Report No. 36671-UA Ukraine Creating Fiscal Space for Growth: A Public Finance Review September 14, 2006 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Region Document of the World Bank TABLE OF CONTENTS EXECUTIVE SUMMARY .........................................................................................................................i 1. WHY IS FISCAL SPACE NEEDED IN UKRAINE? .....................................................................1 A. RECENT MACRO-FISCAL DEVELOPMENTS AND SOURCES OF TENSIONS................................................ 1 B. FUNDING NEEDS AND PRESSURES ARISING FROM THE GOVERNMENT'S REFORM AGENDA.......... 6 C. UNDERSTANDING THE FISCAL SPACE ARGUMENT FOR UKRAINE............................................................ 7 D. CONCLUSION................................................................................................................................................................ 11 2. BROADENING THE TAX BASE AND IMPROVING COMPLIANCE, WITHOUT INCREASING THE TAX BURDEN ..............................................................................................13 A. INTRODUCTION........................................................................................................................................................... 13 B. STRENGTHENING VAT POLICY AND ADMINISTRATION .............................................................................. 14 C. PAYROLL TAXES ......................................................................................................................................................... 24 D. THE SIMPLIFIED TAX SYSTEM............................................................................................................................... 30 E. TAX EXPENDITURES .................................................................................................................................................. 34 F. CONCLUSION................................................................................................................................................................ 39 3. FINDING EXPENDITURE SAVINGS BY IMPROVING ALLOCATIONS ............................41 A. INTRODUCTION........................................................................................................................................................... 41 B. ORGANIZATIONAL STRUCTURE OF THE GENERAL GOVERNMENT BUDGET IN UKRAINE ............ 42 C. ALLOCATION OF BUDGET EXPENDITURES: ECONOMIC CLASSIFICATION.......................................... 44 D. ALLOCATION OF BUDGET EXPENDITURES: FUNCTIONAL CLASSIFICATION...................................... 51 E. SUMMARY OF RECOMMENDATIONS ................................................................................................................... 65 F. CONCLUSION................................................................................................................................................................ 67 4. GETTING PENSION REFORM BACK ON TRACK..................................................................69 A. INTRODUCTION........................................................................................................................................................... 69 B. THE UKRAINIAN PENSION SYSTEM: EVOLUTION, CURRENT ISSUES AND PLANNED REFORMS... 71 C. ARTICULATING REFORM OPTIONS...................................................................................................................... 76 D. FISCAL IMPACT OF RECENTLY IMPLEMENTED, PLANNED, AND ADDITIONAL RECOMMENDED REFORM OPTIONS................................................................................................................................................... 79 E. CONCLUSION................................................................................................................................................................ 82 5. STRENGTHENING CAPITAL BUDGETING IN UKRAINE....................................................83 A. INTRODUCTION........................................................................................................................................................... 83 B. DEFINING CAPITAL.................................................................................................................................................... 84 C. CAPITAL EXPENDITURE TRENDS IN UKRAINE ................................................................................................ 86 D. ISSUES IN CAPITAL BUDGETING IN UKARINE.................................................................................................. 87 E. ISSUES ON PROJECT EXECUTION, CAPITAL ASSET CONDITION, AND MAINTENANCE .................... 90 F. SOUND CAPITAL BUDGETING AND ASSET MANAGEMENT: A FRAMEWORK TO IMPROVE THESE PROCESSES................................................................................................................................................................. 93 G. DONOR FINANCED PROJECTS AND INVESTMENTS.................................................................................................................98 H. CONCLUSIONS AND GENERAL RECOMMENDATIONS ................................................................................. 104 6. CREATING AND ALLOCATING FISCAL SPACE WITHIN A CONSISTENT MACROECONOMIC FRAMEWORK........................................................................................107 A. INTRODUCTION......................................................................................................................................................... 107 B. KEY MACROECONOMIC CONSIDERATIONS ................................................................................................... 108 C. APPLYING A MACRO-FRAMEWORK TO THE FISCAL SPACE EXERCISE............................................... 110 D. DEBT SUSTAINABILITY ANALYSIS...................................................................................................................... 115 LIST OF TABLES Table 1: Selected Macro-Fiscal Indicators for Ukraine and EU-8 Averages, 2000-05 ................................ii Table 2: Capital Investments for EU Aspirations over the Next 10 Years, 2006-15....................................ii Table 3: Projection of Macro Scenarios......................................................................................................xv Table 1.1: Macroeconomic Trends in Ukraine (2000-05) and EU-8 Averages, 2000-05.............................2 Table 1.2: Revenues and Expenditures in Ukraine, 2000-05 (as % of GDP) ...............................................3 Table 1.3: Capital Investments for EU Aspirations Over the Next 10 Years, 2006-15................................7 Table 2.1: Revenues as Percent of GDP, 2000-05......................................................................................13 Table 2.2: VAT Collection as Percent of GDP, 2001-05............................................................................15 Table 2.3: Key Features of the Current and Future Special VAT Regimes for Agriculture.......................17 Table 2.4: Pension Contribution Rates are High in Ukraine Compared to European Countries ................24 Table 2.5: Tax Rates in Social Insurance Programs (as Percent of Employee Wage Income)...................25 Table 2.6: Taxonomy of the Simplified Tax System in Ukraine ................................................................31 Table 2.7: Tax Expenditures as Percent of GDP, 2002-05 .........................................................................35 Table 2.8: Distribution of Fiscal Subsidies to Livestock Producers in 2004 in Ukraine ............................37 Table 2.9: Selected Tax Expenditures by Industry as Percent of GDP, 2002-05 .......................................37 Table 2.10: Tax Expenditures in the Energy Sector as Percent of GDP, 2002-05......................................38 Table 3.1: Hike in Public Expenditure in Ukraine, 2003-05 (as Percent of GDP) .....................................41 Table 3.2: Local Budget Expenditures, 2002-05 ........................................................................................43 Table 3.3: General Government Expenditures by Function, as Percent of GDP, 2002-05.........................51 Table 3.4: Type of Privileges and Budget Allocation for 2006 (in millions of UAH) ...............................52 Table 3.5: International Comparison of Expenditures in Agriculture.........................................................59 Table 4.1: Overall Pension Expenditures as Percent of GDP: An International Comparison ....................69 Table 4.2: Minimum Pension Levels in Comparison with Average Net Wage, in % ................................73 Table 4.3: Pension System Budget Outline, UAH billion, 2003-05 ...........................................................74 Table 4.4: Mandatory Retirement Age in Selected EU, CEE, OECD, and CIS Countries.........................77 Table 4.5: Simulation of Pension Expenditures without Further Parametric Reforms, 2007-15 1/............79 Table 4.6: Fiscal Savings Under the Government's Strategy, 2007-15......................................................80 Table 4.7: The Fiscal Impact (savings) of the Recommended Measures, 2007-15 1/ ...............................81 Table 5.1: Public Capital Investments, Ukraine and Selected Countries....................................................87 Table 5.2: Capital Project Physical Completion and Financial Expenditure, 2001-03...............................91 Table 5.3: Residual Book Value as a Share of Initial Book Value of State Owned and Communal Owned Fixed Assets in Selected Sectors in 2003 (in %) ......................................................................92 Table 5.4: Robust Capital Budget Process Details .....................................................................................95 Table 6.1: Estimates of Potential Investment Needs in Ukraine, 2006-15 ...............................................111 Table 6.2: Fiscal Policy Assumptions for the Macroeconomic Projections .............................................112 Table 6.3: Projection of Macroeconomic Scenarios1/ ...............................................................................114 Table 6.4: Government Contingent Liabilities .........................................................................................116 Table 6.5: Public Debt and Estimated Contingent Liabilities as of 2005 .................................................118 Table 6.6: Public Debt Ratio in 2015 under Various Stress Tests (as Percent of GDP)...........................119 LIST OF FIGURES Figures 1 a-b-c: Decreasing Capital Expenditures and Public Investments (Fixed) in Ukraine, 2002-05.viii Figure 2: Pension System Balance Estimations, 2006-15 (With and Without Recommended Measures).xii Figure 3: Public Debt Ratios under Different Macroeconomic Assumptions (% GDP) ...........................xvi Figure 1.1: Gross Fixed Public Capital in Ukraine is Lower Than in the OECD, and New EU Members, 2002-05.......................................................................................................................................3 Figure 1.2: Ukraine Has a High Tax Burden: An International Comparison 2004-05 (Tax Revenues over GDP)...........................................................................................................................................4 Figure 1.3: Most Problematic Issues in the Tax System as Viewed by Private Businesses ........................5 Figures 2.1-a-b: A Strong Dependence on VAT Collection from Imports.................................................15 Figures 2.2-a and b: Compliance Costs in Ukraine, and International Comparison...................................19 Figure 2.3: Strengthening Core Tasks of VAT (and General Tax) Administration in Ukraine..................20 Figure 2.4: Increasing Number of Registrants in the STS but Decreasing Revenues, 2000-05 .................31 Figure 2.5: Growing VAT Concessions in Agriculture (by Type and as Percent of GDP), 2000-05.........36 Figure 3.1: Organizational Structure of the General Government Budget of Ukraine ...............................42 Figure 3.2: General Fund versus Special Fund Expenditures, 2002-05......................................................43 Figure 3.3: Current and Capital Expenditures in Ukraine and Selected Countries.....................................44 Figure 3.4: Current and Capital Expenditures in Ukraine and Selected Countries.....................................45 Figure 3.5: Pension Expenditures in Ukraine and Selected Countries........................................................47 Figure 3.6: Composition of Capital Expenditures in 2002-2005 and Composition of Capital Transfers in 2005 (as Percent of GDP).........................................................................................................49 Figure 3.7: Ukraine Investments Are Well Below New EU Members and OECD Countries, 2002-05 ....49 Figure 3.8: Education Expenditures in Ukraine and Selected Countries, % GDP......................................56 Figure 3.9: Health Expenditures in Ukraine and Selected Countries, 2002-05 ..........................................57 Figure 3.10: Composition of Budget Expenditures on Agriculture, 2002-06.............................................59 Figure 3.11: Comparison of Costs of Trading Grain in Ukraine and Germany, 1999 and 2005................60 Figure 3.12: Expenditures on the Investment Climate, % GDP .................................................................64 Figure 4.1: Old Age and System Dependency Ratios in the Absence of Reforms, 2005-75......................76 Figure 4.2: Pension System Balance Estimations, 2006-15 (with and without recommended measures)..82 Figure 5.1 a-b: Capital Expenditure in Ukraine and its Composition, 2001-05..........................................86 Figure 5.2: Capital Expenditure: Under-executed Accounts, 2003-05.......................................................92 Figure 5.3: Capital Budgeting Cycle...........................................................................................................95 Figure 6.1: Real GDP Growth and the Current Account Balance in the EU-8 (Average), 1992-2005 ....108 Figure 6.2: The Real Effective Exchange Rates in Selected EU-8 Countries, 1992-2005 (index: 1992=1) ................................................................................................................................................110 Figure 6.3: Public Debt Ratios under Different Macroeconomic Assumptions , 1999-2015 (% GDP) ..118 LIST OF BOXES Box 1: The Trade-offs in Creating and Allocating Fiscal Space .................................................................iii Box 1.1: Ukraine's EU Action Plan Objectives (Paraphrased excerpts)...................................................6 Box 1.2: Risks and Returns of Fiscal Strategies .........................................................................................10 Box 2.1: General Recommendations to Consider Before Implementing New Compliance Procedures ....21 Box 2.2: Basic Criteria for Setting an Adequate Structure of Penalties .....................................................23 Box 2.3: Ukraine's Government Strategy for Improving Payroll Collections (Part of the Government's Strategy for Pension Fund System Development)....................................................................26 Box 2.4: Ukraine's Effort to Reduce Distortion in the Economy: The Curtailment of the FEZ ................36 Box 2.5: Fixed Agricultural Tax (FAT)......................................................................................................38 Box 3.1: Public Procurement Reform in Ukraine is Off Track...................................................................50 Box 3.2. An Example of Cost Tracking......................................................................................................54 Box 3.3: Roadmap for Energy Sector Reform ­ Summary Recommendations..........................................64 Box 4.1: Chronology of Events and Milestones in the Ukrainian Pension System....................................71 Box 4.2: The Second Pillar of the Pension System, as Envisaged by the Approved Legislation...............72 Box 4.3: Main Features of the Government Strategy for Pension System Development...........................75 Box 4.4: Outline of Selected Reform Options (parametric changes to save resources for the system)......76 Box 4.5: A Simple and Cost Effective Strategy to Target Pension Increase to Poor Pensioners ...............78 Box 5.1: Treasury Budget Classification ....................................................................................................85 Box 5.2: Cost Benefit Analysis -A Primer..................................................................................................89 Box 5.3: Sound Overall Public Financial Management (PFM) Process.....................................................94 Box 5.4: Issues with Special Arrangements for Financial Management in Donor-financed Investment Projects in Ukraine ...................................................................................................................99 Box 5.5: An Unusually Complicated Pipeline of Project Processing and Approval in Ukraine ..............100 Box 5.6: Donor Commitments in the Paris Declaration (Some Excerpts)...............................................101 Box 5.7: Synchronizing the Project Cycle with the Budget Process and Streamlining the Project Cycle: Suggestions for Ukraine .........................................................................................................102 Box 5.8: A Goal to be Pursued: Use of Country PFM Systems in Donor-financed Projects .................104 Box 6.1: The Lost Savings of the Former Soviet Union (Sberbank)........................................................117 Box 6.2: Recommendations on Debt Management for Ukraine...............................................................120 ANNEXES ANNEX 1.1: Private Provision of Public Services...................................................................................121 ANNEX 2.1: Tax Structure: Taxes as Percent of Tax Revenue ...............................................................123 ANNEX 2.2: The VAT Stands as a Better Tax Compared to a Turnover Tax.........................................125 ANNEX 2.3: Methodologies to Estimate the "VAT GAP"......................................................................127 ANNEX 2.4: The Relative Size of the Shadow Economy for Selected Countries, 1999/2000................131 ANNEX 2.5: Equations of General Equilibrium Model...........................................................................133 ANNEX 2.6: Tax Systems for Small Businesses .....................................................................................137 ANNEX 3.1: Social Privileges in Ukraine................................................................................................139 ANNEX 3.2: Ukraine's Judicial System: Challenges and Plans for Improving Budget Funding............143 ANNEX 4.1: A Brief Description of the Forecasting Models..................................................................145 ANNEX 4.2: The Notion of Subsistence Minimum in Ukraine ...............................................................149 ANNEX 5.1: Annual Budget Process in Ukraine.....................................................................................151 ANNEX 5.2: Authority to Approve Capital Projects in Ukraine..............................................................153 ANNEX 5.3: Criteria for Assessing the Effectiveness of the Budget Process .........................................155 ANNEX 6.1: Debt Sustainability Analysis...............................................................................................159 PREFACE The Programmatic Public Finance Review (PFR) (in two phases) has the objective of addressing key issues in public finance that face Ukraine today, and recommending options for reform within a consistent, and pro-growth, macro-fiscal framework. The PFR covers the following selected areas and issues: (i) identification of options for broadening the tax base and improving compliance without increasing the tax burden; (ii) identification of options for achieving expenditure savings in selected areas of the budget; (iii) estimation of the likely fiscal impact of key reforms in the pension system; (iv) identification of weaknesses in the process of capital budgeting, providing options for its strengthening; (v) identification of weaknesses in the intergovernmental fiscal framework, identifying options for its improvement; (vi) identification of options for achieving higher levels of efficiency in social sector spending (particularly health and education); and (vii) estimation of the likely fiscal impact of key reforms in the health and education sectors. The first four objectives are covered in PFR Phase I, and the latter three will be covered in PFR Phase II. This report (Phase I of the PFR) was prepared by a Bank team comprising Mark Davis (team leader), Pablo Saavedra, Ruslan Piontkivsky, William Dorotinski, Marina Bakanova, Svetlana Budagovskaya, Zoran Anusic, Katerina Petrina, Hideki Mori, Sergiy Zorya, Svetlana Proskurovska, Taras Pushak, Trichur Balakrishnan, Oleksiy Balabushko, and Maria Koreniako. Background reports were prepared by Richard Bird (University of Toronto), James Alm (Georgia State University), the Institute for Economic Research and Policy Consulting (Kyiv), and Anna Nechai (consultant). The report benefited from contributions made by Maris Jesse, Waleed Malik, Olga Pindiyuk, and Inna Lunina (consultant); and advice from Nina Budina and Luca Bandiera. Emily Evershed edited the English version of this report, and Nataliya Yatsenko the Ukrainian version. Communication and dissemination support was provided by Anna Honcharyk. Document production and organizational assistance was provided by Judy Wiltshire, Tetyana Komashko, and Susana Padilla. The peer reviewers were Kathie Krumm and Anand Rajaram. Asad Alam provided close guidance and advice. Valuable comments provided by Martin Raiser were incorporated in this report. The team is grateful to all government officials from the Ministry of Finance, Ministry of Economy, National Bank of Ukraine, Ministry of Labor, State Treasury of Ukraine, State Tax Administration, State Audit Office, Ministry of Transport, Ministry of Agriculture, and State Roads Agency, who cooperated with the team and/or provided comments on earlier versions of this report (including those in the workshop organized in Kyiv in July 2006). This report also benefited from comments from Albert Jaeger, Andrea Schaechter, Jeffrey Franks, Mark Flanagan, and Maria Gonzales (International Monetary Fund); Paul Bermingham, Dusan Vijovic, Cheryl Gray, Hermann von Gersdorff, Marianne Fay, Craig Neal, and Aleksander Kaliberda (World Bank). EXECUTIVE SUMMARY 1. Recent economic and fiscal trends in Ukraine, combined with the financing requirements of the reform agenda, have brought fiscal pressures to the fore. Ukraine's economy grew by more than 50 percent between 1999 and 2004, but growth decelerated from 12.1 percent in 2004 to 2.6 percent in 2005. Contributing to this slowdown were less favorable terms of trade dynamics (in particular for metal prices)1 and a substantial deceleration in investment demand (partly as a result of uncertainty about government policies and cutbacks in public investment). Despite the recovery of the economy in the first semester of 2006 (5 percent growth y/y), the short term outlook is still threatened by potential further increases in energy prices in 2007.2 At the same time, increasing public spending threatens to crowd out the private sector. Driven by hikes in pensions and public sector wages, public spending soared from 39.4 to 44 percent of GDP in 2005, placing significant pressure on public finances. This high public spending and its consumption orientation risks generating inflationary impulses and higher interest rates, and eroding household wealth. Ukraine also has a high tax burden which discourages the private sector. 2. The current fiscal pressures accentuate the challenges the government faces to meet the country's economic development aspirations. The implementation of the government's reform program of pursuing the EU Action Plan, introducing the second funded pillar in the pension system, reducing payroll taxes, modernizing public sector institutions and improving the investment climate needs to be financed. Moreover, the government needs significant productive investment in infrastructure and human capital to reach a level of development consistent with its EU aspirations. But given that the tax burden is already high, financing reforms through increasing the tax burden is not a desirable option. In addition, Ukraine's authorities have been rightly cautious about increasing public debt. While Ukraine has a moderate debt to GDP ratio (18.7 percent) it should issue new debt prudently given its large stock of implicit and explicit contingent liabilities (estimated at 41.1 percent of GDP in 2005).3 3. Thus the government needs to create sufficient fiscal space to finance its reform program and productive investments, and this must be carried out within a consistent macroeconomic framework. Ukraine is on the cusp of major opportunities and challenges. The vision of an enhanced EU orientation has created considerable expectations among both the population and investors about the country's growth prospects. Investors are beginning to recognize the country's potential in terms of its resources, industry, well-educated population, and strategic geographic location. Achieving this potential will require reform efforts to be further strengthened and accelerated in the context of prudent fiscal and monetary policies. Fiscal space for priority spending needs to be created within the existing (or a reduced) fiscal envelope. Table 1 highlights the scope of this challenge by comparing Ukraine's key macro and fiscal indicators to those of the EU-8 countries4. 1Additionally, China has gained some market share to Ukrainian metal exports. 2Estimates of the impact of recent natural gas import price increase (from US$50 to US$95 per 1,000 cubic meters) indicate a negative effect of 2 percent of GDP on growth, which could potentially add 0.7 percent of GDP to the fiscal deficit (see World Bank 2006 note on the Impact of Energy Prices in Ukraine, available at www.worldbank.org.ua). 3See section on debt sustainability in this Executive Summary (and Chapter 6) for a breakdown of these contingent liabilities and for important clarifications about their nature. 4EU-8 countries are the new Central European and Baltic members of the European Union--The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia. i Table 1: Selected Macro-Fiscal Indicators for Ukraine and EU-8 Averages, 2000-05 EU-8 average for 2000 2001 2002 2003 2004 2005 2000-2004 GDP growth, % 5.9 9.2 5.2 9.6 12.1 2.6 5.2 Nominal Exchange Rate (UAH/USD), aop 5.4 5.3 5.3 5.3 5.3 5.1 - CPI, % change 28.2 12.0 0.8 5.2 9.0 13.6 5.3 Terms of trade (2000=100) 100.0 98.3 98.0 99.3 104.6 112.9 Gross capital formation, % GDP 19.7 21.8 20.2 20.6 21.1 21.8 25.0 Public and publicly guaranteed debt, % GDP 45.3 36.5 33.5 29.0 24.8 18.7 29.8 Total revenues, as % of GDP 33.3 33.2 35.7 35.9 35.0 41.3 39.1 Indirect Taxes 8.6 8.7 9.9 8.8 8.6 12.3 8.6 VAT 5.6 5.1 6.0 4.7 4.3 8.1 7.8 Direct Taxes 19.6 19.2 20.4 21.8 20.6 22.7 13.5 Payroll taxes 6.8 7.2 7.9 7.9 8.4 9.3 12.8 Non-Tax Revenues 5.1 5.3 5.4 5.3 5.8 6.3 Total expenditure, as % GDP 34.7 35.1 35.5 36.8 39.4 44.0 42.5 Pension payments, % of GDP 7.5 7.6 9.0 9.2 11.4 15.3 Public wage bill, % of GDP 7.6 7.4 8.0 10.4 Capital expenditures, % GDP 4.3 6.0 4.3 Capital investments (fixed), % GDP 2.8 2.8 2.0 3.1 Primary deficit, % of GDP 0.9 0.0 1.4 0.1 -2.5 -2.0 -1.1 Fiscal balance, % of GDP -1.4 -1.9 0.2 -0.9 -4.4 -2.7 -3.1 Sources: MoF; State Statistics Committee; State Treasury of Ukraine; Eurostat; Bank staff calculations (and estimations for 2005). 4. Ukraine's level of public fixed capital/investments over the past few years lags behind that of the new EU member states (see Table 1). While the bulk of investment should come from the private sector, the government has a key role to play in facilitating private investment and in providing basic infrastructure that the private sector needs to rely upon. The needs are especially pronounced in the energy sector, transport, basic infrastructure for services (water, sanitation, housing and community services), and environmental clean-up. The upgrading of the capital stock has been very limited in the last 15 years and infrastructure quality has been deteriorating. The government also needs to invest in human capital in order to enhance the technical sophistication of its labor force and to achieve higher levels of productivity. Initial rough estimates developed by World Bank staff suggest that the public investments needed may easily top US$100 billion over the next 10 years (see Table 2). Against this background, public capital expenditures are too low at 4.3 percent of GDP in 2005, particularly as an estimated one-third of these expenditures are subsidies to public and private sector enterprises. Table 2: Capital Investments for EU Aspirations over the Next 10 Years, 2006-15 Sector Amount (Billions of USD) Energy 30 Transport 5 Housing and Communal Services 14 Agriculture and Land Reform 9 Health, Education, Social Protection 6.5 Environmental Protection 15 Market Supporting Institutions 4 Other 16.5 Total 100 Source: Bank staff estimates. 