Finally, the same taxpayer may meet the criteria for more than one ST regime, allowing it to opt for the most favorable regime on the basis of its particular circumstances.

83. In addition to remaining overly complex, the ST regime is excessively concessional. Group 1 and 2 taxpayers—whose income or turnover may be as high as UAH 1.5 million—only pay a minimal flat rate of tax and SSC unrelated to their turnover or income. Group 3 taxpayers—whose income or turnover may be as high as UAH 20 million—also pay low—albeit proportionate—rates of tax, and individuals in that Group enjoy a flat rate of SSC. Consequently, as shown in Table 11, effective ST tax rates for both individuals and legal entities are extremely low. For instance, based on 2014 figures, individual taxpayers of Group 2 enjoy an effective tax rate that is thirteen times lower than the average PIT rate.

84. The ST regime offers ample opportunities for tax planning and arbitrage. Not only is the ST in and of itself an overly generous tax regime, in particular at the higher end of the income/turnover bands, the regime also offers ample opportunities for taxpayers to abuse the system even further. While taxpayers undoubtedly use many other mechanisms and schemes to exploit the ST, the most obvious ones include:

  • Business splitting. While this is a common problem for all turnover-based tax concessions—including for the VAT threshold—the incentives for business splitting to enjoy ST tax concessions are particularly important. This is because ST replaces, in most cases, both CPT/PIT (depending on legal status of the person) and VAT, and allows entrepreneurs to pay a nominal amount of SSC. The SFS currently has no specific powers under the Tax Code to combat this type of avoidance which, at least from anecdotal evidence, is pervasive. The only existing limit is on direct ownership of ST payers by legal entities which are not themselves ST payers,44 but there is no such limit on ownership by individuals nor are there any rules on aggregating activities of closely related individuals (spouses, family members). The main purpose of business splitting is to avoid exceeding the income or turnover limits of a particular ST group. It can also be used to subdivide activities within one business in order to maximize the tax advantage. For instance, it is not uncommon for restaurants—which, depending on turnover, qualify for Group 2 to pay a flat rate of tax—to split off the business of selling alcoholic beverages, an activity that is excluded from the ST and for which standard PIT (or, in the case of a Group 3 legal entity, CPT) rates apply. Restaurant clients are then given two receipts, one for their meal and one for the alcoholic drinks, formally issued by two different but obviously related entities.

  • Profit shifting between related parties. Ukraine’s newly adopted transfer pricing rules do not apply to transactions between resident entities or persons.45 In combination with the business splitting opportunities described above this situation creates opportunities for related parties—one subject to the general tax system and the other to the ST—to engage in transactions designed to shift income from the latter to the former. In the absence of specific or general anti-avoidance rules in the Tax Code these practices are difficult if not impossible to combat effectively.

  • Reclassifying as entrepreneurs. Given the important difference between effective SSC rates for employees (or persons providing services under civil law contracts) versus individuals performing services as entrepreneur under a ST regime—for whom the SSC is calculated on the MSW opposed to actual wages—there is an important incentive for employees to organize themselves as ST entrepreneurs of Group 2 or 3 (depending on income/turnover and the legal status of their ‘employer’/client). Anecdotal evidence suggests that this is a pervasive practice especially in high-paying service sectors. In the IT sector, for instance, approximately 75,000 engineers are now working as independent contractors—representing salaries of UAH 150 million per month or UAH 1.8 billion per year—according to sector representatives.

  • Circumventing other classification provisions. As mentioned above, the Tax Code provisions that define the criteria to qualify for—or be excluded from—the ST regime are often complex and imprecise, resulting in opportunities for arbitrage. Just one example out of many: leasing of real property is an excluded activity, but only if the activity is carried out by individuals. Hence, it is sufficient for a taxpayer to incorporate to enjoy a 2 or 4 percent tax on up to UAH 20 million of leasing income, instead of paying standard CPT/PIT rates.

Design considerations for reforming the STS

85. ST reform should be informed by the objectives of a properly designed small business tax regime. To avoid many of the problems that the tax system is facing today with taxpayers rearranging their affairs to take advantage of the overly generous ST system, the focus should be on simplification rather than on tax incentives. As explained above, the case for simplification—and perhaps some tax concessions—is greatest for the smallest taxpayers (“micro businesses”). Beyond this group there may still be a case for simplification but—importantly—not for significant tax benefits. Furthermore, the simplified tax system for this second group should be as closely aligned as possible with the normal tax regime so as to ensure a smooth transition to the normal regime.

