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15 The Missing Pillar of a Growth Strategy for Ukraine: Reforms for Private Sector Development

Editor(s):
Patrick Lenain, and Peter Cornelius
Published Date:
February 1997
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Author(s)
Daniel Kaufmann*

The King shall protect trade routes from harassment by courtiers, state officials, thieves and frontier guards and from being damaged by herds of cattle…. Frontier officers shall be responsible for the safety of the merchandise passing on the roads and shall make good what is lost….

[Imported goods] shall be sold in as many places as possible…. To encourage the imports of foreign goods needed in the country, local merchants who bring in foreign goods by caravan or by water routes shall enjoy exemption from taxes, so that they can make a profit; foreign merchants shall not be sued in money disputes unless they are legal persons in the country; their local partners can, however, be sued.

From the treatise The Arthashastra, by Kautilya, the preceptor and King’s adviser in ancient India, circa 400 B.C. (pp. 182,235–37).

Strategic Imperatives of a Growth Strategy

Much has been written about Ukraine’s economy during the transition. There is consensus that economic management was poor until late 1994, a period of misguided policies and delayed reforms. By contrast, it is widely acknowledged that over the past two years far-reaching reforms have taken place. Significant gains have therefore been recorded on a number of economic indicators in Ukraine. Notably, there has been a dramatic lowering of the inflation rate. Exports and the external position have improved, trade is partially liberalized, and privatization is accelerating. A new currency, the hryvnia, has recently been introduced, and the exchange rate has been relatively stable. These considerable reform achievements are well documented in other papers in this volume and elsewhere. While important, we will focus on them only selectively here since our emphasis is forward-looking, asking why Ukraine is not yet growing.1

In a country where initial economic mismanagement was so severe, focusing excessively on economic reform achievements so far is insufficient when the objective is to chart an effective strategy for the future. Further, resorting to conventional indicators to assess performance on the three fundamental “pillars” of reform (macroeconomic stabilization, liberalization, and privatization) may not suffice. There is broad consensus everywhere nowadays that full implementation of these pillars of reform is a prerequisite for growth. But, paradoxically, a narrow performance-criteria approach in evaluating each of these components may unwittingly divert attention from the ultimate objective—attaining sustained economic growth. First, when focusing narrowly on performance criteria, insufficient attention is often paid to whether progress in implementing these very reform fronts is sufficient to generate growth in the near future. And second, we often neglect to identify whether there are other important complementary reform components to generate such recovery and growth.2

This empirically based paper focuses on the implications of arguing that major reforms are still needed for growth to take place (and be sustained) in Ukraine. For that to happen, policies and institutions ought to be transformed to become pro-private sector development (pro-PSD). This mainly refers to the establishment of a transparent and deregulated pro-business climate that attracts and facilitates the growth of new firms and new investments, domestic and from abroad. Such a focus has substantial strategic, policy, and institutional implications, which are reviewed here. We derive these implications from micro-survey analysis complemented by aggregate-level data.

Three strategic imperatives with major policy and institutional implications emanate from the focus on sustained economic growth. First, a critical mass of policy reform effort is needed in order to generate growth. In other words, the relationship between reform effort and outcomes is nonlinear, implying that partial reforms, even when significant, will not generate commensurate growth in incomes and output. Conversely, comprehensive reforms would generate fast growth. Consequently, additional reform steps at this juncture may have very high payoffs. Yet, inaction or marginal steps would render the political capital expended so far (in implementing reforms) ineffective.

Second, a crucial source of PSD-led growth in the future could come about from attracting the unofficial economy to operate officially. And third, in order to attain the critical mass of reforms required for a PSD-oriented strategy, and effectively tap into the unofficial economy, the limitations of public administration capacity need to be addressed. In particular, public sector reform and deregulation are needed to reduce rent seeking and corruption, which are imposing a high tax on PSD. We take these issues in turn, below, and then focus on policy implications. At a broader level, the approach and implications of this paper transcend the case of Ukraine. This is because some other post-Soviet economies exhibit similar challenges and bottlenecks. While there are bound to be differences of degree, similar implications for further research and policy emanate for Russia and a number of other (non-Baltic) newly independent states, which have so far neglected to pursue a PSD-oriented strategy.

Reaching a Critical Mass of Economic Reforms for Sustained Growth: The PSD Nexus

For vigorous and sustained growth to take place in the future, much will depend on whether new activities are encouraged to start and grow in the unofficial economy, and whether significant foreign investments and joint ventures materialize.3 A portion of the assets of the old economic structure may also be productively used in the future, but mostly by rebundled (and newer) firms and management, coupled with newer investments. This PSD-led growth is expected to take place in the manufacturing, services, agro-industrial, and agricultural sectors, and would encompass a rapid increase in new exports, and away from the former Soviet Union. The PSD experience of Poland is illustrative in this context.

Absence of an Environment Conducive to PSD-Led Growth

Most reviews of economic reform progress in Ukraine point to substantial progress on the major economic reform areas. However incipient and fragile, Ukraine has attained macroeconomic stabilization. And an accelerated privatization program is finally under way. Hence, politically difficult decisions have been taken in implementing ambitious reforms, laying a foundation that may stem a further decline in economic activity.

But this foundation in itself is insufficient to generate growth, because the enabling environment for enterprise to operate and grow is not yet in place. The main missing component is micro liberalization, namely, reducing the very high cost for firms and investors to operate officially. Until late 1994 a completely neglected pillar of economic reform was market liberalization—at the macro and the micro levels (see Kaufmann, 1994)- Since then, however, there has been significant progress in some conventionally monitored macro liberalization areas, on which the reform team in government as well as international donor support have focused their liberalization efforts. Indeed, even if far from complete, over the past few years there has been a significant liberalization of the more visible and conventionally monitored interventions in the exchange rate, trade, and pricing regimes.4

Yet at the same time, from the (micro) perspective of the enterprise itself, the environment in which firms operate has not become more liberal over the period. There is a clear discrepancy between the (top-down) macro-level liberalization monitoring of progress, on the one hand, and the (bottom-up) actual evidence from a recent enterprise survey we carried out. On the one hand, by the second quarter of 1996 most of the firms surveyed were of the opinion not only that reforms were under way in Ukraine, but also that these reforms were irreversible (Table 1). About one-third were of the opinion that reforms had not yet commenced, which, while significant, constituted only a minority. On the other hand, the vast majority of survey respondents said that reforms have not had any positive impact on their firms (Table 1). In Ukraine and Russia there appears to be a disconnection between the macro reforms and their impact at the micro level.

Table 1.The Enterprise’s Perspective on Reforms Ukraine and Russia Survey Results, 1995–19961(In percent)
UkraineRussia
March 1995March 1996March 1996
Is the reform process irreversible?
Yes456071
No171024
Reforms have not started38306
Have the reforms had a positive impact on your business?
Yes, already142737
Not yet, but soon3280
Not at all546563

Data analysis based on March 1996 survey in five large Ukrainian cities and three large Russian cities. Caution should be exercised in interpretation of the data, which are not representative of the whole country. The 1995 Ukraine survey results are based on a similar survey instrument we carried out that year.

Data analysis based on March 1996 survey in five large Ukrainian cities and three large Russian cities. Caution should be exercised in interpretation of the data, which are not representative of the whole country. The 1995 Ukraine survey results are based on a similar survey instrument we carried out that year.

The Firm’s Perspective on the Enabling Environment

From the firm’s perspective, what is lacking in the reform program implemented so far? In their answers, private sector enterprises perceive the regulatory and tax environment as at least as constraining, if not more so, compared with a few years ago. The severity of impediments as rated by the surveyed private enterprises in our yearly surveys of private enterprises is depicted in Figure 1. Excessive taxation, unstable legislation, and trade/regulatory constraints are seen as extremely serious impediments.

While it is common for managers to complain about taxes and regulations in many settings, the very high ratings given to impediments in Ukraine suggest a significant upward deviation from the “enterprise complaining norm.” The impediment ratings in this survey are even higher than for the sample enterprises in Russia (a country not known for a stellar pro-PS D climate).5 In particular, in Ukraine enterprises rate as significantly higher the following impediments: import and export restrictions, taxes, the remaining price interventions, and slow privatization. Harassment at the local level and foreign exchange restrictions are regarded as similarly constraining in both countries, while inflation and legal instability are considered a somewhat more serious issue by Russian enterprises. And as illustrated later in this paper, Ukraine’s regulatory impediments differ significantly more from those in countries in other regions of the world than they do from those in Russia (see Figure 2 and Figure A2 in the Appendix, both of which point to significantly lower regulatory constraints in other countries that have been subject to the same survey questions).

Figure 1.Severity of Impediment to Official Business—New Private Enterprises

(Severity of impediment rating between 1 (no impediment) and 5 (maximum severity))

Source: Surveys in selected major Ukrainian cities in June 1994, February and April 1995, and March 1996.

Note: Two impediments were not included in the 1994 survey.

Figure 2.Time Cost of Regulatory Constraints

(Average percent of senior management time spent with government regulations/officials)

Source: World Bank Report No. 15352-GU (1996); and surveys in selected major Ukrainian cities.