5. These fiscal tensions imply that trade-offs have to be made (see Box 1). Facing these tensions, and dealing with them effectively, is a crucial element of the program's success. ii Box 1: The Trade-offs in Creating and Allocating Fiscal Space The concept of fiscal space is another way of looking at the fact that resources are always limited, and thus, for any sustainable fiscal program, resources and plans for allocation must add up. When a government puts more public resources into recurrent spending (e.g., wages, pensions, subsidies), it takes up more of the "fiscal space" that could be granted to its reform program and to growth-enhancing public investments in human and physical capital. In the absence of excess fiscal space, increases in investment and aggregate spending increase fiscal deficits and lead to higher debt and accelerated inflation. But ignoring key productive investment needs would keep growth rates at low levels. Broadly, there are several dimensions (sources) through which fiscal space can be created: tax policy and administration (by improving collection performance and compliance, and broadening the tax base); reallocation and rationalization of expenditures (by shifting resources from less to more efficient uses, making ongoing spending programs more efficient, and cutting or phasing out inefficient programs); expansion of government spending financed by debt accumulation, privatization proceeds and donor funding(aid); and through other various sources of non-tax revenues. In cases where there are simply not enough resources to meet priority public needs (and even where there are), private sector participation in public goods provision can provide an efficient alternative, if properly evaluated, structured, and regulated. In all instances, creating and allocating fiscal space has to be achieved in the context of an overall prudent macro-fiscal and social program. Moreover, these processes are country specific, and thus they are intrinsically linked to each country's characteristics, needs, capabilities, and specific reform program. 6. This report concentrates on four key sources of Ukraine's fiscal space and provides a macro- framework to ensure consistency: (i) tax policy and administration, (ii) overall public expenditures, (iii) pensions reform, and (iv) the capital budgeting process.5 (i) Broadening the Tax Base and Improving Compliance without Increasing the Tax Burden 7. Over the past few years Ukraine has made considerable progress in tax policy and administration. In particular, it has halted the growth of tax arrears, ended the practice of issuing tax amnesties, eliminated tax exemptions (although some remain, particularly in agriculture), simplified the system for the corporate income tax (CIT) and personal income tax (PIT), and designed a modernization strategy for tax administration. 8. Going forward, revenue policy should aim at reducing the high marginal rates (particularly on payroll taxes), but coupled (or preceded) by policies geared toward the objectives of broadening the base, improving compliance, and enhancing revenue authorities' administrative capabilities. This would avoid significant revenue losses (due to rate reduction), allowing a gradual and smooth reduction of the tax burden in the country. This report focuses on key selected areas in tax policy and administration. The aim is not to review tax policy and administration comprehensively but to highlight key challenges and opportunities for reform. 9. VAT policy: Despite important progress in VAT policy (e.g., curtailing a variety of VAT exemptions), there is an important reform agenda ahead. The poor past performance of the VAT and the burden of refund arrears on business have brought up discussions about replacing it with a turnover tax. At the same time, a rate reduction on the VAT is being considered (the current rate is 20 percent). Moreover, the VAT has some problematic issues in the agriculture and energy sectors. The "double VAT pass-through" on gas imports, where the VAT only starts to be charged at a third stage in the VAT chain, continues to be a problem. It represents a large subsidy, it may be generating revenue losses since 5This part of the report also contains an analysis of the planning and management of donor-financed investments, proposing alternatives for better integrating them into the core budget process. iii two stages of collection are bypassed (making the job of revenue authorities more difficult), and it may be subject to abuse when refunds are claimed (as the control of having to pay VAT at earlier stages of the chain is not present). The VAT in agriculture is costly and inefficient for the budget as a result of a combination of factors, including the following: a zero rate for milk and meat producers; the retention of VAT collected by agricultural taxpayers; the right of purchasers of agricultural products to claim VAT credit for their purchases; and the fact that meat and milk processing factories charge VAT but not remit it to the budget. Moreover, the VAT system in agriculture is inefficient because its tax expenditures support specific commodities and producers (such as milk and meat products and producers and the livestock sub-sector) at the expense of other commodities and producers. Moreover, evidence shows that a small number of larger (and wealthier producers) are mostly the ones that reap the benefits of this special system. In this context, the following recommendations should be considered: · Maintain the VAT rate at the current level. The ground is not yet ready for reducing the VAT rate in Ukraine. The current rate of 20 percent is not high when compared regionally, and a reduction could cause serious losses to the budget at a time when fiscal pressures are building. · Strengthen VAT policy and administration rather than replacing the VAT as a basis for a potential reduction of VAT rates in the future when the tax base is broader and more stable. A turnover tax is not a solution as it is highly distorting (as the market shifts to less efficient production modes to reduce turnover at every production stage) and it brings about a cascading effect of taxation. Moreover, its potential gains from easier administration are dubious since evasion is harder to identify, and its distributional effects are uncertain. · Consider the elimination of the "double VAT pass-through" on gas imports in the context of an improved energy policy. · Introduce the VAT system for agriculture proposed by the government in 2005, which cuts out several inefficiencies, reduces losses to the budget, and is more in line with EU practice. 10. VAT administration: The VAT has experienced difficulties as a revenue raiser, with declining collection efficiency during the period 1998-2004. Despite the sharp increase in collections in 2005, problematic issues persist in the overall performance and administration of this tax, such as delays in refunds to exporters6 and evasion throughout the system. But these are merely symptoms of underlying administrative weaknesses in core tasks of tax administration, such as screening registrants, reducing high compliance costs, improving monitoring and audit strategies, and developing an efficient system of penalties. In this context, the following actions are recommended: · Enhance the registration processes by screening applicants (to avoid potential evaders). Moreover, voluntary registration of tax payers below the threshold should not be allowed as it complicates administration. · Reduce compliance costs (including reducing the time spent by firms in the required compliance procedures for the VAT and other core taxes, and simplifying the tax forms). · Build a comprehensive monitoring system (beyond risk assessment of exporters and refund controls) based on analytical capabilities and using fraud and collection benchmarks such as "VAT collection gaps" by sectors of the economy, by industry, and by region. In doing so, avoid the higher compliance costs associated with excessive, expensive and ineffective cross- controls. 6The level of VAT refund arrears was at UAH 3.3 billion (0.8 percent of GDP) as of August 2005. This increased level was partly due to the new refund claims generated by enterprises in FEZs (claiming refunds for the first time in 2005) and by SOEs that did hold refund claims towards the end of 2004, but pushed them forward for collection in 2005. Toward the end of 2005, refund arrears dropped to 642 million. In 2006, this amount has been reduced to 586 million as of May 1. iv · Undertake better-informed (that is, targeted on the basis of analytical information gained from monitoring) and coordinated (with other revenue collection agencies) audits. · Move to a more effective system of penalties with fewer criminal prosecutions and more administrative penalties. · Avoid the renewed build-up of VAT refund arrears and reduce further the stock of outstanding refund arrears. 11. Payroll taxes: The high marginal tax burden caused by payroll taxes (social insurance contributions) and their narrow base are issues of concern for both the business community and the government in Ukraine.7 This situation has been exacerbated by two factors: the inefficient and burdensome system of collection through the four different agencies (insurance funds); and the behavioral distortions caused by the Simplified Tax System (STS) for firms and individuals that migrate to this system in order to significantly lower their tax burden. Currently, the pension system is under stress. The increases in pension expenditures have generated a serious deficit in the system, and the implementation of the pension system's second pillar planned for 2008 by the government depends critically on balancing the deficit and generating enough resources afterward to achieve long-term sustainability. At the same time, lowering the high marginal tax burden of payroll taxes in Ukraine is important and needed, but any rate reduction needs to be preceded by the following reforms geared to broadening the tax base and improving compliance: · Strengthening the revenue authorities' administrative capabilities. · Implementing the pension system's second pillar to create a clearer link between payments and benefits. This should include implementing the parametric changes in the first pillar (see pensions section). · Reforming significantly the STS, which is currently eroding the base of payroll taxes.8 12. Payroll tax administration: Ukraine has a rather complex system of four separate social insurance programs that collect payroll taxes. Each program has its own tax rates, its own independent administration and operation, and its own regulation. Currently, each insurance fund administers its own separate collection machinery. These collection systems are largely independent of one another and this occurs despite a broadly common base and method of collection (namely, employer withholding taxes directly on gross wage incomes). The separated administration of these programs is inefficient and wasteful of public resources, and creates high compliance costs for taxpayers. The following recommendations should be considered to achieve higher collection efficiency and lower compliance costs: · Accelerate the process of unifying the common administrative functions (registration, data warehousing, reporting, collection, control, enforcement) of the four social insurance funds under the Pension Fund (PF). This process will render important benefits in reducing compliance and administrative costs. In the medium term the government should aim at full unification, which would imply a single unified tax rate and a single collection agency. 7Currently, the employer contribution rate alone is close to 37 percent, which covers contributions to the four funds (see Table 2.5). Payroll taxes (or social insurance contributions as they are sometimes referred) are made on wage withholding, and do not include the personal income tax (PIT). 8The next section deals specifically with the inefficiencies and problems caused by the STS, and lays out the options available for its reform. v · Improve coordination with the State Tax Administration (STA). The PF (representing all insurance funds) and the STA should establish a formal coordinated compliance program to reduce evasion, involving a formal structure of coordination and joint task teams. · Strengthen analytical capabilities in the PF in order to improve monitoring and fraud detection. 13. The Simplified Tax System (STS): There are well-known compliance, administrative, and efficiency arguments for having a special system for small taxpayers, and there is evidence, albeit mixed, that the STS has encouraged Small and Medium Enterprises (SMEs) registration and entry. However, the current system design has led to substantial abuses, inefficiencies, and base erosion of the regular tax system in the following ways: (i) it creates incentives for legal and illegal migration from the regular tax system, which generates revenue losses for the budget in all major taxes (payroll taxes, the PIT, the VAT, and, more marginally, the CIT); (ii) it distorts taxpayer behavior in inefficient ways for the economy, potentially lowering productivity in the economy (e.g., firms fragment their operations into smaller firms to meet the threshold, losing economies of scale; and production and sales are kept below thresholds hampering output growth); and (iii) it introduces substantial horizontal (and vertical) inequalities to the system (e.g., an individual working as a "consultant" under the STS may pay significantly lower taxes than an individual with the same type of job description at a firm and the same level of income under the regular income tax system). The STS should be kept but the following recommendations should be considered to bring efficiency and equity to the tax system: · Ensure that only "truly" small businesses are accepted into the STS by lowering the upper threshold for legal entities (currently at UAH 1 million) to the VAT entry threshold (UAH 300,000)--which is also important for the VAT. · Modify the upper threshold for physical persons, which is currently 50 times the average annual salary (at UAH 500,000), by reducing it to no more than 2 or 3 times the average annual salary (UAH 20,000 ­ UAH 30,000). · Rationalize the eligibility criteria in terms of employee limits (currently, the threshold for applying is 50 employees, while a level of 15 is more consistent with the type of small business that simplified systems are designed to facilitate). 9 · Limit the type of activities of individuals accepted by the STS, particularly excluding professionals and "consultants," who currently represent the bulk of tax avoiders in the simplified system and who should be able to comply with the regular tax system. · Implement a clear mechanism for "graduation" from the STS system. Effort is needed to improve enforcement (and "graduation" if it applies) in the STS. This could be undertaken in coordination with local governments (in order to reduce administrative costs). 14. Tax expenditures: Tax expenditures have been generating distortions across a variety of sectors in Ukraine's economy, but they are highly concentrated in the agriculture sector.10 Tax expenditures can be found across most major revenue sources, including the VAT, the CIT, the land tax and a variety of excise taxes. However, the government of Ukraine has gradually but steadily curtailed tax expenditures. At the beginning of 2005, a significant reduction of tax expenditures was achieved through the curtailment of exemptions in the free economic zones (FEZs) and various VAT tax expenditures. Although the share of tax expenditures as a percent of GDP was significantly reduced from 7.6 percent 9In addition, this report supports the International Monetary Fund's (IMF) recommendation that calls for the exclusion from the STS of any business that directly or indirectly controls other businesses, and/or that it is controlled by another business entity, or by a person that controls another business. 10Tax expenditures refer to exemptions, privileges, holidays and other loopholes that confer a subsidy on the beneficiary and a cost on the budget (through foregone revenues). For a complete definition see Chapter 2. vi in 2002 to an estimated 3.2 percent in 2005, tax expenditures remain sizable, and transparency in their reporting creates concern. Moreover, the newly appointed administration is considering re-introducing the FEZs, which would represent a step backward in this area. The following recommendations should be considered: · Do not re-introduce tax privileges in the Free Economic Zones. Structure all investment incentives in full compliance with WTO regulations. · Continue curtailing VAT and other tax expenditures. Some good candidates for elimination are those in agriculture, pharmaceutical products, publishing, and car manufacturing. (up to 1.5 percent of GDP could be saved). In this regard, the agriculture VAT regime proposed by the government in December 2005 should be implemented for the 2007 budget. · Discuss tax privileges in the budget process as an expenditure item. This would require a prior analysis and public dissemination of the results to enable policymakers to make informed decisions. · Assure transparency of tax expenditures in all budget documents. (ii) Finding Expenditure Savings in the Budget 15. Public spending in Ukraine is high and has been increasing. Moreover, it is crowding-out private investment; its consumption orientation means that urgently needed public investments are delayed. The allocative efficiency of public spending is questionable in terms of its consumption (and current transfers) orientation, the efficiency of program implementation, and the plethora of subsides in both current and capital expenditures. Public expenditures in Ukraine have grown steadily since 2001, reaching 44 percent of GDP in 2005 (4.6 percent higher than in 2004) driven by hikes in recurrent spending. Pension payments grew from 9.2 percent of GDP in 2003 to 15.3 percent by 2005, while in parallel the pension system balance went from a small surplus in 2003 to a 3 percent deficit in 2005. Although the country is not an outlier for the region, Ukraine's public wage bill registered a record high for Ukraine in 2005 at 8 percent of GDP (from 7.3 percent in 2004). The level has been raised by minimum wage hikes, and is likely to make up 8.4 of GDP in 2006, owing to further planned step-wise increases. 16. But capital expenditures have remained low and decreased significantly in 2005. Moreover, the reported size of capital spending is inflated by misclassified subsidies which crowd-out expenditures for infrastructure and equipment. Total capital expenditures, as listed in the budget, represent 4.3 percent of GDP down from 6 percent in 2004. However, just over half of those expenditures (2.2 percent of GDP) are comprised of the category called "capital transfers to enterprises." Under this category, close to 65 percent are subsidies to SOEs, or transfers to spending units of the government (i.e., Ministry of Agriculture, Ministry of Energy) that in turn run subsidy programs with these resources (see Figure 1 a- b-c).11 This situation has left investments in infrastructure at just above 2 percent of GDP, which is well below new EU member states. Furthermore, public investments in Ukraine are systematically under- executed. In 2005, the category "capital construction" was under-executed by 20 percent on an already small budget allocation. The analysis of capital expenditures shows that low priority has been placed on this critical area of government spending. The 2006 budget reflects a marginal increase in capital expenditures, but a drilling down on the composition of that increase shows that it is composed of increased subsidies, as well as a state guarantee on the bonds of the State Mortgage Institution. In 11Only close to 35 percent of "capital transfers" are actual investments in infrastructure, mostly resources transferred to the State Road Agency (30 percent). There are, in addition, some small investments within these transfers across spending units.. vii particular, the subsidies include increases in the food reserves of the Agriculture Fund and other subsidies for the coal and agriculture sectors. Figures 1 a-b-c: Decreasing Capital Expenditures and Public Investments (Fixed) in Ukraine, 2002-05 Composition of Capital Transfers to Spenidng Units and Enterprises Composition of capital expenditures in Ukraine 4.5 (as percent of GDP) 6 Transfers and 4 Transfer for the Subsidies for the State Roads Agency Agriculture sector New EU 3.5 5 --Infrastructure 0.37 Members Other capital (roads) , 0.63 Average 3 transfers 4 PD 2.5 OECD 3Gfo Capital transfers to DPGfo Average enterprises % 2 (agencies, % organizations) As 2 Purchase of stocks 1.5 Ukraine and state reserves 1 1 Transfers and Infrastructure and equipment Subsidies for the 0.5 0 Energy sector Other transfers and (coal), 0.55 2002 2003 2004 2005 subsidies, 0.66 0 2002 2003 2004 2005 Sources: MoF; State Statistics Committee; Eurostat; OECD. 17. There is the scope and the need for more efficient allocation of funds across spending categories, for better use of allocated funds within these categories, and for a reduction in the overall size of public spending (to below 39 percent of GDP in the medium term). Significant expenditure savings can be achieved by rationalizing and phasing out inefficient and poorly targeted programs. Moreover, part of the savings obtained may be used to finance the government's reform agenda and to increase the low level of capital investments (prioritizing allocations to productive investments). The following selected issues and recommendations should be considered: 18. The rapid growth in the public wage bill should be checked. A short term target would be to stabilize it below the 8 percent of GDP reached in 2005.12 A decompression of civil service wages is necessary, but, to avoid a further increase in wage spending and align worker incentives with program objectives, this policy should be coupled with the rationalization of positions in the civil service system. This would allow more competitive salaries per position. Despite important improvements regarding the streamlining of the pay system (passed in legislation in March 2006), multi-position appointments and bonuses are still used to make jobs attractive and to reward behaviors, while base salaries per position do not correlate strongly with qualifications and responsibilities.13 To achieve the goals stated above, the government needs to revise and streamline institutional procedures and develop a new analytically underpinned remuneration system. Transparency in the pay system is important for improving the efficiency of civil servants. 19. The system of social protection and social privileges is costly, convoluted, and non-transparent, and is ultimately an inefficient way of achieving the goals it aims to pursue (i.e., redistribution and poverty targeting). Moreover, these systems need to create savings to be able to cope with potential increases in the energy/housing subsidy payments connected with rising energy prices and housing and 12This ratio does not consider wages paid to professors in higher education institutions, as the government moved these salaries from the wages category to the R&D category in 2005 (code 1170). The minimum wage is the key determinant of the public wage bill. This recommendation is consistent with aiming for nominal increases in the minimum wage not in excess and perhaps slightly below the rate of inflation. 13Rough estimations suggest that prior to March 2006 the basic salary made up only 30 percent of the total pay. In March 2006, new regulation was approved to streamline the pay system in the country. Owing to this regulation, the portion of the base salary in total remuneration may increase significantly to roughly 60 percent. viii communal service tariffs. The government should consider phasing-out untargeted programs such as occupational benefits, spa/sanatoriums, and telephone benefits and should certainly avoid the introduction of any new privileges in addition to existing social assistance programs going forward. At the same time, it should better target the social assistance programs by tightening the eligibility requirements for utilities subsidies and housing allowances using proxy means testing (PMT). Up to 1 percent of GDP could be saved by this reform without hurting poorer recipients. . 20. Subsidies are crowding out potential productive spending and are damaging Ukraine's economy. For example, subsidies to the energy sector and related quasi-fiscal activities (e.g., under- pricing of energy) have worsened the financial position of energy companies and their ability to attract investments. Moreover, these subsidies and quasi-fiscal activities have sustained inefficient energy use and vulnerability to energy price shocks in the economy. The government should enforce financial discipline on SOE in the energy sector (including companies in which the State is a shareholder) while phasing out under-pricing and cross-subsidization. This should be done in tandem with completing coal sector restructuring and quickly phasing out coal subsidies. As prices of other sources of energy (e.g., gas) go up, coal production acquires a price advantage and producers will increase profitability, which eliminates the rationale for budget support to this sector. Another example of sector subsidies that should be reduced is the repeated re-capitalizing of state-owned financial institutions. Progress has been made with regard to the Savings Bank's restructuring process; this should be continued. Up to 1.2 percent of GDP in savings could be achieved by eliminating the most inefficient subsidies in energy and other sectors (excluding agriculture, which is discussed below). 21. The government's support to agriculture is expensive and inefficient, and creates inequalities. International comparisons suggest that Ukraine's fiscal support to agriculture is high (even above the level of some OECD countries). In 2005, fiscal support to agriculture, including tax expenditures, reached 2.5 percent of GDP (1.5 percent higher than in 2000), and it is increasingly dominated by subsidies.14 But the evidence suggests that subsidies have had little impact on agricultural productivity. For example, subsidies intended to ease farmers' access to agricultural machinery failed to accelerate the technical modernization of the agricultural sector. Most subsidies simply encourage the higher production of targeted products or the increased use of subsidized inputs, and are not focused on improving sustainable efficiency improvements in the sector. Finally, evidence also suggests that subsidies (particularly tax expenditures in the sector) create inequities, as they mostly benefit large producers. 22. Thus, support to agriculture should be shifted from the current inefficient fiscal subsidies to productive investments and competitiveness-enhancing programs such as R&D, extension programs, rural development, disease control, and WTO readiness programs. In parallel, public support to the sector should be improved and geared to market facilitation (land reform, cadastre and registry), and WTO's "Green Box" programs, in partnership with the private sector. Moreover, the changes should be accompanied by the avoidance of market-distorting measures, such as price controls and restrictions on the inter-oblast movements of agricultural commodities. If these actions were taken, significant progress could be made in rural growth and poverty alleviation. Up to 0.4 percent of GDP in savings could be achieved by eliminating the most inefficient subsidies in this sector. This is in addition to the up 1 percent of GDP in expenditures savings that could be achieved by implementing the government's proposed agricultural VAT reform.15 14Actual support to agriculture is even higher (by at least 0.5 percent of GDP) if non-budget public support measures are taken into account, such as the sugar quota, the support of grain prices through pledge and intervention purchases, and the reduced interest rates for machinery leased from UkrAgroLeasing, among other measures. 15 The savings on tax expenditures in agriculture may range from 0 to 1 percent of GDP depending on the cost and input structure of farmers and their patterns of consumption after the reform. ix 23. Further budget consolidation is needed. The creation of the Special Fund (which groups several off-budget categories together and brings them into the budget) was a positive step four years ago. Attention should now be given to further budget consolidation, since preserving the division between the General and Special Funds does not have a clear rationale in a properly functioning budget system. But since the Special Fund protects (to some extent) the resources for some critical public investments in infrastructure, budget consolidation in this area should be preceded by the strengthening of capital budgeting (including capital budgeting and capital transfers to local governments). Higher flexibility and transparency in allocation and better budget management could be achieved with their consolidation. In addition, the government should consider the integration of the Social Insurance Funds into the consolidated budget over the medium term. (iii) Getting Pension Reform Back on Track 24. The pay-as-you-go (PAYG) pension system in Ukraine encompasses a variety of problems that threaten its fiscal sustainability. These problems range from difficulties with designed features of the system to threats posed by a rapidly aging population (by 2055 there will be 1 worker in Ukraine for every 1.42 pensioners). In 2003, the government enacted legislation with the objective of preserving and enhancing the system by adding to it a second fully funded mandatory pillar and a third voluntarily funded pillar. While the core legislation was approved, the envisioned multi-pillar system has not been implemented due to the fact that its institutional and administrative underpinnings are not yet ready and the system remains under fiscal stress. The minimum pension increase introduced prior to the 2004 presidential elections drove pension expenditures up from 9.2 percent of GDP in 2003 to 11.4 percent in 2004 and a record 15.3 percent in 2005 - the highest level in the region (with deficits of 1 and 3 percent of GDP in 2004 and 2005, respectively). 25. The measures introduced in 2005 to reduce pension expenditures and the measures planned by the government's strategy, while tilting the system's balance in a positive direction, are not sufficient to accommodate a smooth introduction of the second pillar, to implement rate reductions in contributions, and to bring long-term fiscal sustainability to the system. The indexation rule changes16 and other additional measures reduced pension expenditures from an expected 17 percent of GDP to 15.3 percent in 2005. Moreover, estimates indicate that pension expenditures would drop to around 14 percent of GDP in 2006 owing to these measures. In addition, the government launched its "Strategy for the Pension System Development" which encompasses additional measures to improve the system's finances.17 The estimation of the overall fiscal impact of the measures envisaged by this strategy shows a moderate positive effect of around 0.42 percent of GDP annually (on average). This takes account of the negative effect of the planned indexation of all pension benefits to 20 percent of nominal wage growth. Without this change, the government's strategy would achieve somewhat higher savings. 