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2 Agenda for Fiscal Reform over the Medium Term

Editor(s):
Patrick Lenain, and Peter Cornelius
Published Date:
February 1997
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David W.H. Orsmond

The progress made in the reform of fiscal policies and structure since the start of the adjustment period in October 1994 has been substantial. Including the buildup of external gas arrears, which carried an official payment guarantee until end-1995, the budget deficit was brought down from about 15 percent of GDP in 1994 to just 5 percent in 1995.1 This consolidation in the size of the deficit was achieved even though the revenue ratio declined by 5½ percent of GDP over the same period.

Further, the fiscal adjustment undertaken was, by and large, the consequence of policy intent, rather than the outcome of ad hoc responses to ongoing developments. The large revenue decline reflected the government’s efforts to restructure the tax regime to make it more supportive of a market-based economic system, with a lowering of rates and a widening of tax bases.2 While these tax reforms were necessary to set the stage for future growth of the private sector, they implied that the bulk of the adjustment would have to come from the reform of expenditure. The government focused its expenditure reduction efforts on subsidies and transfers. Net consumer and producer subsidies fell sharply as agricultural and other prices were increased to market rates from end-1994; to provide appropriate incentives, the full weight of the relative price shift of energy was passed on to enterprises, while the increase in consumer food prices was only partially compensated by increases in benefits and wages. As a consequence, budget support for the agriculture sector and for enterprises fell by 6 percent and 2½ percent of GDP respectively between 1994 and 1995. At the same time, cost recovery ratios for household use of energy and communal services were increased—from 5 percent in October 1994 to 80 percent by July 1996—while a new targeted housing scheme protected the most vulnerable groups from the full impact of these price increases.3 Finally, to contain the cost of pensions within overall revenue to the Pension Fund, the government maintained the real value of the minimum pension while capping the top pensions, accepting as a consequence the compression of the pension scale.

There was, however, some slippage during 1995. The decision by parliament to increase the wages of teachers and health professionals to that of the average industrial wage led to a 50 percent real increase in these wages during the first half of 1995, which more than offset the expenditure savings that had been projected from a decrease in employment. To pay for these increases, local governments—which account for about three-fourths of education and health expenditure—then incurred arrears on the subsidy for household use of energy, the cost of which had to be picked up by the central government as the guarantor of payment for gas imports. As the central government had difficulty recovering these funds from financially strapped local governments, it began to accumulate its own arrears.

The deficit in 1996 is targeted to decline further to about 3 percent of GDP, which is consistent with monthly inflation rates of 1–2 percent. National Bank of Ukraine (NBU) financing is projected to decline sharply as sales under the treasury bill scheme introduced during 1995 increase. On the basis of recent trends, revenue during 1996 is likely to decline by an additional 3 percent of GDP from its 1995 level—resulting mainly from a projected decline in profit taxes as real wages rise and the privatization program picks up, assuming the sale of public enterprises to the private sector accelerates restructuring with consequent upfront costs. This decline in revenue is projected to be offset in 1996 by the recent increase in cost recovery ratios for household energy and communal services, ongoing rationalization of national economy programs, some efficiency savings in education and health expenditure, and cuts in other discretionary expenditure- However, while the adjustments undertaken during 1995–96 will leave Ukraine in a much stronger fiscal position than before the adjustment program began, for the budget to be in a position to support restructuring efforts of the private sector over the medium term, further policy adjustments will be needed.

The Medium Term: A Need for Further Reforms

The main goal for the medium term is to encourage the rapid expansion of private sector activity in Ukraine. The fiscal sector has several roles to play in such a strategy. First, to ensure a low and predictable inflation rate, total budget expenditure will need to be kept within a sustainable revenue envelope and any budget deficit will have to be low and mainly financed by voluntary sales of treasury bills. Second, the budget will have to assist the restructuring efforts of the private sector, for example by taking over from enterprises their obligation to pay for social activities. Third, to make room for these restructuring costs, public expenditure will need to be focused on activities that best enhance private sector productivity, such as capital spending and effective health and education expenditure, while also ensuring the provision of an adequate social safety net for the poorest groups during the transition stage. Finally, these expenditures need to be financed by a direct and indirect tax structure that is as nondistortionary as possible, and efficient tax and expenditure administrative practices should be utilized.

The overall expenditure envelope over the medium term will largely be determined by developments in three areas: (1) the outlook for the revenue-to-GDP ratio; (2) the need to replace NBU and extraordinary foreign inflows with noninflationary financing sources; and (3) the fiscal component of the private sector’s restructuring efforts.