Comparing the severity ratings of impediments at a point in time suggests that firms also distinguish between the severity of different impediments affecting their operations, as illustrated by the sharp contrast between the (very low) ratings in Ukraine of labor regulations as an impediment (1.2 on a scale of 1 to 5), on the one hand, and the (very high) ratings of tax (4-9 on a scale of 1 to 5), trade, and legal regulations, on the other. Further, the fact that the severity of some impediments has increased significantly in recent years in Ukraine—as seen in Figure 1 in particular for tax, export, import, and local level regulations—is also suggestive that the very high ratings given to particular impediments nowadays may concord with the reality of operating a business. Hence, the firms’ responses cannot be easily discounted only because they are “expected to complain.”6

The surveys also provide evidence that new private firms face more daunting regulatory, tax, and local administrative impediments than older firms.7 In particular, new private firms consider the following impediments as more severe than their older counterparts: import regulations, local-level harassment, and remaining price and foreign exchange restrictions. Conversely, inflation is seen as a more severe impediment by older firms.

Another indicator of the severity of regulatory and tax impediments is the amount of unofficial payments that the firm needs to make to officials in order to get around or ameliorate each impediment. The data in Table 2 (derived from the same in-depth survey questionnaire in which specially designed questions were included to empirically assess unofficial behavior) indicate that such payments are widespread and sizable per license as well as per tax, health, or fire inspector visit. And they have not declined since 1994- The evidence suggests that these payments appear to be comparable with the situation in Russia.

Table 2.“Unofficial” Payments by Enterprises for Official Permits, Licences, and Other “Favors” Ukraine and Russia Survey Results, 1996
UkraineRussia
Average “unofficial”

fee required

for “favor”1
Percentage of

enterprises

admitting need to

pay “unofficially”
Average

“unofficial”

fee required

for “favor”1
Percentage of

enterprises

admitting need to

pay “unofficially”
Type of License/“Favor”1996(1994)1996(1994)1996(1994)
Enterprise registration$176($186)66(64)$28844
Each visit by fire/health inspector$A2($40)81(72}$6723
Tax inspector (each regular visit)$87($91)51(56)$25021
Each phone line installation$894($560)78(95)$1,071100
Lease in state space (sq. meter per month)$766(88)$2639
Each export license/registration$123($217)61(96)$64343
Each import license/registration$278($108)71(93)$13350
Each border crossing (lump sum)$211($194)100(90)
Each border crossing (percentage of value)357548
Domestic currency preferential loan (percentage of value)481838
Hard currency preferential loan (percentage of value)4852353
Note: For Ukraine, mid-1994 survey results are in parentheses.

Average among those that admit making unofficial payments. Preliminary data based on March 1996 survey of 150 state/private enterprises in five large Ukrainian cities, and of 50 enterprises in three large Russian cities. Caution should be exercised in interpretation of the data, which are not representative of the whole country (particularly in Russia, where the sample is small). The mid-1994 survey results for Ukraine (in parentheses) are based on a similar survey instrument.

Note: For Ukraine, mid-1994 survey results are in parentheses.

Average among those that admit making unofficial payments. Preliminary data based on March 1996 survey of 150 state/private enterprises in five large Ukrainian cities, and of 50 enterprises in three large Russian cities. Caution should be exercised in interpretation of the data, which are not representative of the whole country (particularly in Russia, where the sample is small). The mid-1994 survey results for Ukraine (in parentheses) are based on a similar survey instrument.

The above evidence is also supported by an independent body of data, compiled through the Ukraine Rapid Enterprise Survey (URES) by the Soros International Economic Advisory Group (SIEAG). Through monthly interviews, the data follow a panel sample of about 50 firms in Kiev and Lviv. Every month during 1996 the firms have reported that their tax burden is up compared with the previous month, and since March 1996 they have also every month reported increased bureaucratic problems in paying such taxes.8 Similar results emerge from URES on the government’s administrative, policy, and regulatory constraints on enterprise’s production, pricing, credit, exports, imports, and investment: for all these regulatory impediments firms reported every month throughout 1996 a deterioration compared with the preceding month.

High Costs and Uncertainty for Foreign Investors and Business

A variety of selected or informal surveys and memoranda in the recent past in Ukraine suggest that the climate for foreign business is also subject to daunting constraints. Many observers and confidential memoranda by European, U.S., and multilateral institutions indicate that these constraints have worsened during the second half of 1996. Among others, legal-regulatory instability, discretionary application of licensing rules, a fragile banking system, and widespread corruption are often mentioned as severe impediments to concluding foreign investment deals and conducting business. This closely mirrors the obstacles that domestic entrepreneurs face, and has similar dire implications for the economy. For instance, the most recent lists (and memoranda) prepared by U.S. institutions on the serious impediments for Western investors in doing business in Ukraine include the following (not necessarily in descending order):9

  • Commercial, tax, and land codes are lacking. Related to the lack of commercial code, Western businesses find that very few business contracts are regarded as final or binding in Ukraine.
  • Oblast administrations ban grain exports in order to ensure the sale of grain crops under state contract—regardless of whether or not the agricultural producer owned the grain. Consequently, Western companies that are owed money for the season’s inputs are not being repaid.10
  • Tax laws, customs regulations, and specialized licensing procedures are cumbersome and ambiguous, which leads to arbitrary implementation of regulations and to corruption.
  • Bankruptcy law does not permit restructuring—it permits companies to accumulate debts and then simply close down.
  • There are limitations on the number of bank accounts (usually to one) and on the amount of cash Ukrainian resident or nonresident companies can withdraw from their bank account. Frequent and discretionary “freezing” of funds in their accounts is common.
  • Corporate profit tax has highly variable and multiple rates. Further, significant tax exemptions exist, which are discriminatory. And local tax offices exercise considerable discretion, resulting in abuses.
  • The payroll tax, including various social security, Chernobyl Fund, Pension Fund, and other withholding taxes, is prohibitively high. Further, personal income taxes are also high.
  • Value added and excise taxes currently are levied on excisable capital (charter fund) contributions and offset of such taxes against other taxes (e.g., corporate profit tax) is not permitted. In practice, refund regulations are nonfunctioning.
  • Registration procedures for firms and investments are nontransparent and time consuming, resulting in arbitrary implementation by officials. Procedures and requirements for registration can vary among localities. High filing fees discourage resort to legal means.
  • Licensing of loans in foreign currency is extremely cumbersome and bureaucratic, hampering foreign financing.
  • Administrative control by the National Bank of Ukraine (NBU) over foreign currency purchases was recently tightened, requiring vetting, registration, and prepayment of contracts. Further, additional limitations have been imposed on companies’ holding of hryvnia settlement accounts. Also, there are short time limits to settle export payments.
  • The Antimonopoly Committee intervenes administratively in broad (and unwarranted) areas of the economy.
  • Real estate laws and lease law agreements (including subleasing) are ambiguous.
  • The law on pledges is inadequate, and the state fee structure for pledge agreements is burdensome.
  • Bidding process state procurement guidelines are unclear and discretionary.11
  • Crime and corruption are prevalent.12
  • There is no ombudsman (or similar) office that would assist foreign businesses in concluding transactions and sorting out difficulties.

Against the background of such an imposing list, echoed in many memoranda and letters, it is no surprise that foreign direct investment amounts from the rest of the world to Ukraine have been so small (even by the region’s standard), averaging less than US$4 per capita per transition year. And some of the few large promising foreign investments that were at advanced stages of preparation have recently become stuck in a myriad of bureaucratic red tape.

Neglected Potential for PSD in Agriculture

[The King] shall protect agriculture from being harassed by onerous fines and taxes…. Arable land shall be allotted to tax-payers for their lifetime…

The Arthashastra, by Kautilya, circa 400 B.C. (pp. 181, 179).

Agriculture and agro-industries have traditionally held vast potential as one engine for growth in Ukraine. Unfortunately, such potential is unfulfilled, as the sector continues to decline. While surveys similar to the one carried out for the enterprise sector have not recently been implemented in agriculture, there is consensus that reforms in this sector have moved more slowly than in the rest of the economy.

Agriculture has experienced extremely slow privatization. Divestiture of land by the state or cooperative sector has been virtually nil. Although about 14 percent of land is being held as (fully or quasi-) private subsidiary plots, it is not tradable. Only recently has the privatization of agro-industry started to gather some momentum, following major delays. And there is not yet a clear policy regarding land privatization and ownership in Ukraine. Whatever legislation exists remains contradictory, open to interpretation, and plagued with weak implementation.

Liberalization in agriculture has been rather partial: government interventions in agriculture appear to be even higher than for the enterprise sector. In particular, significant administrative interventions by the state prevail in agricultural marketing, state procurement, and exports, and some remain in pricing. Nonmarket state procurement has recently resulted in restrictions being imposed on interregional (oblast) trade of agricultural commodities, as well as restrictions being placed on exports of these commodities (notably grain) out of the regions.13 This has been fueled by increased quotas on state procurement of grains (for which out of the recently increased figure of 7 million tons, the procurement of 2 million tons is now being administered—in discretionary fashion—at the regional level). Further, some oblast government administrations are forming Commissions on Movements of Agricultural Commodities. Only those farm directors and few others who have close relations with the Commission members manage to get the required permits. Processing and exporting is near impossible for those without such connections.