86. Partitioning taxpayers into different regimes is best done on the basis of turnover or gross income alone. While not without its shortcomings,46 on balance, turnover or gross profit is the easiest and most straightforward basis for vertically classifying taxpayers into different regimes. It also allows to align the small business regime with the VAT regime. On the other hand, number of employees as a criterion should be avoided, as this may create adverse incentives towards informality or to reclassify employees as independent entrepreneurs.47

87. VAT taxpayers should no longer qualify for the reformed simplified regime. The main argument for this is that VAT taxpayers—because of their bookkeeping and filing requirements for VAT—can be presumed to have sufficient capacity to deal with the normal tax system.48 Of course, this presupposes that the VAT threshold is set at an appropriate level. The existing VAT threshold of UAH 1 million (approximately USD 47,500)—raised from UAH 300,000 (approximately USD 14,200) in January 2015—is broadly in line with that of many countries, slightly below the average for selected developed countries but higher than the average for selected emerging economies (see Table 12). In addition to adjusting it for inflation, and considering the tax increases stemming from the proposed imposition of normal PIT and SSC rates on entrepreneurs above the threshold for the smallest taxpayers, consideration could be given to raising the VAT threshold somewhat further, say to UAH 2 million.49 This would allow the vast majority of current Group 2 and 3 ST taxpayers—more than 99% of Group 2 and more than 95% of Group 3 taxpayers—to remain outside the VAT system50 (see Table 14).

Table 12.

VAT registration thresholds (selected countries)

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Source: Prepared by staff with data from WEO and IBFD.
Table 13.

Comparison between normal GAAP and proposed cash flow taxation

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Source: Adapted from UK Office of Tax Simplification, 2012.
Table 14.

Ukraine: Revenue Estimates of Moving Individuals from Single Tax Regime to PIT, 2014

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Source: SFS data and IMF FAD staff estimations.

88. Similarly, legal entities should be excluded from the reformed simplified regime. The most common practice is for countries not to extend their simplified tax regime to legal entities.51 The rationale for relieving taxpayers from disproportionate compliance burdens—particularly bookkeeping requirements—usually does not apply to legal entities which are typically required to keep double-entry accounts under general company and accounting law, as is the case in Ukraine. Finally, excluding legal entities streamlines the simplified regime as no special rules are needed to deal with specific issues for legal entities (e.g. with respect to mergers, acquisitions and dividend distributions).

89. Except for the smallest taxpayers normal SSC rates should apply to entrepreneurs and their employees. A major incentive of the current ST regime is to avoid proportional SSC rates by reclassifying as individual entrepreneur. To eliminate this incentive individual entrepreneurs qualifying for the reformed simplified regime should be subject to normal proportional SSC on their business income, and should be required to withhold SSC and PIT at the normal rates on wages paid to their employees. Micro businesses (current Group 1) could continue to be subject to nominal SSC in lieu of the proportionate rate, in which case it would be advisable to continue to prohibit them from hiring employees.

90. But for a narrow list of excluded activities, taxpayers in the reformed simplified regime should be allowed to engage in any economic activity. In a simplified regime redesigned along the lines described here there is no reason to define the economic activities qualifying taxpayers are allowed to engage in too narrowly. In particular, taxpayers in the reformed simplified regime should be allowed to deal with all customers irrespective of their legal and tax status. While it might make sense to continue to exclude certain activities from the reformed simplified regimes, these exclusions should be limited, well-defined and only apply to activities which are already subject to special (tax or non-tax) rules such as financial intermediation, lottery and gambling, mineral resource extraction and manufacturing of excisable goods.52 Reducing such limitations and restrictions would simplify the regime and reduce opportunities for arbitrage and potential disputes between taxpayers and the tax service. For micro businesses (current Group 1) the existing limitations should be maintained given the concessional nature of their tax and SSC treatment.

91. Imposing PIT on entrepreneurs of Groups 2 and 3 on a cash flow basis is superior to a flat tax on turnover. The advantage of taxing on a cash flow basis is that businesses can immediately deduct capital expenses. Pure investments—both income and expenses—would not be taken into account. This means that, as is the case under the current ST regime, interest and dividend income would be subject to normal withholding tax, while financial expenses such as interest would not be deductible. Similarly, it would be advisable to exclude deductions for real property to further simplify the system and prevent abuse—see Table 13. Another advantage of taxing entrepreneurs at regular PIT rates on a cash basis is that it more closely approximates their tax burden under the regular system. It thus allows for a smoother transition to the normal regime and reduces the tax (and SSC) incentive for taxpayers to ‘hide’ in the simplified regime. Finally, it requires only moderate sophistication in record keeping—sales and purchase records should suffice—which would not be a disproportionate burden for current Group 2 and 3 taxpayers.