Future Revenue Declines

Even after the 5½ percent of GDP decline experienced in 1995 and the 3 percent decline projected for 1996, the revenue ratio of Ukraine would still be somewhat above the ratio of 30–35 percent for countries of the former USSR that are already substantially along in the transition to a market economy. Transition economies have often seen a sharp decline in their revenue ratio, reflecting (1) the restructuring of the tax system toward that of a market economy; (2) a dearth of new taxes that have rates high enough to support the revenue ratio; (3) the granting of exemptions to sectoral lobbies, regions, and foreign investors in an effort to alleviate the cost of adjustment; (4) large declines in the bases of traditional taxes, while growth areas such as exports, agriculture, services, and the informal sector largely escape taxation; and (5) outmoded tax administration systems that are ill suited to tax an emerging private sector.4 Though Ukraine has made strong efforts to restructure its tax system, it has shielded itself from several of these difficulties; in 1995, new oil and gas measures raised 1 ½ percent of GDP, a 15 percent excise on petroleum products was recently introduced, and all ad hoc exemptions including new exemptions for foreign investors have been removed.

Nonetheless, several growth sectors are at present lightly taxed, agriculture is only subject to a land tax, and the informal sector completely escapes direct (income) taxation. Further, ongoing restructuring costs of newly privatized enterprises are likely to cut into profits, and the tax administration may be poorly positioned to collect income and payroll taxes as new private sector activities emerge. To support the revenue ratio, it will be important to increase collections of oil and gas royalties as domestic payment discipline for energy improves, to introduce a presumptive tax to bring informal activities into the tax net, and to widen the use of excise taxation (see below). In recognition of this potential, and of the efforts Ukraine has already undertaken to avoid the full scope of the revenue decline experienced in other countries, the revenue ratio in the medium-term projections presented in this paper (Table 1) is assumed to flatten out at about 35 percent of GDP.

Table 1.Operations of the Consolidated Budget

(In percent of GDP)1

OutturnProjection
199219931994199519961998200020022004
Revenue34.242.844.338.936.335.135.135.135.1
VAT9.711.611.48.67.67.67.67.67.6
Excises1.21.71.50.80.81.01.01.01.0
Enterprise tax (including presumptive taxes)5.69.812.59.27.05.05.05.05.0
Personal income tax3.02.03.03.03.03.33.33.33.3
Chernobyl Fund2.41.72.11.91.81.61.61.61.6
Pension Fund10.19.08.17.98.07.57.57.57.5
Foreign economic activity0.01.30.80.80.61.01.01.01.0
Gas and oil1.41.82.02.02.02.0
NBU profit transfers0.30.10.10.10.10.1
State reserve1.30.70.40.30.30.30.30.3
Energy Stabilization Fund0.30.80.80.80.8
Other revenues2.24.43.94.95.05.05.05.05.0
Expenditure58.454.553.543.539.337.137.137.137.1
Social protection7.212.26.26.66.63.83.33.33.3
Benefits(3.2)(4.4)(1.8)(2.0)(3.8)(3.8)(3.3)(3.3)(3.3)
Subsidies(4.0)(7.8)(4.4)(4.6)(2.8)(0.0)(0.0)(0.0)(0.0)
National economy27.817.919.26.23.14.04.04.04.0
of which Capital outlays(4.2)(2.7)(3.8)(2.6)(1.1)(3.0)(3.0)(3.0)(3.0)
Sociocultural expenditure9.39.011.311.410.510.110.510.710.8
Education(4.6)(4.4)(5.5)(5.5)(5.1)(4.4)(4.4)(4.4)(4.4)
Health care(3.6)(3.8)(4.9)(4.8)(4.3)(3.6)(3.6)(3.6)(3.6)
Other (including social assets transfers)(1.2)(0.8)(1.0)(1.0)(1.0)(2.0)(2.4)(2.7)(2.8)
Administration and justice1.42.02.62.72.72.72.72.72.7
Defense2.21.81.92.01.61.61.61.61.6
Chernobyl Fund2.21.32.01.81.81.51.51.51.5
Pension Fund7.28.37.87.88.07.57.57.57.5
Interest0.21.21.61.51.82.12.12.4
Energy Stabilization Fund0.11.20.80.80.80.8
Other expenditure (including unemployment costs)1.21.81.43.32.33.43.22.92.5
State and local balance-24.2-11.8-9.2-4.4-3.0-2.0-2.0-2.0-2.0
Extrabudgetary funds balance1.02.01.0-0.4
Consolidated budget balance-23.2-9.7-8.2-4.9-3.0-2.0-2.0-2.0-2.0
Foreign financing (net)-0.30.7-1.00.0-0.6-0.2-0.3-0.2
Domestic financing (net)23.210.07.55.83.02.72.32.32.3
Bank financing23.210.07.35.72.61.91.31.31.3
of which Treasury bills0.41.41.51.31.31.3
Privatization receipts0.20.10.1
Other nonbank financing0.30.81.01.01.0
Memorandum items: (percent of GDP)
Foreign budget debt stock13.17.55.34.43.8
Domestic treasury bill debt stock0.41.94.87.69.711.3
Sources: Data provided by the Ukrainian authorities; and IMF staff estimates.