More generally, farms do not regard the environment they operate in as being liberal or market oriented—in the sense of having autonomy in making decisions in response to market incentives. And private input suppliers report to have reduced confidence in their ability to conduct business as a result of these restrictions. Further, reports of some pricing restrictions remaining at the processing level still prevail: the result of national (e.g., “strong recommendations” from the Ministry of Agriculture) as well as regional- and local-level interventions.

Broadly speaking, neither the appropriate mode of land (and agro-enterprise) ownership nor the incentive structure for efficient growth in agriculture is yet in place. Not surprisingly, the performance of the sector throughout the transition has been extremely poor.

High Cost of Doing Business in Ukraine: Simple Analytics

In many economies in transition, politicians and bureaucrats try to acquire as many control rights on the operations of the enterprise sector as possible. Such control rights are often exercised through administrative controls and regulations, which give rise to side payments. Such discretionary administrative controls, regulatory impediments, and high and volatile taxes have implied a large operating cost for businesses in Ukraine. Whenever an impediment becomes more severe, the cost of doing business increases. Since the regulation is by definition (officially) imposed on the official operations of the enterprise, this imposition directly raises the cost of doing official business. The increase in doing official business is the outcome of either (1) paying the higher time (regulatory) and financial (taxation and licensing fees) costs, or (2) bribing an official to expedite a “signature” (and to continue operating in the official economy).

This does not imply, however, that the cost of operating unofficially stays constant: as taxes or other administrative impediments are raised, the illicit rents extracted from the enterprise (to evade taxes and official impediments) increase as well.14 In essence, given the degree of oversight of bureaucrats and politicians over the enterprise sector in much of the former Soviet Union, a signature of sorts is required to operate unofficially. Such a signature-nod from an official comes at a private price. Under reasonable assumptions, however, it can be expected that the direct cost increase on official business (resulting from an increase in official impediment severity) will be greater than the indirectly induced cost increase of operating unofficially—from that same official impediment. In other words, the overall cost of doing business (whether officially or unofficially) increases when a regulatory/tax impediment is imposed, yet at the same time the relative costs are altered: operating officially becomes relatively more costly than operating unofficially.

This simple analytic helps in understanding the behavior of business and the PSD outcomes in Ukraine. From this perspective, the absence of micro liberalization would have two types of effects on the economy: (1) slower overall output recovery than otherwise, because the overall higher cost of doing business meant that many potential new firms did not enter any activity in Ukraine (and others entered but did not grow or survive), and (2) a flight from the official to the unofficial economy, due to the relative cost increase of doing business officially compared with operating unofficially.

Regarding the first (“overall cost”) effect, which predicts a delayed output recovery and growth for the overall economy, it is telling to look at Ukraine and Russia, countries that have yet to attain positive growth, on the one hand, and compare them with Poland, which has been growing rapidly for a number of years, on the other. Ukraine and Russia share an anti-PSD regulatory and tax environment, that is, a nonliberalized economy from a microeconomic perspective. This is in sharp contrast with Poland, which has had a pro-PSD environment for years. Not surprisingly, Russia and Ukraine have only a small fraction of the number of new enterprises that Poland has, although the latter is by far the least populated of the three countries (see also Shleifer, 1996).

The second analytical corollary resulting from the imposition of anti-PSD regulations, namely, the relative cost effect, predicts a flight from the official to the unofficial economy. Here it is also revealing to compare Poland, a country with few anti-PSD impediments, with Ukraine and Russia. Poland’s unofficial economy is estimated to be about 15 percent of the overall economy, which in fact declined in recent years, following iberalization, while in Ukraine and Russia the unofficial economy represents significantly more than double the share in Poland, and the share has increased throughout the transition (see Kaufmann and Kaliberda, 1996). Compared with the overall cost effect of regulatory and tax burden, this relative cost effect (with its impact on the evolution of the unofficial economy) is often neglected. Yet it is of such importance for Ukraine that we delve into it in detail in the next section.

The Need to Reclaim the Unofficial Economy

A country where significantly over one-third of its economy is operating unofficially (i.e., unrecorded value added) requires a different framework of analysis, and faces different policymaking challenges, from a country where the unofficial segment of the economy is small. Taxation, regulatory reform, and social protection are some of the policy areas where conventional advice needs to be revisited.

In this section we first review the size and evolution of Ukraine’s unofficial economy. Then this evolution is compared with other countries in the region. We briefly explore the possible determinants for the different paths of unofficial economies in 16 countries in Eastern Europe and the former Soviet Union. To suggest what policy actions may be needed, we then focus on Ukraine in particular: what are the reasons for such a large unofficial share in the economy nowadays? Regulatory and taxation issues are briefly reviewed. Then we assess whether “unofficialdom” in Ukraine is deeply entrenched or “shallow” (i.e., whether it can be reversed by appropriate policies). Specific policy recommendations follow at the end of this section.

Evolution and Size of the Unofficial Economy in Ukraine

We summarize the stylized findings here, presented in detail elsewhere (Kaufmann and Kaliberda, 1996).

  • Prior to the transition, the share of the unofficial economy in overall GDP was estimated to be 10–15 percent. A midpoint of 12 percent was taken from Soviet studies for the initial point in 1989. Rapid growth of the unofficial segment of the economy meant that by 1994 the size of the economy had been estimated to have grown to over 40 percent of overall GDP, and by mid-1996 it was estimated to be about one-half of overall GDP.
  • The large increase in the share of the unofficial economy is the result of the significant decline of the official economy and the tripling in the absolute size of the unofficial economy during the period. Many activities crossed from “officialdom” to “unofficialdom,” at least in large portions of their operations. Some new operations are unregistered and became new direct entrants to the unofficial economy. But most activities are officially registered, visible, receive some state support (i.e., social protection), and are not necessarily small or unsophisticated. They officially report a portion of their operations, and hide the rest.15 The share of their activities that firms report (as opposed to those that they do not) depends largely on the costs and benefits of operating in each economy.

The evidence for the above empirical results on the unofficial economy comes from two independent empirical approaches.

1. Macroelectric methodology. This methodology uses yearly changes in electricity consumption as estimate proxies for overall GDP changes (which can be done because of the relative stability of the electricity consumption-output elasticities around the world). For the evolution of the unofficial economy in Ukraine during the transition, following the calculations derived from the “main conservative” scenario, see Figure 3. The estimations suggest that nowadays one-half of the economy is estimated to operate officially, and one-half unofficially.

Figure 3.Official and Unofficial GDP

(Overall GDP Index = 100 in 1989; 88 in 1989)

2. Micro-survey data. In surveys, enterprises were asked for their own estimate of what portion of overall activities in the economy were conducted unofficially, and depending on the type of enterprises their estimates vary between 35 percent and 60 percent. They were also asked what percentage of sales (turnover) and salaries they do not report, and by how much they overreport their costs. By the inherent nature of this line of questioning, their responses can be assumed to err in a conservative direction. And the survey did not include unregistered firms, further biasing the results in a conservative direction. Even then, as seen in Table 3, the admitted misreporting of registered firms is very significant.

Table 3.Extent of Misreporting by Firms Ukraine Survey Results, March 1996
All FirmsState

Enterprises
Collective/

Leaseholders/

Privatized
New Private

Enterprises
Hidden percentage of sales (underreporting)39234148
Percentage overreporting of input costs13593143149
Percentage underreporting of payroll51355068

The firms’ responses indicate that on average (for this sample of 150 firms) they report hiding about 40 percent of their turnover, and one-half of the payroll. And they overreport costs by a factor exceeding two. Even if we give extra weight to state enterprise firms in order to simulate the actual economy in Ukraine, and ignore that unregistered segment of the unofficial economy which does not report anything, overall misreporting in the economy would still be very large.

If we make any sensible assumptions about the proportion of costs in gross revenues, from the above micro evidence it is straightforward to also derive estimates of underreporting of value added exceeding one-half of total value added.

Empirical Caveats: Attempting to Err in a Conservative Direction

While the macro methodology utilizes conservative elasticity assumptions for its main scenario, the nature of the methodology itself, as well as the data, suggests that caution is in order in using these estimates. Instead of interpreting the figure for Ukraine’s unofficial economy in 1996 as a precise point estimate, it ought to be interpreted as an order of magnitude falling within a range. Such a range for the unofficial economy share in the overall economy is likely to start at about 40 percent, and would exceed 50 percent of GDP. At a minimum, therefore, the evidence does suggest that the unofficial economy share today in Ukraine significantly exceeds one-third. In other words, it has become an extremely important part of the overall economy.16 And even though the rapid pace of expansion of the unofficial economy experienced during the early years may have tapered off somewhat during 1995, there is no indication of a reversal in the trend taking place yet (Figure 3).