16According to changes in the indexation rule, instead of an increase in the minimum pension benefits being made at the beginning of the year, the minimum pensions would gradually reach the minimum subsistence level by December 2006. Additional measures included the abolishment of the rule that allowed 1 percent of minimum pension increment for each additional year of service above 20/25 years for women and men, respectively; and the abolishment of the rule that allowed increases in supplementary payments to special categories of pensioners based on the increase in the minimum pension. 17The Government's Strategy measures include the following: (i) an increase in the retirement age for women to 60 at the rate of 6 months per year, but starting only in 2010; (ii) the introduction of the indexation of all pension benefits in payment status by 20 percent of the nominal wage growth; and (iii) the suspension of the increase in pension benefits up to the subsistence minimum for working pensioners, retaining payment of only the formula part of the benefit. The introduction of the indexation of all pension benefits in payment status by 20 percent of the nominal wage growth would increase expenditures x 26. In order to move the system onto a long-term path of fiscal sustainability while fulfilling the government's agenda of reducing the high marginal burden of payroll taxes and introducing the second pillar in 2008, this report recommends the following additional savings measures: · Increase the retirement age for women from 55 to 60 years, with an increase of 6 months per year, starting in 2007. This measure would save an average of 0.32 percent of GDP annually, starting from 0.1 percent in 2007 and increasing to 0.7 percent by 2015. As life expectancy continues to grow, the retirement ages for men and women would need to be further increased. · While continuing to pro-rate pensions for those with less than the minimum required contribution period for the full minimum pension, lengthen the minimum period for a full pension to 30 and 35 years for women and men, respectively. This measure would save an average of 0.17 percent of GDP annually, starting from 0.1 percent in 2008 and increasing to 0.2 percent by 2015. · Suspend the increase in pension benefits up to the subsistence minimum if the pensioner continues to work. This measure would save an average of 0.49 percent of GDP annually, starting from 0.5 percent in 2007 and decreasing to 0.4 percent by 2015. · Replace the minimum pension with means-tested benefits for any pensioner whose family's per capita income falls below the minimum subsistence level.18 Only low income pensioners whose household income is below the notional amount of the "subsistence minimum" should receive the automatic increase. This measure would save an average of 0.33 percent of GDP annually, starting from 0.4 percent in 2007 and decreasing to 0.3 percent by 2015. · Introduce a regular contribution rate for those taxed under the STS. This measure would save 0.1 percent of GDP annually from 2007 to 2015.19 · Maintain over the medium term the current indexation rule (as applied for 2006). 27. The recommended measures would affect poorer pensioners least (since targeting is involved) and would generate more than three times the savings of the measures envisaged under the government's Strategy. The expected savings for the system would be, on average, 1.4 percent of GDP annually from 2007 to 2015 (starting from 1.1 percent of GDP in 2007 and increasing to 1.7 percent in 2015). These savings would outgrow revenues passed on to the funded second pillar, allowing a fiscally smoother transition. The savings would also allow more fiscal space for rate reductions in payroll taxes, which is a crucial and appropriate policy in the government's reform agenda (see Figure 2). Moreover, the rising "dependency ratio" (the product of an aging population and the early retirement age provisions) will continue to cause strains on Ukraine's pension system over the long term. The reforms proposed here are thus critical to maintaining sustainability in the system for current and future retirees, and they actually follow the path taken by new EU members that inherited similar problems. 18The increase in the minimum pension currently occurs automatically up to the level of the "subsistence minimum." The subsistence minimum is a notional amount set by the government each year in the annual budget. This link between the "subsistence minimum" and pension insurance blurs the distinction between social insurance and poverty targeted social assistance, confuses the pension dialogue, and leads to wasteful transfers which poorly target poverty. 19This estimation is based only on the wage income reported by employees and individuals under the current STS regulation. xi Figure 2: Pension System Balance Estimations, 2006-15 (With and Without Recommended Measures) 0.5 Pension System Balance 0 with recommended savings measures. Core Assummptions: Introduction of the second pillar in 2008; -0.5 Rate reduction of 2% annually from 2009 to 2013 PDGfo (total reduction 10%) -1 %sA Pension System Balance -1.5 without recommended savings measures. Core Assummptions: Introduction of the second pillar in 2008; Rate reduction of 1% -2 annually from 2009 to 2013 (total reduction 5%) -2.5 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 (1) A full set of measures and assumptions for the pension and macro-scenarios considered can be found in Chapter 4. Source: Based on a projection of the Ukrainian Pension Model- developed in collaboration by the Government of Ukraine, the National Academy of Sciences of Ukraine, and the World Bank. (iv) Strengthening the Capital Budgeting Processes 28. Capital spending in Ukraine is not efficiently targeted towards the expressed priorities (e.g., the EU Action Plan). A strengthened capital budgeting process would help policymakers redirect capital expenditure toward productive investments. Moreover, an improved capital budgeting process will be critical to ensure that resources freed up by reform measures proposed elsewhere in this report are used efficiently. While there are some formal capital budgeting processes that are well structured (for example, the line ministries and their programs are the unit of analysis for capital spending and select projects that are within their annual budget ceiling), significant efficiency gains could still be achieved. 29. Coordination and integration of overall budget. Capital budgeting in Ukraine is not well integrated into the overall budget process. The following recommendations should be considered: · Establish a formal structure of collaboration between the Ministries of Finance and Economy to review all aspects of capital budgeting, from identification and evaluation through completion and monitoring. · Prepare a report to the Cabinet of Ministers on changes in and improvements to the process, including specific steps that would strengthen the integration of capital budgeting into the core budget process. 30. Project planning and evaluation: In this area the major shortcomings are the following: (i) the absence of multi-year ceilings for both capital and recurrent spending; (ii) the absence of a central assets registry, including asset conditions, for planning maintenance and replacement spending; (iii) the absence of strategic plans for line ministries; and (iv) the weakness in the economic evaluation of projects. This is partly due to a lack of coordination in functions between the Ministry of Economy (MoE) and the Ministry of Finance (MoF) and the analytical weaknesses of sectoral ministries for planning and evaluation. The following recommendations should be implemented: · Establish multi-year ceilings for total spending and for line ministry spending (including capital and recurrent spending). · Introduce multi-year sector strategies/planning for all line ministries. · Establish a central database of current assets with links to all line ministries. · Strengthen project evaluation capabilities in the Ministries of Economy and Finance. xii · Apply consistently (and selectively) cost-benefit analysis as part of the formal process of capital budgeting. · Enforce the use of economic project evaluation (using cost-benefit analysis) in the sectoral ministries as part of their project submission to the MoE and MoF. 31. Project implementation, execution, and monitoring (including O&M): Capital project completion has been a persistent problem. Poor completion rates stem from a budgeting process which favors funding new projects over ongoing projects. This behavior is observed in both the government and the Rada. In addition, maintenance spending is not keeping pace with asset acquisition and maintenance requirements. The following recommendations should be implemented: · Strengthen coordination between the MoE and MoF to closely monitor capital project implementation during the year with line ministries. This would help assure that progress is being made and would help identify and resolve bottlenecks as they arise. · Review the current budget execution procedures for capital projects to assess their adequacy and ensure that they are not contributing to the under-execution of capital spending. · Improve the monitoring and assessment of adequacy of operations and maintenance. The MoE and MoF in coordination (and together with line ministries) should monitor information and feed it back into the assets database (which, as recommended above, needs to be created). 32. Capital budgeting in sectoral ministries: There are also problems with the handling of capital budgeting in the sectoral ministries. The analytical capacity to perform project evaluation is poor in most ministries. Moreover, management and internal controls in the ministries are weak in terms of project oversight; this is coupled with a lack of central agency monitoring. Poor accountability and oversight also contribute to low completion rates. The ineffectiveness discussed here, combined with the low level of capital spending has led some spending units to advance new financing techniques such as Public-Private Partnerships (PPPs). But with weak targeting and screening, and weak analytical capabilities, additional financing is likely to be ineffective (and contingent liabilities may arise for the state), particularly if structural enhancements to capital budgets are not implemented at the level of the spending units (sectoral ministries and agencies). The following recommendations should be implemented: · Strengthen project economic feasibility assessment and project evaluation in all line ministries. The Ministry of Economy should take the lead in this process. · Set common (and high) standards for project evaluation for line ministries. This also implies the implementation of transparent and standard methodologies of evaluation (based on cost- benefit analysis). · Strengthen analytical capabilities to evaluate potential risks in all types of Public Private Partnerships and privatization schemes. This is critical as flawed designs and evaluation may generate liabilities of different kinds for the state in the future. 33. Donor financed investments and projects: Donors contribute significant resources to fund capital investments in Ukraine (total support is estimated at US$ 1.5 billion, of which two thirds are loans for investment or budget support and one third is technical assistance and grants) and donor funding may rise significantly going forward. Yet, current systems for planning, approving and executing donor funded projects are complex and reduce the effectiveness of this assistance. This stems from a variety of sources, including the following: (i) donor-financed investments, even when executed by the recipient, are not well integrated into the budget process; (ii) the use of parallel administrative structures to prepare and implement donor funded investments raises transactions costs, fails to build xiii capacity in counterpart agencies, and may reduce government ownership; (iii) the procedures of project approval in Ukraine are complicated and time consuming causing delays and preventing the government to reliably plan and budget donor assistance; (iv) complex existing procedures for implementation (e.g., release-of-funding requests within the Ukrainian government) slow disbursements and delay project completion; and (v) supply driven initiatives and remaining weaknesses in donor coordination undermine strategic coherence and government ownership. Moving forward the following broad options for reform should be considered: · Bring up to 100 percent the recording of donor financed public sector transactions in the annual budget and their execution details in government internal control reports. In parallel, establish a comprehensive information reporting system of external assistance (including inflows and execution). In the short term, this does not apply to donor executed technical assistance, for which full integration into budget planning and reporting is not realistic, although the objective of maximum transparency should equally apply. · Integrate donor financed investments (and assistance) to the core capital budgeting process (and to the overall budget process) by streamlining the complex procedures of project processing and approval in the government, and by synchronizing project preparation to the budget cycle. · Plan donor funding aligned with the country's strategy and on a multi-year basis. This should be integrated with the multi-year planning recommended in this report for all public capital investments. On the donors' side this should involve further strengthening coordination to harmonize and complement aid efficiently. · Continue improving PFM systems to allow donor funding, in the near future, to be channeled and executed fully through the country's own budgetary institutions and controls. In the meantime, the following suggestion could be considered: (i) facilitate more direct involvement of staff and management of the beneficiary agencies in project preparation and implementation in order to improve ownership and implementation; (ii) donors could phase-in the use of the country's (PFM) system, and supplement them, as needed, by additional arrangements in those areas where weaknesses in the country's PFM system pose fiduciary risks. Creating and Allocating Fiscal Space within a Consistent Macro Framework 34. The creation and the allocation of fiscal space should be carried out in the context of a consistent macroeconomic framework. Thus, this report presents an adding-up exercise based on the recommended sources and uses of fiscal space, using two sets of macro-fiscal projections. These projections exhibit the ways in which different policy packages would be likely to affect economic outcomes. These projections also highlight the inter-temporal dynamics that take place between investments and macro-fiscal variables. 35. The first macro-fiscal scenario, called here the "base case" scenario, tracks the expected path of the economy under a moderately fast and well-implemented reform package, including improved recurrent and capital spending, better revenue policy and administration, and improved public finance management. This scenario assumes the implementation of a portion (not all) of this report's recommendations. The scenario shows that policies and specific savings measures to create fiscal space allow for higher public (and private) productive investments, and also allow for the introduction of the critical reforms planned by the government (e.g., the reduction of payroll taxes by a total of 10 percent from 2009 to 2013, along with the introduction of the second pillar in 2008), while maintaining moderate fiscal and external deficits, an average GDP growth of 5 percent, and allowing inflation to decelerate over the projection period (2006-15). xiv 36. The base case leaves considerable room for an upside should all the recommendations made in this report be implemented and should the external environment remain favorable. The rationale behind showcasing a moderate base case scenario (and a lower more conservative one as depicted below) is that it is much better to plan conservatively and efficiently, and benefit from a windfall, than to expect a windfall and find that available fiscal resources impose considerably higher constraints than had been envisaged. 37. A second macro-fiscal scenario, called the "conservative case," assumes a policy status quo that is relatively slow and uneven, but with some continued progress in reforms (e.g., a reduction in payroll tax rates of 5 percent from 2009 to 2013), and slightly less favorable external conditions (reflecting Ukraine's increased vulnerability to these conditions in this scenario). The projections of this scenario show that it allows for considerably less public investment (i.e., almost at the current level). It also involves higher fiscal deficits, persistent inflation dynamics, and moderate domestic investments and FDI (which in turn implies somewhat lower current account deficits than in the base case). Together, this is projected to yield an economic growth in the 2.5-3 percent range over the medium term. The macro projections of both scenarios are presented in Table 3. Table 3: Projection of Macro Scenarios Base-Case Conservative-Case 2006 av 2007-10 av 2011-15 2006 av 2007-10 av 2011-15 Real GDP, % growth 4.5 5.0 4.6 3.0 3.0 2.5 GDP per capita, USD 4244 3318 Consumption, % growth 7.3 3.1 3.7 5.9 1.5 1.7 Investment, % growth 8.5 9.7 5.1 3.8 4.1 2.8 private investment, % growth 8.4 6.9 5.2 2.7 4.0 2.8 Real wage, % growth 9.0 7.0 6.2 5.0 4.3 3.5 GDP deflator, % growth 12.3 8.6 5.4 13.8 10.8 9.0 Current Account Balance, % GDP -2.2 -4.3 -3.9 -2.3 -3.5 -1.9 Gross National Savings, % GDP 17.5 17.3 18.9 17.2 16.6 18.1 Budget Revenues, % GDP 41.0 39.0 35.8 40.9 39.4 38.6 tax revenues, % GDP 35.3 34.0 31.9 35.1 33.4 32.9 direct taxes, % GDP 22.9 21.5 18.7 22.9 21.8 22.2 indirect taxes, % GDP 12.4 12.5 13.2 12.3 11.5 10.6 non-tax revenues, % GDP 5.7 5.0 3.9 5.8 6.0 5.7 Budget Expenditures, % GDP 44.1 42.4 38.5 44.3 43.8 42.2 public consumption, % GDP 15.6 15.4 14.7 15.6 15.7 15.2 public investments, % GDP 2.1 3.7 4.3 2.0 2.2 2.2 capital transfers, % GDP 2.2 1.7 1.3 2.3 2.2 2.2 current transfers, % GDP 20.8 18.5 15.5 20.8 19.9 18.1 subsidies, % GDP 2.5 1.9 1.4 2.5 2.2 2.0 Fiscal Balance, % GDP -3.1 -3.3 -2.7 -3.4 -4.4 -3.6 Direct Public Debt, % GDP 14.5 17.2 21.9 15.0 20.5 25.5 Source: Bank staff estimations. 38. A debt sustainability analysis embedded in this fiscal space exercise reveals that under the base case, the increase in public debt is limited, whereas the conservative case involves significantly higher debt financing. Figure 3 shows the path of public debt under the two scenarios. In the base case, direct public debt increases moderately to an average of 17.2 percent for the period 2007-10, and 21.9 for the period 2011-2015, whereas the conservative case implies a higher increase in direct public debt up to an average of 25.5 for the period 2011-2015. 20 20As of 2005 direct public debt was 15.1 percent of GDP; additionally, publicly guaranteed debt was 3.6 percent of GDP. xv 39. While these are still relatively moderate debt ratios, Ukraine should be cautious about new debt issuance, especially in view of its relatively large stock of explicit and implicit contingent liabilities. A rough estimate of the stock of contingent liabilities amounts to 41.1 percent of GDP in 2005. This estimate includes 29.2 percent of GDP corresponding to the so-called "lost savings of the Former Soviet Union Savings Bank." However, these calculations deserve two important clarifications: first, the "lost savings" are an implicit contingent liability21 not likely to become explicit debt all at once, but rather, if at all, throughout a long and structured process; second, so far, the fiscal authorities of Ukraine have been able to address this issue (i.e., lost savings) prudently minimizing any impact on the budget and the economy. Assuming conservatively that only 30 percent of the contingent liabilities become explicit liabilities and 50 percent of the guaranteed debt is called evenly over 10 years and that no additional contingent liabilities are contracted, Figure 3 shows the path of public debt under the base case rising to around 40 percent of GDP by 2015. Figure 3: Public Debt Ratios under Different Macroeconomic Assumptions (% GDP) 50 45 40 35 30 25 20 15 10 Base Case Conservative Case 5 Base Case with recognition of some contingent liabilities 0 9991 0002 1002 2002 3002 4002 5002 6002 7002 8002 9002 0102 1102 2102 3102 4102 5102 Source: World Bank estimations Summary of Recommendations 40. The fiscal analysis presented in this report shows that there is scope in Ukraine for a better, more efficient, and smaller government. To achieve this Ukraine should change the consumption (and current transfers) orientation of its budget, which is hampering future growth, and move towards a 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 (not higher) social spending on improving human capital, 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 direct taxes, particularly on payroll taxes (also called social insurance contributions). But, as stressed in this report, this policy should be preceded by specific reforms geared to broaden the base and to improve compliance. 21 Based on the interpretation of the Budget Code of Ukraine this would not be considered a liability or a commitment based on a guarantee (Part 2, article 8). For this reason, and considering the background of this issue, the "lost savings" are onsidered in this analysis as an "implicit contingent liability". Also, this implicit contingent liability is linked to the State and not to the current state company called "Savings Bank" xvi 41. This report highlights the urgent need for setting budget policy in a strengthened medium-term framework that would allow better planning and continuity, and less wasteful spending. The tables below summarize the options for reform outlined throughout this first installment of the Public Finance Review, including broad suggestions on sequencing them and the positive impacts that can be expected if reforms are fully implemented (more detailed recommendations can be found in the respective chapters of this report). Moving forward, the stage is set for a second phase PFR which will examine in detail issues of local government finance and the efficiency of health and education public spending. Area Options for Reform and Suggested Expected Impact Recommendations Sequencing Tax Overhaul the simplified tax system (STS)- Prepare the · Base broadening would take place Policy reducing the opportunities to hide taxable amendments during for the VAT, PIT, payroll taxes, and income. Only "real" small business should be 2006-07 and more marginally for the CIT. allowed in the STS. Most physical persons implement in 2008. · Increased compliance rates. should pay regular taxes. Set a maximum threshold for firms at UAH 300,000, so it matches the VAT entry threshold and reduce maximum threshold of individual to the level of 2-3 annual average wage salaries. Also rationalize the eligibility criteria, leaving out of the STS all categories of professional and consultants. Eliminate the double pass-through for VAT on Effectively · Reduction of the burden on revenue gas. implemented by authorities 2008. · Reduction of leakages of revenue that may be taking place at later stages of collection. Implement the government's proposed Implement for the · Up to 1 % of GDP of potential amendment to reform the VAT in agriculture, 2007 budget. savings. which in parallel would curtail the VAT tax · Lessening of distortions in the sector. expenditures. Reduce payroll tax rate only after Phase-in rate · Lower marginal tax burden on implementation of the second pillar in the reductions in 2008-9 payroll taxes. pension system, unification of the insurance (if second pillar is · If done as recommended it may funds (under the PF), and the reforms suggested introduced in 2008) increase compliance rates. for the STS. Strive for a single rate in payroll taxes. Tax Adm. Strengthen tax administration by: enhancing the Enhance data and IT · Higher compliance rates. registration processes (with screening of capabilities of the · More efficient use of revenue potential evaders); reducing compliance costs; single window of authorities' resources. building a comprehensive monitoring system; registration (2007). · More targeted audits (less hassle to performing better, well informed, and Establish revenue coordinated audit strategies; and moving to a intelligence units to compliant taxpayers) more effective system of penalties (fewer monitor compliance · Expansion in audit coverage. criminal prosecutions and more administrative (in STA). penalties) Accelerate the process of unification of common Start process in 2006 · Higher collection efficiency through administrative functions (registration, data lower administrative and compliance warehousing, reporting, collection, control, costs enforcement) of the four social insurance funds under the Pension Fund. In the medium to long- run the government should aim at full unification, which would imply a single unified tax rate and a single collection agency with all functions incorporated. Enhance coordination in collection, monitoring, Set a formal · Higher compliance rates. and auditing among STA, SCA, and PF, with framework for this · More efficient use of revenue participation of MoF. Establish a coordinated coordination during authorities' resources. compliance program. 2006. xvii Area Options for Reform and Recommendations Suggested Expected Impact Sequencing Public wage Keep the public wage bill below 8% of GDP (2005 Start the · Expenditure neutral bill level). De-compression of the civil service wages is evaluation of · More transparency in civil necessary but coupled with rationalization of personnel. civil service service pay. Revise and streamline institutional procedures, and remuneration · Rationalization of positions. develop a new analytically underpinned remuneration and reform in · More competitive salaries system. 