The IMF staff presentation of the state budget differs from the official presentation as follows: on the revenue side, the proceeds from privatization and drawings from foreign loans are classified as financing; on the expenditure side, the amortization of foreign loans and of the NBU are also reclassified as financing items.

Sources: Data provided by the Ukrainian authorities; and IMF staff estimates.

The IMF staff presentation of the state budget differs from the official presentation as follows: on the revenue side, the proceeds from privatization and drawings from foreign loans are classified as financing; on the expenditure side, the amortization of foreign loans and of the NBU are also reclassified as financing items.

Growth of Noninflationary Financing Sources

The ability to use the NBU as the primary financing source for the budget will vanish as inflation is consolidated in the range of 10–15 percent a year and most domestic credit is thereafter provided to the emerging private sector to underpin economic growth. The medium-term projections assume that NBU financing is completely replaced as receipts from treasury bill sales rise to about 2½ percent of GDP, roughly half of which are assumed to be sold to the nonbank and foreign sector. The grace period for the amortization of Russian and Turkmen gas debts restructured in early 1995 ends during the period 1997–99; while this increases amortization costs in dollar terms, its impact on the budget as a share of GDP is contained by a projected real appreciation of the exchange rate over the same period. Assuming some foreign inflows to the budget to assist restructuring efforts, these assumptions suggest the noninflationary target for the annual deficit over the medium term is about 2 percent of GDP.

Restructuring Costs and Further Fiscal Consolidation

Over the medium term, the budget will need to take on several new expenditure obligations to encourage restructuring of the private sector, which, relative to the 1996 forecasts, will entail additional annual costs of about 4–5 percent of GDP.5 These costs include the following five components.

First, social services that are currently provided by enterprises are assumed to be transferred gradually to the budget. These costs will be mainly for education and health facilities currently provided by enterprises to their workers, as well as maintenance costs for the stock of housing owned by enterprises.6 The current cost of these activities is estimated by the IMF staff at about 3 percent of GDP.7 In the medium-term projections shown in Table 1, it is assumed that a managed transfer sees budget costs rise gradually from the current level of 0.5 percent of GDP in 1996 to reach 2 percent by the year 2001. Net savings of 1 percent of GDP are assumed to be realized from the rationalization of some of these programs within the existing budget expenditure.

Second, for the purposes of the projections it is assumed that, during the medium term, bonds are issued to the banking sector as part of a restructuring package, which are thereafter serviced by the government.8

Third, restructuring of the energy sector is assumed to continue, costing about 1 percent of GDP initially, and then declining in later years.

Fourth, public investment is assumed to increase from 1 percent of GDP in 1996 to 3 percent of GDP so as to support private sector activity.9

Finally, unemployment expenditure is assumed to rise by 0.5 percent of GDP relative to its level in 1996 because of enterprise restructuring.

Assuming a relatively constant share in GDP is spent on administration and military expenditure over the medium term, and factoring in a rise in interest expenditure, the above revenue, deficit, and restructuring costs suggest that, relative to 1996, other annual budget expenditures need to be gradually reduced by about 6–7 percent of GDP over the medium term, whereupon total expenditure would be about 37 percent of GDP. Relative to their costs in 1996, these savings could arise from reform of social protection (3 percent), Pension and Chernobyl Funds (¾ percent), national economy (1 percent), education and health (1½ percent), and other expenditure (¾ percent). Details of potential new policies that could sustain the revenue ratio, and could achieve these expenditure savings, are outlined in the balance of this paper.

Agenda for Tax Reform and Administration

Following the wide scale reforms undertaken in 1995, the tax reform agenda for the medium term is mainly concerned with improving equity of tax between activities, achieving efficiency of the resultant tax system, and improving tax administration.