Significance of Ukraine’s Unofficial Economy Relative to Other Countries in the Region

Placing the evolution of Ukraine’s unofficial economy in the comparative context of other economies in the region (16 countries, utilizing the macroelectric methodology) points to Ukraine as possibly having the largest unofficial economy in a country that did not experience war (see Table A1 in the Appendix). Only Georgia and Azerbaijan in this sample have a larger unofficial economy share.17 Ongoing research work with this comparative data set suggests possible determinants of different paths of the unofficial economy in the region. Countries with a more liberalized and pro-PSD environment, as well as bureaucratic discretion by officials to make (extra-legal) decisions, appear to be associated with a lesser increase (or even with a decrease) in the share of the unofficial economy (see Tables A1 and A2).18

Table A1.Evolution of the Unofficial Economy in Countries of Eastern Europe and the Former Soviet Union and Possible Determinants1Main Conservative Scenario
Degree or Increase in

Unofficial Economy

Country
Unofficial

Economy

Change

1989–1994

(Percentage

points)
Unofficial

Economy

Share 1994

(Percentage

of total)
PSD and

Liberalization

Index

(0–100)
Inflation

(Annual

average

percentage)
“Bureaucratic

Discretion”

Index

(0–100)
I. Extremely high increase/war
Georgia52542230936
Azerbaijan46531720832
Average49612025934
II. Very high increase
Ukraine34461339346
Russia28403223043
Moldova28402729935
Average30422430741
III. Medium increase
Kazakstan22342241435
Latvia22344010646
Lithuania17294416554
Estonia13254912344
Czech Republic1218601565
Average17284316549
IV. Low increase
Belarus7191336240
Bulgaria629497949
Hungary129692374
Poland015691167i
Average3235114558
V. Decline in unofficial economy share/repressed politics
Uzbekistan–2101917726
Romania–5173910426
Average–4132914127
Overall average17323719545
Sources: Freedom House; and De Melo, Denizer, and Gelb (1996).Notes: PSD and Liberalization Index ranges from zero (anti-PSD/liberalization) to 100 (maximum pro-PSD/liberalization). The Bureaucratic Discretion Index has been standardized to range between 0 and 100 (maximum discretion); based on yearly Freedom House indices of civil/political liberalization. Annual inflation rates based on geometric averages.

Unofficial economy change 1989–1994 is the difference in the unofficial economy share (in the overall economy) between 1994 and 1989. Calculations based on main conservative scenario of aggregate electricity consumption methodology (Kaufmann and Kaliberda, 1996).

Sources: Freedom House; and De Melo, Denizer, and Gelb (1996).Notes: PSD and Liberalization Index ranges from zero (anti-PSD/liberalization) to 100 (maximum pro-PSD/liberalization). The Bureaucratic Discretion Index has been standardized to range between 0 and 100 (maximum discretion); based on yearly Freedom House indices of civil/political liberalization. Annual inflation rates based on geometric averages.

Unofficial economy change 1989–1994 is the difference in the unofficial economy share (in the overall economy) between 1994 and 1989. Calculations based on main conservative scenario of aggregate electricity consumption methodology (Kaufmann and Kaliberda, 1996).

Table A2.Private Sector Development and Privatization Index (PSDI) and the Evolution of the Unofficial Economy in 16 Countries of Eastern Europe and the Former Soviet Union
PSD Index

(0–100)
PSDI

Average

for Range
Unofficial Economy

Change in 1989–94

(Percentage points

difference)
Unofficial Economy

Share in 1994

(Percentage of

overall economy)
0<PSDI<20153244
20<PSDI<40281328
40<PSDI<10057420
Overall average291732
Note: PSDI is the Private Sector Development Index averaged for each country for the overall transition period, standardized to range from 0 (totally adverse environment to privatization) to 100 (perfect environment for privatization). PSDI calculations based on De Melo, Denizer, and Gelb (1996). The PSDI is a subcomponent of their overall PSD/Liberalization Index presented in Table A1. (Results of the overall index relationship with the evolution of the unofficial economy are very similar to the PSDI results reported above.) The unofficial economy share calculations are from the author’s “main conservative scenario” calculations for 16 countries of Eastern Europe and the former Soviet Union (as in Table A1) and Kaufmann and Kaliberda (1996).
Note: PSDI is the Private Sector Development Index averaged for each country for the overall transition period, standardized to range from 0 (totally adverse environment to privatization) to 100 (perfect environment for privatization). PSDI calculations based on De Melo, Denizer, and Gelb (1996). The PSDI is a subcomponent of their overall PSD/Liberalization Index presented in Table A1. (Results of the overall index relationship with the evolution of the unofficial economy are very similar to the PSDI results reported above.) The unofficial economy share calculations are from the author’s “main conservative scenario” calculations for 16 countries of Eastern Europe and the former Soviet Union (as in Table A1) and Kaufmann and Kaliberda (1996).

The Firm’s Perspective in Ukraine: Causes and Costs of “Unofficialdom”

Earlier in the paper we presented the survey evidence on the regulatory and tax impediments, as reported by the enterprises themselves in the survey (Table 2). Further, Table 3 provided data on the unofficial payments required per license and per tax inspector visit. Not surprisingly, the majority of firms admit paying unofficially in order for their official tax burden to be lowered, and for securing licenses. The firm’s struggle to survive the regulatory maze and high taxes results in significant resources being expended by each surviving firm every year. This is particularly the case for new firms. The evidence on the overall burden on enterprise of the lack of micro liberalization is presented in Table 4. Inter alia, it provides the estimate by the firm of the total yearly unofficial payments that are incurred to get around impediments.19 Further, the extent of illegal payments extracted from the enterprise appears to be related to the tax and regulatory burden imposed on them, which in turn forces it to mis report turnover costs and payroll in order to avoid taxes (Table A4).

Table 4.Overall Costs of Taxes and Regulations Ukraine Survey Results, 19961
Type of Enterprise
State

enterprise
Lease/collective/

privatized
New private
Share of taxes/actual sales2 (in percentage)393639
Share of taxes/reported sales (estimated)3 (in percentage)475259
Rating of obstacles by local authorities (severity of impediment on a scale of 1–5)2.82.83.7
Extra-legal payments per firm/year (bribes, protection, etc.)$3,340$21,900$26,400
Median of bribes paid per firm’s employee$3$40$400
Percent of management time spent with tax/license officials (in percentage)212937

Based on survey of 150 enterprises in five Ukrainian cities.

Includes all taxes. “Actual sales” includes officially reported and unreported revenues.

Estimate, subject to a margin of error.

Based on survey of 150 enterprises in five Ukrainian cities.

Includes all taxes. “Actual sales” includes officially reported and unreported revenues.

Estimate, subject to a margin of error.

Further, as we can see in Table 4, an attempt is made to extract higher tax rates from new private enterprises than from others. The evidence also suggests the extremely high share of senior management time that new private enterprises are forced to spend with public officials in securing licenses, permits, negotiating taxes, penalties, etc. A cross-country comparison of the time-costs of regulation is provided in Figure 2, indicating how high the overall regulatory burden on private enterprises is in Ukraine compared with other countries for which similar survey data were available.20

The analysis of the data is at least suggestive that the official tax rate burden on enterprise is positively associated with the amount of unofficial payments to officials, and with the extent of the firm’s official misreporting of turnover and costs (see Table 5). New enterprises, which in practice are hit the hardest by taxes and regulatory impediments, are not only levied higher tax rates, but are also forced to pay significantly more in bribes and unofficial payments and thus misreport larger shares of their value added in order to survive. This provides further evidence of the three-prong nexus of regulatory and tax burden on enterprise, corruption, and the extent of “unofficialdom” by the enterprise. Also suggestive of the negative impact of this anti-PSD environment is the emerging evidence that in recent times the number of registered private enterprises in Ukraine may have stagnated.

Table 5.Tax Burden and Firms’ Misreporting Strategies Ukraine Survey Results, 1996
Official Tax Burden

(Estimated Tax/

Officially Reported

Turnover)1
Evaded Taxes as

Percentage of

Turnover
Percentage

Turnover

Underreported
Percentage

of Cost

Overreported
Percentage

Wage Bill

Underreported
Yearly Extra-

Legal Payments

per (Firm’s)

Employee
Illegal Payments

per Visit of Tax

Official
Extralegal

Payments as

Percentage

of Turnover
Lowest tercile4209039$14$321.8
Middle tercile113617050$22$462.8
Highest tercile396515066$62$558.6

The ratio of overall taxes in officially reported turnover is an estimate based on enterprises’ responses on actual taxes paid and their acknowledged misreporting. It is subject to a margin of error.

The ratio of overall taxes in officially reported turnover is an estimate based on enterprises’ responses on actual taxes paid and their acknowledged misreporting. It is subject to a margin of error.

In sum, from the firm’s perspective, the regulatory and tax regimes are very costly. To ameliorate such costs, the firm is forced to become partly unofficial. But such “unofficialdom” is no panacea. First, it is also costly, as seen in the high extra-legal payments required to operate unofficially and evade taxes (Table 5). Further, it reduces confidence and certainty for entrepreneurs, and hence longer-term investment is absent. It fuels the rationale for further regulations and corruption in the public sector. At the national level, it undermines the capability of the state to manage the economy, by reducing the tax and official foreign exchange base (and increasing capital flight).21 Indeed, the evidence in Table 5 is suggestive of the higher incidence of tax evasion for those subject to a particularly high (official) tax burden.