2007-8. per position. Pensions Increase female retirement age from 55 to 60 years by Starting in 2007. Would save an average of 2017, with an increase of 6 months per year. 0.32 % of GDP annually, starting from 0.1% in 2007 and increasing to 0.7 % by 2015 Lengthen the required contribution period for eligibility Starting in 2007. Would save an average of for a full minimum pension to 30 and 35 years for 0.17 % of GDP annually, women and men, respectively starting from 0.1% in 2008 and increasing to 0.2 % by 2015 Suspend the increase in pension benefits up to Starting in 2007. Would save an average of subsistence minimum if pensioner continues to work. 0.49 % of GDP annually, starting from 0.5% in 2008 and increasing to 0.4 % by 2015 Replace minimum pension with means tested benefits Starting in 2007. Would save an average of for any pensioner whose family's per capita income falls 0.33 % of GDP annually, below the minimum subsistence level. starting from 0.4% in 2007 and increasing to 0.3 % by 2015 Introduce a regular contribution rate for those taxed Starting in 2007. Would save 0.1 % of GDP under the simplified tax system (STS) annually from 2007 to 2015. Privileges Reform systematically the privileges system. Phase-out Implement in · More transparency and and social poorly targeted programs such as occupational benefits, 2007-8 efficiency in the system, with assistance spa/sanatoriums, and telephone benefits. Target better fewer abuses. programs social assistance programs (using proxy means testing). · Up to 1% of GDP saved by Tighten eligibility for utilities subsidies and housing phasing out only the most allowances. inefficient programs and through better targeting. Subsidies Phase out subsidies to non-viable enterprises in the coal Start phasing out (through sector. Gradually reduce agriculture subsidies subsidies with · Up to 1.2 % of GDP in transfers to (commitments under WTO). Phase out the practice of the 2007-8 savings by phasing the most SOE and re-capitalization and provision of guarantees to state- budget. inefficient programs in government owned financial Institutions (e.g., State Mortgage energy and other areas. agencies) Institution). Improve financial position of energy · Reduction in Quasi-Fiscal enterprises by phasing-out the under-pricing and cross- Activities (currently at 4.3% subsidies in energy. Enforce financial discipline. of GDP) Agriculture Shift government support to agriculture from the current Start in the · Expenditure savings up to inefficient fiscal subsidies to competitiveness-enhancing 2007-8 budget 0.4% of GDP-by cutting the programs (WTO compliant). most inefficient subsidies Avoid price controls, restrictions on inter-oblast · Improved efficiency and movements of agricultural commodities, and other productivity in the sector. inefficient measures that hamper proper market functioning and hamper farmer profitability. Budget Consolidate the budget further by integrating general Discuss · Higher flexibility in process and special funds. In addition, consider the integration amendments in budgetary allocations. of the Social Insurance Funds into the consolidated 2007.Integration · Better budget management. budget. in 2008. · Higher transparency in the allocation of capital budgeting. xviii Area Responsible Options for Reform and Suggested Expected Impact Agent Recommendations Sequencing Capital MoF/Cabinet of Introduce multi-year ceilings for total 2007-8 Better fiscal planning. Budgeting Ministers spending (capital and recurrent). Improvement in selection Introduce multi-year sector criteria and priorities. strategies/planning within resource ceilings in all line ministries and agencies MoE Establish a database of current assets and Start in 2006-7 Better monitoring. The their condition for each line ministry. database can be used by line ministries to monitor progress and by MoF/MoE for monitoring and assessing the adequacy of operations and maintenance spending and longer run affordability. MoE, MoF, and Strengthen project evaluation Start in 2006 Improved quality of projects all line capabilities in the MoF and the MoE, selected. Higher level of ministries. and all sectoral ministries. Apply productive investments. consistently cost-benefit analysis as part of the formal process of capital budgeting. Enforce the use of economic project evaluation (using cost befit analysis) at the sectoral ministries as part of their project submission to MoE and MoF. Set common (and high) standards for project evaluation for line ministries. Implement transparent and standard methodologies of evaluation. Strengthen analytical capabilities to evaluate potential risks in PPPs and privatization schemes to avoid the financial risk they may carry. MoE/MoF Monitor closely capital project Start in 2006 Higher levels of execution implementation with line ministries to with full Improved assessment of assure progress is being made and to implementation operations and maintenance identify and resolve any bottlenecks. by 2007 needs. MoE/MoF/ Establish a formal structure of Formation of More coherence throughout Cabinet of collaboration between MoE and MOF, the group in the process of capital Ministries with the oversight of the Cabinet of 2006. Start budgeting. Minister (within the PFM context). function in Priorities and objectives will Coordinate functions on capital 2007 be discussed more budgeting through a formal working transparently. group. The recommended working group should review all aspects from identification through completion. Improve the timing and integration of the Targeted Programs process better into the annual budget process. MoF/Treasury Revise current budget execution Start in 2007 Improved project execution procedures for capital projects to check Improved assessment of adequacy and execution. operations and maintenance KRU Perform annual audits of internal control Start in 2006 needs. in line ministries to assure that they support capital project management and completion, particularly for high risk ministries. xix Area Responsible Options for Reform and Suggested Expected Impact Agent Recommendations Sequencing Donor MoF and MoE Continue improving PFM systems to Start in 2006 Improved PFM system upon financed allow donor funding to be channeled and which domestic and investments controlled through them (in this regard, international resources can and projects procurement continues to be an obstacle flow efficiently and with and should be strengthened in line with accountability. best international practices) MoF, MoE, and Examine transition options to move Start in 2006 Improved aid effectiveness, the donor closer to the use of country systems. reduced under-execution of community International experience provides some projects, increased options that could be examined, including government ownership. eliminating parallel accounts of disbursement and execution controls, financing projects with domestic resources to later be reimbursed by donors with certain checks and balances, and financing projects already approved in the capital budget applying certain procurement and audit agreements; phasing in use of PFM systems by supplementing them with additional arrangements where specific fiduciary risks are identified MoF, MoE, and Integrate donor financed project into the Start in 2007 Improved aid effectiveness, the donor budget process by streamlining harmonized investment community procedures of project processing and strategy, higher productive approval within the government. Plan investments donor funding aligned with the country's strategy, and on multi-year basis. This planning should also be integrated into the multi-year framework recommended in this report for all public capital investments. On the donors' side this should involve ample coordination to harmonize and complement aid. MoF and MoE Bring up to 100 percent the recording of Start in 2007 Improved transparency, donor financed and recipient executed improved coordination, transactions in the annual budget and improved accountability on their execution details in government public investments. internal control reports xx 1. WHY IS FISCAL SPACE NEEDED IN UKRAINE? A. RECENT MACRO-FISCAL DEVELOPMENTS AND SOURCES OF TENSIONS 1.1 Ukraine's economic performance has been strong since 2000 and poverty has declined sharply. GDP growth totaled more than 50 percent for the period 1999 through 2004. This, combined with significant improvement in the country's fiscal position, led to a dramatic lowering of the debt-to- GDP ratio (from 61 percent of GDP in 1999 to 26 percent in 2004). The mix of a favorable exchange rate in the years following the 1998 financial crisis, the strengthening terms of trade (fueled by growth in world commodity prices), and financial discipline in the post-1999 environment, encouraged enterprise restructuring and increased capacity utilization, particularly in the traditional industrial sectors (metals, chemicals, and agro-processing). These factors went hand in hand with strong export growth and a current account surplus which reached a record high of 10.5 percent of GDP in 2004. International reserves have accumulated to a value of more than 3.5 months of imports. Real demand for money has grown rapidly, encouraged by financial discipline, increased confidence in the UAH and growing incomes. These factors have also helped facilitate rapid financial sector growth (bank assets have grown from 19 to over 50 percent of GDP since 1999), while inflation has remained at marginally tolerable levels. 1.2 The economy grew by more than 50 percent between 1999 and 2004, but growth has slowed. Growth rates fell from 12.1 percent in 2004 to 2.6 percent in 2005 (see Table 1.1). From around mid-2003 through 2004 the terms of trade moved strongly in Ukraine's favor, leading to the 2004 growth and current account surge. But with volatile international prices for metals in 2005 (Ukraine's main exports), and higher energy prices in 2006 the country's terms of trade have been less favorable. The value added of metals production, oil refined products, agriculture, and construction slowed throughout 2005. A gradual real appreciation of the UAH also played a role in the decline of exports in 2005. Investment demand fell in 2005 due to political instability combined with a cutback in official public investment, contributing to the downward trend. In 2005, the current account surplus declined to 3.1 percent of GDP and will move into deficit in 2006 with a substantial growth in imports. The annualized growth rate for the first semester of 2006 recovered (to 5 percent y/y GDP growth) but the outlook remains subject to the risk of further increases in energy prices in 2007 remains. 1.3 While growth has slowed, the economy has begun to diversify. This could set the stage for an improved quality and sustainability of growth over the medium term. Positive signals of such a trend towards diversification include the following: a heightened investor interest and a surge in FDI; sale by financial industrial groups of subsidiaries and banks; continued growth (particularly in the first half of 2006) of services, manufacturing of machinery and equipment, and non-traditional sectors such as retail and transportation); and continued entry of new SMEs. These early signs of diversification are a highly positive development that could, in the future, help to reduce the economy's vulnerability to energy prices and to international prices of metals (and other commodities exported by Ukraine). 1 Table 1.1: Macroeconomic Trends in Ukraine (2000-05) and EU-8 Averages, 2000-05 EU-8 average for 2000 2001 2002 2003 2004 2005 2000-2004 GDP growth, % 5.9 9.2 5.2 9.6 12.1 2.6 5.2 Nominal Exchange Rate (UAH/USD), aop 5.4 5.3 5.3 5.3 5.3 5.1 - CPI, % change 28.2 12.0 0.8 5.2 9.0 13.6 5.3 Terms of trade (2000=100) 100.0 98.3 98.0 99.3 104.6 112.9 Gross capital formation, % GDP 19.7 21.8 20.2 20.6 21.1 21.8 25.0 Public and publicly guaranteed debt, % GDP 45.3 36.5 33.5 29.0 24.8 18.7 29.8 Total revenues, as % of GDP 33.3 33.2 35.7 35.9 35.0 41.3 39.1 Primary deficit, % of GDP 0.9 0.0 1.4 0.1 -2.5 -2.0 -1.1 Fiscal balance, % of GDP -1.4 -1.9 0.2 -0.9 -4.4 -2.7 -3.1 Sources: MoF; NBU; State Treasury of Ukraine; Bank staff estimations. 1.4 Monetary policy conditions, combined with fiscal looseness after the 2004 election, have not facilitated the announced goal of single digit (consumer) inflation. Inflationary pressures have been building over the past two years and continue to represent significant tension. The consumption orientation of the budget in 2005, for example, has contributed to demand-push inflationary impulses. Inflationary pressures deriving from speculative capital inflows also took place during 2005, and in response, the NBU allowed a one-off shift of the de facto peg by 2.7 percent (from UAH/USD 5.19 to 5.05). More recently, a substantial increase in the price of imported natural gas has added to inflationary pressures. 1.5 Higher gas prices are expected to have a negative impact on growth and on the fiscal stance. Net energy imports represent around 16 percent of GDP. While this is high, the energy intensity of use in Ukraine is remarkable -- 22 times more than in Germany on a GDP basis, and 3.6 times higher than in Germany on a purchasing power parity basis. This high energy intensity makes Ukraine especially vulnerable to both oil and gas price increases. Estimates of the impact of the recent increase in natural gas import prices (from US$50 to US$95 per 1,000 cubic meters) suggest a potential reduction of GDP of 2 percent in 2006 with a knock-on increase of 0.7 percent of GDP in the fiscal deficit.22 1.6 Ukraine has a relatively low debt-to-GDP ratio (at 18.7 percent) but carries a significant stock of contingent liabilities that could become explicit debt. Ukraine has been successful in lowering the debt-to-GDP ratio after the late 1990s crisis (the ratio was 61 percent of GDP in 1999), and successive governments have since remained cautious about significant levels of new borrowing. The President recently expressed his desire not to see an increase in the ratio of public debt to GDP over the coming years. Yet a rough estimate of the stock of contingent liabilities amounted to 41.1 percent of GDP in 2005, which, combined with investment needs consistent with Ukraine's growth plans, suggests that explicit debt levels may grow. This further emphasizes the need to create fiscal space for growth within the budget. 1.7 Public spending in Ukraine is high and is increasing. Public expenditures in Ukraine grew steadily since 2001, reaching 44 percent of GDP in 2005 (4.6 percent of GDP higher than in 2004), a record level for Ukraine and one of the highest levels in the region. This trend has been driven by hikes in recurrent spending (capital spending has actually been falling), which have arisen mostly from the fulfillment of pre-Presidential election commitments to raise pensions and minimum wages (first by an act of the Cabinet of Ministers, and then by both candidates, and finally by Parliament). Pension payments grew from 9.2 percent of GDP in 2003 to 15.3 percent in 2005; in parallel, the pension system balance moved from a small surplus in 2003 to a deficit of 3 percent in 2005. The wage bill, while not high by regional standards, registered a record high for Ukraine in 2005 reaching 8 percent of GDP (see Table 1.2). The driver has been significant increases in the minimum wage (which affects significantly 22See the World Bank Note (2006) on "The Impact of Higher Natural Gas and Oil Prices in Ukraine," available on www.worldbank.org.ua. 2 the public wage bill), and further increases planned for 2006 may yield a total public wage bill of 8.4 percent of GDP for the year. As both public sector wages and pension benefits are heavily determined by minimum levels (that is, both the wage and pension scales are very compressed), the overall pay and transfer system of Ukraine erodes work and growth incentives at the individual level ­ and this hurts productivity. Table 1.2: Revenues and Expenditures in Ukraine, 2000-05 (as % of GDP) 2000 2001 2002 2003 2004 2005 Total Revenues 33.3 33.2 35.7 35.9 35.0 41.3 Tax revenues 28.2 27.9 30.3 30.6 29.2 35.0 Indirect Taxes 8.6 8.7 9.9 8.8 8.6 12.3 Direct Taxes 19.6 19.2 20.4 21.8 20.6 22.7 Non-Tax Revenues 5.1 5.3 5.4 5.3 5.8 6.3 Total Expenditures 34.7 35.1 35.5 36.8 39.4 44.0 Pension payments 7.5 7.6 9.0 9.2 11.4 15.3 Public wage bill 7.6 7.4 8.0 Capital expenditures 4.3 6.0 4.3 Capital investments (fixed) 2.8 2.8 2.0 Primary deficit 0.9 0.0 1.4 0.1 -2.5 -2.0 Fiscal balance -1.4 -1.9 0.2 -0.9 -4.4 -2.7 Sources: MoF; State Treasury of Ukraine; Bank staff calculations. 1.8 The consumption orientation of public spending in Ukraine is crowding-out investments (both private and public); this will constrain future growth. Capital expenditures have remained low and decreased significantly in 2005. Moreover, the reported size of capital spending is inflated by misclassified subsidies which crowd-out expenditures for infrastructure and equipment. Total capital expenditures, as listed in the budget, represent 4.3 percent of GDP (they fell significantly from 6 percent of GDP in 2004).23 However, just above half of those expenditures (2.2 percent of GDP) are comprised by the so called "capital transfers to enterprises". Close to 65 percent of transfers under this category are either direct subsidies to SOEs or transfers to spending units of the government that in turn use them to run subsidy programs. As a consequence, Ukraine is investing less public fixed capital than the new EU members (see Figure 1.1). Moreover, the excess capacity that allowed Ukraine to grow in recent years has largely been utilized, while the country's infrastructure continues to deteriorate. In this context, and while keeping in mind that the lion's share of investment will need to be provided by the private sector, the deficiencies of the capital budget and public spending on investment represent key constraints for medium-term and long-term growth. Figure 1.1: Gross Fixed Public Capital in Ukraine is Lower Than in the OECD, and New EU Members, 2002-05 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 2002 2003 2004 2005 year Ukraine OECD Average New EU Members Average Sources: MoF; State Statistics Committee; Eurostat; OECD; Bank staff calculations. 23One of the reasons for the decline in public investment in 2005 was the new government's reaction to the capital budget approved by the previous administration, which was viewed as the fulfillment of a pre-election political formula. It was largely scrapped in amendments to the 2005 budget. The 2006 budget process, however, also did not lead to a reformed capital budget process and was also kept relatively small. 3 1.9 Ukraine has a relatively high tax burden which discourages private investment. In 2005, Ukraine's tax burden stood at 35 percent (or 41.3 percent considering non-tax revenues, most of which are in fact different forms of fees on production and economic transactions). This is average burden is high for an emerging economy (see Figure 1.2). Payroll taxes in particular are characterized by high statutory rates that on average reach 42 percent (most of the rate -- around 37.5 percent -- is the employer's share). The high marginal burden on payroll taxes is coupled with a sizable shadow economy consisting largely of underreporting of income. This is somewhat different from countries at similar level of income in other regions, which often experience the bulk of their shadow activity through unregistered businesses. Figure 1.2: Ukraine Has a High Tax Burden: An International Comparison 2004-05 (Tax Revenues over GDP) 50.0 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 eli )6( nai n a y d 8- y d nam etiV andlai ocix se T aer )11( nt eyk ua ani aivt ar Ch nats .deF ania p.eR EU antsi eniar dnal sural Me kh LA Ko S acirfA Th zaaK gerA paaJ Tur La ak ailarts CI naiss h ovdol attS anlerI anlniF Au Uk Po Be Ru utoS M ugrU uahtiL edtniU moR ovlS bekzU nguH Note: Data for Ukraine are for 2005 (all other countries for 2004). Sources: IMF GFS; World Bank (LDB); Eurostat; OECD; Bank Staff calculations. 1.10 Reforms in taxation have taken place, but much remains to be done in the areas of both policy and administration. Through the elimination of mutual offsets, tax amnesties, budget arrears, bankruptcy proceedings and administrative pressures on enterprises (especially SOEs), the government has been able to improve financial discipline and halt the growth of tax arrears. In addition, through piecemeal legislative changes and annual budget laws, a large number of tax exemptions have been abolished (although some remain, particularly in agriculture). Moreover, reforms to the CIT and PIT have introduced simple flat rates (i.e., 13 percent for the PIT and 25 percent for the CIT). In response, the CIT has performed well, while a decline in PIT collections (as a share of GDP) has been observed. The PIT's performance (below expectations) may partly be explained by the fact that other parts of the tax system have not yet been reformed, keeping incentives for accurate income reporting almost unchanged (for instance, payroll taxes ­ which remain very high - have almost the same base as the PIT)..In addition, improved tax administration and coordination between revenue agencies are needed. Finally, there has been a shift toward dependency on collections from the VAT on imports, as well as persistent problems with VAT administration (e.g., regarding fraud and refund arrears). These factors, combined 4 with the high marginal burden of the payroll tax system and the base erosion generated by the simplified tax system (STS), present significant challenges. Figure 1.3 shows the major problematic issues regarding the tax system as indicated by private businesses. 1.11 Given that the tax burden on the economy is already high, the creation of fiscal space through increasing taxes is not an option. Collections went up significantly in 2005 (mainly driven by the VAT) owing to a variety of factors. These include legislative changes that curtailed tax exemptions at the beginning of 2005, the fact that the VAT on oil imports from Russia began to be collected by Figure 1.3: Most Problematic Issues in the Tax Ukraine (Russia was charging an export VAT but System as Viewed by Private Businesses stopped this practice for 2005),24 changes in leadership and personnel in key areas of the STA 0 0.5 1 1.5 2 2.5 3 3.5 4 and Customs, and an anti-corruption program related High sanctions to Customs ("Contraband Stop") initiated early in 2005. Yet these are largely one time effects; and Predictability of tax liability 2005 collections are likely to be a high base for measuring future increases. Instead, and consistent Extrajudicial confiscations with the government's desire to reduce tax rates, possibility policy should aim at reducing the high marginal Dependency on tax inspectors rates (particularly on payroll taxes), but coupled with broadening the base and improving compliance High tax rates to avoid significant revenue losses, thus, allowing a gradual and smooth reduction of the average tax burden Once tax reform has matured, it will be Note: The scale above ranks the most problematic issues in important to lock the changes into a new tax code, the tax system from 0 to 4 (4 being the most problematic) particularly in light of recent enterprise surveys Source: Cost of Doing Business Survey, World Bank, 2004. which show that businesses worry particularly about inconsistent and uncertain tax rules (see figure 1.3) . 1.12 Despite these fiscal pressures and the recent growth slowdown, Ukraine is potentially on the cusp of major steps forward. The country's strong commitment to accelerated reforms in the context of its EU accession aspirations has brought considerable growth expectations. Moreover, it has made Ukraine a focus of attention for investors that recognize the country's potential in terms of its natural resources, its industry, its well-educated population, and its strategic geographic location. Indeed, Ukraine has a good mix of economic resources to further advance its economy ­ the challenge ahead is to capitalize on these factors through accelerated reforms and greater economic diversification. Ukraine's major financial industrial groups have begun to improve their transparency and business practices.25 This promises better opportunities for market entry and domestic competition, complemented by more private investment, both foreign and domestic. It is critical for Ukraine's future development prospects that these positive trends continue. 24Roughly 89 percent of Ukraine's oil imports come from Russia (Bank estimate based on 2002 WITS figures). Assuming this is the current share of oil imports to Ukraine from that country, and applying the VAT rate to imports for 2005, VAT revenues on these imports would reach just above UAH 4.4 billion. This represents around 13 percent of the net VAT collection for 2005. Of course, this is not the amount of revenue gained, since VAT was being charged at later stages before 2005 (without a VAT credit). However, the loss may still be significant, as the first stage of VAT collection (the most effective) was forgone. 25See "Big Business: Institutional Role and Interrelation with Government and Society," Center for Economic Development, April 2006, and forthcoming on www.worldbank.org.ua. 5 B. FUNDING NEEDS AND PRESSURES ARISING FROM THE GOVERNMENT'S REFORM AGENDA 1.13 Reaching Ukraine's EU Aspirations and growth expectations will require significant resources. The government has been actively engaged in discussing and planning a comprehensive reform package, while the hike in recurrent spending has left little fiscal space to cover the costs. The reform areas listed below are just part of the overall reform agenda, but they highlight the fiscal pressures on the budget, and all of them have been highlighted recently by the government as priorities: (a) Making investment consistent with the EU Action Plan (e.g., energy and basic infrastructure) (b) Introducing the second funded pillar in the pension system and providing for the long-run sustainability of the system (c) Reducing payroll tax rates (d) Implementing public sector reforms (e.g., judicial reform, financial management reform, civil service reform, public salary decompression, etc.) (e) Providing investments that will improve education and health services (and specific reforms in these areas). Box 1.1 provides specific examples of those EU Action Plan objectives for Ukraine for which planning and financial sources will be needed to support the reform. Box 1.1: Ukraine's EU Action Plan Objectives (Paraphrased excerpts) Strategic Introduce strategic planning at the national and regional levels in Ukraine, and elaborate a draft state Planning strategy for regional development up to 2015. Fiscal Reinforce fiscal sustainability, including by implementing tax reforms and streamlining expenditure Management programs. Improve transparency of public finance management, including by development and restructuring of the system of public financial control and audit. Social Services Take measures to address imbalances in the pension system. & Social Develop sustainable systems for education, health and other social services with access for all. Assistance Institutions Ensure the effective implementation of independent and well-trained supervisory authorities to monitor for Consumer regulatory frameworks in accordance with internationally recognized standards. and Business Adopt regulations concerning licensing, interconnection, numbering and generally accessible Services telecommunications services. Carry out judicial and legal reform, strengthening the administrative capacity. Infrastructure Identify and commit sources of financing and adopt financing strategies for transport infrastructure development, while implementing an action plan for improving road safety. Pursue gradual convergence towards the principles of the EU internal electricity and gas markets. Develop infrastructure for the diversification of oil and gas supplies. Environment Enhance/adopt national programs and plans for key environment sub-sectors. Public-Private Address issues of infrastructure financing, including through the use of public-private partnerships. Partnership Implement a privatization program, including large-scale privatization (with transparency). Encourage the restructuring of the state-owned port sector (separating operational and commercial functions). Further explore the possibilities for the financial and legal restructuring of the gas transit business. 6 1.14 While the bulk of investments should come from the private sector, the needs are high and there is a role for the state.26 Investments in productive infrastructure and human capital are key ingredients for economic growth and for capitalizing on the mix of resources the country already has as it moves towards an EU standard of living. However, as is mentioned earlier and discussed in greater detail throughout this report, the government has not been spending effectively in these areas. As basic infrastructure has deteriorated, the need for public investment has increased. Strategic infrastructure in the energy sector (especially in areas where the private sector is unlikely to invest in the short run, such as district heating) needs to be upgraded to ameliorate Ukraine's high vulnerability to energy prices (and to improve energy efficiency). Investments are also urgently needed in transport, housing and community services (e.g., water, sanitation, heating) and environmental cleanup. In addition to purely physical investments, investments are needed in human capital in order to enhance the technical sophistication of Ukraine's labor force (in both the public and the private sector) and thereby achieve the higher levels of productivity consistent with Ukraine's wealth aspirations. 1.15 Institution building is needed to support a market economy. The movement toward a more modern way of business can herald the enactment of the needed corporate governance legislation, the improvement of the regulatory systems, a reduction in distortions and quasi-fiscal activity in the economy (e.g., energy tariff cross-subsidization, tax exemptions, nonpayment), and a better rule of law. But along with these changes, and in order to benefit from them, Ukraine needs to continue building complementary market supporting institutions, such as independent, accountable and effective regulatory agencies, a competent and transparent judicial system, and a better working system for state enterprise management. 1.16 In light of the EU Action Plan and Ukraine's growth prospects, Table 1.3 summarizes some estimates of key investment needs over the next 10 years. These figures are merely a rough estimate of the potential public investment needed in view of the EU Action Plan and the concomitant growth expectations and should be viewed as preliminary at this point. Feedback from the government on their estimates will be integrated into a future version of this report. The Bank's team expects to revise and update the estimates jointly with the government through the process of discussion and dissemination of this report. Table 1.3: Capital Investments for EU Aspirations Over the Next 10 Years, 2006-15 Sector Amount (Billions of USD) Energy 30 Transport 5 Housing and Communal Services 14 Agriculture and Land Reform 9 Health, Education, Social Protection 6.5 Environmental Protection 15 Market Supporting Institutions 4 Other 16.5 Total 100 Source: World Bank estimates in consultation with the Government of Ukraine. C. UNDERSTANDING THE FISCAL SPACE ARGUMENT FOR UKRAINE What Does "Fiscal Space" Mean? 1.17 The concept of fiscal space is another way of looking at the fact that resources are always limited, and thus, for any sustainable fiscal program, resources and plans for allocation must add 26The government has a special role in addressing market shortcomings in investment and providing public goods. For example, a trucking company that wants to ship goods to Europe or Russia will hardly take it upon itself to fix the roads along those routes. Rather, the company will make choices subject to the quality of roads, the availability of complementary transport services, and the institutional quality of customs and border processes. Similarly, parents on their own will not be able to establish a modern education environment for their children, nor quality health care. 7 up. When a government puts more public resources into recurrent spending (e.g., wages, pensions, subsidies), it takes up more of the fiscal space that could be granted to other expenditures, such as investments for enhancing infrastructure and human capital. 1.18 There are several dimensions (sources) through which fiscal space can be obtained. Fiscal space can be obtained through tax policy and administration by broadening the tax base, improving compliance, and using other policy instruments to raise higher revenues. Fiscal space can be obtained through the reallocation of expenditures (that is, through shifting resources from less efficient to more efficient uses), included by the phasing out or cutting of spending that is inefficient. It can be obtained though borrowing (government debt), or just through more efficient use of donor support. Privatization proceeds also have the potential to create fiscal space, since they are a source of finance (representing the conversion of a non-liquid asset to a liquid asset of the government, and sometimes complemented by the elimination of the recurrent and capital expenditures needed to run these enterprises).27 1.19 Fiscal space also has an important inter-temporal component. Essentially, the effective use of resources today which leads to increased productivity in the economy generates a larger base of resources (human and physical capital, and incomes) for tomorrow's economic choices (wealth can be saved and invested, or consumed). When significant investments are required, as in Ukraine today, decisions are needed as to whether to reduce current or future consumption to pay for them. Public consumption today can be increased (at the cost of future public and private consumption) through borrowing or through the sale of assets (such as oil and gas reserves). But in this case the economy can quickly come up against two broad tensions: debt sustainability and macroeconomic pressures. Thus, policies geared to create fiscal space also create fiscal solvency for the future by allowing more productive and growth enhancing public spending and by reducing distortions that hamper growth. 1.20 Fiscal space is country-specific. The policy choices available for finding fiscal space depend on the country's unique fiscal framework, including its characteristics, constraints, and policy agenda. Thus, while some countries may need to raise more revenues to finance their expenditure envelope, others may want to reduce the tax burden. While some countries may be able to acquire more debt cheaply, others may be above their debt limits or may be able to raise funds only at high overall costs to the economy. And while some countries may want to reallocate expenditure from one area to another while maintaining the same level of expenditure, others may want merely to phase out or cut programs, thus reducing the overall size of the government. How Can Fiscal Space Be Created and Allocated in Ukraine's Budget? 