Tax Reform for NoivEarmarked Revenues

Rather than changing overall tax rates—which are about at OECD averages with the exception of payroll and energy excise taxes (see below)—tax reform efforts in Ukraine should be focused on widening the base of existing taxes by removing the remaining exemptions written into current laws, capturing the emerging private sector in the tax base (exports, agriculture, the services sector, and the informal sector), and strongly resisting any efforts to grant ad hoc tax exemptions.

As noted, significant progress was made toward establishing a sound tax system during 1995, with the removal of tax exemptions for new foreign investments from January 1, 1995; removal of ad hoc domestic exemptions that had been introduced by the parliament, president, and cabinet of ministers; use of a uniform VAT rate and a uniform enterprise profit tax rate for most transactions; unification of domestic and foreign excise rates; abolition of virtually all export taxes and duties; inflation adjustment of the tax structure through the use of ad valorem excise and customs rates; and the establishment of bands for personal income tax at multiples of the minimum wage. These efforts must not be reversed.

Nonetheless, some areas for reform still remain. Commission sales are differentially taxed under the profit tax (at 45 percent rather than the standard 30 percent rate). The profit tax exempts agricultural activities, which are likely to be one of the growth sectors for Ukraine. (However, in 1995 the land tax raised 1.5 percent of GDP.) The VAT exempts some major items like electricity and coal, and parliament is considering changing the VAT’s complex and inefficient administrative aspects toward more orthodox approaches. The list of goods subject to an excise tax is extensive, including some products that raise little revenue, while the excise revenue collected from other goods such as petroleum products is much lower than in other countries. Finally, the range of import tax rates is wide (though 85 percent of imports from countries of the former Soviet Union come from Russia and Belarus, which are free of duty under the free trade agreement). Reforms in these areas are outlined in Box 1.

Renewed efforts should be made to bring the emerging private sector into the tax base. At present, apart from a license fee, the government charges a presumptive tax only on foreign exchange bureaus, casinos, and a few kiosks. The presumptive tax in lieu of profit and VAT obligations could be widened to include all new entrepreneurial activities, set for instance on the basis of turnover. New businesses could be identified from telephone directories, classified advertisements, and banking data. For the tax to be effective, premises would need to be inspected by the tax administration staff. Simplified bookkeeping requirements should also be established for the presumptive tax. Taxpayers using the presumptive tax regime should be allowed to opt to pay income tax and VAT under the normal tax regime—and over a certain income or threshold should be obliged to switch—provided they comply with the more rigorous bookkeeping standards required by the normal regime. This will ensure that the tax net widens over time.

Box 1.Outstanding Areas for Tax Policy Reform

The following steps toward tax policy reform remain to be taken.

  • Enterprise profit tax: unify the 45 percent and the 30 percent rate; bring agriculture into the tax base and remove the land tax.
  • Presumptive tax: introduce a presumptive tax for small businesses in lieu of profit and value-added tax obligations; set a maximum turnover that can be subject to the presumptive tax before paying under regular taxes; allow small traders to appeal and pay under the regular taxes.
  • Value-added taxes (VATs): pass the draft law before parliament to approve use of the invoice method rather than a fixed margin method for wholesale and retail trade (requiring improvements in accounting standards); enforce the uniform use of cash or accrual methods to calculate VAT obligations; legislate use of the destination principle for all trade with zero-rated exports; impose VATs on all imports; allow full credit for VATs paid on capital assets; include adequate provisions for excess credit carryforward with inflation adjustment; remove exemptions such as coal and electricity.
  • Excises: prune the list of goods subject to an excise to delete goods that raise little revenue; gradually increase excises on energy.
  • Trade taxes: narrow the spread of import tariff rates to preferably no more than three rates.
  • Payroll taxes: abolish contributions to the Social Insurance Fund, with enterprises instead taking over the responsibility to pay sick and maternity pay, and have health sanitariums funded by voluntary contributions rather than being mandated; over time reduce the functions of the Chernobyl Fund, merging its expenditure with other categories in the budget.

Tax Reform for Earmarked Revenues

At present enterprises pay a wide variety of payroll as well as other fixed taxes to extrabudgetary funds. The fixed taxes perform quasi-fiscal activities—such as for road maintenance, labor protection, and payment for communications—which hide an explicit account of the extent of budgetary activities and are complex for enterprises to administer. The fixed taxes should be abolished and their expenditure functions incorporated into the budget, financed by a limited increase in the profit tax rate.

