Why Drive Business Underground? An Alternative Way To Increase Government Capacity Exists

Apart from the fact that Ukrainian business continues to suffer from unpredictable actions of the government and pressure from law enforcement agencies and numerous regulatory bodies, it is being driven underground at a frantic pace. And this is happening during a long war and with a huge state budget deficit.

It should be noted here that our partners give us money exclusively for social and infrastructure projects. We support the army only by filling the budget with taxes from businesses and citizens. There is a good chance that we will be able to use a significant portion of the future revenues from the frozen assets of the Russian Federation under the G7 “50 billion program” for military needs, but the details are currently unknown.

At the same time, the initiatives of some government agencies may literally lead to a decrease in budget revenues. We are talking about increasing the tax burden and tariffs. The Verkhovna Rada also passed a law on the White Business Club, which negatively changes the rules of the game for small and medium-sized businesses.

Not to mention the fact that against the backdrop of the Ministry of Economy’s attempts to support the development of Ukrainian producers, the Verkhovna Rada is making decisions aimed at destroying them. For example, it has once again adopted a decision that gives preferences to importers over domestic producers of energy equipment (particularly in the area of energy storage).

“White Business Club”

The motivation behind the creation of the White Business Club seems rational: the introduction of a risk-oriented approach. Moreover, 20% of entrepreneurs believe that this is a positive idea.

But does this mean that those who are not part of this “club” for one reason or another automatically become “black” or dishonest businesses? Why should integrity be determined by the level of salaries? This is a matter of business models and competition. And the state has no right to tell businesses how they should form their own strategy.

Moreover, under the conditions set out in the law on the so-called White Business Club, no more than 10% of Ukrainian business will be able to physically enter it. And it will be mostly international business and big companies.

Therefore, 90% of businesses will automatically be classified as gray market businesses. According to this law, such businesses become dishonest by default, and will automatically face heightened pressure.

However, I would like to remind you that, according to Ukrainian law, neither the Prosecutor General, nor the tax authorities, nor Mr. Hetmantsev himself (Chairman of the Verkhovna Rada Committee on Finance, Taxation and Customs Policy), nor any official in the country in general, can call a business dishonest. Only a court can do that.

Before that, the state — and each of its institutions and representatives — should treat business as a virtuous one. As one that, in addition to taxes, annually donates about UAH 200 billion to the army. Implements humanitarian projects. Invests in the defense industry. Creates jobs for the adaptation of veterans.

Raising taxes

Another prospect for Ukrainian business is the tax hike announced by the Ministry of Finance and the Verkhovna Rada Committee on Taxation, Finance and Customs Policy. According to our estimates, under the best and most optimistic scenario, this measure could result in an increase in state budget revenues of 150 billion UAH next year.

This is if we take into account the natural growth, which is going to be at the level of 340 billion UAH next year due to inflationary processes, economic growth and business activity. Of course, if growth is not destroyed by tax increases, because in this scenario, the modeling indicates a 3% economic decline instead of growth in the coming years.

We have calculated the consequences of the tax increase for several years to come, taking into account the fall in investment inflows and the reduction in business activity, and have obtained the following results. In this scenario, instead of a 150 billion UAH growth in 2025, we will have a 50 billion UAH decline in the budget in 2026. These are the consequences.

First of all, this is because instead of economic development, business incentives and support, we have a completely Soviet economic policy, as in the proverb about a cow which moos a lot but gives little milk. People try to convince us with the experience of the United States 80 years ago or high taxes in the EU, but they forget the key logic of comparisons. We need to look not at what developed countries do, but at what they did to become developed.

The key rule here is to ensure economic growth. The increase in state budget revenues should result from the expansion of the tax base, i.e., primarily from an increase in business turnover, profits, household income and consumption.

Although in the first year of the tax hike, businesses will continue to operate inertially and the state will receive an increase in tax revenues, massive business closures, suspension of investment projects and shadowing of the economy will occur in parallel.

For example, an increase in VAT will lead to a 30% increase in tax evasion schemes. Similar losses to the economy will occur if a turnover tax is introduced.

If labor taxes are raised, unofficial wages will increase. While we currently have 34% of shadow wages, after the military tax grows to 5%, the shadow part of wages will increase to 45% (modeling by Advanter Group and the Office of the Chief Economist of the Coalition of Business Communities for the Modernization of Ukraine).

There is an alternative — economic reforms

What are economic reforms? These are primarily reforms of the rule of law and economic freedoms.

A customs reform has long been on the top of the list, and it means more than 100 billion UAH of additional revenues to the state budget annually. This is a tax reform. For example, reducing the practice of blocking tax invoices means returning 40 billion UAH to the economy. In general, improving administration means about 60 billion UAH of additional effect for the state budget.

So, if you do the math, you can have hundreds of billions in economic reforms instead of 150 billion UAH in the first year with a further decline in revenues. And in a positive scenario, we could have up to 1 trillion UAH in increased state budget revenues. But all of this is all possible if truly large-scale economic reforms take place, including the following:

• economic mobilization deferment: the introduction of economic mobilization deferment for key specialists will help preserve the country’s production potential and reduce budget losses by 19 billion UAH when 500,000 people are conscripted. Provided that 20% of employees with a salary of UAH 30,000 or more are reserved, additional budget revenues due to the de-shadowing of 570,000 salaries will amount to 165 billion UAH. Obviously, even this one step is more effective than the cumulative effect of raising taxes;
• fighting corruption and shadow schemes;
• improving the quality of customs administration and eliminating shadow schemes, which could bring up to 160 billion UAH in additional revenues;
• reform of the BES, SMCOR (automated system for monitoring the compliance of tax invoices with risk assessment criteria) and avoidance of inefficient tenders, this could save about 100 billion UAH and stimulate business turnover growth by 5%;
• review of the land and real estate taxation system, eliminating unjustified privileges and improving the efficiency of these taxes, which could bring in up to 40 billion UAH in additional revenues;
• optimization of state budget expenditures. There is promise in the field of state and local procurement and the educational sector, etc. In particular, the very finalization of the audit of the efficiency of human and financial resources in the Armed Forces of Ukraine can also demonstrate opportunities for redistributing the current budget;
• de-shadowing of the economy: bringing salaries out of the shadows, combating conversion centers and optimizing taxes through individual entrepreneurs will help to significantly increase budget revenues;
• tax reform. This is a separate topic that can give the Ukrainian economy a huge boost and significantly fill the country’s coffers. I would like to remind you that think tanks have developed proposals for liberal tax reform supported by many economists worldwide.

Increased predictability of the authorities will lead to increased confidence. Consequently, we will have a greater effect on the issuance of government bonds. Likewise, the trust of international partners will allow us to receive additional revenues from Russian assets.

In the language of numbers, in the scenario called “Economic Reforms,” taking into account the cross-impact of factors, the expected growth of consolidated budget revenues could range from 400 billion UAH in the short term to 1,100+ billion UAH in the medium term, which is much higher than in the case of a banal tax increase.

Even if we proceed from a pessimistic scenario, 400 billion UAH can actually be obtained if we implement quite understandable tactical reforms. Those reforms, most of which are not even opposed by the Ministry of Finance.

Thus, it is safe to say that “hole-patching” gives a false impression of a positive effect. In fact, not only in the medium term, but also in the short term, raising taxes will cause significant damage to both the economy and the ability of businesses to develop the defense industry and help the defense forces directly, compensating for the existing failures in centralized supply by the state.

Economic reforms aimed at de-shadowing, increasing the efficiency of public spending and creating a favorable investment climate are a more stable and promising path for Ukraine, both in terms of long-term strategy and short-term needs.