Lead Authors: Mark Davis and Pablo Saavedra September 2006 There is scope in Ukraine for a better, more efficient, and smaller government. To achieve this, Ukraine must change the consumption orientation of its budget, which is hampering future growth, and move towards more productive and efficient spending, and overall toward a pro-growth fiscal policy. The broad goals on the expenditure side of the budget should be to have higher productive spending on infrastructure and more efficient social spending, while reducing the overall size of public spending. The fiscal space for this can be found by phasing out the most inefficient subsidies and poorly-targeted social assistance programs in the budget. In addition, significant fiscal savings can be obtained from parametric changes in the pensions system, as recommended in detail in this report. On the revenue side, the broad medium-term objective should be to lower the average tax burden through lower rates on indirect taxes, particularly on payroll taxes. However, this policy should be preceded by specific reforms geared to broaden the base and to improve compliance.
1. Why is Fiscal Space Needed in Ukraine?
Ukraine’s policymakers face important choices and trade-offs that will affect the country’s development outcomes significantly. This Chapter examines recent macro-fiscal development and sources of tensions, funding needs, and pressures arising from the Government’s reform agenda. The Chapter also explores what the term “fiscal space” means and how fiscal space can be created and allocated in Ukraine’s budget.
2. Broadening the Tax Base and Improving Compliance, without Increasing the Tax Burden
This chapter stresses the importance of the value-added tax (VAT) to the tax system and the need to improve its administration significantly, while at the same time fixing some VAT policy issues. High marginal rates of payroll taxes must be lowered, but coupled with reforms geared to broadening the tax base and improving compliance. This chapter also recommends to keep the Simplified Tax System, but to thoroughly reform it in order to stop the perverse incentives, inequalities, and inefficiencies generated by this system for the regular tax system.
3. Finding Expenditure Savings by Improving Allocations
In Ukraine’s public spending, there is the scope and need for better allocation efficiency, for better use of allocated funds, and for a reduction in the overall size of public spending. Significant expenditure savings can be achieved by rationalizing and phasing out inefficient and poorly-targeted programs. Part of the savings obtained can be used to finance the government’s reform agenda and increase the low level of capital investments.
While the government’s strategy measures are positive for the system’s balance, they are not sufficient to introduce the second pillar and reduce contribution rates, and to bring long-term fiscal sustainability to the system. Consequently, additional savings are urgently needed. The rising dependency ratio poses a serious risk to the long-term sustainability of the system. The measures recommended here are geared to mitigate those risks, to protect the poorer pensioners, and are in line with international practices.
Public investment is an important potential contributor to economic growth and to achieving Ukraine’s development objectives. Public capital spending in the country has increasingly supported subsidies to enterprises, rather than fixed capital investment. Moreover, capital spending is not efficiently targeted towards expressed priorities. Significant efficiency gains could be achieved by enhancing the processes of planning, formulating, allocating, and supervising capital expenditures.
6. Creating and Allocating Fiscal Space within a Consistent Macroeconomic Framework
When fiscal programs are not realistic regarding their resource constraints, tensions begin to arise that can lead to fiscal crises and/or periods of stagnation. This chapter showcases an exercise based on the sources and uses of fiscal space outlined in this report. It shows that different fiscal strategies are associated with different investment outcomes. The scenarios presented here highlight the inter-temporal dynamics between investments and macro-fiscal variables and illustrate the ways in which different policy packages are likely to affect economic outcomes.
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