The payroll tax, at 52 percent, is a huge distortion to the labor market and reduces budget flexibility by earmarking some revenue to expenditure.10 The overall payroll contribution should be reduced by reallocating some of its expenditure functions. In particular, given the mandatory contribution paid to the Social Insurance Fund to cover sick and maternity leave, as well as health sanitariums, there is no incentive for employers to manage these activities efficiently. In addition, ten years after the tragedy, Chernobyl-related expenditure should soon start to diminish—especially that associated with the building of housing and other investment activities. The Chernobyl Fund should eventually be downsized with its investment and health functions combined with other similar activities in the budget (such as under the health appropriation). Instead of the current payroll tax—which exempts many enterprises and activities11—an alternative, wider-ranging source of revenue should be sought. Ideally, this revenue should not be explicitly linked to Chernobyl expenditure, so as to enhance budget flexibility. In contrast, the Pension Fund and Employment Fund payroll taxes should be maintained because of the large number of existing pensioners and the likely future need to fund higher unemployment levels.

Tax and Customs Administration

With the escalating number and diversity of taxpayers, the overriding task of tax and customs administration will be to ensure that procedures are in place that enable tax policy to be enforced and bring the nascent private sector into the tax net.

The State Tax Administration (STA) needs to encourage voluntary compliance and self assessment, which entails the use of simple printed tax forms, filing, and payment procedures, as well as provision of adequate free information to taxpayers. Detection procedures should be strengthened after the planned assignment by end-1996 of a unique taxpayer identification number, and the identification system should be extended to cover all tax obligations. Developing detection procedures in the form of an up-to-date and accurate taxpayer registration system that can detect stopfilers and delinquent taxpayers immediately, particularly the most recent ones, is also important. Efficient enforcement and collection procedures would include the sending of notices, an adequate penalties structure that is impartially enforced, and simple disputes settlement procedures. Further, the present policy whereby enterprises are audited every two years should be replaced with an explicit audit plan, with use of single-issue and in-depth audits, modern information systems to select taxpayers for audit, and employment of qualified audit personnel, combined with adequate taxpayer protection via an appeals system.

Computerization will aid the efficiency with which these functions are undertaken. The pilot VAT computer project at Darnitsa should be extended to other taxes and to other regions within Kiev, and then across the country. The organizational aspects of the STA should be strengthened by shifting from a tax-by-tax basis to a functional one—with departments concentrating on functions such as collection, enforcement, or taxpayer education—to facilitate staff specialization and eliminate duplication. The STA’s effectiveness has in recent years been eroded by inadequate resources, which at times has led to a reported 70 percent vacancy rate. Staff need to be well trained and remunerated, and vacancies should be filled promptly.

Finally, customs functions should be strengthened by better control over the transit of goods, enhanced procedures for the selection of inspection targets, improvements in staff training, better use of computers and customs classification systems, and development of a legislative base for a customs code.

Agenda for Expenditure Reform and Administration

Expenditure Policy

As suggested by the above, expenditure policies must take into account the need to remain within the noninflationary deficit target and the available level of revenue. As for all public expenditure, the focus should be on activities that complement rather than compete with the private sector—so as to raise productivity of the private sector—while supporting the restructuring of the private sector and providing an effective social safety net targeted to the poorest groups. The main reform areas are subsidies and benefits, pension reforms, national economy, health and education, and the civil administration (Box 2).12

Box 2.Outstanding Areas for Expenditure Policy Reform

The following steps toward expenditure policy reform remain to be taken.

  • Housing subsidy schemes: eliminate all pricing preferences; make the un-registered unemployed eligible; introduce random audits.
  • Child, maternity, sickness allowances, and unemployment benefits: means test child benefits, with savings used to increase the average allowance; make nonworking mothers and the unregistered unemployed eligible for child benefits; extend maternity benefits to unregistered unemployed; introduce flat wage replacement ratio of 80 percent for sickness benefits and shift the cost of sick leave to enterprises for at least the first two weeks; finance medical rehabilitation and recreation schemes on a voluntary basis; reduce or abolish retraining schemes and the interest credit unemployment program.
  • Pensions: raise the retirement age for men and women by 6 months each year to eventually reach a uniform retirement age of 65; limit the nominal pension for working pensioners and do not allow them to increase their nominal pension as their working wage increases; unify preferential with standard retirement age and pay pensions made before the standard age from the Pension Fund; means test future pension increases to target the poorest groups; lower the replacement ratio and include only years of contributions in calculating the replacement ratio rather than also years of military service, schooling, and maternity leave.
  • National economy: fund (adequately) just, say, ten high priority programs; discontinue support for agriculture from the budget.
  • Education and health: reduce the disproportionate funding provided for preschools; try to ensure vocational training is appropriate for the new market economy; rationalize central, local, and enterprise activities with a view to closing overlapping centers; charge limited user fees, especially for tertiary education and advanced health care; reduce staffing levels to European averages; eliminate low-priority activities such as for extracurricular activities; target food and lodgings payments to just the most needy.
  • Civil service reform: clarify roles of each unit within the government; merge existing units to about 20 ministries over time; review pay and employment procedures.

