By Krasen Stanchev
Just before Christmas in 2021 I was in Kyiv with the Polish economist Janusz Schirmer for a meeting the chairmen of committees in the Verkhovna Rada, the presidential adviser on economic issues and leading business associations. Our goal was to help improve the tax system. The war postponed these reforms. My last visit in Ukraine was in the end of March this year, and the occasion was a conference under the auspices the country’s president on the subject “Tax reform and overcoming corruption”.
An understanding of Ukraine's public finances cannot but be influenced by personal impressions and experiences. The thought that constantly blew my mind during my journey, stay in Kyiv and visit to the city of Irpin was “how many more opportunities for destroy and sow death” there are before the aggressor. It is extremely important that these opportunities are blocked and the aggressor is punished. By protecting themselves, their families and future, Ukrainians are actually protecting us. This assessment is not an emotion, but a consequence from my understanding of the nature of this war.
War in a legal context
The invasion of the Russian troops on February 24, 2022, for me, is equal to the beginning of the WWII, although this comparison is extremely inaccurate – from an international-legal point of view. Hitler’s Germany wasn’t bound by international treaty to protect the independence of any country. Back then the aggressor was even somewhat encouraged by the “Munich agreement” from 1938, and his “success” is guaranteed by the “Ribbentrop-Molotov” treaty from August, 1939 and the invasion of the Soviet army into Poland on September 17 the same year.
The new war against Ukraine, judging by the beginning of the aggression, is seen by Kremlin as a mixture between Anschluss of Austria in March, 1938, the annexation of Sudetenland in the Czech Republic in October 1938 and the occupation of Czechoslovakia by the Warsaw Pact in August, 1968 – the landing and leap march to the capital Prague without military resistance. The militia of the Ukrainians and the response of the Armed Forces of Ukraine after the beginning of the Russian aggression proved how stupid and illusory Putin's new plan is.
The USSR (now Russia) is a founding member of the United Nations, and Ukraine is a co-founding member, with the Russian Federation (RF) also a member of the UN Security Council. All three of its roles require by statute to be a guarantor of the prevention of wars, of the right of defence against aggression and imply actions (sanctions and others) against the aggressor in the name of preserving peace in the world.
Russia is one of the guardians of the independence of Ukraine under the Budapest Memorandum of December 1994. Together with the United States and Great Britain, it undertakes to protect the independence, sovereignty and borders of Ukraine, to refrain from threatening the use of force against the territorial integrity or political its independence, not to undertake economic coercion against Ukraine, not to use nuclear weapons against it, and "to seek immediate action in the UN Security Council…, if Ukraine becomes the victim of an act of aggression or the subject of a threat of aggression" with such arms and to consult each other when the performance of these duties is threatened.
Political-economic context
The war began with the annexation of Crimea. Since then, there have also been sanctions against companies and citizens of the Russian Federation. The encouragement of both the seizure of Crimea and the two eastern regions of Luhansk and Donetsk, as well as the war of 24 February 2022, comes from the silence of the EU and NATO on the 2008 war in Georgia, the Kremlin-ruled territories of the former USSR and from the soft sanctions after the annexation of Crimea.
The EU until 2022 preferred diplomacy, negotiations, mutual concessions and the implementation of commitments in conflict resolution. This expectation conveniently coincides with increases in trade and imports, construction of natural gas and oil pipelines, and increased imports from Russia. On the one hand, the sanctions are soft, on the other hand, the growth of dependence on such imports seems certain, due to the energy and green policies of the EU. Natural gas is a "transition fuel" to a carbon-free future. The cancellation of measures against Covid accelerated economic growth, the demand for energy resources and, accordingly, their prices, not only in the EU. As a result, Russia's budget revenues also increased. Politicians and public opinion of the EU hardly assumed that the Kremlin would sacrifice 40% of its passes and undertake, according to the now fashionable definition, full-scale military aggression against Ukraine – a country that is part of its history, with kinship ties of population and which is "probably" already permeated by hybrid influence and secret service agents.