Hence, stemming the decline in the official economy share is important. But can something be done about it?

How “Entrenched” or “Shallow” Is Unofficialdom in Ukraine?

To answer this question, we need to revisit whether the main obstacles to a firm operating officially could be ameliorated by policy decisions. By summarizing the firm-level evidence on the main impediments for them to operate (and grow) officially, we revert to Figure 1; taxes were at the top of the obstacle list, and the other (mostly regulatory) severe impediments are also largely amenable to policy-related improvements. Then, we asked the firms whether they would return to operate officially if the government implemented the required measures. And if they were prepared to return to the official economy, we asked them how long would it take for them to returen to operating officially. Their responses are summarized in Figure 4. We see that the unofficial economy in Ukraine is still relatively “shallow”: the trend of relative growth of the unofficial economy can be reversed by appropriate economic and institutional reforms. There is an entrenched hard-core unofficial segment amounting to about 15 percent of all unofficial activities.22 The remaining 85 percent are prepared to return, over time.23

Figure 4.“Shallow Unofficialdom”

(Percent of unofficial activities prepared to return to official economy under credible liberalization and tax reform program)

Source: 1996 Ukraine and Russia surveys.

Note: Preliminary data based on March 1996 survey. The enterprises were questioned on their preparedness to return to official operations (and on their time frame) assuming significant deregulation and lower tax rates implemented in late 1996.

On the High Costs of Doing Business in Agriculture

We briefly discussed the extent of administrative impediments to operating in the agricultural sector, as well as the official reticence in embracing private property and privatization for the sector. This has a large cost for the economy. Much has been written in specialized reports regarding the link between disincentives and performance in the sector. For our particular PSD perspective, we limit our focus to one telling recent empirical estimate by the World Bank: the 14 percent of all arable land in private or quasi-private hands produces about half of agricultural output. The 86 percent in collective and state hands is producing the other half.

These data illustrate (and mask) the “overall cost” as well as the “relative cost” implications of regulatory impediments and ownership disincentives—in this case, for agriculture. A fully privatized agricultural sector facing fewer interventions would be able to generate significantly more agricultural produce. The enormous “overall tax” of state interventions on agriculture, through administrative restrictions and state orders for grain procurement, exacts a large toll on production.24 But not all the difference in yields between the private and the public sector can be attributed to pure productivity differences. Some of the variation is due to the larger application of fertilizers and capital inputs in private plots. Some of these inputs are purchased by collective and state farms, yet they are “unofficially” siphoned off to many of the private farms that border the ailing large state and collective farms. Hence, the “relative cost” differentials providing an incentive for “unofficialdom” appear to be strongly at play in agriculture as well—even if the illegal payments and unofficial trading mechanisms differ from those in the enterprise sector.

Policy Implications for Deregulation, Taxation, and Ownership

The analysis indicates that the costs of doing business in Ukraine for domestic firms and foreign investors are very high, while the benefits to the private entrepreneur can be uncertain at best. Further, most firms face the choice of operating officially or unofficially. And they do exercise such choice, depending on the costs and incentives they face in each “economy.” In addition to these micro considerations, we put forth the economic policy notion that there are crucial complementarities at play when implementing a reform package: when a key component is missing, most of the others may be in place but growth will be elusive (the “critical mass of reforms” argument).

These macro- and microeconomic notions, coupled with the evidence presented here, have the following corollaries regarding the next stage of reforms: a pro-PSD environment needs to be put in place for sustained growth to take place, and bold deregulation and tax reform is required for a pro-PSD environment. Particularly in light of Ukraine’s economic circumstances and troubled past economic management legacy (still hampering credibility in the eyes of prospective investors today), boldness in the next stage of reforms is fundamental.

Marginal improvements or partial changes will not reap the desired benefits for the economy. This is because (1) entrepreneurs face the choice of staying in the unofficial economy, and hence the costs of operating officially have to come down sharply to levels comparable to operating unofficially; (2) there are fixed costs of “crossing over” to the official economy (such as the risk of being penalized for past evasion, learning to operate under a new set of rules, or investing even more time in haggling with officials for licenses); and (3) there are crucial complementarities between a deregulated environment at the micro level, on the one hand, and the already implemented macro reforms and privatization on the other, as well as complementarities between the various pending tax and regulatory reforms. Hence, an integrated and bold package of tax and regulatory reforms would need to be implemented. We turn to salient recommendations of such a package.

1. Major deregulation to level the playing field for new enterprises, which at present are significantly discriminated against in practice.25

Among others, a deregulation program would contain the following components:

  • elimination of all licenses and permits on enterprises other than minimal permits for health and safety reasons, for which simple and transparent rules would apply;
  • elimination of abuse of discretionary powers and forced delays at customs;
  • elimination of export registration requirements and indicative prices for exports;
  • elimination of any inter-oblast trading restrictions or oblast-specific exporting barriers (for grain, coal, or any other commodity);
  • elimination of abuses due to discretionary powers to revoke enterprise permits (or to levy steep penalties) under the guise of quality control, consumer protection, standards, etc., for imports and domestically;
  • ease of registration of a new enterprise (one-stop and, more generally, facilitating rather than hindering entry);
  • elimination of agricultural domestic trade restrictions, of the discretionary application of state contract enforcement, and of remaining interventions in the sector;
  • deregulation (and hence demonopolizing and opening up effective and transparent competition) in the gas sector; and
  • elimination of any price controls for “artificial” monopolies, as well as closure of the price inspectorate units in the center and localities.

2. Acceleration of privatization. Acceleration of medium- and large-scale enterprises is now taking place. But only 25 percent of medium- and large-scale enterprises have been subjected to the privatization process, only about 70 percent of their shares privatized. And much of the privatized assets have been transferred to “old” managers, which fully control the enterprise. This, coupled with the absence of deregulation, has not been conducive to enterprise restructuring. Furthermore, about 80 percent of the assets in the medium- and large-scale enterprise sector are yet to be privatized. In particular, the “negative list” of enterprises that are still not allowed in the privatization pipeline comprises the lion’s share. Hence, it is imperative to convert such a list into a “positive” list of privatization. Second, further streamlining and expediting of agro-industrial privatization needs to take place. And third, privatization of land needs to begin and spread rapidly.

3. On taxes, a bold reduction of tax rates would be called for. If the tax reduction ends up being somewhat more gradual for state enterprise (and if politically feasible), the tax rate reduction ought to be particularly steep up front for new enterprises, since they continue to pay more because of a lack of tax exemptions, their vulnerability to demands for bribes, and a lack of good official contacts, as well as high regulatory discretion.26 Generous tax regimes ought to apply to foreign investors. Exporters ought to enjoy exemptions from import duties.

4. Much of the reduction in the overall tax burden ought to be focused on significantly reducing the excessively high payroll tax. Chernobyl taxes, contributions to various funds, and so on, ought to be eliminated, while at the same time a far-reaching reform in the pension system would accompany the reduction of the pension contribution component of the payroll tax.

5. While corporate taxation has abandoned the distortive turnover tax, a more complete implementation of a reform in corporate taxes is still needed so that it is in practice a tax on net revenues (profits). Consideration needs to be given to reducing the corporate tax rates over time, and the rates would be expected to be more uniform. Similarly, the VAT would be expected to become a real value added tax, properly crediting inputs and avoiding cascading taxation. Over time, consideration could also be given to reducing VAT levels.

6. Consideration ought to be given to a one-time tax forgiveness for past evasion (up to a well-defined date in the very recent past). It would be announced with the overall (bold) reform package, stressing that a new tax administration and tough enforcement would apply to the moderate, stable, and transparent reformed tax regime. A credible and tough enforcement of evasion (as well as elimination of special privileges, exemptions, etc.) in the new regime would have to be in place for any tax forgiveness program to be effective.

7. Elimination of all tax exemptions, which are still rather prevalent and discretionary. They are still an obstacle to private sector development, in addition to undermining fiscal stability and fueling corrupt practices. The elimination of exemptions is a crucial component of any tax reform, in order to expand the tax base at the same time that tax rates are reduced.27

The elimination of exemptions ought to take place up front, particularly considering that on the tax evasion reduction front there will only be a gradual return of unofficial activities to the official economy (see Figure 4). Thus, the gains from the expanded tax base derived from a reduction in evasion would not all come immediately, but only incrementally over a period of a few years.28 Over the first year immediately after the tax reforms, no more than 15 percent of all unofficial activities could be expected to become official (and mostly in the second half of that year). And even such modest gains for officializing unofficial activities depend on up-front deregulation as well. Implementation of an integrated package of deregulation and tax reform would result in additional “crossovers” from the unofficial to the official economy after the first year, and during the second year another 20–25 percent might be added, for a total of about 30–40 percent over the first two years.