Subsidies and Benefits

The generalized housing scheme will soon be completely replaced by the targeted scheme that limits household payments for energy and communal services to 15 percent of their income. As real wages rise over time, the cost of the targeted scheme will diminish. The statutory norm for which a subsidy is granted was recently lowered to be in line with the average size of apartments. However, several housing privileges are still currently granted to groups such as judges, tax inspectors, and military pensioners. Metering of households also needs to proceed as rapidly as possible, which will encourage households to use energy efficiently. Combined, these measures would speed the pace of housing privatization.13

There are now multiple overlapping benefit programs paid by different deliverers, with no consolidation of the various benefits. Given the dearth of financing opportunities, the trade-off between higher benefits and fewer participants must be addressed over the medium term. During the rationalization process, categorical eligibility for child and other benefits should be broadened, but the benefits should also be carefully targeted to ensure they reach all the poorest groups. The cost of sick leave for at least the first two weeks should be shifted to enterprises, which would prevent enterprises from lowering their wage bills by encouraging workers to apply for sick leave, which is paid by the Social Insurance Fund. The current financing of questionable retraining and favorable credit schemes for the unemployed should be scaled back, and replacement wage ratios should be set to ensure that total budget costs for the unemployed are kept manageable.

Pensions

The Pension Fund, which is a pay-as-you-go plan, will come under increasing stress over the medium term owing to a high ratio of recipients relative to the working population, combined with a likely containment of revenue as some emerging private sector activities escape taxation. Already, there are approximately 14 million pensioners, supported by only 22 million workers. Given the projected revenue decline to the Pension Fund over the medium term, savings in the cost of providing pensions will be necessary. This can be achieved through a combination of increasing fairly rapidly the retirement age, placing limits on the rate of increase of pensions paid to persons who continue to work, lowering replacement ratios, and including only the years of actual contribution when calculating a pension. Pension payments should also be included in the personal income tax base.14 Finally, given the high payroll tax rate and the need for the budget to continue to finance existing pensioners, it is unlikely that there will be significant development of a more differentiated pension scheme instead of the current virtually flat rate pension system during the coming years.

National Economy

Following the adjustments since 1994, national economy expenditure is now mainly composed of a plethora of small programs. These functions should be transferred to the private sector, with the budget focusing on just a few activities that make a strong contribution to the productivity of the private sector.

Health and Education

While education and health expenditures have been largely protected from the costs of the transition, this was the result of a substantial increase in real wages and the maintenance of a high level of inputs, rather than a strong focus on maintaining or improving measures of success in these sectors such as education standards or infant mortality rates.15 Broad principles for reform should include increasing basic education and health aspects such as preventative health and out-patient services at the expense of more “sophisticated” elements such as vocational training, long-term hospital-based treatment, and specialized and research-oriented institutions. Staffing levels have to be reduced further—though there has been a decline of about 7 percent since 1992. A rationalization of responsibilities between central and local governments as well as enterprises is needed (the latter in the context of the transfer from enterprises of their social activities to the budget). Greater use of user fees is being considered; a wage tax for health is not recommended because of the already high payroll tax rates.

Civil Service Reform

The effectiveness of the central administration should be improved. Currently it is impeded by fragmented and overlapping responsibilities. For instance, there are 75 central bodies with executive power, which is a high number relative to other European countries. Over the medium term, these functions should be rationalized.

