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21 October, 2016  ▪  Lyubomyr Shavalyuk

Speculations on the state budget

Some interesting details about the national budget for the upcoming year

On September 15, the drop-dead deadline provided in the Budget Code, the 2017 Budget Bill was registered the Verkhovna Rada after having been approved by the Cabinet at an unscheduled session just days before. And so, the budget race was on. This is the perfect moment to analyze the country’s main financial roadmap and for civil society and the public to debate its merits: what should be in it, and what shouldn’t.

A qualitative breakthrough

First of all, the Government deserves a medal. It did not take the bill back for revisions right after registering it in the legislature, the way its predecessors had done for the last few years. That’s already a good sign. The overall impression is that preparations for the 2017 Budget have been going on for some time in a fairly systematic fashion: the budget resolution was passed back in June and, judging by the notices that appeared from time to time in the press, MinFin worked continuously with all the government agencies on the actual draft.

Most likely this budget bill was ready even earlier, along with a number of variations depending on how events unfolded, but the Government had to wait for the IMF to make up its mind whether to carry out a second review of the Extended Fund Facility (EFF) and issue the third tranche of Ukraine’s credit. If its decision was positive, it meant that Ukraine would be able to use at least US $3.5-4bn from the IMF and other international donors, enabling a positive outlook for next year. If things had gone the other way, based on current indicators, the country would have had to tighten its belt considerably in the last few months of this year, which would have had a negative effect on economic growth in 2017—and hence on 2017 budget figures.

On September 14, the IMF ended up making a positive decision, announcing that this was a kind of advance, exactly a day before the deadline for submitting a Budget Bill to the Verkhovna Rada. The Cabinet met the deadline, the process was launched, and short-term expectations based on the latest portion of foreign loans are positive. For this, the Cabinet deserves to be praised.

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But let’s not get carried away with its merits just yet. 2016 appears to have marked the end of the country’s crisis and its sharp economic decline, so 2017 should be the first year of statistically significant growth since 2011. Or are we living in Greece? Yet this requires a completely different approach to putting together a budget—and far less time and effort spent on the process itself. When an economy is stagnating or in decline, there is no certainty where and when it will bottom out or in the tax base, so the Government has to look for various means to expand it, using measures that are often questionable and artificial, to raise rates and fees, and increase tax pressure. When an economy is in a growth phase, things are very different: the tax base is predictable, budget revenues don’t tend to decline, and no painful moves are necessary, such as spending cuts.

This leads to a number of conclusions. Firstly, the fact that the previous budgets were approved just before the New Year may have been embarrassing, but it was largely justified by the crisis and made it possible, to some extent, to establish the most realistic and freshest forecasts and indicators in the bill. This reduces the level of blame on the post-revolutionary predecessors, as well as the merits of the Groisman Cabinet. Secondly, since we’re talking about a budget in a growing phase, its weak points will not be where to find revenues but how to most effectively distribute them across expenditures. This is what needs to be considered when analyzing the bill.

The revenue side

In the current Budget Bill, 2017 revenues are expected to be UAH 706bn, which is 17.3% more than was planned in the current year. Tax revenues, which constitute 83% of all planned income, are expected to rise by the same amount. And this is the first spot where questions arise about how realistic the numbers are. If real GDP is expected to rise 3.0% and consumer price inflation 8.1% in 2017—GDP deflator-based inflation could be a slightly different figure—, this suggests nominal GDP in the range of 11-12%, although current inflation rates suggest that even this growth might not happen. On average, the tax base should grow approximately the same. So where will the 5-6pp difference, UAH 30-36bn, come from if the Government upholds its promise not to increase tax pressure? What is the likelihood of this turning into a hole in the budget in the end?

There are two possible answers to these questions. The first is simpler, but also somewhat superficial: either a simple mathematical miscalculation or putting bets on the best-case scenario. That’s what happened in 2016: initially, nominal GDP growth of 14% was used, meaning 2% real growth plus 12% inflation, and a presumed budget revenue increase of 15%. When it turned out that the economy was growing more slowly than anticipated, the budget was saved by a somewhat unexpected devaluation of the hryvnia at the beginning of the year, which led to an average UAH/USD exchange rate of 25.3/1 for the first eight months rather than the projected 24.1/1 in the 2016 Budget—and it’s unlikely to go any lower by the end of the year. This ensured higher than anticipated nominal GDP and made it possible to fulfill the planned revenue side.