Putin's announced plan to connect the Chinese and European markets with a single Russian-owned gas transmission infrastructure (to switch supplies from west to east depending on prices and as a means of economic coercion) appears unfeasible. The capacity of the eastern gas pipeline "Power of Siberia 1", when it is reached in 2025, will be 3.5 – 4 times smaller than the EU market. The construction of the new Power of Siberia 2 gas pipeline takes between 12 and 15 years, and it is highly unlikely that China will agree to be blackmailed by Russia. On top of all this, the motives for a full-scale aggression against Ukraine have long remained completely misunderstood.
The awkward example
According to Credit Suisse’s wealth reports, from 2000 to 2021, the wealth of senior citizens of Ukraine increased 22.3 times, and that of Russia – 12.4 times. In 2012, a quarter of Ukraine's income came from exports to the EU and Russia, but after 2013, exports to the EU began to overtake those to Russia, and by 2021, Ukraine's business income with the EU and Russia was already 8:1!
In 20 years, Ukraine has changed through free elections five presidents, while in Russia only Putin has always been the president. During this period, Ukraine repeatedly improved its ranking on the indicators of democratic governance, fair elections, economic, human freedom and the rule of law. While Russia consistently remains in the group of worst performing countries.
The example of Ukraine, as well as that of Georgia, is contagious. That is why the Kremlin is taking action against them, and the war is simply an expression of Moscow's fear of political contagion.
Attitude towards the war
Between February and the end of March 2022, the EU and NATO's deterrence of aggression has already been completely overcome. The Ukrainian citizens and army managed to stop the aggression and repulse the leap march towards Kyiv. The Kremlin’s so-called “collective West” is uniting in its efforts to protect Ukraine and deter the aggressor. NATO begins to expand, with new members Finland and Sweden not being consumers but producers of armaments and security. The logic of unification behind the Ukrainian cause in this war is obvious and internationally confirmed. After April It is obvious to all that an end to war can be achieved in three ways: Ukraine is the winner, Russia manages to assert itself, or the conflict is frozen in some kind of stalemate. The last two scenarios would actually only mean a continuation of the war: both on the part of Russia, but also on the part of other political regimes similar to it – incl. China.
The imposition of the sanctions by the West against Russia aims precisely to block the danger of the realization of the last two scenarios. The ever-probable boomerang effect of sanctions in the case of this war is preferable to the challenges of its escalation. After 2012 and the annexation of Crimea, Russia's economy has decreased its share in the world GDP, and compared to that of the EU, it is in a ratio of 1:11 (forecasts for 2023).
In the summer-autumn of 2022, Russia changed tactics and began to wage a war of attrition on Ukraine, aided by the destruction of military, urban and, above all, civilian infrastructure.
Initially, a week after the start of the war, the concept of sanctions was developed by Ukrainian economists, political scientists and lawyers, and was laid out in an Appeal to the leaders of the world financial community and politicians. On the legal basis of the sanctions in connection with the annexation of Crimea, the sanctions are beginning to expand, broadly following the logic of this Appeal. S&P monitoring gives a relatively complete picture of their development.
However, the economy is an inertial system: there is a time lag from announcement to action, investors leaving Russia need a divestment process and value chain realignment, and often continue to fulfil their supply contracts on already concluded deals.
But their expansion proceeds in concentric waves. At the company level, global risk is often judged to be more significant than the loss of market share in Russia. In this context, it maintains relative stability due to the increase in exports and supplies during the lag between the announcement and the effect of the sanctions, partially replacing the final buyers and suppliers (for example from China, India, Iran, Saudi Arabia and South Africa). A particular development is also observed in the Eurasian Union (EAU). After its final establishment in 2015, the economies in it began to trade less with each other and more globally (including with the EU), the benefit is mainly for Russia, and beyond the EAC – mostly for China. In 2022, the EAC countries will volley increase their imports from the EU and their exports to Russia will increase by the same percentage.
The military-financial system of Ukraine
A war is not won with sanctions, but with resources – human, material and financial, which can change the balance of forces on the front. In the case of sanctions, the most important upcoming development is their expansion to third countries beyond Russia and Belarus. It is likely that even Russia's aforementioned supplier countries would prefer stability in dealings globally rather than with Russia's relatively small economy – it is projected to account for just 2.85% of global GDP (including the grey sector) in 2023.