Public Expenditure Administration Reform

Ukraine relies heavily on an extreme system of cash rationing, whereby expenditures are planned daily on the basis of revenues received. The resultant uncertainty has led local governments and spending ministries to delay transfers to the center and to build balances after receipt of any funds to cushion themselves against the risk of nonreceipt of future funds. This has caused contentious and uneven implementation of spending decisions across ministries and regions. It has also led to a lack of control over aggregate spending by the center since the funds, once disbursed, are largely out of the control of the central government, which can compromise the government’s capability to remain within its intended expenditure ceiling. Further, not all revenues and expenditures are included in the budget, which weakens the capability to set priorities, reduces flexibility, and encourages a lack of control and audit. The budget system should be strengthened through better use of orthodox budgeting with design and ratification of a transparent, comprehensive, and realistic budget, and elimination of sequestration and cash rationing so that all units can trust they will receive their allocations as agreed during that process.16

Reform of public expenditure management has begun. Ukraine has established a nascent manual treasury system, and computerization of the treasury is planned. This will have significant advantages in terms of greater control over cash and expenditure, and the consequent ability to better deliver a deficit target. However, further reforms are outstanding: a significant amount of training of new personnel in treasury functions has to be undertaken, especially at the new regional treasury offices; a list of all the spending ministry and institutional bank accounts needs to be established, monitored, and then consolidated into a single account; large payments on behalf of spending ministries should begin to be transacted through the new treasury; and an overall direction and plan for the computerization of the treasury needs to be determined.

Other changes are also needed. The Fiscal Management Unit in the Ministry of Finance should be strengthened, putting it in charge of overseeing the macroeconomic framework, budget preparation, and analyzing actual budget developments. The effectiveness and discipline of budget preparation should be enhanced, ideally by using cost-benefit budgeting techniques. Strategic reviews of public expenditures and functions should be conducted, based on sectoral analysis and analysis of the economic impact of such spending. Budget classification along international standards should be adopted, using a new chart of accounts, and budget coverage could be enhanced by including the numerous extrabudgetary funds. The need to provide quarterly budgets to parliament for its approval should be abolished, since it results in an endless process of budget negotiation. Finally, a budget bank should not be established since its responsibilities already lie within the treasury.

Financing Issues: A Sustainable Level of Debt?

The medium-term financing projections assume the continued growth of the treasury bill market, with net financing rising to 2½ percent of GDP to replace reliance on NBU borrowing. The authorities are in the process of removing some hindrances to the sale of treasury bills so as to make them more attractive, especially for foreigners. This includes the issuance of certificates to bond holders, issuance of bonds with small face value and bonds with short- and long-term maturity, and clarification of the tax treatment for sales to foreigners.

In the medium-term projections shown in Table 1, both the foreign and domestic debt stock appear to be easily sustainable. The stock of domestic treasury bills—excluding those for any prospective bank restructuring operation—is expected to rise gradually to 10 percent of GDP, while domestic interest payments remain at about 1–2 percent of GDP owing to the fall in the inflation rate. No interest is currently paid on NBU credit to the budget; were the NBU to do so, it is assumed that NBU profit transfers would rise commensurately with no net effect on the size of the fiscal deficit. Foreign debt that is the obligation of the budget declines from the current ratio of 13 percent of GDP to just 4 percent of GDP by 2004- Repayments of foreign amortization and interest remain at a manageable rate of about 1–2 percent of GDP a year.

Reform of Governance

It is widely recognized that major reform is needed in governance issues in Ukraine. There is currently a tendency for players to resist taking responsibility for their own actions, which weakens the capacity of the government to make and execute effective decisions. There are several sources of difficulties.

First, different agents often mandate increases in expenditure but do not take responsibility for financing them. Parliament frequently legislates new initiatives, such as the increase in wages of teachers and health workers during 1995. Similarly, the central government can set wages for government employees in general, but these are mostly paid at the level of the local government, which may then have to run arrears on its other expenditures to meet these mandated wage levels.

Second, there can be a lack of realism in some budgeting activities. There is an incentive for the government and parliament to accept high revenue estimates at the time of the budget, which enables high expenditure appropriations, but these must then be controlled through cash rationing and sequestration when the revenue fails to materialize.

Third, there is a need for greater clarity in central-local government relations. The continual shifting of revenue and expenditure responsibilities leads to confusion, opportunities for evasion, and an incentive for government units to withhold tax payments. These relationships need to be put on a more stable revenue and expenditure footing—for instance, with revenue assignment specified on the basis of population—so that local governments can better predict their own revenues over the medium term. Local governments also need to be able to supplement these revenues by building their own tax bases—for example, through property taxes and possibly surcharges on the personal income tax. These new arrangements would also, however, entail responsibilities, and local governments have to accept paying for all their own obligations so that the center does not have to pay for these as well as its own.