Further calculations and simulations would be needed in order to provide precise tax recommendations, which is beyond the scope of this paper. Yet the overall direction appears to be clear: for reform and restructuring to gain momentum in Ukraine, particularly in spearheading private sector growth, a comprehensive effort to deregulate the economy at the micro level, as well as reforming the tax structure, will be needed. A substantial reduction in the tax burden on enterprises is required. Yet, at the same time, to ensure overall fiscal consistency, it is essential to approach the various tax measures as an integrated package. Hence, as tax rates are reduced, tax compliance improvements, as well as virtual elimination of exemptions and privileges, are required complementary measures, in order to expand the tax base. Remaining subsidies, such as those in agriculture, need to be reduced further. And there may also be a need to cut residual nonpriority public expenditures.29 More effective spending in the social sectors could result in savings as well. In particular, accounting for the unofficial economy in the population’s survival strategies could result in better designed and targeted social protection programs (and in less anxiety about the ability of separated state sector workers to cope).30

Since much of the regulatory system is associated with particular interests that benefit from discretionary provision of licenses, permits, and signatures, the success in deregulating will also depend on reforms of government institutions and of the civil service. The incentives to engage in corrupt practices need to be substantially reduced, since this has become a major developmental challenge for Ukraine. While Ukraine is not unique in this respect, the prevalence and orders of magnitude of corruption have led to very high costs of doing business, further impairing productive investments and growth prospects.

Consequently, in designing the bold deregulation program that Ukraine’s business sector and foreign investors would need for their contribution to growth to become important, public sector reform will be necessary. We address this issue next.

Reforming the Public Sector to Support a PSD-Oriented Growth Strategy

We may have abolished many controls and regulations, but we have not abolished the controllers and regulators.

P. Chidambram, India’s Finance Minister, in video-conference during a Harvard Institute of International Development conference on India’s Economic Reforms, Madras-Harvard, December 14, 1996.

The analysis in this paper, focusing on the need to deepen economic reforms (so as to attain a “critical mass”), to emphasize a PSD-oriented growth strategy, and to tap into the large unofficial economy, has major implications for the reform of the public sector. We briefly touch upon some salient features of these required public sector reforms—particularly as they relate to our PSD-growth focus here.31

In the design of the next stage of the reform program, as well as the public sector reforms required in the short term, it is key to account for the present limitations of public administration capability. This has three major implications for the design of institutional reforms. First, focusing on the crucial components of reform in the next stage, without overloading the existing institutional capacity. Hence, only measures of utmost priority ought to be included at present. The focus on PSD-oriented growth for Ukraine suggests a framework for prioritizing (as per recommended actions that emanate from such approach).

Second, in the design and implementation of economic reforms, emphasis ought to be given to “institutionally relieving” (rather than “institutionally demanding”) measures—wherever feasible. To operationalize such an approach, the following principles should be considered:

  • Bottom-up and market-driven solutions, rather than heavy top-down regulatory approaches. In countries with institutional capacity limitations there is a rationale to search for bottom-up and market-based solution even in areas where in some other earlier country experiences (such as in East Asia) it has been suggested that particular regulations and interventions did work. For instance, in the case of Ukraine the regulatory environment in the banking and capital market sectors should not be top-heavy, and should rely on self-regulatory mechanisms where possible. Indeed, recent tightening of some financial sector regulations by the NBU have been anti-PSD. Similarly, industrial policy interventions or selective protectionism should be avoided. Regulation of natural monopolies (which technological advances are quickly transforming into an endangered species in any case) should be kept at a minimum, and designed as simply as possible. In countries like Ukraine, for any such “gray area” of intervention, the cost of additional demands on the scarce administrative capacity (as well as the likelihood of government failure in such intervention) ought to be fully factored in.
  • Liberalization, deregulation, and privatization. The overall implementation benefits are obvious in these (non-”gray area”) components, where a more liberal and competitive climate is needed for economic reasons—far transcending institutional considerations, as with a full liberalization of the current account and the foreign exchange regime, or opening up the financial sector to foreign competition, for instance. A similar argument applies to the legions of bureaucrats that nowadays are occupied with price setting and “monitoring” throughout the country and with licenses, permits, and discretionary signatures for various areas of a firm’s operation. They would be far more productive collecting taxes from heretofore exempted firms, for instance. In a similar vein, accelerated privatization in the agricultural and enterprise sectors would also substantially relieve the overstretched government capabilities, and enable them to attend to productive endeavors in other areas where public sector involvement is justified and needed.
  • Avoiding institutionally creating (or demanding) measures. While this is self-evident and stems directly from the above approach, it is worth reiterating. Recommendations still abound to create yet additional public sector institutions, commissions, and related bodies. Creating a new institution is still seen as a “quick fix” to solve a particular problem. At best, most of those institutions have no impact. At worst, they become another conduit for anti-PSD interventions.Third, there is an urgent need for reform of the public sector itself. That urgent need ought to be balanced with a sense of realism, taking account of the (first) “no-overload” principle in the short term—that is, the focus needs to be on the priority areas. In terms of areas of emphasis, we identify five priority issues below:
  • Consolidation of institutions and agencies within the government. Many branch ministries could be abolished, since they are not consistent with the transition to a market economy. Central government agencies could be merged with each other (e.g., the ministries of finance and economy).
  • Reform of the budgetary and public finance institutions, including the creation of a well-functioning, transparent, and accountable treasury department,32 the transformation of the tax inspectorate, and the revamping of the customs department and border controls.
  • Civil sector reform. A major overhaul of personnel policies is needed, as well as a strategy for human resource development consistent with the development of a modern civil service. The reform of the system of pay and incentives will be crucial. As stated above, corruption is nowadays a growth-retarding obstacle for the overall economy. Better pay for civil servants needs to be one area of focus,33 complemented with the replacement of some personnel (including at the local level, at customs, etc.) with better motivated civil servants, instituting a system of rotation of others, implementation of a code of ethics, and better enforcement and supervision of illegal activities and of misappropriation of public funds (with stricter penalties and much-improved enforcement).34
  • “Special levers” to expedite reforms in the public sector in the near term. It is difficult to spearhead reforms in the public sector anywhere, given the natural resistance by many officials and decision-makers, and because it is a complex institutional field where there is often insufficient consensus as to what the preferred approach and priorities ought to be.35 Consequently, it is important to identify levers that can spearhead the priority institutional reforms. Two such levers could be (1) the fiscal lever, such as it has been utilized in Hungary36 and in El Salvador to implement reforms in the public sector by targeted administrative cuts through the budget process (to ensure actual consolidation of public agencies, elimination of unnecessary ministries and departments, etc.), and (2) the accelerated privatization lever, which would render the justification for the continued existence of a number of branch ministries increasingly moot.
  • Reforming local administration. This is such an important task that no justice can be done to it here. We limit ourselves to suggesting that reforms of local institutions will be an important prerequisite for a pro-PSD environment being established on the ground. Currently many local politicians and bureaucrats do not support entry and growth of competitive business. Many attempt to maintain monopolistic control and have vested financial interests with a particular business in the area (usually older and larger). The local authorities also have significant authority over the allocation, marketing, and trading of goods and services in their regions. Given the lack of a fully functioning competitive market in some goods (such as energy), as well as the small share of assets that are officially privatized (particularly in agriculture), the oblasts and localities exercise authority and discretion in allocating crucial commodities according to nonmarket principles, and in prohibiting the private sector from using silos or purchasing and transporting grain.The reforms that may be needed in this area of local and oblast administration transcend narrow technocratic measures in “institutions” or “economics.” As in Russia, they may relate to electoral politics instead—how to develop a cadre of democratically elected politicians and officials that represent the interests of a broader-based business sector in the localities. This conversion to pro-PSD support is happening in selected localities in Ukraine, which, although in a minority, may serve as examples to others.37 At the same time, the system of appointing representatives from the center in the localities could be reviewed, since often regulatory impediments implemented in the localities are mandated from the center in the first place (rather than originating from local authorities themselves). In fact, of all the regulations and permits that an enterprise needs to operate at the local level, the majority of the obstacles and permits required are imposed from the center. They may in many instances be carried out by local officials, yet these bureaucrats just carry out orders in the local chapters of the central agencies.38 Thus, the relationship between the center and the oblasts, as well as the anti-PSD nature of many of the directives from the center to the localities, ought to be reviewed in depth as well. Reforming local government alone will not suffice.

Concluding Remarks

Working from our analysis, we outlined the main elements of an ambitious reform program at the present juncture of Ukraine’s transition. Is there a chance of such a program being adopted and effectively implemented? And if so can it make a difference? We conclude by touching upon these questions and suggesting that they have broader implications for other countries in the region.

A “Reform” Window of Opportunity?

It is still argued that after more than 70 years of authoritarian control by Moscow and its concomitant nonmarket experience, Ukraine could not have expected to form an entrepreneurial class in merely five years of independence. And tellingly, the Ministry of Statistics still reports that only 5 percent of the economy is in the private sector.