1.21 Improved fiscal policy and public finance management will create fiscal space. Fiscal space for a rate reduction in payroll taxes can be achieved by improving collection efficiency through broadening the base and through achieving better compliance, without increasing the tax burden in the system. Chapter 2 deals with concrete issues in selected areas of tax policy and administration and provides concrete recommendations for achieving these broad objectives. The fiscal space for the pressing need to upgrade and build new infrastructure could be achieved through a rationalization of several expenditure programs. This process would involve the phasing out and the reallocation of resources from inefficient programs to productive investments. Fiscal space for social programs can be found by better implementing them within current expenditure allocations and/or by raising allocations when efficiency has clearly improved. An overview of the expenditures in the budget, and options for achieving expenditure savings, are provided in Chapter 3. Fiscal space for the sound introduction of the second funded pillar into the pension system can be achieved through a combination of savings measures 27On the other hand, should large injections of capital be needed to prepare enterprises for privatization and/or to mitigate the social consequences of privatization, those expenditures should be factored into the fiscal framework. 8 (parametric changes) in the PAYG system. Chapter 4 examines the current issues in the pension system and calculates the fiscal impact of planned reforms (by the government) and additional recommended reforms (in this report) that should achieve the necessary savings to bring long-run sustainability to the system. It should also be noted that the savings in the pension system (achieved through the parametric changes suggested in Chapter 4) would be large enough to reduce the deficit of that system currently covered by the budget; this would further free up resources for productive investments and social expenditures once efficiency has improved. 1.22 As noted above, fiscal space for human capital investments could be achieved through more efficient use of resources within the health and education sectors. To achieve higher efficiency in these sectors, it is necessary to revisit their intergovernmental fiscal and administrative relations. These relations are fundamental for financing and regulating the operations of the bulk of these services in Ukraine, but several features of these relations need to be restructured if resource allocation efficiency is to be enhanced. This important issue will be a key focus of the second phase of the Programmatic Public Finance Review in Ukraine. 1.23 In parallel with gaining more fiscal space for public investment, capital budgeting needs to be improved, or scarce resources will be wasted. A better capital budgeting process would, on its own, create fiscal space, as better planning, evaluation, and allocation would channel resources to more productive investments (and away from economically poor choices). Moreover, this process would permit better use of the fiscal space created in other areas of the budget. Chapter 5 provides concrete recommendations for an improved capital budget process. Another related issue is the reform of the financing, implementation, and management of investments financed by donors. Strengthening these processes, and better integrating them into the core budget process, would allow for a more efficient use of these funds. Moreover, efforts by the government and the donor community in Ukraine toward harmonization would need to be scaled up as donor support may increase over the coming years. 1.24 As noted in Box 1.1 above, the EU Action Plan also envisages the use of public-private partnerships (PPPs) (in different formats and to different degrees) to finance capital spending. This could be an important factor in creating fiscal space in Ukraine. However, in order to utilize PPPs effectively, the government would need to strengthen the analytical and technical capabilities of its spending units so that they could make a proper evaluation of the fiscal implication of these financing schemes. The design aspects of PPPs can be crucial to their success; legal and regulatory issues almost always arise, and some PPPs imply significant contingent liabilities which the authorities would need to factor into their medium-term thinking.28 Finally, improvements in debt management can reduce borrowing and debt service costs, can reduce macroeconomic risks in the economy, and can even help facilitate financial intermediation by the private sector. This is addressed in Chapter 6 in the context of the macroeconomic framework and debt sustainability analysis. Fiscal Space within a Macro-fiscal Framework 1.25 The policy choices for obtaining and allocating fiscal space are unavoidably linked to the macro-fiscal framework of the country. Thus, creating and allocating fiscal space is in effect an adding- up exercise based on an underlying macroeconomic framework that provides key parametric inputs (i.e., inflation, growth, and the exchange rate, among others) and an inter-temporal dynamic. As every policy program needs to be financed, realistic, and typically conservative, economic projections are required. As projections are about the future, there should not be just one projection but rather a distribution (or a range) of possible outcomes. Chapter 6 of this report performs this adding up exercise through two 28See Annex 1.1 for a discussion on PPPs and other countries' experience with this issue. 9 macroeconomic scenarios. These scenarios present a consistent macro-framework and projections within an expected distribution of outcomes for Ukraine. Moreover, they integrate the choice between creating and not creating fiscal space, offer choices of meeting or partly meeting the reform agenda, and consider two different levels of public and private investment for the next 10 years. Related to this exercise, but not explicitly modeled in this report, is an underlying risk/return relationship. Among consistent macroeconomic programs, some fiscal strategies will be characterized by high risks / high returns, and others by lower risks / lower returns. 29 This is discussed in more detail in Box 1.2. Box 1.2: Risks and Returns of Fiscal Strategies All else being equal, and assuming that countries have the foresight, capacity, rigor, and discipline to implement well structured public investment programs (i.e., channeled to productive investments), a program which finances relatively larger public capital investments by running relatively larger fiscal deficits could be considered high risk / high return. Some of the Asian Tigers followed this path. On the other hand, if the same objective could be achieved by letting the private sector fulfill the investment needs (assuming that the government creates the proper conditions to that effect), this would be an ideally lower risk / higher return strategy. The Central European countries tended to follow this path owing to the fact that they were already on an EU accession track, which attracted a high level of private investment. If public infrastructure clearly represents a binding constraint to growth, recurrent expenditure reductions cannot be found, and the strategy is thus to maintain a low deficit through relatively low capital expenditures: this would be considered a low risk / low return strategy. A number of countries have followed this path, largely because of financing constraints, an inability to sufficiently rationalize expenditures, and the absence of the prerequisites for good public investment programs. In reality, there are more choices than those outlined here, and the choices are ultimately more complex. These characterizations are designed to help provide an understanding of the underlying tensions. In considering its options, Ukraine should take guidance from the experience of other countries. Countries that went through significant periods of economic growth have successfully harnessed some combination of public and private provision of public goods and services, and investments in infrastructure. The Asian Tiger economies (Malaysia, Singapore, Thailand, South Korea) tended to lean toward public investment (averaging between 5 and 10 percent of GDP, especially during the early years of the growth surge). The figure below depicts the high levels of investment (both public and private) in Malaysia in the years leading up to the 1998 financial crisis. This can be compared to the EU-8 countries which followed a more conservative path from the perspective of public investment, benefiting significantly from their EU accession processes and proximity to European investors. Malaysia Selected EU-8 countries 50 35 40 30 30 20 25 %10 20 0 15 -10 1981 1984 1987 1990 1993 1996 10 -20 5 Year 0 Overall budget balance, including grants (% of GDP) Poland Slovenia CzechRepublic Hungary GDPgrow th (annual %) -5 Public capital expenditure (% of GDP) -10 Overall budget balance, including grants (% GDPgrow thCountr (annual %) Total gross fixed capital formation (% of GDP) y Capital expenditure (% of GDP) Gross fixed capital formation (% of GDP) Source: WDI, World Bank. 1.26 Two important dynamics arise from the fiscal space adding up exercise: the "debt tension" and the "macro tension." In simple terms, expenditures greater than revenues (i.e., deficits) can be 29 There are many programs that are characterized by high risks, low returns; ideally, one would search for the program characterized by lower risks and higher returns. 10 financed through debt issuance.30 As debt levels rise, debt service in future years can represent a significant drag on the budget and the economy. There is a level of debt which is simply unsustainable, and the closer the economy comes to that level, the worse terms it will experience for new borrowings (higher interest rates and shorter maturities). This is referred throughout the report as the "debt tension." While the public debt stock is less than 20 percent of GDP in Ukraine, and thus the country could afford prudent debt increases, the government also needs to weight-in the fact that it has acquired (and inherited) over the years a large stock of contingent liabilities (e.g., the so called "lost savings" in the former USSR Savings Bank, 100 percent guaranteed deposits in state banks, and even pensions if not properly addressed by reforms). Thus, debt accumulation could take place with surprising rapidity.31 In addition, public borrowing reduces the foreign and domestic savings available for private sector borrowing, in effect crowding-out private sector investment. This is fine if public expenditures are more productive than private expenditures, which is often the case with the provision of truly scarce public goods, but will hurt growth and national wealth if this is not the case. 1.27 More immediately, the macro tension can come into play if fiscal expansion at the cost of future consumption begins to overheat today's economy. This can lead to inflation, increased risks in the economy, and higher borrowing costs for both public and private spending. In considering the macroeconomic program, governments must take into account the impact (stimulus) that deficit spending will have on economic activity (e.g., will it crowd out or help facilitate the private sector?). Critical to this is the type of expenditure that drives the deficit (that is, consumption or productive investments, the latter typically being more beneficial for future growth). At the same time, larger deficits may raise red flags about the ability of the government to manage the country's finances and contain inflation, which in turn may deteriorate borrowing terms. In short, there are a number of inter-linkages to consider here, and clearly Ukraine has some careful choices to make. We display some of these dynamics specifically in relation to Ukraine in the macro-frameworks developed in Chapter 6. D. CONCLUSION 1.28 Given the macroeconomic constraints that Ukraine faces, the level of investment needs consistent with its growth and welfare aspirations, the costs associated with planned and needed reforms, and the room for improvement in the structure and implementation of the consolidated budget, Ukraine's policy- makers face important choices and trade-offs, which will affect Ukraine's development outcomes significantly. The chapters in this report examine and provide selected sources of fiscal space throughout the budget in order to manage fiscal pressure, strengthen the capital budgeting processes and make the best use of donor financing. This is done within a consistent macro-fiscal framework. 30There are, of course, other ways to finance deficits including privatization revenues and donors' aid. 31And, as Chapter 7 shows, this is especially the case should macroeconomic tensions negatively feed back into the debt tension, and vice-versa. 11 12 2. BROADENING THE TAX BASE AND IMPROVING COMPLIANCE, WITHOUT INCREASING THE TAX BURDEN A. INTRODUCTION 2.1 Over the past few years Ukraine has experienced considerable progress in tax policy and administration. In particular, it has halted the growth of tax arrears, ended the practice of issuing tax amnesties, eliminated tax exemptions (although some remain, particularly in agriculture), simplified the system for the CIT and PIT, and designed a modernization strategy for tax administration. Not surprisingly, however, many challenges and opportunities for improvement remain. Issues such as the poor performance of the VAT in the period 2000-04, the refund arrears and excessive fraud in the VAT system, the high marginal tax burden on payroll taxes, the problems in the design and application of the simplified tax system, and the high compliance costs borne by taxpayers in the country have raised concerns in the government and among the business community. Moreover, recent discussions on lowering the rate for certain taxes (e.g., payroll taxes) have again brought the tax policy and administration agenda to the fore. Table 2.1: Revenues as Percent of GDP, 2000-05 2000 2001 2002 2003 2004 2005 TOTAL REVENUES 33.3 33.2 35.7 35.9 35.0 41.3 VAT 5.6 5.1 6.0 4.7 4.3 8.1 Other taxes on goods and services 3.0 3.6 3.9 4.1 4.3 4.3 Taxes on international trade 0.9 1.0 1.0 1.4 1.5 1.6 Personal Income tax 3.8 4.3 4.8 5.1 3.8 4.1 Payroll taxes 6.8 7.2 7.9 7.9 8.4 9.3 Enterprise Profit Tax (CIT) 4.5 4.1 4.2 5.0 4.7 5.6 Property and land taxes 0.8 0.8 0.8 0.8 0.7 0.6 Other taxes 2.8 1.8 1.7 1.6 1.5 1.4 Total Tax Revenues 28.2 27.9 30.3 30.6 29.2 35.0 Non-Tax Revenues 5.1 5.3 5.4 5.3 5.8 6.3 Sources: Ministry of Finance; IMF; Bank staff calculations. 2.2 This chapter focuses on the policy and administration aspects of selected critical taxes and issues: the VAT, the payroll taxes, the STS, and tax expenditures. It provides concrete recommendations to strengthen tax administration for these taxes (particularly core tasks such as the registration processes, compliance procedures, monitoring, audit strategies, and the system of penalties). It calls for an overhauling of the simplified tax system so as to reduce the opportunities for taxpayers to hide income under this scheme. Attention is given to the need to enhance coordination in collection, monitoring, and auditing among all revenue authorities (the State Tax Administration [STA], the State Customs Administration [SCA], and the Pension and Social Insurance Funds). 2.3 This chapter argues that given that the tax burden on the economy is already high, the creation of fiscal space through increasing taxes is not a sound option. Instead, and consistent with the government's desire to reduce tax rates, the policy should aim at reducing the high marginal rates (particularly on payroll taxes), but coupled (or preceded) by broadening the base, improving compliance, and enhancing revenue authorities' administrative capabilities in order to avoid significant revenue losses, and thus, allowing a gradual and smooth reduction of the average tax burden in the country. Furthermore, it argues 13 that significant reductions in payroll tax rates would be fiscally prudent only after the implementation of the second pillar in the pension system (which creates a clearer link between payments and benefits), and after visible improvements in collection efficiency are under way. While this report commends the government's actions on significantly curtailing tax expenditures during the last three years, it advocates further streamlining. Finally, this report recommends locking planned and recommended reforms into a well thought out tax code before the budget process of 2008. B. STRENGTHENING VAT POLICY AND ADMINISTRATION Context 2.4 Since its full implementation in 1997, the VAT has been the backbone of the tax revenue system in Ukraine.32 However, during recent years (between 2000 and 2004) it has performed poorly in revenue collections, it has created additional burdens for businesses, and its administration has experienced difficulties, particularly in tackling fraud. For these reasons, the VAT has been heavily criticized, and proposals for its replacement by a turnover tax have been under discussion.33 Indeed, the VAT has experienced difficulties as a revenue raiser, with declining collection efficiency during the period 1998- 2004. Despite the sharp increase in collection in 2005 (see Table 2.2), problematic issues persist in the overall performance and administration of this tax. It is also true that refunds to exporters have experienced delays (and to a lesser extent, still do so). This and other problems that the VAT is facing in Ukraine stem from the administrative weaknesses in managing this important tax. 2.5 This section evaluates the past and current performance of the VAT in Ukraine. It examines the underlying policy and administrative factors that contribute to the weaknesses of the VAT, and identifies concrete alternatives for addressing them. The measures and alternatives articulated here for the improvement of VAT administration can be applied to tax administration in general. VAT Collection Performance: Past and Present 2.6 From 1998 to 2004, VAT collection performance in Ukraine declined significantly. The revenue yield of VAT as a share of GDP declined almost steadily during that period. Although fluctuations in revenue yield are hardly unique to Ukraine, such a prolonged decline in VAT yields is quite unusual considering that VAT yields commonly should tend to rise with GDP growth and import growth.34 In Ukraine, however, although real GDP rose by 49 percent in the 1998-2004 period, VAT as a share of GDP actually fell by 33 percent.35 Annex 2.1 contains an international comparison of "VAT efficiency" in which Ukraine ranked poorly during that period.36 32Although a value added tax was first introduced in 1991 it was only in 1997 that a "modern" type of VAT, allowing in principle for freeing both investments and exports from tax, was introduced. 33As is argued later in this chapter, the potential outcomes of such a measure are unambiguously negative. 34See, for example, the econometric analysis in T. Baunsgaard and M. Keen, IMF Working Paper No. WP/05/11, June 2005. 35Commonly, a general consumption tax such as VAT would exhibit a (nominal) GDP elasticity on the order of 1 over a period of years. In Ukraine, however, the arc GDP-elasticity of VAT from 1999 to 2004 was an incredibly low 0.38. 36VAT efficiency (or productivity) is the actual collection as a ratio of GDP, divided by the standard rate of the VAT in the country. 14 Table 2.2: VAT Collection as Percent of GDP, 2001-05 2001 2002 2003 2004 2005 VAT Net collection 5.07 5.97 4.71 4.29 8.08 VAT Gross collection 6.97 8.56 8.57 8.32 11.26 Gross Domestic 5.17 5.56 5.04 4.81 5.75 Imports 1.80 3.00 3.53 3.52 5.50 Refunds -1.90 -2.60 -3.86 -4.03 -3.18 Sources: Ministry of Finance; Ukraine State Tax Administration; Bank staff calculations. 2.7 Concurrent with a poor collection performance, a sharp change in VAT collection composition took place. In 1999, the collection on net domestic VAT (gross domestic collection minus refunds) was 84 percent of the total VAT collection, while VAT on imports was 16 percent. By 2004 this relationship was almost inverted: net domestic VAT collection dropped to just 28 percent, while VAT on imports rose to 72 percent of the total VAT collection. The change towards dependence of VAT collections on imports is noteworthy. The growth of the share of imports in GDP over the past five years may explain some of this shift, yet it is difficult to point to any other country with such a marked and rapid change toward dependence on imports for VAT revenue. After several years of strong import growth and an expected worsening of the terms of trade over the next few years, Ukraine needs to be ready to absorb a slowdown of import growth from the point of view of VAT revenues. 2.8 In 2005 VAT collection rose sharply but dependence on imports persisted; this creates a risk of volatility in future collections. The actual VAT net collection was UAH 33.8 billion, which represented around 8.08 percent of GDP. In the context of other revenues, the VAT collection for this year represented 23 percent of total tax revenues (see Annex 2.1). This is a critical weakness since imports over time are likely to be more volatile than domestic production and sales, and thus, such a high reliance on imports as a VAT tax base creates significant risks of volatility in future tax revenues. Figures 2.1-a-b: A Strong Dependence on VAT Collection from Imports VAT collection compostion (1999-2005): net domestic vs. VAT on imports as % of net VAT collection: An International imports comparison 70% 1 Net VAT 0.9 Domestic 60% (Gross domestic 0.8 -Refunds) as % 0.7 of total net 50% VAT collection 0.6 40% 0.5 0.4 VAT on 30% Imports as % of 0.3 total net VAT 20% 0.2 collection. 0.1 10% 0 FY99 FY00 FY01 FY02 FY03 FY04 FY05 0% Albania Peru Philippines Russia Ukraine Georgia Zambia Sources: Data from MoF; Bank staff calculations; Ebrill et al. (2001). 2.9 The 2005 increase in collections was driven mainly by three factors. First, there were legislative changes that curtailed VAT exemptions at the beginning of 2005. This was a commendable action which helped to broaden the VAT revenue base. Second, prior to this year, Russia charged VAT on its oil exports to Ukraine; however, Russia stopped this practice for 2005, allowing the Ukrainian government to charge VAT on these imports.37 Finally, the changes in leadership and personnel in key areas of the STA and Customs was also a factor in increasing VAT collections. 37Roughly 89 percent of Ukraine's oil imports come from Russia (Bank estimate based on 2002 WITS figures). Assuming this is the current share of oil imports to Ukraine from that country, and applying the VAT rate to imports for 2005, VAT revenues on these imports would reach just above UAH 4.4 billion. This represents around 13 percent of net VAT collection for 2005. Of 15 2.10 But the sharp increase in 2005 may be a one-time effect. Because of the nature of the factors that drove collections up, another sharp increase in collections for 2006 is not likely to occur. In this context, the initial government forecast for VAT collection for 2006 is overly optimistic (above 20 percent growth) as the 2005 collection is likely to be a high base for measuring future increases. Thus, setting recurrent expenditure increases for 2006 on the basis of these revenue forecasts is not prudent. VAT Policy Issues and Recommendations 2.11 While significant improvements have taken place in VAT policy, such as the curtailing of exemptions in several sectors, there are a variety of unresolved issues that need to be addressed about this tax in its relation to the energy and agriculture sectors, and the STS. Moreover, the discussions about rate reduction and the arguments about replacing the VAT altogether (by a turnover tax) have brought the policy discussion on the VAT to the fore. Policy Issues 2.12 The poor past performance of the VAT and the burden of refund arrears on business38, have brought up discussions about replacing it with a turnover tax. But it should be considered that a turnover tax would bring more problems than solutions to Ukraine's tax system.39 A turnover tax brings distortions to the economy, as the market may shift its choices of production to less efficient ones based on the incentives generated by this tax. This type of tax would bring about a cascading effect of taxation that could harm economic activity. Moreover, evasion schemes are easier to undertake under this tax, and thus potential gains from easier administration are dubious. Finally, a turnover tax has uncertain distributional effects. 2.13 A rate reduction on the VAT has also been under discussion. The current rate of 20 percent in Ukraine is not high according to regional comparisons. Several countries in the EU are within the same range. In fact, one lesson from international experience is that lowering taxes is easy but raising them again later, if needed, is extremely difficult and politically costly. 2.14 The gas sector continues to be a problem for the VAT (the issue of the double pass- through). Since 2004, gas imports have not been charged with VAT at the border. Furthermore, domestic purchases of gas from the gas company continue to be zero-rated if the purchaser is a VAT registrant. That is, after the initial pass-through at the border, the gas company does not charge VAT to its direct wholesale customers if they are VAT registrants. VAT is charged only at the third stage in the chain. But VAT is charged to municipal gas companies and other non-VAT registrants. This policy has important implications, including the following: (i) it represents a large subsidy for those companies that do not pay the VAT at the first two stages of the chain; (ii) it may be generating revenue losses since two stages of collection are bypassed, making the job of revenue authorities more difficult (that is, single collection at the border is easier than collection from hundreds of companies); (iii) it may be subject to abuse when course, this is not the amount of revenue gained since VAT was being charged at later stages before 2005 (without a VAT credit). However, the loss may still be significant as the first stage of VAT collection (the most effective) was forgone. 38The level of VAT refund arrears was at UAH 3.3 billion (0.8 percent of GDP) as of August 2005. This increased level was partly due to the new refund claims generated by enterprises in FEZs (claiming refunds for the first time in 2005) and by SOEs that did hold refund claims towards the end of 2004, but pushed them forward for collection in 2005. Toward the end of 2005 refund claims in arrears dropped significantly to 642 million. In 2006, this amount has been marginally reduced to 586 million, as of May 1. 39Annex 2.2 contains a comparative table on the VAT and the turnover tax from a variety of different perspectives. 16 refunds are claimed, as the control of having to pay VAT at earlier stages is not present; and (iv) it has equity implications for households across Ukraine that purchase from municipal companies paying VAT. 2.15 The VAT in agriculture is inefficient and costly to the budget. The costs result from a combination of factors, including the following: (i) a zero rate for milk and meat producers; (ii) the retention of VAT collected by agricultural taxpayers; (iii) the right of purchasers of agricultural products to claim VAT credit for their purchases; and (iv) meat and milk processing factories that charge VAT in their sales but do not remit VAT collection to the budget but instead submit these resources to a special account earmarked for the sector. The government administration proposed an amendment to the current system but it was not approved by the Parliament for implementation in 2006 (Table 2.3 shows a comparison between the current system and the proposed amendment). The VAT system in agriculture is inefficient because its tax expenditures support specific commodities and producers (such as milk and meat products and producers and the livestock sub-sector) at the expense of other commodities and producers. Moreover, evidence shows that a small number of larger (and wealthier) producers are the ones that mostly reap the benefits of this special system (see section E of this chapter for a detailed analysis on VAT tax expenditures in agriculture) Table 2.3: Key Features of the Current and Future Special VAT Regimes for Agriculture Features Current VAT regime Future VAT regime VAT rate for agricultural products, % 20 10 during first year and 9 afterwards VAT rate for milk and meat, % 0 10 during first year and 9 afterwards VAT rate charged on purchase of inputs, % 20 20 Restrictions on use of accumulated VAT Purchase of production inputs only No restrictions Payment to the budget VAT not paid VAT not paid 2.16 There are good reasons for having a simplified tax system (STS) in Ukraine, but the current system has led to an erosion of the VAT base. There are several well-known efficiency and administrative reasons for keeping small taxpayers out of the VAT.40 Both the compliance costs (borne by taxpayers) and the administrative costs (borne by the tax administration) of dealing with such taxpayers are high compared to the potential revenue yield. Moreover, the idea of having such a system in Ukraine was to bring to light the small businesses operating in the shadow economy. However, the current structure of the STS allows medium businesses to migrate to this system, causing erosion in the VAT base. The behavior of taxpayers is tied to the opportunities to significantly lower the tax burden under the STS. Anecdotal evidence suggests that businesses break their operation into pieces and use other schemes to fit the requirements of that system. Recommendations on VAT Policy 2.17 First, replacing the VAT is not a solution. Rather than stepping away from the VAT (i.e., replacing it with a turnover tax), Ukraine should place its efforts on strengthening the VAT policy, bringing it closer to European standards and international best practices. 2.18 Second, there are no solid grounds for a rate reduction in VAT. This is not a pressing issue in Ukraine, and currently a policy in that direction could cause losses to the budget. Only structural improvements in tax policy and administration that are geared to broadening the base would open the way to discussing this possibility in the future. 