1Over the same period, the cash deficit fell from 8.2 percent of GDP to 4.9 percent. The 3 percent of GDP contraction in National Bank financing in the same period laid the groundwork for the stabilization most recently illustrated in monthly inflation rates of about 1–2 percent.
2In particular, the (uniform) value-added tax (VAT) rate was lowered from 28 percent to 20 percent, and the top personal income tax rate lowered from 90 percent to 40 percent. The enterprise tax was converted into a profit tax—with wages and other benefits removed from the tax base—and the base tax rate was only partly increased (from 22 percent to 30 percent) to recapture revenue.
3Under the new scheme, payment for household use of energy and communal services cannot exceed 15 percent of household income, and the size of an apartment for the purpose of calculating the subsidy is capped. To date, single pensioners have been the major beneficiaries.
4Richard Hemming, Adrienne Cheasty, and Ashok K. Lahiri, 1995, “The Revenue Decline,” in Policy Experiences and Issues in the Baltics, Russia, and Other Countries of the Former Soviet Union, ed. by Daniel A. Citrin and Ashok K. Lahiri, IMF Occasional Paper No. 133 (Washington: International Monetary Fund, December), pp. 76–92.
5It is assumed that these transition costs are taken on by the budget within the overall financing envelope so that the private sector can use the freed up resources for growth-creating activities.
6Enterprises own one-quarter of all houses, and are obliged to pay the difference between the cost recovery ratio for household use of energy and communal services and the full cost of providing these services. This cost for enterprises will vanish once full cost recovery is achieved. Note that since the cost of the targeted housing scheme is fully paid by the budget, the gradual move to full cost recovery has implied substantial savings for enterprises.
7The estimate here is calculated by taking the 1995 total cost of these services and applying the 1993 breakdown of the type of spending that was undertaken (the only available data). On this basis, enterprises spend 1.75 percent of GDP on housing construction, 0.5 percent on the provision of energy to households and for their maintenance, 0.5 percent on education services, 0.25 percent on culture and sports, 0.25 percent on canteens and shops, 0.25 percent on health-related services, and 0.5 percent on other social services. For an expanded discussion, see Adrienne Cheasty, 1995, “Social Divestiture in Ukraine,” paper presented at IMF-EBRD-World Bank workshop on Enterprise Restructuring, Washington, November 7.
8The size of nonperforming loans in Ukraine is still being estimated by the World Bank, and the likelihood or form of bank restructuring has not been discussed. The assumptions here are purely illustrative.
9As is common in transition situations, capital expenditure fell sharply from 4 percent of GDP in 1994 to an estimated 1 percent in 1996. Since operations and maintenance expenditures were not reduced over this period, this was probably an optimal response, which will have only minimal long’term effects provided capital spending is now increased. Given the rapidly changing relative prices since the start of the transition in October 1994 (including the exchange rate) and the nascent private sector, it would have been difficult to know the priorities for capital investment during the initial years of the adjustment phase.
10Of the 51 percent paid by enterprises, 32.56 percent is paid to the Pension Fund to fund old age and disability pensions (other benefits are paid by the Pension Fund and reimbursed by the budget), 4–44 percent to the Social Insurance Fund, which pays sick leave, maternity leave, and finances health sanitarium vouchers, 12 percent to the Chernobyl Fund, which funds benefits and related investments, and 2 percent to the Employment Fund. One percent of payroll is paid by individuals to the Pension Fund.
11Though the statutory rate is 12 percent of payroll, the average contribution rate is just 7.1 percent.
12Most of these proposals are outlined extensively in work undertaken by the IMF’s Fiscal Affairs Department, the World Bank, and the International Labour Organisation.
13At the start of the transition, the government owned about one-third of houses, of which about half have now been privatized. As noted earlier, enterprises own roughly one-fourth of houses, the ownership of which will over time be transferred to local government along with other social assets.
14Most countries tax either pension contributions or pension payments; Ukraine does neither.
15Pupil-teacher ratios in some areas are reportedly as low as 8:1 for primary levels, compared with ratios of about 20:1 in other European countries, and the physician and hospital bed per person ratios are up to six times higher than in European countries. Seventy-eight percent of health costs are spent on hospitals, and the top-heavy ratio of doctors rather than skilled public health managers and nurses, as well as overspecialized clinics and doctors, have led to the current unintegrated system and its high costs. Further, wages in these sectors are now equal to or above that for the industrial sector, a ratio far higher than in other countries of the former USSR. Meanwhile, life expectancy, infant mortality, and spread of diseases have reportedly worsened.
16Adrienne Cheasty and Jeffrey M. Davis, 1996, “Fiscal Transition in Countries of the Former Soviet Union: An Interim Assessment,” Most: Economic Policy in Transitional Economies (June), pp. 7–34.

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