Revenue implications

92. Reforming the ST system along these lines could raise significant additional income tax revenue. In addition, it would establish horizontal equity between employees and entrepreneurs in terms of their tax burdens. Imposing general PIT rates on individual taxpayers of Groups 2 and 3 has a revenue potential of UAH 32.6 billion (2.3 percent of GDP – see Table 14).53 Given that under the proposed regime entrepreneurs will be allowed to deduct their business expenses on a cash flow basis, the revenue gain will be less than this amount.54 Assuming that half of the affected taxpayer population (Groups 2 and 3) is or could convert into a legitimate independent entrepreneur and could obtain a 50 percent profit margin55, the expected revenue gain would be UAH 24.3 billion (1.6 percent of GDP). However, critically, those affected with a higher tax burden (Groups 2 and 3) could move into the informal economy. If they behave just as the average does, anywhere between 30 and 50 percent of income would be informal and remain untaxed. Potential revenues, more realistically viewed, could range therefore more likely between UAH12 and 17 billion. It is assumed, conservatively, that legal persons moved into the general regime would not pay more taxes as they do now.

93. In addition to paying general PIT rates Group 2 and 3 entrepreneurs would also pay regular SSC. Currently these taxpayers pay a flat SSC of UAH 422.6 per month. Under the proposed regime in Chapter II of this Report their aggregate SSC payments would increase from UAH 5 billion to UAH 55 billion—an increase representing 3.2 percent of GDP. As shown in Table 15, most of the additional SSC revenue would be generated from taxpayers with an annual turnover or gross income under UAH 1 million. However, this is not a realistic expectation: not all individuals in these groups are employees and many will move fully or partially into the informal economy, or may seek to reclassify under Group 1, as there is a considerable overlap in income levels between groups.56 Applying the same assumptions used in the estimation of PIT revenue gains of ST taxpayers, i.e., one half remain as entrepreneurs with a 50 percent profitability rate, the potential SSC that could be raised from individuals currently under Groups 2 and 3 of the Single Tax regime, would be between UAH 18.7 and 26.3 billion (1.2 to 1.7percent of GDP). And these amounts may prove difficult to collect due to administrative difficulties in taxing this segment of the population.

Table 15.

Estimated Social Security Contributions of Single Tax Groups 2 and 3 Taxpayers, 2014

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Source: SFS data and IMF FAD staff estimations.

94. Incorporated business currently in Group 3 would be excluded from the simplified system and pay normal CPT. The revenue effect of this change would be negligible. Because under the ST regime their effective tax rate is higher than the effective tax rate of taxpayers paying under the CPT system.

Revenue administration considerations

95. The design and management of a simplified tax system should not be directed exclusively by current deficiencies in tax administration. There is general consensus that both the current design of the ST and the lack of administrative control57 over its application have been largely driven by mutual distrust between taxpayers and the SFS. Concerns of taxpayer harassment and corruption are widely reported and acknowledged by all stakeholders. It is imperative that this vicious cycle between poor design and poor administration is broken, as the current situation—characterized by huge horizontal inequities, distortions and perverse tax incentives—is unsustainable. Hence, without wanting to downplay the tax administration challenges, any sustainable reform of the ST and SSC—and indeed the tax system more generally—must be premised on the expectation that, at least gradually, the quality of tax administration will improve and mutual trust between taxpayers and tax authorities is restored to a level that is required for a normal tax system to operate. Concretely, this means that moratoria on audits must be phased out and should not be reintroduced.

Recommendations

  • Keep the ST regime for individual entrepreneurs of Group 1 unchanged, and replace the ST regime for individual entrepreneurs of Groups 2 and 3 by a simplified tax system imposing normal PIT rates based on cash flow.

  • Allow entrepreneurs in the reformed simplified tax system for Groups 2 and 3 to engage in any type of economic activity (except for a narrowly defined list of excluded activities) and to employ an unlimited number of employees.

  • Impose proportionate SSC at normal rates on all entrepreneurs in the simplified tax system, including on their employees.

  • Exclude all VAT taxpayers—including those who are voluntarily registered for VAT—from the simplified regime.

  • Exclude all legal entities from the simplified regime.

  • Consider raising the VAT registration threshold to up to UAH 2 million.

  • Remove—or at least do not extend or reintroduce—moratoria on tax audits, including of taxpayers under a simplified regime

IV. Excise taxation

A. Room for increasing rates

96. Excise taxes have become an important source of budgetary revenue over the last few years but remain low by international standards. Revenue from excise taxes accounted for almost 3 percent of GDP in 2014 or 8 percent of total tax revenue (Table 16). This revenue has about doubled in real terms from 2008. While before 2014 the share of domestic excise taxes accounted for about ¾ of the total excise tax revenue, in 2014 it dropped to about 60 percent. This was largely due to exchange rate deprecation, which inflated the customs value of imported goods. Despite its increase in recent years, the revenue from excise taxes is one of the lowest in the region (Figure 8).