40This section is limited to discussing some of the most pressing issues between the VAT and the simplified system for legal entities. However, sections C and D of this chapter provide a detailed discussion of the simplified system for individuals (and legal entities) and its relation to other important sources of revenue (for example, payroll taxes, PIT and CIT). 17 2.19 Third, the VAT on gas needs to be treated urgently within the context of a broader energy policy discussion. Although this issue goes well beyond a tax policy and administration discussion in Ukraine, it should be kept in mind that this tax, and tax policy in general, should not be used to cope with other inherent structural problems of the country such as the quasi-fiscal activities taking place through the under-pricing of energy. Fiscal discipline also implies keeping the tax system free of distortions. 2.20 Fourth, the VAT in agriculture requires urgent reform. This report supports the prompt introduction of the government administration's proposed amendment to the VAT law (Art. 8.1-on VAT on Agriculture). While revenue collection from the sector is not likely to improve significantly, the new system reduces most tax expenditures and is more compatible with EU legislation in this matter. 2.21 Fifth, a critical step in resolving the poor relationship between the VAT and the STS is to have matching thresholds. Currently, there is a mismatch of thresholds between the VAT and the STS. Lowering the threshold for legal entities in the STS from the current UAH 1,000,000 to the VAT threshold (UAH 300,000) is a reasonable option. One advantage of this option would be that the entry level to the VAT system and the maximum level for firms in the simplified system would then be identical. If a business has taken on legal form and with it the obligation to maintain books and records at a certain level, there is absolutely no reason why it should not be a registered VAT payer (again, above the UAH 300,000 threshold). In addition, having matching thresholds at UAH 300,000 would be a barrier to medium firms' migration to this system. There are two reasons for this. The first and the obvious one is that in theory only small businesses (below the VAT threshold) would be accepted in this system. The second is that dismembering a business into pieces would be more costly with a lower threshold. This is a politically difficult reform but a necessary one. In fact, little can be done to expand the base of the VAT and the bases of other important taxes (for example, payroll taxes) if the incentives and regulations of the STS are not changed (see next section of this chapter) VAT Administration (and Tax Administration in General) Issues and Recommendations 41 2.22 This section discusses the administrative problems that the VAT system faces in Ukraine, arguing that the current focus of the debate is too narrow, as the VAT problems cannot be attributed solely to such issues as the level of refund claims,42 fraudulent refund claims, or the refund system. Instead it argues that these issues are merely "symptoms" of broader and more structural administrative weaknesses in such core tasks of tax administration as improving registration processes, reducing compliance costs, enhancing monitoring, and improving auditing and enforcement. Administration Issues 2.23 The refund arrears and the fraudulent refund claims are merely symptoms of underlying administrative weaknesses. Thus, it is necessary to shift the focus of the discussion from these issues and to concentrate on the underlying weaknesses in the operation and capabilities the of collection agencies. Historically, the tax administration in Ukraine has concentrated its efforts on temporary pressing issues while, to some extent, ignoring the bigger picture. Thus, more needs to be done to enhance the tools for the core tasks of tax administration and to provide taxpayers with an encouraging environment for self-compliance. As noted earlier, the rise in overall VAT collection in 2005 was mainly 41While VAT revenues are collected through both Customs and the STA, this chapter concentrates primarily on STA functions. However, some of the lessons that emerge from this discussion are also applicable to the management and operations of the Customs Administration and other revenue agencies. 42In fact, refund levels for a given year in Ukraine are not well above an "expected" range. In 2004, new refund claims amounted to 41.3 percent of collections. Using the refunds empirical modeling in Harrison and Drelove (2005) IMF WP/05/218, we find an "expected" level of 46.5 (see Annex 2.2). 18 generated by legislative changes that expanded the base, but that increase was not necessarily a sign of better tax administration. 2.24 The capabilities to handle core tasks of tax administration need to improve. These capabilities span a range of areas from the tools for executing a rapid and controlled registration process to the tools for carrying out a proper monitoring of collections and taxpayers. The critical tasks that require strengthening are discussed below. 2.25 The current registration process is slow and unable to screen potential evaders, and its regulation complicates tax administration. A fast, client-friendly registration system is very important for improving the country's business environment. While some steps have been taken in this regard, such as the recently established single window for business registration, anecdotal evidence of improvement needs to be confirmed. The Doing Business Survey 2005 finds that the registration process for a business in Ukraine takes 34 days on average, almost double the OECD country average.43 In addition, a reliable screening of registrants is also important for improving VAT compliance. This is not taking place in Ukraine: the single window for business and tax registration has no screening processes for applicants that register (including the shareholders of new firms). Thus, shareholders of companies that have committed tax fraud in the past, and may be prone to fraudulent activity in the future, are not identified at this critical early stage. Moreover, the VAT (Art 9.4) allows registration to any taxpayer below the threshold (of UAH 300,000). This raises administration costs while providing little additional tax revenues. 2.26 Ukraine has high tax compliance costs. Despite some progress much remains to be done. Payment and tax reporting procedures are costly owing to their frequency and the complexity imposed by ever-changing legislation.44 The Doing Business Survey published in 2005 shows that Ukraine ranks poorly internationally in this regard (see Figures 2.2-a and b). The time spent by firms following the procedures needed to comply with core taxes such as the VAT, CIT and payroll taxes (withholding) continues to be excessively high. Moreover, the number of payments made by a company to the tax administration (without considering payroll taxes) highlights the need for major streamlining in tax compliance procedures. Figures 2.2-a and b: Compliance Costs in Ukraine, and International Comparison Average number of tax payments companies make in one fiscal year: Number of (man) hours spent by a company in a fiscal year filing taxes or international comparison related procedures (includes labor taxes) 90 2500 80 70 2000 60 1500 50 40 1000 30 20 500 10 0 0 Bulgaria Mexico Moldova Poland Russian Ukraine OECD Bulgaria Mexico Moldova Poland Russian Ukraine OECD Federation Federation Source: Doing Business Survey 2005. 2.27 Currently, the STA (and the SCA) lack the analytical capabilities for carrying out a proper monitoring and risk profiling. If the current capabilities are not enhanced, the task of curtailing fraud on 43This survey was collected toward the end of 2004, and initial evidence presented by the STA suggests that the days needed to register for VAT have been reduced significantly. If so, this will be picked up by future surveys, and would be a good sign of improvement in the business climate. 44The IFC survey on the Business Environment in Ukraine found that the VAT was among the most difficult taxes to file owing to the complexity posed by the large number of amendments this tax experiences each year. 19 all taxes, but particularly on VAT, could prove to be unrewarding. Moreover, the cost of tackling fraud without adequate analytical capabilities can be high, not only in terms of the loss of efficiency in resource allocation, but also in terms of image deterioration, if good taxpayers continue to be targeted. 2.28 Audit planning and practices remain problematic. In the past, one of the major taxpayer complaints has been the hassle of audits and the corruption sometimes present in this process. While progress has been achieved during the last year, improvement on this front needs to continue. The strategy to improve this task in STA needs to be strengthened. At the same time, coordination with other revenue authorities needs to be improved. 2.29 The current system of penalties seems inefficient. The criminal prosecutions carried out for VAT fraud in Ukraine are excessive (in number), costly and lengthy, and are not producing results in terms of recovering revenue and encouraging compliance. Thus, the system of penalties should strive for a better balance between administrative penalties and criminal prosecutions. Currently, most of the efforts rely on the latter. A criminal prosecution should be pursued only as a last resort, for large and egregious fraud.45 2.30 The task facing tax administration has been made incredibly difficult by many developments in the last few years. This is due, in particular, to the following: lack of consistent support from political leaders; frequent changes in tax legislation; problems with the legal and judicial system; weak corporate governance legislation and practices; the low level of accounting standards; and the rapidly changing structure of private activity. Recommendations for Strengthening VAT Administration and Tax Administration in General 2.31 This report proposes strengthening six basic core tasks of tax administration. These tasks are: (i) registration processes, (ii) the reduction of compliance costs, (iii) comprehensive monitoring, (iv) allocation of resources, (v) audits, and (vi) the system and enforcement of penalties.46 This set of tasks does not represent the full spectrum of tax administration activities. Rather, this selection showcases priorities for strengthening VAT administration in Ukraine (see Figure 2.3). The recommendations listed below can be applied to tax administration tasks in general. In fact, tax administration should consider all the recommendations within a comprehensive-functional framework. Figure 2.3: Strengthening Core Tasks of VAT (and General Tax) Administration in Ukraine 6. More effective 1. Better Registration enforcement of Process: Fast, client friendly, penalties but able to reject potential evaders 7. The Ukrainian STA needs sufficient 5. Better Audit Practices: More targeted, political support. well informed, avoiding hassles for good 2. Reduction of Compliance Costs: taxpayers Making taxes easier to pay 4. More efficient 3. Better risk monitoring tools: allocation of resources: Using benchmarks of collection and Based on monitoring fraud (by sectors of the economy; results by type of tax payers; by geographical regions) 45In the United Kingdom, with 1.4 million registrants, only a few hundred cases a year go to prosecution. 46These are some priorities in the same line of the basic preconditions for a self-assessed VAT as presented by Ebrill et al. (2001), "The Modern VAT." IMF, Washington, DC. 20 2.32 First, a thorough, but rapid, screening of new VAT registrants should be implemented. This screening should include the main shareholders of registrant companies. This is a common and fruitful practice in most developed countries, and certainly in developing countries that are tackling fraud successfully (such as Chile). At the time of registration, an information system should be able to quickly elicit data on past compliance for any applicant. In many countries, interconnected systems with customs and other government agencies have helped to facilitate this process (for example, in Australia). This screening process should also stop the registration of taxpayers below the threshold established (UAH 300,000) to avoid higher costs of tax administration. 2.33 Second, Ukraine must continue to simplify procedures for tax compliance. Reducing the complexity of tax forms is just a first step. The number of payments made by a company to the tax administration (and other collection agencies) also requires major streamlining. The STA and other collection agencies (namely, the four social insurance funds for payroll tax collection) need to design and articulate a coordinated plan for reducing compliance costs.47 Most developed countries during the last 10 years have established (and renewed) clear strategies for tackling this issue (for example, France's "making taxes easier to pay" program, which contains a list of 30 measures to achieve that goal). Box 2.1 presents a framework for evaluating new compliance measures in order to avoid extra and cost-inefficient burdens on taxpayers. Box 2.1: General Recommendations to Consider Before Implementing New Compliance Procedures · Implement a process of cost-benefit analysis of tax compliance procedures. This process should include at least the following: the evaluation of revenue potential, a change in compliance costs for taxpayers and administrative costs for the revenue authority. · Evaluate and streamline unnecessary procedures that are not essential. · New IT can help to streamline compliance procedures (for example, electronic filing) but this should be on a voluntary basis, bearing in mind that the objective of this is to reduce compliance costs for taxpayers and that it is not a monitoring tool for the revenue administration. · Consider the implementation difficulties of each new procedure. · Try to avoid imposing extra administrative burdens on compliance procedures as a reaction to concern regarding abuse and fraud. 2.34 Third, monitoring needs to be effective and comprehensive throughout the system. Thus, risk profiling can work only in the framework of a broader monitoring strategy. As discussed earlier, tackling the symptoms (e.g., refund claims through the refund system) does not resolve the underlying problems. While it seems reasonable to have some system in place to better handle specific areas, the need for better and comprehensive monitoring has to be central to the strategy for better VAT administration in Ukraine. The following concrete measures are recommended for setting an analytical and comprehensive framework for monitoring: (a) Identify the size of the problems: In the case of the VAT it is necessary to establish the "VAT Gap," which is the difference between the VAT actually collected and that potentially realizable (or theoretically feasible) given the level of economic activity in the country (or a specific sector), and the VAT regulations. (b) Identify the nature of the problem, whether it is non-registration, false registration, non-filing, under-reporting of sales, over-reporting of purchases, or non-payment. 47Section C of this chapter deals in more detail with reducing compliance costs through the eventual unification of insurance funds that collect payroll taxes. 21 (c) Establish specific benchmarks for (a) and (b): For instance, VAT gaps by sector of the economy, by geographical region, and by groups of taxpayers are critical benchmarks. There are several methodologies for calculating these benchmarks (see Annex 2.3). Basically, they serve as standards (that is, benchmarks) from which considerable deviations raise red flags about taxpayers' behavior and compliance. Benchmarks for monitoring the nature of problems can be constructed using the results of audits (see Annex 2.3). For other taxes, benchmarks following the same principles can be established. The State Customs Administration can also build up benchmarks for VAT on imports, based on targeted audits (by industry) and on the evaluation of the prices of imported merchandise. Moreover, it can support the construction of these benchmarks using methodologies such as "mirror statistics"; that is, comparing imports registered in Ukraine to exports to Ukraine declared by other countries.48 (d) Update and monitor changes in the benchmarks: In a changing environment these benchmarks inform the Tax Administration (and Customs), so that these institutions can address problems in a more targeted and efficient manner. (e) Improve systems to transfer data from the local operational levels to central units. While a lot of data are gathered by STS, an important portion are not properly processed and transferred to the analytical personnel in charge of monitoring. (f) Create a tax analysis unit in the MoF, and a revenue intelligence unit in the STA, with SCA participation. This is necessary in Ukraine because the technical analysis of tax policy always lags behind the pressure of the writing and passing new legislation, and the Tax Administration is always burdened by its efforts to cope with fraudulent practices. The approach suggested here is not new; intelligence units that monitor VAT (and other taxes) have been implemented within ministries of finance, tax administrations, and customs agencies in most OECD countries and in many developing countries facing VAT problems similar to those in Ukraine. This type of unit can start by incurring very small costs and with few staff members (typically, a small group of young and well-trained economists and accountants). (g) Establish a formal structure of coordination among revenue collection agencies. For the VAT a formal structure for coordination in the form of a committee and working group should be established among the STA, the SCA, and the MoF. For other taxes (for example, payroll taxes and PIT) a similar arrangement should be made among the STA, the MoF, and the social insurance collection entities. A formal structure in the form of a committee and working group is critical for proper monitoring. 2.35 Fourth, analytically based monitoring can help substantially in allocating tax administration resources more efficiently. Experience in several European countries, particularly in the United Kingdom and in Latin American countries, shows that monitoring based on analytical information can be most efficient in terms of revenue recovery vis-à-vis the administrative costs incurred.49 Moreover, having this type of systemic and comprehensive monitoring could be critical in allocating and re- allocating STA resources for auditing (for example, pre-refund and post-refund in the case of the VAT), in tackling the issue of fraudulent claims, and in pursuing other basic administrative tasks. 48 Data on exports from other countries to Ukraine can be gathered using databases such as WITS and COMTRADE. However, pilot exercises could be implemented mirroring statistics gathered directly for one or two countries. Using that methodology, the recent Trade Policy Study for Ukraine (2005) found that under-reporting of imports is taking place in Ukraine. The Trade Study is available on www. worldbank.org.ua. 49 In the United Kingdom's tax administration, the "shadow economy team for VAT registrations" alone has an annual return of a half million pounds per officer. 22 2.36 Fifth, audits should be better targeted on the basis of information obtained from comprehensive monitoring. The first step is to take stock of the results of past audits: that is, to look at the percentage of audits by sectors, recovery by audit, recovery by officer, cost by audit, and lessons learned. Such a stocktaking exercise is important to planning any strategy for improvement. Preparing collection and fraud benchmarks (see Annex 2.3) using audit surveys is also a key part of this exercise. These tasks would be typical for a revenue intelligence unit like that proposed in this report. Once some initial benchmarks are in place, audits can be directed to sectors of the economy (or groups of taxpayers, or geographical areas) that deviate from historic behavior (in other words, those that show greater VAT gaps than in previous periods of time). Setting priorities is the basis for stating an audit strategy for the following months. Results of future audits would feed back into the proposed intelligence unit to further develop the benchmarks, so that a portion of the future audits could be further targeted and better informed.50 2.37 Sixth, the government should consider re-shaping the system of penalties to place more emphasis on administrative penalties. The introduction of a well thought out structure of "quicker" and more easily enforceable penalties that would include deregistration, fines, temporary closures of businesses, and other administrative penalties should be established and pursued actively. The implementation of such a system should be accompanied by at least the following actions: (i) swift and vigorous enforcement when violations are found and proven; (ii) further curtailment of corrupt practices; (iii) transparency (including wide public dissemination) in the system of administrative penalties; and (iv) the strengthening of current mechanisms for listing taxpayers' complaints and appeal processes. Additionally, when criminal prosecutions are set, then a course of action for some small number of cases, and the publicizing of convictions (carried out through a fair process at the courts), may help to reinforce compliance.51 Box 2.2 contains a list of five critical guidelines for establishing a structure of administrative penalties. Box 2.2: Basic Criteria for Setting an Adequate Structure of Penalties Based on lessons learned from international experience, an adequate and equitable structure of penalties should consider, at least, the following elements: · Penalties should increase with higher potential revenue loss due to the tax offence/fraud. · Penalties should increase together with the difficulty and administrative cost of detecting the tax offence. · Penalties should increase with the effects of the tax offence on other taxpayers. · Penalties should be applied considering the motive of the tax offence, that is, higher penalties if the offence is deliberate and planned. · Penalties should consider the difficulties and costs encountered by the taxpayers to comply with the tax. Source: Extracted from Bird (2004). 2.38 In addition, the STA needs sufficient political support from the higher executive and legislative authorities to enable it to perform its job. Good tax administration is not simply a matter of more and better directed efforts on the part of the tax administration. It is also critical, for example, not to burden the tax administration with constantly changing and more complicated laws. Moreover, tax authorities need adequate resources and sufficient political support to enable them to carry out their 50It is important to mention that a portion of the audits needs to be made (remain) on a random basis. In fact, random audits are the ones that feed the samples through which analysis is undertaken to create collection /fraud benchmarks (see Annex 2.3). 51Canada is good example of the success of this policy. Publicizing convictions for the evasion of taxes helped in that country to send a strong message to the community that non-compliance is not acceptable and it leveraged the impact of tax prosecutions (OECD 2004). 23 essential tasks. In all these respects, the situation in Ukraine remains far from ideal, thus substantially complicating the task facing even the best-intentioned tax administration. C. PAYROLL TAXES Context 2.39 The high marginal tax burden on payroll taxes (social insurance contributions) and their narrow base are issues of concern for both the business community and the government in Ukraine (see Table 2.4). This situation has been exacerbated by two factors: (i) the inefficient and burdensome system of collection through the four different agencies (insurance funds); and (ii) the behavioral distortions caused by the STS for firms and employees that seek refuge within that system to significantly lower their tax burden.52 Increases in pension payments approved in 2005, and collections that cannot catch up with that hike, have also generated a serious deficit in the pension system, putting its sustainability at risk. The implementation of the second pillar in the pension system in 2009, as planned by the government, depends critically on balancing the deficit by 2008 and generating enough surpluses afterward to finance the first years of the introduction of that pillar. Table 2.4: Pension Contribution Rates are High in Ukraine Compared to European Countries Country Percent Country Percent Country Percent Albania 39 Austria 23 Spain 28 Bulgaria 29 Czech Republi 28 Turkey 20 Estonia 35 /1 Finland 27 Poland 33 Hungary 26 /1 France 16 Romania 35 Latvia 20 Germany 20 Russia 28 Lithuania 26 Italy 33 Slovak R. 26 Moldova 30 Netherlands 28 Ukraine /2 33.8 1/ includes other social insurance programs. 2/ There four social insurance funds in Ukraine; the largest contribution rate is for the Pension Fund (33.8 percent of wage income) as depicted in the table above. But when pulling together the contribution to all four social insurance funds the rate soares to around 40 percent of the contribution, with the employer's share standing at around 37.5 percent of that. See Table 2.5 for a detailed desegregation of the contribution rate of all four social insurance fund. Sources: ISSA, EU, World Bank. 2.40 In response to this situation, the government has been discussing a rate reduction (and other reforms) hoping to provide an adequate incentive for firms and employees to accurately report incomes, and consequently to generate higher revenues for the government (namely, following a "Laffer" type effect). But this policy needs to be evaluated cautiously and realistically for at least three reasons. First, the tax liability offered by the STS is considerably lower than any rate the government could establish for social insurance contributions; second, for individuals (in collusion with employers) it is easy to migrate and stay within the STS, thereby reducing the likely impact of a rate reduction on payroll tax collection; and third, currently the link between social insurance contributions and pension benefits is almost nonexistent, lowering incentives for individuals to comply. In this context, this chapter argues that it is unlikely that a rate reduction alone could improve the current situation. Rather, it argues that if a rate reduction is to be effective in terms of broadening the base and avoiding proportional revenue losses, this policy needs to be preceded by structural reforms, including: (i) improving the collection efficiency of collection agencies/funds through accelerating the unification of functions under the Pension Fund, and in the medium term through full unification with a single collection agency, and a single rate; (ii) providing 52While this section of the chapter provides a clear idea that distortions and negative incentives are caused by the STS in relation to the collection of payroll taxes, the next section deals exclusively with the STS, its problems and the avenues for reform. 24 structural reforms in the STS that will put an end to migration and tax avoidance through this system; (iii) providing a clear linkage between contributions and benefits in the pension system (that is, the introduction of the second pillar); and (iv) enhancing the coordination between the insurance funds and the STA in order to improve monitoring and enforcement throughout the system. In this context this chapter provides concrete recommendations to prepare the payroll tax system for a rate reduction once the second pillar is introduced. Payroll Taxation in Ukraine: Current Structure and Planned Reforms 2.41 Ukraine has a rather complex system of four separate social insurance programs that collect payroll taxes. Each program has its own tax rates, its own independent administration and operation, and its own regulation. These programs are pension insurance, unemployment insurance, temporary disability insurance, and industrial accident insurance. The payroll taxes collected by these insurance funds are all imposed on the same base (payrolls) but they have an income ceiling. Thus, rates are levied only on up to seven times the average wage in the country.53 In total, the combined tax rate for all programs often exceeds 40 percent depending on the risk of industrial accidents, and as Table 2.5 shows, the vast bulk is the employer's share. The single largest fund is the pension insurance fund (PF). Table 2.5: Tax Rates in Social Insurance Programs (as Percent of Employee Wage Income) Contributions(*) Pension Unemployment Temporary Industrial Total Insurance Insurance Disability Accident Insurance (2) Insurance. Employer 31.8 1.3 2.9 1.5 (4) 37.5 Employee 1.0 /2.0 (1) 0.5 0.5 / 1.0 (3) --- 2-3.5 Total 32.8 ­ 33.8 1.8 3.4 ­ 3.9 1.6 39.5- 41 (*) Rates as established in the 2006 budget of Ukraine. (1)Includes sickness, maternity and funeral insurance. The average total rate for the Pension Fund alone is 33.8 % of wages. (2)An average weighted rate. The rate the employer pays varies from 0.66 percent to 13.6 percent depending on the degree of hazardous risk level. (3)1.0 percent of gross taxable income under UAH 150; 2.0 percent of gross taxable income over UAH 150. (4)0.5 percent for wages below the subsistence threshold; 0.1 percent for wages above the subsistence threshold. Sources: MoF, MoL, Budget 2006. 2.42 Currently, each insurance fund administers its own separate collection machinery. These collection systems are largely independent of one another and this occurs despite a common base and method of collection (that is, employer withholdings on gross wage incomes). There is much that is wasteful and duplicative in the separate administration of the programs. The administrative inefficiency and compliance burden this creates is high, and this is widely recognized by the government. 2.43 From the perspective of employers, there is also much that is costly and cumbersome in complying with these taxes. This is due to the complexity of the separate programs and the duplicative nature of the withholding and paying of these taxes. This situation is further exacerbated by the existence of multiple rates within a single insurance program that apply to different types of employees working for the same employer. 