Among the aids, the most important is the military support. Supplies here are gradually moving away from purely political decision-making procedures and towards design decisions, such as a "coalition of the willing". From April 2022 to April 2023, global military, humanitarian and fiscal aid to Ukraine amounts to between $10 and $11 billion per month, and with an increase in military supplies in the summer, this is likely to rise to around $13 billion. US aid is less than 0.3% of GDP, and those from the EU – slightly above this percentage.
In Ukraine itself, the fiscal and economic stress is enormous. According to estimates by the Kyiv Center for Economic Strategies, the economic decline for 2022 will be 31-32% of GDP, and the budget deficit – between 37% and 46% of GDP. This deficit is financed with international transfers and government loans. In this situation, the welded fiscal system of the country practically ceased to function in April last year.
Before the war, direct taxes were 18% of the income of individuals and companies. (before Crimea – 17%). Since 2016, a military tax of 1.5% of every income has been introduced. This is the only tax that is readily paid by all. VAT is 20%, with various discounts. However, direct taxes are only "flat" in appearance. There are tax-free minimums for different categories of taxpayers, combined with different tax regime and declaration options.
From April 2022, direct taxes are effectively voluntary, with the exception of financial institutions, some large taxpayers (mostly state-owned enterprises) and foreign individuals. The simplified tax regime is 2% of income, accounting is also simpler. A tax collection rate of 60% can be considered a success for governing the country during wartime.
Post-war challenges
This year, Ukraine's GDP is expected to be between $135 and $140 billion. Recovery funds are currently estimated at around $420 billion and will likely grow to more than three times GDP by 2023 – barring more significant destruction, refugees and victims. Adding in rising government liabilities, it's entirely possible that recovery funds could reach $600 billion, or four times GDP, by 2023.
It is not clear how much of the debts will be restructured or simplified, but the challenges remain along two main lines – fiscal recovery and the rational use of recovery resources. Based on experience, the following principles can help overcome these challenges.
Regarding the fiscal system
- It seems rational to improve the income tax scheme.
- To unify the tax thresholds at relatively low levels – probably 10 or 5%, which is possible problem with the future membership of the country in the EU, if the Union does not accept lower than the current thresholds in Bulgaria, Estonia, Romania and Hungary.
- At a low level of direct tax, there should be no tax-free minimums. Currently, this principle is extremely unpopular in Ukraine.
- Labour taxes, the so-called social contributions should be at the approximate level of direct taxes, no more than 1.5 – 2 times above them, taking into account the fact that so far all countries that have restored progressive taxation after the operation of a "flat" tax system have done so due to a disproportionate or constantly changing scale of social contributions'. This is the case with Albania, Slovakia, Serbia and the Czech Republic.
- Corporate tax, given the massive and possibly huge international post-war recovery programs, would be wise to abolish it except on repatriated profits.
Regarding the reconstruction funds
The experience after World War II shows the following.
- Europeans rebuilt their countries' GDP after World War II often before international reconstruction programs began to operate. The 1938 level of GDP per person (measured in 2011 USD) was restored in 1947-1959 in France, Belgium, the Netherlands and Italy, in Germany in 1951.
Germany's success was due to full liberalization, competition in government procurement, and the general removal of price controls and barriers to market entry (including a minimum wage) in 1948. These reforms were supported by monetary reform and a monetary policy aimed at price maintenance. Capital and enterprises are preserved, regardless of their policies and the behavior of the owners before and during the war.
However, physical recovery takes ten years and more in the most devastated of war zones.
Apart from competition, a major factor in recovery is the relatively small share of grant schemes in the allocation of resources and implementation of the recovery programme. Grants are around and below 25% of the resource directed to these programs.
In the countries where governments pursue relatively aggressive industrial and protectionist policies, the recovery is lingering, and the economic growth – slower.
The process and decisions to redistribute recovery resources is largely depoliticized.
Many of these principles regarding both positions are challenging or are still not popular in Ukraine, or it are yet to be recognized as guiding principles of post-war economic and fiscal policy. The administration of the country during the war, however, gives ample grounds for common sense in politics after it.
THE BOTTOM LINE Funds for the reconstruction of Ukraine at this stage amount 420 billion dollars, but if the destructions continue, it could reach even 600 billion dollars, or a level of four times GDP in 2023.