Fortunately, both statements in the above paragraph are myths, which the real experience of Ukraine in transition has already debunked. Ukraine’s entrepreneurship has been amply demonstrated, even if largely in spite of past government policies. About one-half of the economy is unofficial, attesting to the creativity of Ukrainian entrepreneurs in surviving under difficult circumstances. Yet this is more a “survival” economy than an investment or growth economy. A major revamp within government, and in its official policies, is now needed to attract this (heretofore unofficial) economy to be a contributor to a growing official economy. Private and export sector development would be expected to figure prominently in this strategy. The main measures recommended have been discussed above, particularly with respect to deregulation, taxation, and public sector reforms. Further, some of the additional emphasis that needs to be placed on liberalization and deregulation ought to be at the sectoral level at this juncture. For instance, opening up the agricultural and gas sectors, which have lagged behind in reforms, at an enormous cost for the economy (and inducement for large-scale corruption), is a priority.

Furthermore, complementary legal reforms are also extremely important, and are coverd in chapter 10. Within these, some are directly related to the measures we have emphasized as in instituting tax, land, and commercial codes (and more broadly safeguarding property rights) as befitting a more modern market economy. And capital market development, still incipient in Ukraine, needs to be accelerated.

In spite of the difficult challenges facing Ukraine today in instituting a pro-PSD and pro-export environment, there is room for hope at this juncture. The evidence suggests that domestic and foreign entrepreneurs are prepared to contribute to a growing economy if an enabling environment is firmly in place. The leadership is now aware of the significant impediments for PSD and growth that have emerged, and has also acknowledged the prevalence of rent-seeking activities in the public sector, and it appears to be leaning toward implementing the necessary measures and reforms. The “reformist” camp in the administration has prepared an ambitious reform agenda, which, if supported by the rest of the administration and parliament, they would carry out early 1997. At the same time, it is widely recognized that there are considerable political forces that oppose a change toward a more open, competitive and transparent environment.39 Thus, present-day Ukraine cannot be regarded as experiencing a period of “extraordinary politics” as did Poland in the early 1990s. The winding road already traveled since independence has already entrenched vested interests, with delayed privatization and liberalization having contributed to this entrenchment.

But a window of opportunity to take bolder measures is presently ajar. With the support of the international financial institutions and bilateral donors and advisers, the top leadership working in tandem with the reformists may be able to carry out a bold reform program—as it did at the initial stages of the reforms started in late 1994. In that sense, there is a historical opportunity now. If seized, Ukraine could look forward to growth in the near future.

The role of the donors and the international financial institutions will therefore be crucial in Ukraine during this period. On substance, focusing squarely on the heretofore neglected priorities for PSD-led growth will be a major challenge (including the crucial public sector, structural, and sectoral reforms needed to create a more transparent and competitive environment). And the amounts, timeliness, and uses of the financing will need to be fully consistent with maximizing support for these focused structural and sectoral reforms.40

When Will Russia and Ukraine Grow?

We close on a speculative note, starting with the giant: will Russia grow soon? Clearly, in this paper we cannot provide a full answer. Yet it is pertinent to raise it for Russia, as well as some other states of the former Soviet Union, because of some similarities with Ukraine. Russia started reforms much earlier than Ukraine, and for well over a year analysts and officials have been expecting positive output growth for Russia. But growth will elude even Russia for the whole of 1996, and by a margin. The framework and evidence presented in this paper indirectly supports and expands upon the tenet for Russia in Shleifer (1996), which we have explicitly analyzed here for the case of Ukraine: the fruits of macroeconomic stabilization will elude countries like Ukraine and Russia until major deregulation and public sector reforms are implemented.

Ukraine initiated reforms later than Russia, and although much progress has been attained over the past two years, an environment fully conducive to private sector development is not yet in place either. Ukraine’s official output decline is expected to be almost 10 percent in 1996. Even accounting for the unofficial economy, Ukraine’s overall economy continues to shrink. Other countries of the former Soviet Union, such as Azerbaijan, are also likely to record negative output growth. These countries have brought down inflation to manageable levels, yet they share an anti-PSD environment.41 The growth prospects in Russia and Ukraine for next year may be a tad better if they consolidate the macro stabilization and privatization gains achieved so far. Hence, a bottoming out of the output decline may be apparent during 1997, and these countries may avoid another year of significant output decline. Yet vigorous and sustained growth rates, exceeding 4–5 percent a year, will elude them until significant pro-business and pro-investment reforms are implemented through deregulation and government reform.

There is room for some optimism, however, drawing from the lessons of experience of other countries in the region. Armenia, the Kyrgyz Republic, Georgia, Moldova, and the Baltic countries, which not only have implemented the “macro” pillars of reform but also have made significant strides in deregulating their economies, will grow in 1996. And the earlier reformers in Central and Eastern Europe, which also deregulated earlier on in the transition, complementing their macroeconomic reforms, have already been growing vigorously for a number years.

Appendix

Figure A1.Severity of Impediment to Official Business—All Enterprises

(Severity of impediment rating between 1 (no impediment) and 5 (maximum severity))

Source: Surveys in selected major Ukrainian cities of June 1994, February and April 1995, and March 1996 (Kaufmann, Novitsky and Novitsky).

Figure A2.Rating of Regulatory Impediments by Private Firms

(Latin America and Ukraine; Scale of 1 (no impediment) to 5 (very severe impediment))

Source: World Bank Report No. 15352-GU (1996); Ukraine survey data; and author’s calculations.

Table A3.Overall Liberalization and Private Sector Development Index (OLPI) and the Evolution of the Unofficial Economy in 16 Countries of Eastern Europe and the Former Soviet Union
Overall