2.44 These payments finance a wide range of benefits. For example, the unemployment insurance finances unemployment benefits to unemployed individuals and their dependents, benefits to unemployed 53 The cap is established as seven times the average wage in the country. The monthly average wage in 2005 was UAH 806, so the ceiling in that year was UAH 5,642. This ceiling is set in the annual Budget Law. 25 individuals who participate in job training programs, and funeral benefits that are paid to survivors in the event of the death of an unemployed individual. The temporary disability insurance funds benefits for maternity, childbirth, child care, and funeral benefits, in addition to temporary disability benefits. The industrial accident insurance finances a wide range of benefits intended to ameliorate the effects of industrial accidents and occupational diseases which lead to income loss due to health problems. 2.45 But the link between payments and benefits is weak, almost nonexistent. Despite some changes made in the legislation and the benefit formula, currently the benefits are almost flat. Thus, the only significant link between payments and benefits is to be a participant in the system and consequently to receive a pension payment almost regardless of the amount contributed. Clearly, this does not create an incentive for contributors to report their "real" income to the system, particularly contributors in the mid- range and higher income brackets 2.46 The government's strategy for "Pension Fund System Development," which includes several measures to improve the efficiency of payroll tax collection, has set several objectives that are in the right direction. Indeed, the measures contained in that strategy are relevant to improving compliance, reducing administrative costs, and enhancing the overall collection performance of the system. Box 2.3 contains a summary of selected policy measures envisaged to improve payroll collections. Box 2.3: Ukraine's Government Strategy for Improving Payroll Collections (Part of the Government's Strategy for Pension Fund System Development) In December 2005 the government established a strategy to push the long awaited pension reform. Several goals and guidelines in this strategy are expected to improve collection efficiency of payroll taxes, including the following: introducing a Single Social Insurance Contribution payment; stimulating the wages and pensions payment through banking institutions; and creating the system for electronic reporting by employers on the insurance contributions payments. The Draft Law on Single Social Contribution (possibly the most important administrative reform in payroll tax collection) is geared to consolidate some administrative functions of the insurance funds into the Pension Fund. According to the proposed Law the Pension Fund would perform the following functions: (a) a single registration of insured individuals for all insurance programs; (b) central registration of contributors through State Registration Office; (c) collection of contributions with Treasury control; and (d) a central recordkeeping for all social insurance programs. The central social insurance administration system would also have information exchange with the other tax authorities. Source: Extracted from WB Pension Administration Project Preparation Aide-Memoire (2005-06). Issues and Challenges Ahead 2.47 Broadly speaking, the policy measures to improve payroll taxes envisaged by the government are positive; however, steps and detailed actions need to be articulated. While these measures are aimed at simplification and a single payment, complementary legislation is geared to the opposite direction. For instance, a recently approved supplementary regulation shows that rates for the Industrial Accident and Occupational Insurance vary with disability risk, spanning 67 different risk categories and some 30 rates. Moreover, there is more variety in alternatives for companies that employ the disabled, working pensioners, and farmers. Thus, there is a wide range of variations in individual liability even within a single company. This type of complexity adds an extra burden to the withholders (and taxpayers) and makes collection monitoring and control more difficult.54 54The State Treasury Administration would have to handle a large number of accounts in each case if automatic funds distribution is desired (as envisaged by the government strategy). Employers would have to use a different account number when 26 2.48 The tax rates of the payroll-based programs are somewhat high. Despite several very small and marginal rate reductions in these social insurance contributions over the last eight years, the total rate of contribution remains high by international comparison, particularly the share of the tax rate borne (statutorily) by the employer.55 On this issue there have been discussions about shifting a share of the statutory rate borne by employers to employees. 2.49 The bases of these taxes have been substantially reduced by evasion. Evasion has taken place through under-reporting (and non-reporting) of income. This has led to large, but largely unknown, revenue losses. The large shadow economy in Ukraine has a large proportion of individuals and entrepreneurs that, while having some sort of official registration, under-report a significant share of their income.56 2.50 The bases of these taxes have also been substantially reduced by tax avoidance. Tax avoidance (which is "legal" as apposed to evasion) takes place mainly through the use (and abuse) of the STS. In Ukraine it is a well-known practice to take advantage of the STS in order to avoid regular PIT and payroll taxes. A common example is an employee (or potential employee) who agrees to provide services to a firm and to that effect signs up as a "consultant" under the STS, although in practice he/she is (will be) a regular employee. In other words, this "consultant," while having the same functions as other peer employees, takes on a different status before the tax authorities (that of individual entrepreneur within the STS) in order to have a much lower tax burden. For example, consider an individual with a turnover of UAH 119,000;57 if this represents the annual taxable income, then this individual would pay a regular income tax of UAH15,470; the maximum tax burden under the STS is UAH 200 per month, or UAH 2,400. 2.51 The relationship between payroll taxes and the STS introduces substantial horizontal and vertical inequities.58 The horizontal inequities take place between individuals with similar incomes who work in the formal taxed sector and those who work in the untaxed sector, between taxpayers who are able to elect to be taxed under the simplified tax system (and so who are not subject to the regular payroll taxes) and others, and between those who evade and those who do not. These taxes also introduce vertical inequities under the same scenarios depicted above (that is, between individuals with a high income who are taxed under the simplified tax system and low wage earners with 40 percent of their wage withheld by the employer). Both horizontal and vertical inequities are harmful to taxpayers and undermine the sustainability of the tax system in the country. 2.52 Moreover, the budget subsidizes the contributions of individuals in the STS. Under the simplified tax regime, companies pay a fixed rate or patent which is then distributed between the state budget and social insurance revenues. But because the amount received by the pension fund is far from enough to pay a minimum pension, the budget, using other resources from other revenues, makes a transfer to the pension fund to compensate for the shortfall in payments. It should be clear that this subsidy is undertaken at the expense of other taxpayers the effective contribution rate and/or its structure changes (from WB Pension Administration Project Preparation aide-memoire 2005-06). 55Although they were informal, there were some discussions within the government about shifting statutory tax rate shares between employers and employees. Clearly, any relative change in employer-employee statutory tax rate shares is unlikely to have any substantive or significant economic impact. 56Shadow income may also take place in large companies with poor corporate governance. Annex 2.4 contains some comparative data on the shadow economy across the country and its effects on revenue collection. 57This is one of two thresholds for individuals in the STS (see Section D). 58Horizontal inequities refer to those among taxpayers with a similar level of income (ability to pay). Vertical inequities refer to those among taxpayers with different levels of income (different abilities to pay). 27 2.53 The introduction of the second pillar of the pension fund is needed to strengthen the link between payments and benefits. The government's strategy envisages its introduction within the next three years, a timeframe that would appear ambitious but appropriate. In this context, this report stresses the importance of having in place the necessary fiscal adjustments and institutional changes underpinning the viability of this reform. 59 2.54 The pension system also receives revenues from a tax on foreign exchange transactions, which is acting increasingly as a barrier against the development of financial markets. The tax was introduced as a stop gap measure after the 1998 Russian financial crisis at a rate of 1.5 percent, reduced in 2005 to 1.3 percent. Revenues under the tax go to the Pension Fund and have assisted in plugging the pension deficit in recent years (revenues in 2005 were HUA 2.1 billion or roughly 0.4 percent of GDP). These are substantial revenues and the tax may have served a purpose in earlier years. However, it does increase the cost of foreign exchange transactions, which will limit the development of a mature domestic foreign exchange market and at the margin discourages both portfolio and foreign direct investment flows. As the reform options to balance the pension system listed below are introduced, the government should re-consider the rationale for this tax and strive to eliminate it or at least agree to phase it out over a fixed timetable. Options for Reform and Recommendations 2.55 There are several avenues for reform of the policy and strengthening of the administration of these taxes. The following recommendations should be considered.60 Policy Recommendations 2.56 First, expand the tax base of the payroll taxes by reforming the STS. As discussed earlier, there are powerful incentives for individuals to find a way to be taxed under the STS. Reforms in the STS are necessary to allow the base broadening in the payroll taxes and the PIT, to improve the overall collection efficiency of the tax system, and to substantially reduce the existing vertical and horizontal inequities (and other inefficiencies) in the tax system. Given the perverse incentives and the economic inefficiencies generated, the government should consider a complete reform of the STS. The next section of this chapter discusses in detail the main problematic issues with the STS and lays out concrete options for its reform. Additionally, the single social contribution law and its supplementary acts provide an opportunity to phase out the subsidy for pension contributions received by individuals in the STS. 2.57 Second, accelerate the process of unification of common administrative functions (registration, data warehousing, reporting, collection, control, enforcement) of the four social insurance funds under the Pension Fund. This process will render important benefits in reducing compliance and administrative costs. In the medium to long run, the government should aim at full unification, which would imply a single unified tax rate and a single collection agency with all functions incorporated. 59A full description and discussion of the introduction of the second pillar of the pension system can be found in Chapter 4 of this report. 60The analysis behind these recommendations is based on the Ukraine institutional framework, international experience, and the assistance of a Simple General Equilibrium Model that considers three sectors in the economy: a sector in which labor is subject to payroll taxes and contributions, a sector that is legally exempt from all taxation (i.e., the STS), and a sector that is legally subject to taxation but that escapes all taxes because its activities are hard to tax (e.g., the informal sector). One of the basic intuitions of this model is that if labor is mobile between those three sectors, then the imposition of payroll taxes, and contributions in the taxed sector, will cause labor to respond by moving to the untaxed sectors (see Annex 2.5 for a detailed explanation of this model and its underpinnings). 28 2.58 Third, together with base expansion that is due to reforms in the STS, higher collection efficiency, and the introduction of the second pillar in the pension system, a corresponding reduction in contribution rates should be considered. Having a clear linkage between contributions and benefits such as the one provided by the second pillar would introduce the incentive to more accurately report real wages and thus increase compliance. This, together with the successful implementation of the other recommendations provided above, would allow the beginning of a base expansion that could be accompanied by a rate reduction. (a) The timing of the rate reduction: This would depend on the timing of the reforms in the three key areas suggested, namely the following: reforms to the STS, visible improvement in collection efficiency, and the introduction of the second pillar in the pension system. If reforms to the STS and the collection agencies take place during the 2006-08 period, then the government could consider a rate reduction in parallel with, or just after, the introduction of the second pillar of the pension system. (b) The pace/size of the rate reduction: The pace and size of rate reduction is interlinked with improvements achieved in the suggested reforms (in this chapter and parametric changes to the pension system suggested in Chapter 4) . If no reforms are made, even small rate reductions may generate large revenue losses (in proportion to the rate reduction). Marginal reforms are likely to generate marginal results, and in that case rate reductions would again pose a threat to revenue collection performance. But substantial achievements in those reforms are likely to allow a gradual but significant rate reduction over a period of time. Improvements in complementary factors, including coordination between the STA and the Pension Fund (PF) on revenue administration tasks, and a better system of penalties, would also help with compliance, and consequently would facilitate an increased pace of rate reduction. Estimations on the effects of rate reduction (shown in Chapter 4, Figure 4.2) show that even moderate rate reductions (5 percent total over a period of 5 years, 2009-13) would hold the system in deficit if the reforms recommended above and the parametric changes in the pension system recommended in Chapter 4 are not implemented. On the other hand, those estimations also show that a significant rate reduction (10 percent total over a period of 5 years, 2009-13) may be fiscally possible only if all the reforms and parametric changes suggested are implemented.61 (c) Shifts or changes in the shares of the statutory rates borne by employers and employees: These shifts are not likely to have any significant effect on compliance in the short run. There are several arguments behind this statement. First, it is likely that most of the burden of payroll taxes in Ukraine is borne by labor (employees). While this argument requires empirical evidence, some facts support it: (i) employment has been relatively stagnant despite high rates of growth in the economy between the period1999-2004; (ii) most constraints to the labor market come from business environment issues; and (iii) labor regulation is not seen as a major constraint to employment in Ukraine.62 Second, in Ukraine it is a well-known practice for employers and employees to enter into collusion to lower the tax burden (either through under- reporting of wage income or through the STS). Thus employers and employees are likely to negotiate over net take-home pay, taking into account the relative cost of payroll tax evasion for both sides. 61See pension system assumptions in Figure 4.2 (Chapter 4) and macro-fiscal assumptions in Table 6.2 (Chapter 6). A description of the model used is also available in Annex 4.1. 62See Ukraine Job Study ­World Bank, 2005. 29 2.59 Fourth, consider an increase in the penalties for violating the regulations for the contribution of social insurance taxes. The current penalties are too low by any standard. Consequently, they have no effect in discouraging evasion. Recommendations for Strengthening Administration 2.60 First, expand the tax base by instituting a coordinated compliance program to reduce tax evasion (in coordination with the STA). While there are some coordinated activities currently taking place and others are envisaged (particularly sharing audit results), there is much more to be done. For example, a formal structure of coordination and a joint task team for the PF (representing all insurance funds) and the STA should be considered. Both payroll taxes (currently collected by the PF and the other insurance funds) and the PIT (currently collected by the STA) are collected on the same reported income. Both are withheld by the same agent (the employer). Thus, much more coordination is needed for monitoring and audits, including joint strategies for these core tasks of tax administration. 2.61 Second, a single form could be used to collect all payroll taxes and the individual income tax (PIT) in the medium term. This recommendation only applies to individuals whose only income is their wage. The form would have, for each employee, a separate entry for the PIT and for any other payroll taxes or contributions withheld. Payments could be deposited with a single receiver in accounts earmarked for each program. The use of a single form would be facilitated by the common tax base and the use of proportional (flat) tax rates. This may not be possible immediately as it requires improvements in IT capabilities and data sharing structures as a first step, but would be highly efficient in the medium term. 2.62 Third, the registration, the cancellation of registration, and a change in the status of insured individuals should be carried out only by the PF. This would avoid duplication and communication transaction costs between the PF and the State Employment Service. This seems reasonable if we consider that the PF would be in charge of the "Registry" of insured individuals. D. THE SIMPLIFIED TAX SYSTEM Context 2.63 The Simplified Tax System (STS) was established by Presidential Decree in 1998 as a temporary measure.63 There are several well-known compliance, administrative, and efficiency arguments for having a special system for small taxpayers. As commented upon earlier, the compliance and administrative costs of dealing with such taxpayers are high compared to the potential revenue yield. Moreover, the idea behind such a system for Ukraine was to bring to light the small businesses operating in the shadow economy. While the objectives envisaged for the STS were good in principle, its design has created a number of problems for the tax system. The design generates incentives for taxpayers to migrate out of the regular tax system, it creates vertical and horizontal inequities among taxpayers, it generates economically inefficient choices for taxpayers, and it undermines the bases and the collection efficiency of major taxes (payroll taxes, the PIT, the VAT and, more marginally, the CIT). 2.64 While this chapter argues that the STS should be kept, it also suggests its complete reform. Structural changes are required, in particular to make feasible the broadening of the base of payroll taxes (and the bases of the PIT and the VAT). Furthermore, a full-fledged reform would benefit the tax system 63The STS became fully operational in 2000. 30 in several other ways, making it more efficient and equitable. This section provides an overview of the STS. It discusses the design features that generate perverse incentives and inefficiencies in the tax system and the economy, and proposes concrete options/recommendations for reform. Current Structure and Issues 2.65 Despite its name, the simplified tax system is in fact fairly complex in its design. This is due to the wide range of options provided for individual entrepreneurs and businesses to fit into the system. Its design, regulation, and operation are convoluted compared with similar systems in other countries (see Table 2.6).64 Table 2.6: Taxonomy of the Simplified Tax System in Ukraine Options Subject of Eligibility criteria Base Tax Rate taxation The unified Legal entities Annual gross (last 12 months) turnover Gross 6%; but not exempt Tax (firms) does not exceed UAH 1,000,000; firm Turnover from VAT. does not have more than 50 10%; exempt from employees. VAT. Physical persons or Annual gross turnover (last 12 months) Gross 6%; but not exempt "individual does not exceed UAH 500,000; Turnover from VAT entrepreneurs" entrepreneur does not have more than 10%; exempt from (individuals) 10 employees. VAT. Fixed Tax Physical persons Annual turnover (last 12 months) does -------- Patents vary from (individuals) not exceed UAH 119,000; do not have UAH 20-200 per more than 5 employees. month. Other (Trade Levied on legal Small firms as assed by local -------- Various amounts patents, fees entities and governments (LG) (assessed by LG). and permits) individuals. 2.66 Given the low rates of taxation in the STS, it is clear that there is a strong incentive to elect to be taxed under this system.65 Not surprisingly, the number of individuals and businesses opting for the STS has increased significantly since 2000. Although the revenue collection from this system is not significant, as expected, the 2002-04 trend seems almost flat despite the growth in number of registrants (see Figure 2.4). Figure 2.4: Increasing Number of Registrants in the STS but Decreasing Revenues, 2000-05 1400 1 Number of legal 1200 entities (under the 0.8 unified tax) 1000 )sdnasuo Number of 800 0.6 )PDGfo individuals (across the STS) th % n(i 600 s 0.4 (a 400 Total revenue 0.2 collection 200 from the STS as % of GDP 0 0 2000 2001 2002 2003 2004 2005 (as of July) Source: STA; Bank staff calculations. 64See Annex 2.6 for an international comparison. 65It should be recalled that the tax rates in the regular system are as follows: 13 percent for the personal income tax, around 40 percent for payroll taxes, and 25 percent for the corporate income tax. In addition, the example of an individual with a turnover at a threshold of UAH 119,000 should be recalled. If this represents his/her annual taxable income, then this person would have to pay UAH 15,470 just for the personal income tax in the regular system while the maximum tax burden under the STS is UAH 200 per month, or UAH 2,400. 31 2.67 The STS distorts taxpayer behavior in significant and economically inefficient ways. First, firms have an incentive to fragment their operations (to split a firm into smaller firms) in order to meet the threshold requirements.66 Such purely tax-driven fragmentation is an appealing choice that the taxpayer faces (legitimately or not), and one that may harm the economy through lower levels of productivity. For example, firms fragment their operations into smaller firms to meet the threshold, thus losing economies of scale and hampering output growth. Second, there is a major "notch" problem facing taxpayers. Consider a legal entity with a turnover of exactly UAH 1 million, or exactly 50 employees. An increase of one unit in either turnover or employees would generate an enormous increase in tax liability, as the taxpayer must legally move into the regular tax system, thereby paying the regular income tax as well as the VAT and all of the payroll taxes. These disincentives for growth in turnover and in employment are also economically inefficient. 2.68 In addition, there are legal, though largely artificial, methods by which individuals can become eligible for STS participation. These tax avoidance schemes involve an individual's changing his/her status from an "employee" (who is subject to income tax and regular payroll tax withholding by the employer) to an individual entrepreneur, typically a "consultant," who is taxed at far lower rates under the STS. This is done in collusion with the employers who have the incentive of not paying their large share of payroll taxes in the regular system. Under this scheme a business simply pays fees for services to an individual who may be in fact a regular employee of the firm but who is registered legally as an individual entrepreneur under the STS. 2.69 The turnover upper limits (thresholds) in the STS are too high. The establishment of appropriate levels for these thresholds is a crucial design feature. A threshold that is set too high will undermine the regular tax system because many agents will opt for the reduced rate of taxation in the STS; a threshold that is set too low will fail to achieve the goal of simplification for many small taxpayers, thereby imposing compliance costs on many for whom the intent was to make their tax calculations much less burdensome. Ukraine has the first of these scenarios: for example, the threshold for individuals at UAH 500,000 is around 50 times the average annual wage level in Ukraine (for 2005). The same occurs with the upper limits for legal entities. There is little question that many enterprises currently under the STS are fully capable of being taxed under the regular tax regimes. 2.70 A related issue is that there is no apparent mechanism by which taxpayers will "graduate" to the regular tax system (except of course when they exceed the established thresholds). But because there are no significant controls of tax authorities over the STS, this provision has no "graduation encouraging" power. In many countries there is a limit to the number of years that a taxpayer can participate in a simplified tax system, even if the taxpayer meets the formal eligibility requirements. 2.71 The relation of the STS to the regular tax system is problematic. The impact of the STS on the revenues of other taxes is almost certainly negative. As noted earlier, individuals and legal entities under the STS are not liable to comply with regular PIT and payroll taxes, and thus the STS has a significant negative impact on the collections of those two taxes. If legal entities opt not to register for the VAT­ and most firms take this option­ then VAT revenues will also be negatively affected by the STS. Even aside from this latter revenue impact, firms that opt out of the VAT break the chain of transactions in the VAT, thereby destroying for many enterprises the paper trail of invoices that is central to VAT enforcement. More marginally, the STS also affects the CIT as many-medium size firms are hidden in this system while their real size would require them to be within the regular tax net. 2.72 There is no thorough (ex ante or ex post) verification that those taxpayers who elect to be taxed under the STS are in fact legally eligible. This may suggest that the enormous increase in the 66Officials from the MoF noted examples of firms that split into 20 (and more) smaller firms. 32 number of STS participants has been generated by the illegal migration of taxpayers to the lower-cost tax system. Government officials believe that perhaps as many as 50 percent of all participants (individuals and firms) are fraudulently in the STS. 2.73 The STS contributes to horizontal and vertical inequities in the tax system. Individuals and firms with equal "true" incomes are taxed very differently if one is subject to the regular tax system and the other is in the STS. Similarly, a high income individual in the STS may pay significantly lower taxes than an individual with a much lower "true" income if the latter faces the full force of the regular income tax system. Employees subject to income tax withholding by their employers seem particularly likely to be treated unfairly relative to those in the STS, because wage earners have little recourse other than to pay the regular individual income tax. Recommendations and Options for Reform 2.74 The STS should be retained, but it requires a complete overhaul. As discussed earlier, there are sound reasons for a separate tax system for "small" taxpayers, but the STS in Ukraine has severe weaknesses that need to be addressed. To summarize: (i) it creates incentives for legal and illegal migration from the tax system which generate revenue losses for the budget in all major taxes (payroll taxes, the PIT, the VAT, and, more marginally, the CIT); (ii) it distorts taxpayer decision making in production; (iii) it introduces substantial horizontal and vertical inequities among taxpayers; (iv) there is no clear mechanism for "graduation" from the system; and (v) the assessment and verification eligibility are weak. Thus, the system requires urgent reforms. The government may want to consider the following concrete recommendations, which are in line with EU and international good practices. Policy Recommendations 2.75 First, re-evaluate the threshold for legal entities so as to ensure that only truly "small" businesses are eligible for the STS. The current threshold is very high and allows some firms that are fully capable of paying the regular income tax to choose the STS and also breaks the VAT chain of transactions. The upper threshold for legal entities should be linked directly to the VAT entry threshold (that is, at UAH 300,000).67 2.76 Second, re-evaluate the threshold for physical persons. The current upper limit of UAH 500,000 is too high. A threshold of UAH 20,000 (or twice the average annual wage in Ukraine) is recommended. This would benefit the tax system significantly and is more in line with good international practices. 2.77 Third, require legal entities to withhold payroll and PIT taxes for their employees. A firm that employs as many as 10 employees (let alone 50) should be capable of withholding payroll contributions. The reforms in collection agencies would make this process easier in 2008-09, particularly after the introduction of the second pillar in the pension system. 2.78 Fourth, adjust periodically the thresholds for inflation and other changing economic circumstances. Thresholds are a tool for assuring administrative efficiency and better compliance, not an entitlement for taxpayers. 67In addition, this report supports the IMF recommendation on this that calls for the exclusion from the STA of any business that controls directly or indirectly another business, and/or is indirectly controlled by other business entity, or by a person that controls another business. 