Table 16.

General Government Revenue from Excise Taxes, 2008-2015

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Estimate.

Source: Ukrainian authorities; and IMF staff estimates.
Figure 8.
Figure 8.

Excise Tax Revenue in Central and Eastern Europe and CIS

(in percent of GDP)

Citation: IMF Staff Country Reports 2016, 025; 10.5089/9781498315906.002.A001

Source: IMF country reports.

97. Domestic tobacco accounts for the lion’s share of excise tax revenue. Excise taxes are levied on tobacco, alcohol beverages, petroleum products, motor vehicles and electricity.58 All rates are specific with the exception of tobacco and electricity. Tobacco has a specific and an ad valorem component while excise on electricity is ad valorem. Except for petroleum products and motor vehicles, all excise tax rates are set in hryvnia. Domestically produced tobacco contributes almost 40 percent of the total excise tax revenue. It is followed by gasoline and other oil products, both accounting for about another one third of the total excise tax revenue.

98. There are also excises on motor vehicles which vary by size of engine and age. Ukraine appropriately taxes more heavily older and bigger motor vehicles. Considering the number of taxes on vehicles and the recommendation made in the March 2105 FAD report on circulation taxes for luxury cars, this report does not discuss excises on motor vehicles and endorses the relevant recommendations of the previous report.

99. In response to budgetary pressures, the government introduced a number of changes in excise taxation during the last 18 months. In March 2014 specific excise tax rates were raised on tobacco by 33 percent, on beer by 40 percent and on ethyl spirits by 25 percent. In addition, the government unified excise rates on diesel fuel and increased the maximum rate by more than 30 percent. Additionally, the December 2014 tax reform: (i) increased proportionally the taxation of petroleum products substituting for an environmental tax; (ii) introduced electricity as an excisable commodity following the elimination of the earmarked surcharge to the existing tariff; (iii) unified excise tax rates on filtered and unfiltered cigarettes at a higher rate; and (iv) introduced a new excise tax on retail sales of alcohol and tobacco at 5 percent of the sales value, which aims to strengthen the revenue base of subnational governments.

100. Following the large exchange rate depreciation and inflation most of the excise rates are lower than in the neighboring countries. The hryvnia depreciated by 100 percent since the March 2014 tax code amendments that increased excise tax rates. Year-on-year inflation is currently running at 60 percent, making most excise duties a smaller share of retail prices. As a result, excise tax rates on tobacco and alcohol are among the lowest compared to most other countries in the region, particularly EU members (Table 19). The specific excise tax rate on cigarettes is 1/9th of the average in the EU, almost 1/ 2.5th of the rate in Russia, and half the average in Belarus. Similarly, excises on beer are only a small fraction of those in neighboring countries: 15 percent of the rate in Russia, 22 percent of that in Belarus, 30 percent of that in Georgia, and 50 percent of that in Moldova. The excise rate on ethyl spirits is also one of the lowest. However, the rates on petroleum products, while significantly lower than those in the EU, are higher than in CIS peers.

Table 17.

Comparison of Excise Tax Rates in Ukraine and Neighboring Countries

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Sources: Ukraine - http://zakon4.rada.gov.ua/laws/show/2755-17; EU - http://ec.europa.eu/taxation_customs/taxation/excise_duties; Russia - http://base.garant.ru/10900200/34/#block_20022#ixzz3gG772TcD; Belarus - http://etalonline.by/?type=text&regnum=Hk0900071 Moldova - http://base.spinform.ru/show_doc.fwx?rgn=3834; Georgia - https://matsne.gov.ge/ka/document/view/1043717.Notes:Specific rates only. Does not include ad valorem rates. Adjustments were made to make the rates comparable.Tobacco rates are for filtered cigarettes, wine is for standard natural wines.For EU, excise rates on tobacco include only specific rates. According to the EU directive 2011/64 overall excise duty on cigarettes shall represent at least 60 % of the weighted average retail selling price of cigarettes released for consumption.Exchange rates used in calculations are from the rates around mid-July. For Ukraine, projected average exchange rate for 2016 is used.EU average rate is calculated as a simple average. Russia excise rates are those that will become effective from January 1, 2016.For excise taxation filtered cigarettes in Belarus are divided into three categories.
Table 18.

Ukraine: Tax Burden of Selected Products

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Source: IMF FAD staff calculations.
Table 19.

Excise Tax Revenue under Different Scenarios

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Sources: Ukrainian authorities; and IMF staff calculations.