Despite all this, talk about a possible failure to fulfill the 2016 Budget continued well into September, when the IMF issued a third tranche not entirely justifiably but based on all these discussions and the risks that had appeared on the horizon. If the 2017 Budget, put in the context of a steep decline in real inflation, also counts on something similar to happen and save it, then this will do no good because it simply sets up the real risk of macroeconomic imbalance: a rise in the budget deficit beyond the caps established in the IMF program, a new wave of devaluation and the accompanying rise in inflation, even if the wave is modest. If it was a mere miscalculation, then it would be good to correct it prior to the passage of the final version.

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A second possible answer: the Government wants to increase revenues by improving tax administration. According to a number of top officials, this is one of the Cabinet’s top priorities today. Still, there is an internal contradiction in this particular answer. Improving tax collection primarily means cutting the time businesses spend on accounting and reporting, and the money they waste on bribes. Most of the time, this doesn’t represent a clear benefit in terms of increased budget revenues. If, however, it means eliminating loopholes that will result in increased VAT contributions, nominal GDP will also grow with these additional revenues as the shadow economy shrinks.

And so, improving tax administration increases revenues to the Treasury in proportion to the increase in nominal GDP, particularly that part that was in the shadows. Still, this does not explain the different pace of growth. Beyond this, is there any guarantee that, with better tax administration, the necessary large sums established in the budget will be covered? Among others, the 2017 Budget Bill projects an increase in net VAT revenues from goods and services made in Ukraine by 33.9%. But this figure seems far too bold and will more likely be achieved because of increased taxes and a new wave of delays in VAT refunds to exporters—and not streamlined administration. So why divvy up the pelt of a bear that’s still lumbering around in the forest? Hoping for a miracle again? Instead of making life easier for business, this will only lead to new problems for it.

Good news, bad news

There is also no reason to talk about higher individual taxes and fees as a factor in the higher growth of budget revenues compared to nominal GDP. Tax rates are only going up significantly on goods subject to excise tax, which means excise revenues could go up 29.3% on goods made in Ukraine and 42.1% on imports. This step is nothing new, as it is part of the Association Agreement with the EU, according to which Ukraine is supposed to bring its excise tax rates in line with European ones over the course of a number of years. This is, in fact, the only significant increase if we ignore the fact that the special tax breaks for the farm sector was finally dropped, as its impact on revenues was seen already in 2016.

Instead, we should be talking about the decline in the tax burden in the broader list of taxes and fees: the reduction of rates, the provision of tax breaks and the cancellation of certain fees. In an entire slew of cases, these reductions are the first indicators of the end of economic decline, the period during which additional or increased payments were instituted. The AA actually establishes further gradual reductions in import duties for products made in the EU. At the same time, revenues from customs duties are supposed to grow 16% according to the Cabinet, although it’s not clear exactly how. Could it be through better management of the Customs Service, the results of which are quite hard to predict, although it also represents enormous potential?

Pensions will now be taxable, starting at 10 subsistence minimum incomes, not at three minimum monthly incomes, which almost amounts to canceling this tax, given how small the tax base for this group is. Starting in 2017, moreover, all individuals whose income is below 1.4 subsistence minimums—which includes millions who have two pay packets: a minimal official taxed one and the rest as cash in an envelope—, the state will be giving a social benefit worth 50% of the subsistence minimum. And this means, in fact, reducing taxes by this amount. Both of these innovations will result in reduced personal income tax revenues, although the 2016 Budget Bill says that they will grow by 14.2%. Once again, this figure is greater than nominal GDP growth, which only raises more questions.

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The well fees for extracting petroleum, natural gas and gas condensate are also being cut, so planned revenues will be reduced 31.1%. 22.2% and 15.5%. On the other hand, revenues from the transit of ammonia and the use of radio frequencies will nearly double as fees are raised on both, but this will still be a substantially smaller amount.

In short, based on current macroeconomic forecasts, it’s doubtful that the revenue side of the 2017 Budget will be fulfilled. The current Government, which has criticized its predecessors for the unrealistic 2016 Budget, has embedded a similar little bomb in the upcoming budget. Perhaps its reasons for doing so are to pull up revenues to cover basic expenditures and the budget deficit dictated by the IMF cooperation program.