Liberalization Index
OLPI

Average
Unofficial Economy

Change 1989–94
Unofficial

Economy Share 1994
0<OLPI< 25182739
25≤OLPI≤45361630
45≤OLPI≤10059623
Total average371732
Note: OLPI is the Overall Liberalization/PSD Index averaged for each country for the overall transition period, standardized to range from 0 (totally nonliberalized economy) to 100 (totally liberalized). OLPI from DeMelo, Denizer, and Gelb (1996), and presented in Table A1. The unofficial economy share calculations are from the author’s “main conservative scenario” calculations for 16 countries of Eastern Europe and the former Soviet Union (as in Table A1) and Kaufmann and Kaliberda (1996).
Note: OLPI is the Overall Liberalization/PSD Index averaged for each country for the overall transition period, standardized to range from 0 (totally nonliberalized economy) to 100 (totally liberalized). OLPI from DeMelo, Denizer, and Gelb (1996), and presented in Table A1. The unofficial economy share calculations are from the author’s “main conservative scenario” calculations for 16 countries of Eastern Europe and the former Soviet Union (as in Table A1) and Kaufmann and Kaliberda (1996).
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*Visiting Scholar at the Harvard Institute for International Development, on secondment from the World Bank. The views are the author’s, and do not necessarily reflect those of the institutions. I am responsible for any errors. Lorena Barberia provided excellent research assistance. I have benefited from comments from, and discussions with, I. Figlus, S. Fischer, J. Graf Lambsdorff, N. Jaresko, S. Johnson, A. Kaliberda, S. Konoplyov, J. Kornai, J. Linn, V. Litvitsky, V. Nanivska, I. and V. Novitsky, B. Nunberg, A. Pivovarsky, V. Pynzenik, J. Sachs, E. Segura, M. Selowsky, A. Shleifer, O. Soskin, and A. Stone. Materials for this paper were presented at the July 1996 seminar under the heading “Unofficialdom, the Role of the State, and Private Sector Development in Ukraine,” and were updated in January 1997.
1Ukraine’s official statistics, which lack reliability, suggest that the economy is expected to contract by about 8–10 percent during 1996. Even accounting for the unofficial economy (for our purposes in this paper defined as unreported value added), a contraction in overall GDP is anticipated during 1996, continuing the downward trend throughout the transition.
2A broader concern of an excessively retrospective (and narrow) performance approach is that a false sense of confidence within Ukraine and abroad may set in (however impressive achievements on some reform measures so far may be). Some advance the mistaken notion that merely the reforms achieved so far, coupled with further aid from the West, will somehow suffice in leading to sustained increases in standards of living.
3The unofficial economy may have served a useful role during the transition as a “survival” economy, and thus in mitigating the spiraling decline in official activities. Yet it is no panacea for future recovery and sustained growth, as it is not an “investment” (and longer-term horizon) economy—and it also impairs macroeconomic management by the state due to the erosion of the tax and foreign exchange base. (See Kaufmann, 1994, for details.)
4See Kaufmann and Kaliberda (1996) for the exposition of a numerical index measuring (antiliberalization) administrative controls and interventions in Ukraine, 1992–1996. In spite of the prevalence of a number of remaining visible trade and pricing interventions today, the reforms carried out over the past two years, having started from an interventionist “peak,” have by now resulted in a substantial decline in the index.
5Shleifer (1996) compares government interventions in privatized small shops in Moscow with those in Warsaw. As expected, interventions and rent seeking in Moscow appear to be orders of magnitude higher than in Warsaw. Further, a recent survey by the Merchant International Group of 2,500 Western firms finds Russia to be about the riskiest of the emerging markets for foreign investors (Ukraine was not included in that survey). It is thus reasonable to suggest that Russia is a very high-intervention (anti-PSD) benchmark comparator.
6Consider the case of a high level of taxes being regarded as a serious impediment, for instance, that is expected to draw universal complaints. The real issue is whether there is a significant upward deviation from some “normalized” base complaining factor about any taxes. Compared with the 4–9 rating in Ukraine, in Russia it rates as a 4.5, in Peru 4.0, in Uruguay 3.8, in Mexico 3.4, in Guatemala 2.6, and in El Salvador 2.1.
7In the Appendix, Figure A1 presents the results for the overall sample.
8URES, in various monthly reports and quarterly report of December 1996. Data extend to November 1996.
9The list of constraints in memoranda by multilateral as well as non-U.S. bilateral institutions is similar. Numerous letters by foreign investors to senior government officials and to international financial institutions also attest to such binding constraints for investing in Ukraine. See, for instance, JKX Oil Co. Chairman’s statement at the Paris Consultative Group Meeting for Ukraine, October 1996. Inter alia, evidently JKX Oil had misplaced a US$20 tax receipt from 1994. Tax authorities were demanding penalty payments of several hundreds of thousands of dollars in 1996 for such a “violation,” and had frozen JKX bank accounts.
10Thus, next year’s supply of these inputs is being jeopardized.
11One recent U.S. document on this issue, communicated to Ukraine’s leadership, clearly states: “American business people, for example, bound by the U.S. Foreign Corrupt Practices Act, often must walk away from a transaction….”
12As stated in one memorandum (and similarly in others), “Ukraine’s crime problem extends significantly beyond the street. Unfortunately, some of what is perceived to be mafia crime in Ukraine today is official corruption and extortion/protection rackets, which directly affect foreign businesses.” Similarly, in a recent Christian Science Monitor article on corruption in Ukraine (Greenwald, 1997), the author writes: “Things have gotten so tense that the United States, Ukraine’s main patron, is no longer saying encouraging things about the economic prospects of its third-largest foreign aid recipient…. American businesses are not the only ones to confront such graft…. The government’s response has been half-hearted….” Further, the Kiev-based Weekly Mirror newspaper, on December 28, 1996, quotes a leaked letter of the President of the World Bank to the president of Ukraine as expressing serious concern over the deteriorating business environment, government interference, and corruption.
13Some local administrations, in fact, in the old mode of operating, still intervene by establishing targets at the farm level, such as giving directives on the number of cattle.
14It is by now acknowledged that in many countries one of the main reasons to impose such impediments is to extract illicit rents. This “endogeneity” in initiating administrative interventions is, however, not crucial for the thesis that illicit rents increase when administrative impediments on official business are imposed.
15Thus, in all these respects, this economy is very different from conventional African, Peruvian, or South Asian notions of the “informal sector.”
16At times, other estimates are mentioned in Ukraine about the share of the unofficial economy, ranging between 30 and 50 percent. It should also be noted that other methodological approaches, not explored here, may yield different estimates. One such approach relies on monetary balances in circulation. However, using such an approach in settings with a volatile velocity of money is problematic. At any rate, for Ukraine such an approach would also suggest a very high share of the unofficial economy (for any sensible assumptions about the initial share in base years in the early 1990s).
17For further details, see Kaufmann and Kaliberda (1996), Fig. 4.4, p. 99.
18However, there is no comparable cross-country and time series on tax burden on enterprise, so the independent effect of taxes on the unofficial economy could not be tested in this comparative methodology.
19The estimates on tax burden (taxes over gross revenues) cannot be regarded as very precise, given the difficulties for interviewers/interviewees in incorporating all taxes that need to be paid. But as orders of magnitude within a range they do suggest a very high tax burden.
20A cross-country comparison of the enterprise’s rating of regulatory impediments is presented in Figure A2.
21For details on the “negatives” of the unofficial economy, and a few (mild) positives, see Kaufmann (1994).
22These 15 percent of “entrenched” respondents either said that they would not come back regardless of what government policies were in place, or doubted that the government would ever implement pro-business policies in the first place.
23In this context we ought to also note that the aggregate electricity consumption cross-country comparative evidence is supportive of the “shallowness” hypothesis: countries that liberalized early, such as Poland, saw a reversal in the evolution of the unofficial economy share from 1992 onward.
24A telling example of the “tax” imposed on agricultural production by rent-seeking regulations is provided by the current situation in grain procurement. The recent imposition of regional-level state procurement of grain from farms means that some local officials extract rents from such forced procurement at the expense of the farms, which will be unable to honor their (grain) repayment contracts to input suppliers. As a result, the input availability situation from private suppliers, and thus agricultural prospects, looks uncertain for the 1997 crop.
25See Table 4 for a comparison of total unofficial payments by new enterprises with those by older firms.
26Deregulation will take some time to complete, and thus the playing field will not be leveled for some time.
27Reduced evasion would be the other source of tax base expansion, but the gains would be gradual.
28From earlier on, however, lower tax rates will result in less tax arrears accumulation.
29For instance, the 1997 draft budget version in December 1996 still included financing for completion of a state steel mill.
30See Johnson, Kaufmann, and Ustenko (forthcoming) for evidence on the significant rate of reemployment from outgoing state workers in Ukraine, as well as the prevalence of other coping and “survival” worker strategies. In that research we also attempt to identify a vector of characteristics of the “noncoping” worker, to improve targeting.
31For an in-depth review of institutional specifics not covered here (including the issues of overlapping jurisdictions of ministries and unclear delineation of authority between center, oblast, and municipality) see chapter 16 in this volume.
32For a detailed review, see chapter 2 in this volume.
33The need for civil service pay reform, against the backdrop of the current rent-seeking behavior of many public servants, can be illustrated through a simple calculation: if we assume that our survey is representative of the registered enterprise sector, then the overall direct payments from enterprises to officials far exceed US$1 billion a year. This implies ewer US$3,000 per (central/local) administration official on average—exceeding average salaries. These are, of course, conservative figures, masking considerable variance and the fact that there are many honest public servants. Further, these figures do not include the energy, agriculture, and real estate sectors, where significant corruption appears to exist, nor do they include bribes from unregistered activities.
34While corruption in the public sector has been successfully addressed in many countries (such as Botswana, Chile, Hong Kong, New Zealand, Singapore, and some OECD countries), it is an age-old phenomenon prevalent in many settings. Kautilya, in the 2,000-year-old Arthashastra wrote: “Just as it is impossible not to taste the honey or the poison that finds itself at the tip of the tongue, so it is impossible for a government servant not to eat up at least a bit of the King’s revenue…. There are about forty ways of embezzlement [by the government servant, enumerated below]….”
35The state of the art and lessons from evidence are much less advanced on this issue, than, say, on the theory and lessons from macro-stabilization or trade liberalization.
37See Shleifer (1996) for a discussion of this very issue in Russia.
38Informal interviews by the author of Ukrainian experts suggest that over two-thirds of the constraints and regulations on enterprise in the localities originate from the center. This still implies, however, that about one-quarter to one-third of the impediments that a business finds in operating in the localities are still solely driven by local authorities themselves. The results of SIEAG’s Ukraine Rapid Economic Survey also support these propositions: while they find that impediments to enterprise by local authorities have continuously increased throughout 1996, the respondents still rate the obstacles originating from the center as significantly higher.
39In fact, consistent with the absence of a full consensus, as of late 1996 (at least) two very different sets of draft decrees and regulations to affect changes in the economy were being prepared in government. One set, supported by the reformists, was consistent with substantial reforms to improve the PSD climate, while the other, supported by the “old regime,” intended to impose further trade impediments, tariffs, and other administrative interventions. About the antireform forces still in government, Greenwald (1997) writes in the Christian Science Monitor: “The corruption in Ukraine is a legacy of Soviet rule across the region. The old regime left behind an orphaned, state-owned economy and a managerial class used to treating public assets as its own. These graduates of the Soviet school of doing business now fill Ukrainian ministries and regulatory agencies. Brisk black-market business is the result of punitive taxes and red tape imposed on legal enterprises.”
40In this context, the crucial upcoming instruments by the international financial institutions would be (1) the IMF’s Extended Fund Facility, expected to be approved by early 1997 (and within which a major focus on a pro-PSD and pro-growth strategy would be needed), and (2) the World Bank’s sectoral program packages in the form of the Privatization, Energy, Agriculture, Legal, and Public Sector Reform Loans—which together would be expected to support an integrated program of the emergence of a competitive environment in various sectors (including energy), of tax reform and deregulation, of accelerated enterprise, energy, and agricultural privatization, and of pension and public administration reform. It is also imperative that other donors supplement these programs by opening their markets to Ukrainian exports and through adequate financing for an ambitious pro-PSD reform program.
41We do not address the special cases of Belarus, Tajikistan, and Turkmenistan, which cannot be regarded as being on a reform path. Hence, the task of distinguishing between implementation of macroeconomic versus structural/microeconomic reforms is clouded. It is worth noting, however, that Belarus, although not in a serious reform program, has brought inflation down considerably as well. It has done little, if any, privatization, liberalization, or deregulation. It will also record negative growth during 1996, as in all previous years this decade.

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