War on new rates. What effect will the tax increase have

The Cabinet of Ministers is preparing to raise taxes to cover the budget gap, Ekonomichna Pravda reports. What consequences will this have?

First of all, let's define the need. As a conservative estimate, we can take the $5 billion recently announced by Finance Minister Sergiy Marchenko. This gap is caused by the delay in military aid, which forced the government to go beyond its budgeted defense spending.

To mobilize in 2024 to replace at least part of those who have been defending the country for more than two years, and in case of further intensification of hostilities (defense or offense), at least the same amount will be needed.

These funds were not foreseen, as last year's basic assumption in the development of the 2024 budget was a decrease in the intensity of hostilities in the second half of this year after a successful counteroffensive.

What taxes may be raised

As you know, the government is considering raising the value-added tax (VAT) and military duty rates. The former may increase by 3 percentage points to 23%, and the latter by 3.5 percentage points to 5%.

According to our estimates, such an increase in the VAT rate would potentially bring additional UAH 93 billion to the state budget on an annualized basis. However, this will depress consumer demand, create direct inflationary pressure, and increase the attractiveness of "export" schemes with a tax credit (having zero VAT liabilities, some exporters will overstate the volume of purchased goods subject to VAT in order to receive a refund).

The issue of introducing a 5% military tax (on income) for single tax payers of the third group is also being discussed, which could bring the state an additional UAH 33 billion a year. But only in theory.

In practice, the actual doubling of the single tax rate (5% - the current rate and 5% - the proposed military fee) will lead to a reduction in the number of taxpayers.

And not only because of going into the shadows, but also because of switching to the second group or to the general taxation system in cases where the key factor will be the tax burden, not the cost of administration. 10% of the turnover is comparable to, and often more than, what entrepreneurs under the general taxation system pay.

We expect that after the introduction of the 5% military tax, the third group of the simplified taxation system will be mainly occupied by the professional services segment, some IT sole proprietorships, those who provide other business services, and some "smuggling" trade. In other words, those engaged in high-margin activities, for which it is justified to increase the tax burden under current circumstances.

Another UAH 90 billion a year can be generated by raising the military tax for employees. It is understandably unpleasant, but it generally fits the concept of wartime, when "you either fight or work for defense." Also, an increase in excise taxes on motor fuel will bring UAH 20 billion this year and UAH 60 billion in 2025.

Thus, the proposed initiatives will generate UAH 240-250 billion annually (UAH 60-70 billion by the end of 2024 if they are implemented in August-September). These revenues are muchneeded, but they will come at a cost to the economy.

Are there any alternatives?

It is impossible to do without raising taxes in these circumstances. This is an unpopular decision that President Volodymyr Zelenskyy and the financial bloc must make. However, there are steps that, if combined, could reduce the budget gap and the need for tax increases even without systemic changes. What are the criteria for choosing certain tools to fill the budget, apart from minimizing market distortions and damage to economic activity?

First, the fairness of the burden increase. Although fairness is a subjective concept, it is an important factor of unity in the state and support for the government. That is why, for example, hryvnia emission and the accompanying inflation are instruments of the "last resort" because the "inflation tax" affects low-income Ukrainians the most.

Secondly, the ease of tax collection, the ratio of administration costs to revenues, and, on the other hand, the ease of tax evasion and shadow economy. This is, in particular, an argument against raising corporate income tax, which will push businesses to use a wide range of tax base erosion tools.

The (un)legality of such methods and additional charges can only be established through a tax audit, which takes time and is costly. However, the state collects indirect taxes quite effectively. Currently, 43% of these revenues to the state budget come from value-added tax, and almost 10% from excise taxes.

In addition, VAT and excise taxes are consumption taxes. It is clear that the poor will feel their increase. However, people with low incomes spend a larger share of them on consumption in the informal sector. And as incomes rise, the share of "white" consumption increases: wealthy people tend to buy more food in supermarkets rather than markets, and fill up on more expensive fuel in networks that do not evade taxes.

Thus, the increase in consumption taxes is progressive - the effective tax rate, i.e. the share of taxes in expenditures, is higher for wealthier households. In this regard, raising the VAT rate is a relatively good tool for budget revenues. What else can be done to reduce the budget gap with minimal damage to the economy?

On the revenue side, there is an urgent need to strictly limit obvious tax evasion schemes, primarily those involving excisable goods and shadow imports. The first steps have already been taken and are yielding results (excise tax revenues in April increased by 19% compared to March), but with proper work of customs officers, tax authorities and law enforcement, it is possible to reduce annual budget losses by UAH 50-60 billion.

Another UAH 10 billion are losses from the gambling industry's evasion of personal income tax and military duty on winnings. Here, the key solutions are the introduction of an online monitoring system and restrictions on p2p transfers (the latter will also complicate other tax evasion schemes).

Another UAH 10 billion would come from a one-year acceleration of the plan to increase excise taxes on tobacco products and to cancel the privileges for the import of electric vehicles (especially in the context of the energy sector). It would also be advisable to extend the military tax to "premium consumption," primarily to jewelry, which was exempt from the pension tax, as well as to cars above a certain value and real estate.

Finally, if the current monetary policy design is maintained, it is justified to retain the 50% income tax rate for banks. Currently, they earn money not through entrepreneurial talent and lending to the economy, but through the preservation of liquidity by the state.

On the expenditure side, it is high time to finally conduct a real functional spending review. Expenditure reviews, which were previously conducted in the mode of a cargo-cult and bureaucratic replies, should first cover the functionality of the largest ministries and lead to the implementation of the program-target method. The goals and indicators of budget programs should correspond to the actual goals and available wartime resources.

According to our estimates, "soft" spending cuts can save UAH 45-50 billion, primarily in higher education and healthcare. Such steps require responsibility and political will, but they could significantly reduce the budget gap and the need for tax increases.

Yuriy Gaidai, senior economist at the Center for Economic Strategy.