The problem with this is twofold. First, for a poor country to start with expenditures when drafting its budget is a mistake that has been made by just about all of Ukraine’s Cabinets in the last quarter-century—and one that the previous Government under Natalie Jaresko tried to correct, but was unable to bring to its logical conclusion. Second, if the foundation of a budget is built on unrealistic revenue projections, in the best-case scenario, there will be constant stress and regular debates about sequestering. In the worst case, taxes will have to be increased and the deficit allowed to inflate, which will only lead to another break in IMF funding. Obviously, the paradigm by which the state budget is drafted needs to be changed. This year, all the necessary conditions are in place to actually do so—except for an understanding of how critical this is among the country’s leadership.

Raising expenditures to reduce costs

The expenditure side of the 2017 Budget is UAH 775bn or 14.9% higher than planned for the current year. Taken in isolation from possible problems with tax revenues, this is a fairly modest indicator. Still, we’re talking about a growth budget: the minute additional revenues appear, the army of pockets eager to take a cut grows in leaps and bounds. In published documents from the main budget spending managers that were submitted to the Finance Ministry in the process of drafting this budget, the number of requests or “wish lists” added up to UAH 1,084bn, of which the bill takes into account only UAH 721bn in expenditures. The difference is equal to 50% of the budget.

This raises the idea of an “ideal” budget—which, of course, does not exist. If the state tries to satisfy everyone, there will never be enough money, but if it tries to economize as much as possible, then there will always be unhappy recipients. This is the choice that those drafting the 2017 Budget tried to resolve by allocating substantial sums to fund priorities while strictly constraining all the other expenditures. Maybe this is the right approach.

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Among the top priorities in the 2017 Budget are: the 5% of GDP or UAH 129.3bn defense allocation, which is not a new item: a major increase in salaries for teachers and doctors, which is supposed to be the first step towards raising the prestige of these professions to finally attract real brains to the two sectors and revive education and healthcare in parallel with much-needed reforms; and a roadworks fund into which 26.75% of revenues from customs, excise and other duties related to petroleum products and vehicles will be directed. After all, good roads are probably the second best way after “chickens in pots” to improve political ratings: roadways are used by everybody and those who keep them in good condition are remembered for a very long time, which cannot be said about a pot of chicken. The fourth priority is the allocation of UAH 5.6bn in support to farmers, with a focus on small and medium holdings, which is of an order higher than previous support. With the appearance of mechanisms that can ensure the effective utilization of these public monies and prevent embezzlement and corruption, all four priorities are quite justified.

One final priority that can be observed across the board in the 2017 Budget is an increase in pay scales for certain categories of civil servants, such as personnel working for the courts, prosecutors and so on. As a result, these spending items have risen noticeably: the budget for the Prosecutor General’s Office is up 41%; that for the Supreme Court is up 850%; the State Judiciary Administration’s allocation is up 57%; the Constitutional Court’s is up 63%, and so on. This rise in salaries is a very logical factor in reducing the temptation to engage in corruption—provided that the current lot of dirty-handed officials is immediately weeded out, along with the corrupt networks and legislative loopholes that allow them to appear

The usual pitfalls

The expenditure side has its weak spots as well, mainly related to social populism. Last year, when the second IMF tranche came in, the Government significantly increased social standards as of September 1 without waiting for December, when these raises were to go into effect according to the budget. Even without the third tranche, this year the new Government started amending the budget that have made the December pay rises more substantial than they were initially: the minimum wage has been raised 10.5% vs 6.9% in the initial 2016 Budget. But then it was faced with the problem of where to get the money to cover these expenditures. Next year, social standards will be raised twice again, in May and December, more than 10% altogether, but so far not any more.

This raises the question whether this policy has been well thought through. If we consider that 2015 was the year for eliminating all the economic distortions after the steep economic decline inherited from the previous regime and the Russian war, and the year of macrofinancial stabilization, then its indicators should be taken as the baseline for further calculations. According to Government forecasts, nominal GDP will be 31% greater in 2017 than last year, 83% of that due to inflation. By contrast, the minimum wage at the end of next year will be 45% higher than prior to September 2015, when it was UAH 1,218 and had stayed at that level for 22 months, that is, since before the fateful Euromaidan. In other words, the minimum wage is growing at 50% more than the pace of nominal, rather than real, economic growth.

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However, all rate schedules for salaries in the public sector are tied to the minimum wage. And if the state starts handing out money to people without goods to back it, this will lead either directly to inflation, or to growing imports, a worsening balance of trade, the devaluation of the hryvnia as long as the exchange rate remains flexible, and indirect inflation.

Social populism is the fatal flaw of Ukraine’s governments and no one seems to be able to get rid of it. Even Viktor Yanukovych’s experience failed to teach anyone, when minimal wages grew 38% and average wages by 55%, yet none of it was backed by goods. And so production costs went up for domestic manufacturers, reducing the competitiveness of Ukrainian goods on foreign markets while import volumes skyrocketed. Since the hryvnia exchange rate was fixed, this meant that gold reserves rapidly disappeared and became one of the key reasons for the hryvnia’s dramatic decline to one third of its 2013 value over 2014-2015.

That imbalance accumulated for a few years and led eventually to an economic collapse. Now, with the exchange rate flexible, imbalances caused by social populism won’t accumulate but will immediately affect the currency market, either through growing imports or through a rise in direct demand for hard currency for personal savings. This will spill over into a permanent devaluation, which will give rise to inflation that will rapidly eat up those raises in wages and pension that Ukraine’s Governments so stubbornly include in their budgets at the first opportunity.

The Groisman Government needs to understand that it cannot just hand out money because it feels like it. It can’t hand it out when there are not enough goods and services on which this money will be spent. No matter how benign the intentions, if wages and pensions are raised with an economic foundation, they will end up being worthless, inflation will eat them up, and not only will they not improve the domestic situation, but they will make it worse, as expectations of inflation skyrocket and lead to the repeat dollarization of the economy.

A far more effective approach would be to spend that same money on roads, i.e., that same wage except for work laying roads, manufacturing gravel, sand and so on, or on corruption-fighting raises for judges, who won’t reduce their levels of consumption but will stop using dirty money gained through bribery to pay for things and thus will not put upward pressure on prices. This lesson in economics needs to be absorbed once and for all by those in power in Ukraine. And it’s noteworthy that a flexible hryvnia exchange rate will foster this, because any imbalance won’t accumulate for years, making it impossible to understand who is at fault when everything goes into collapse, but will immediately be felt on the currency market.

The tight spots

Other than this main flaw that will continue to have a destabilizing impact on the macroeconomic situation in 2017, there are a few other Achilles’ heels here. Firstly, servicing the national debt will rise to UAH 111bn, which is 12.4% higher than in 2016. The good news there is that this increase will be almost the same as nominal GDP growth, which means that economic will continue to pick up pace—depending on reforms, of course—so that the burden of these debts on the economy could begin to ease as early as in 2018. At that point, Ukraine will have the resources to pay off foreign loans that come due in 24-30 months.

Secondly, the state of the Pension Fund deficit is not entirely clear. For 2017, its been set at UAH 156bn. If we look at what was planned for this year, UAH 145bn, then that’s an increase of only 7.6%, meaning that the deficit will shrink slightly. But at this pace, decades will be needed to resolve the problem. The pension system desperately needs reform, an issue that became one of the stumbling blocks between Ukraine and the IMF, which held back the third tranche for over a year as a result. Something must be done about the Pension Fund deficit, but the figure in the 2017 Budget shows that the Cabinet intends to maintain status quo.

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Thirdly, the notorious utility subsidies also raise serious questions. The thing is that UAH 40bn were allocated for them this year, a figure that is slated to rise by 26% in the 2017 Budget, to nearly UAH 51bn—a figure that is completely divorced from reality. For the first seven months of 2016, UAH 25.6bn went to cover these subsidies. A large portion of this was spent on natural gas that was half as expensive as it is now and subsidized utility rates that were considerably lower than they are today. In those few months that are left until the end of the year, just those households that already had a subsidy will require an amount that is 1.5-2 times larger, and that’s not even counting new applicants for utility subsidies. How is it possible to allocate UAH 40bn for this year, let alone UAH 51bn next year? Of course, that’s a rhetorical question. Word is that the IMF suggested that the Government provide subsidies on a more selective basis.

All in all, it has to be said that the 2017 budget has more that is positive than negative for the country and its people. Since Ukrainians are building a democratic state with a strong civil society, it would be pretty nice if the Government, as part of the budgetary process, allowed itself to explain the tight spots to the public and correct the flaws and errors raised, including the ones mentioned here.

Translated by Lidia Wolanskyj  

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