33 2.79 Fifth, limit the eligibility criteria of the number of employees for legal entities. The current upper limit of 50 employees is out of any international range for this type of simplified system. A more justifiable upper limit should not be above 10 or 15 employees. Again, only "true" small businesses should be allowed into the STS. 2.80 Sixth, rationalize the eligibility criteria by type of activity for individuals (physical persons) in the STS. In particular, exclude all categories of professionals and "consultants." Only small individual entrepreneurs such as small street merchants, technicians (such as plumbers and the like), and low-skilled individuals and activities should be allowed in the STS. The acceptance of other activities should be evaluated carefully. The idea of limiting the activities in this system is to properly target the system's benefits to small entrepreneurs and to avoid the inequities caused in the tax system by the "collusion" between employers and employees to avoid taxation. 2.81 Seventh, increase the penalties for employers and taxpayers that do not meet the eligibility criteria. The current fines are too low and have no "compliance-encouraging" power (particularly considering that no actual auditing processes take place in this system). Recommendations for Strengthening Administration 2.82 Improve enforcement in the STS (in coordination with local governments). There must be some official verification that individuals and firms who participate in the STS are in fact eligible for participation. There must also be an attempt to reduce purely artificial accounting or other schemes that allow STS participation. The STS should set up a small program aligned with local government (and their incentives) that will detect potential violators and firms ready to "graduate" to the regular system. E. TAX EXPENDITURES Context 2.83 Tax expenditures have been generating distortions across a variety of sectors in Ukraine's economy, but they are highly concentrated in the agriculture sector.68 Tax expenditures can be found across most major revenue sources, including the VAT, the CIT, the land tax and a variety of excise taxes.69 However, the government of Ukraine has gradually but steadily curtailed tax expenditures. At the beginning of 2005 a significant improvement was achieved by curtailing most of the tax expenditures related to the free economic zones (FEZs) and various VAT tax expenditures. Nevertheless, the budget and the economy could benefit from further streamlining. Although the share of tax expenditures as a 68Tax expenditures are defined here as concessions or exemptions that depart from the "normal" or "benchmark" tax structure and reduce government revenue collection. Because the government policy objectives could be achieved alternatively through a subsidy or other direct outlays, the concession is regarded as equivalent to a budget expenditure. To define the benchmark structure this report considers the benchmark tax legislation and international best practice. Tax expenditures are estimated here following the methodology recently established by the Ministry of Finance. This definition is a slightly modified version of the IMF definition contained in the Manual of Fiscal Transparency. 69The sources of revenue affected by tax expenditures are the following: VAT, CIT, excise duty, land tax, tax on vehicle owners, tax on geological prospecting (which is financed through public funds), payments for the special use of natural resources, natural resources extraction fee tax on environmental pollution, local taxes and fees, state duties. 34 percent of GDP has been significantly reduced from 7.66 percent in 2002 to an estimated 3.27 percent in 2005 (see Table 2.7), tax expenditures remain sizable and their reporting could be improved.70 2.84 This section examines recent trends in the size and composition of tax expenditures, with emphasis on the agriculture sector. It also focuses on the issue of transparency in the reporting of tax expenditures, arguing that the current legislation lacks clarity in the definition of tax expenditures and does not provide a due and transparent process for the discussion of these expenditures in the budget process and beyond. The section also argues that the methodology established for the estimation of tax expenditures, despite improvements, is still incomplete as it does not account for key tax expenditures (for example, special VAT treatment for agriculture). Finally, the report argues that this situation weakens the accountability of public finances. Tax Expenditure Trends 2.85 The share of tax expenditures in GDP has declined considerably since 2003. By the end of 2002 tax expenditures amounted to more than UAH 23.77 billion, or 8.89 percent of the country's GDP (see Table 2.7). By 2004 they were reduced to UAH 9 billion, which represented 3.92 percent of GDP. This report estimates that tax expenditures as a percent of GDP will be reduced to around 3.27 for 2005. The government's effort of almost halving tax expenditures each year during the last four years indicated a serious commitment to improving tax policy. Table 2.7: Tax Expenditures as Percent of GDP, 2002-05 Tax expendtures 2002 2003 2004 2005 (estimation) CIT 0.81 0.37 0.31 0.11 VAT(1) 4.99 6.59 3.13 2.8 Excise 1.3 1.48 0.12 0.05 Land 0.55 0.45 0.34 0.28 Other taxes 0.01 0.01 0.01 0.01 Total 7.66 8.89 3.92 3.27 (1) Includes VAT tax expenditures granted to the agriculture sector. Sources: STA; Bank staff estimates based on the MoF unified methodology. 2.86 While tax expenditures exist in a variety of government revenues, the major sources affected in 2005 were the VAT and the land tax. Together, the tax expenditures in these two categories represented 88 percent and 95 percent of the total amount of the tax concessions in 2004 and 2005, respectively. VAT and land tax exemptions and privileges historically have made up the bulk of tax expenditures. Third in importance are the losses generated through the CIT, which were significantly reduced in 2005. 2.87 The substantial decline in CIT and VAT tax expenditures in 2005 can be explained, in particular, by the cancellation of privileges in FEZs and TPD. This was a commendable and bold action taken by the government at the beginning of 2005. 70The amounts reported here do not account for VAT zero-rated products, such as the gas imports double pass-through discussed in section B of this chapter. 35 Box 2.4: Ukraine's Effort to Reduce Distortion in the Economy: The Curtailment of the FEZ Ukraine maintains extensive sectoral subsidies and has a multitude of free trade zones and priority development areas. A variety of industries and specific projects within those industries were receiving subsidies under the FEZ agreement. The main goal of zone formation was regional development through establishing business-friendly enclaves. But this scheme of subsidization was born with an ad hoc nature in terms of regulations. Moreover, international experience with free trade zones is mixed and suggests the following: (a) they are not a first-best solution ­ overall liberalization of the economy is first best, (b) they tend to have limited applicability and impact, (c) they work best when they are appropriately set up, managed, and WTO compliant, (d) they work best in countries with developed infrastructure and financial markets where downward linkages can be developed to domestic economic activity, (e) they are distortionary trade instruments which introduce discretion into the policy environment, and as such they are vulnerable to abuse, and (f) they tend to stick in the system, that is, once privileges are provided lobby groups help to maintain and expand them. One special aspect of FEZ's that is often overlooked, is that they act as a safety valve for attracting investment when the overall business climate is poor, and as such they reduce pressure on the government to improve the business climate for all investors (domestic, foreign, large and small). Typically, the investment attracted through them is small as a share of GDP, and can draw attention away from improvement of an overall investment climate. In light of this evidence, and in the context of the overall program of elimination of tax privileges in Ukraine, it was clear that regulations on these zones needed to be revamped. Source: Extracted from the World Bank note on "The debate on the elimination of free enterprise zones in Ukraine," prepared by Mark Davis, Kyiv 2005 Current Issues and Challenges Ahead Tax Expenditures for the Agriculture Sector 2.88 VAT tax expenditures in the agriculture sector increased during the 2002-05 period. Tax expenditures in this sector were around 0.5 percent of GDP in 2002 and increased steadily to 1.04 percent of GDP in 2005. 2.89 Tax expenditures in agriculture, stemming from VAT exemptions, are large. There are four major types of VAT expenditures granted to agriculture (see Figure 2.5):71 (i) VAT charged on sales of agricultural products stays in the farm accounts to be used to purchase production inputs; (ii) VAT charged on sales of meat and dairy products is not paid to the budget by processing plants but is returned to primary milk and meat producers; (iii) VAT charged on sales of dairy and meat products produced in on-farm processing capacities stays in the farm accounts to be used for livestock support; and (iv) milk and meat sold by agricultural producers is taxed at a zero VAT rate. The special VAT regime for agriculture is an example of how measures originally envisaged as temporary become long-term privileges that are difficult to withdraw. Figure 2.5: Growing VAT Concessions in Agriculture (by Type and as Percent of GDP), 2000-05 1.20 Zero VAT for milk and meat products 1.00 Livestock support 0.80 0.60 Returns to milk and meat producers 0.40 Inputs purchase 0.20 0.00 2000 2001 2002 2003 2004 2005 Sources: MoF; Bank staff calculations; 2005 calculations are Bank staff estimates based on preliminary data from the MoF. 71The agricultural producers have also benefited from overdue payments of taxes and tax debt write-offs (in the years 2000 and 2001). These benefits are not shown in Figure 2.5. 36 2.90 The VAT tax expenditures create inefficiencies that undermine long-term farm competitiveness. They may have an adverse effect on the overall agriculture sector, as the VAT fiscal concessions target specific commodities and producers (such as milk and meat products and producers and the livestock sub-sector) at the expense of other commodities and producers. The VAT expenditures on the livestock sub-sector, for example, create distortions, as they stimulate greater production while cheaper market-compatible responses for dealing with the insufficient production of livestock products remain overlooked.72 The government has a variety of choices available for making spending in the agriculture sector more efficient. Chapter 3 of this report highlights these choices. 2.91 Tax expenditures and subsidies may be increasing income disparities among farmers. This is because these fiscal concessions mainly benefit a smaller group of large producers at the expense of a larger portion of smaller farmers. For example, Table 2.8 shows the distribution of fiscal subsidies (consisting mainly of VAT expenditures but also of direct budget expenditures) among livestock producers in 2004. Only 7 percent of the farms received 75 percent of all fiscal subsidies. While the share of subsidies in the gross income of livestock producers was 3.8 percent on average, the small privileged group of large farms received 10.4 percent of their gross income from the budget. Table 2.8: Distribution of Fiscal Subsidies to Livestock Producers in 2004 in Ukraine Subsidies, Hrv. Million Number of farms in Share of group in terms of total Subsidies per farm (in Share of subsidies in total each group subsidies value, % Thousands of Hvr) farm revenue, % No subsidy 1,982 0 0 0 0-5 1,059 0.3 2.3 0.2 5-25 1,698 2.6 13.4 1 25-50 858 3.4 35.6 1.9 50-100 810 6.5 71.6 2.6 100-250 716 12.6 155.7 3.7 > 250 551 74.6 1,201.10 10.4 Total 7,674 100 94.5 3.8 Sources: Institute for Economic Forecasting, National Academy of Science of Ukraine (unpublished report). Tax Expenditures in Other Sectors of the Economy 2.92 Several tax expenditures have been curtailed in various sectors, but some remain. There are exemptions (particularly in VAT) in the automotive industry, publishing, and pharmaceutical products (see Table 2.9) that, although small compared to those granted to the agriculture sector for example, add up to a sizable amount. For example, the VAT exemptions granted to pharmaceutical products may appear reasonable on the surface (with people buying cheaper /tax free medicines) but anecdotal evidence suggests that this exemption is used by pharmaceutical companies and their distributors as an implicit price mark-up instrument. Thus, the distributional impact of this tax expenditure may be quite inequitable, contrary to the original intent. Table 2.9: Selected Tax Expenditures by Industry as Percent of GDP, 2002-05 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 P u b l i s h i n g 0 . 2 2 0 . 2 1 0 . 0 8 0 . 0 9 M o t o r - c a r c o n s t r u c t i o n 0 . 0 9 0 . 3 6 0 . 4 3 0 . 0 8 M e d i c i n e s 1 . 3 8 1 . 2 0 0 . 3 4 0 . 3 2 Sources: MoF; Bank staff calculations; 2005 calculations are Bank staff estimates based on preliminary data from the MoF. 2.93 Tax expenditures in the energy sector have been declining (see Table 2.10). The energy sector has traditionally been privileged with a variety of tax expenditures and the like. Apart from the VAT issue 72These responses include such measures as easing imports of breeding stock, improving the domestic breeding system, dealing with the chronic shortage of quality protein feeds and providing investment grants to the agricultural producers. For a detailed discussion of this issue, the interested reader may refer to the background note on agriculture prepared for this report. 37 regarding the gas sector, discussed in section B of this chapter (the double pass-through), there are tax expenditures in VAT and CIT that are also granted to this sector, although the bulk are VAT-related. Table 2.10: Tax Expenditures in the Energy Sector as Percent of GDP, 2002-05 2002 2003 2004 2005 (9 months) Electricity, Oil, and Gas 0.23 1.85 0.18 0.11 Prospective activities oil, gas, coal 0.01 0.03 0.02 0.00 Total 0.24 1.88 0.19 0.11 Sources: STA; Bank staff estimates based on the MoF unified methodology. 2.94 Attempts to eliminate privileges for land taxes have failed. Thus, the losses caused by such privileges remain practically unchanged. Land tax privileges represent around 9 percent of the total amount of tax expenditures in 2005. While the government has been moving forward in curtailing exemptions in other critical taxes (such as the VAT and CIT), much remains to be done in the area of land taxes. Reporting of Tax Expenditures 2.95 Up to 2004, the government did not have a clear definition of "tax expenditures" nor did it have a methodology for their estimation in the budget process. This led to contradicting estimates from the MoF and the STA.73 During 1998-2004, estimations by the STA accounted for some tax exemptions that are part of a normal tax system and not considered tax expenditures internationally, such as exemptions from VAT for financial services and zero rates on exported goods and services. In addition, the STA form which monitored tax exemptions included multiple counting of the same exemption along the VAT chain. This led to gross overestimation of tax expenditures and unfortunately misinformed the debate on this issue. Owing to the absence of a clear and appropriate definition of tax expenditures, the fiscal authorities in Ukraine were unable to come up with accurate estimates during that period of time. 2.96 The recently established "unified methodology" has brought more uniformity to the estimation of tax expenditures, but it has yet to become part of any approved legislation. In 2004 the MoF drafted a methodology which was submitted to the Cabinet of Ministers for approval. Although it has not yet been approved, this methodology is now used by the STA to assess tax privileges and to provide an officially recognizable unified set of data. But the "unified methodology" does not consider some tax expenditures that most countries account as such. For example, the "unified methodology" does not include exemptions through the Fixed Agricultural Tax (FAT) (see Box 2.5) and the special VAT regime for farming, forestry and fishery activities. Box 2.5: Fixed Agricultural Tax (FAT) The FAT, introduced in 1999, is a substitute for 12 other direct taxes and levies including the profit tax, personal income tax, land tax, local taxes, and pension and social insurance contributions. The FAT is in fact a variation on the land tax because it is assessed on the value of agricultural land as of July 1997. Livestock producers benefit more than crop producers from the FAT, because the base of the FAT is land area owned. Overall, however, the tax is much less distortive than VAT exemptions, as it does not stimulate the higher production of specific products. It is difficult to quantify the precise amount of all revenues forgone owing to the FAT, but the transfers from the budget to the Pension Fund also to compensate for the revenue forgone in payroll taxes was close to 0.4 percent of GDP in 2005. That said, the concession on pension contributions is being phased out, and by 2010 agricultural workers will have to pay these payroll taxes in full. 73The STA defined an exemption as a full or partial tax privilege provided to certain taxpayers, or as an exemption of part of the tax base from tax obligations, duties, and mandatory payments (STA reports 2001-03). 38 2.97 New tax expenditures are introduced throughout the year, which harms the predictability of budget forecasts. In accordance with current legislation, any changes in tax policy (that is, amendments to tax bills) for the introduction of tax privileges should be implemented not later than six months before the beginning of the budget year. However, in practice these tax exemptions are introduced even after adoption of the budget. This situation may further exacerbate any inaccuracies in revenue estimates. 2.98 The discussion of tax expenditures is not an integral part of the budget process. This points to a lack of transparency in their consideration. An informed consideration of tax concessions by the Parliament at the budget planning stage could not only help to better define priorities but could also improve the effectiveness of budget spending in this area. Recommendations 2.99 First, further curtailment of tax expenditures should continue. Some VAT-related tax expenditures which are good candidates for eliminating (such as those for agriculture, pharmaceutical products, publishing, and car manufacturing) could generate savings for the budget of up to 1.5 percent of GDP. In this regard, the agriculture VAT regime proposed by the government in December 2005 should be implemented for the 2007 budget, as it cuts out several inefficiencies, reduces losses to the budget and is more in line with the EU legislation in this area.74 2.100 Second, a deeper technical and economic analysis of tax concessions should be implemented. This implies the following: (i) more attention on the part of the fiscal authorities to the measurement of tax expenditures; (ii) a complete analysis of the economic effects and distortions created by the proposed (and current) tax incentives; (iii) the performance evaluation of tax concessions provided in the past; and (iv) a lawful due process for this technical evaluation. 2.101 Third, any tax privilege should be discussed in the budget process as an expenditure item. In other words, tax concessions should be subject to the same rules and requirements that apply to other expenses in the budget process. This would require a prior analysis and open (that is, public) dissemination of the results, as recommended above, to enable policymakers to make informed decisions. 2.102 Fourth, more transparency regarding tax expenditures in the budget documents is needed. Lack of clarity in the reporting of tax expenditures in the budget documents reduces transparency and weakens the possibility of future monitoring and analysis of the effects of these tax expenditures on the economic sector that is receiving these concessions. F. CONCLUSION 2.103 The analysis and recommendations presented in this chapter show that there are important issues to address in tax policy and administration in Ukraine. This chapter stresses the importance of the VAT for the tax system and the need to improve its administration significantly, while at the same time fixing some policy issues of this tax on the energy sector, on the agriculture sector, and on its ill relation with the STS. It also stresses the importance of lowering the high marginal rates of payroll taxes (social insurance 74There is detailed discussion of this issue in section B of this chapter and in the background note on agriculture prepared for this PER. 39 contributions) in Ukraine, but coupled with reforms geared to broadening the tax base and improving compliance, such as introducing the second pillar of the pension system (to create a clear link between contributions and benefits); accelerating the process of unification of common administrative functions of the four social insurance funds under the Pension Fund; improving core tasks of tax administration in STA restructuring the STS to reduce base erosion (generated by taxpayers abusing this system to lower their tax burden), and cutting tax exemptions. This chapter also argues for keeping the STS, but with a complete reform in order to stop the perverse incentives, inequalities, and inefficiencies generated by this system for the Ukrainian regular tax system. Only "real" small business should be allowed in the STS and most physical persons should pay regular taxes (including all categories of professionals and consultants). 2.104 Looking at the medium term, the recommendations of this report are also geared to signal that government should gradually lower the tax burden in the economy through lower rates on direct taxes, particularly on payroll taxes /social insurance contributions. In general, direct taxes tax labor and capital, and at a high marginal burden they deter growth and encourage underreporting of income (which is the bulk of the shadow economy in Ukraine). The government should aim at relying more on indirect taxes such as the VAT (and excise taxes75) that bring about less distortion to the economy. If equity concerns arise from relying more on consumption taxes (although empirical evidence is not conclusive on this), they can be addressed through more targeted (pro-poor) spending. This broad recommendation is also embedded in the long-term revenue forecasting discussed in the macro-fiscal framework of this report (see Chapter 6). Finally, this report stresses the importance of pulling together a carefully constructed tax code before 2008, in order to have clarity of rules and transparency in their existence. This will help to build understanding and trust among taxpayers, while reducing their costs of doing business. 75Here we refer to excise taxes related to domestic consumption; not to excises that affect international trade. 40 3. FINDING EXPENDITURE SAVINGS BY IMPROVING ALLOCATIONS A. INTRODUCTION 3.1 Public spending in Ukraine is high and has been increasing. The consumption orientation of the budget is crowding-out public and private investment. The allocation efficiency of public spending is also questionable, both in terms of its consumption orientation and because it is financing a variety of inefficient subsides and untargeted programs. Public expenditures in Ukraine grew steadily since 2001, reaching 44 percent of GDP in 2005 (4.6 percent of GDP higher than in 2004) (see Table 3.1). This is a record level for Ukraine and one of the highest in the region. This trend has been driven by hikes in recurrent spending. Pension payments grew from 9.2 percent of GDP in 2003 to 15.3 percent of GDP by 2005, while in parallel the pension system balance went from a small surplus in 2003 to a 3 percent deficit in 2005. Although not an outlier for the region, Ukraine's public wage bill registered a record high for Ukraine in 2005 at 8 percent of GDP (from 7.4 percent of GDP in 2004). The public wage bill has been pushed by minimum wage hikes, and is likely to make up 8.4 of GDP in 2006 owing to further planned step-wise increases this year. On the other hand, capital expenditures, as listed in the budget, have remained low and decreased significantly in 2005 (from 6 percent of GDP in 2004 to 4.3 percent of GDP in 2005). However, just above half of those expenditures are comprised of the category called "capital transfers to enterprises." Under this category, close to 65 percent are subsidies to SOEs, or transfers to spending units of the government (i.e., Ministry of Agriculture, Ministry of Energy) that in turn run subsidy programs with these resources. Table 3.1: Hike in Public Expenditure in Ukraine, 2003-05 (as Percent of GDP) 2003 2004 2005 Total expenditures 36.8 39.4 44.0 Current expenditures 32.5 33.4 39.7 Pension payment 9.2 11.4 15.3 Public wage bill 7.6 7.4 8.0 Capital expenditures 4.3 6.0 4.3 Capital investments (fixed) 2.8 2.8 2.0 Source: Ministry of Finance and State Treasury of Ukraine; Bank staff calculation (and estimation for 2005) 3.2 This chapter provides a review of the trends and composition of public expenditures in Ukraine, highlighting potential expenditure savings that could be achieved by rationalizing, phasing out or cutting specific untargeted programs and inefficient subsidies. The objective of identifying potential expenditure savings is that they can be sources of fiscal space that later can be re-allocated to more efficient spending (e.g., productive public investments) and can be used to finance the government reform agenda. The chapter is organized as follows. Section B starts by outlining the organizational structure of Ukraine's budget and the relative expenditure trends of its parts. Among other things, this provides a basis for understanding the rest of the chapter. Section C provides an analysis of public spending using the economic classification of the budget. It highlights issues of allocation and it points out potential expenditure savings that could be achieved from curtailing inefficient subsidies. Pension expenditures are briefly overviewed, as the bulk of that discussion is taken up in Chapter 4. Section D provides an analysis of public spending using the functional classification of the budget. It provides an overview of the core sector programs, and focuses in more detail on social assistance programs (especially social and occupational "privileges'), agriculture and the energy sector. This section also highlights issues of allocation and it points out potential expenditure savings that could be achieved from curtailing inefficient 41 subsidies, phasing out some untargeted programs, and improving others. Section E provides a summary of recommendations to improve public spending and Section F provides a summary of the discussion and concluding thoughts. B. ORGANIZATIONAL STRUCTURE OF THE GENERAL GOVERNMENT BUDGET IN UKRAINE 3.3 This section provides a brief overview of the particular and unique characteristics of the budget structure in Ukraine and its main expenditure trends. In Ukraine, the General Government Budget (as broadly defined internationally) comprises two main components (see Figure 3.1): the Consolidated Budget (as defined by Ukrainian legislation); and four off-budget Social Insurance Funds, of which the Pension Fund is the largest. The Consolidated Budget is further divided between the state budget (that is, the central budget) and the local budgets. Both the state budget and the local budgets are additionally subdivided between a General Fund and a Special Fund. Figure 3.1: Organizational Structure of the General Government Budget of Ukraine General Budget of Ukraine Consolidated Budget Social Insurance Funds State Budget Local Budgets Pension Fund General Fund General Fund Industrial Accident and Occupational Disease Fund Special Fund Special Fund Unemployment Fund Temporary Disability Fund Note: It is important to clarify that Ukraine's legislation does not have a "General Government Budget" but two separate branches: the "Consolidated Budget" and the off-budget Social Insurance Funds. For the purpose of this analysis (and to enable international comparisons) we consolidate both branches under the broad definition of General Government Budget. State and Local Budgets 3.4 The share of local budgets in total spending has been declining. During 2002-05 local budget expenditures grew as a ratio of GDP, but at a slower pace than other components of the General Government Budget (i.e., the state budget and social fund expenditures). As a result, the share of sub- national spending in total spending fell from 34.2 percent in 2002 to 29.8 percent in 2005. Local budget expenditures play an important role in various budget programs, especially in education and health (see Table 3.2). 42 Table 3.2: Local Budget Expenditures, 2002-05 2002 2003 2004 2005 Local budget expenditures, percent of total expenditures 34.2 32 30.2 29.8 Local budget spending in education, percent of total spending on education 57.8 61.7 60.7 60.9 Local budget spending on health, percent of total spending on health 79 75.8 71.7 77.4 Source: Ministry of Finance and State Treasury of Ukraine; Bank staff calculations (estimations for 2005) 3.5 Among a variety of issues, the problem of unfunded mandates at the local level persists. The share of financed delegated expenditures for local budgets fell from 81 percent of total local expenditures in 2002 to 72 percent by 2005, but the scope of responsibilities was not reduced accordingly. This is especially acute in relation to social privileges, which are discussed later in this chapter. While this first programmatic PFR for Ukraine does not analyze expenditures in detail at the local level, such an exercise is planned for the next PFR. In particular, this exercise should focus on education, health, social assistance, and housing and community services, all in the context of the intergovernmental fiscal framework of Ukraine and the role of state and local institutions in program implementation. The Special Fund 3.6 The creation of the special Figure 3.2: General Fund versus Special Fund Expenditures, fund was an important step in the 2002-05 direction of budget consolidation. The main rationale behind this reform 35 (established in the 2001 budget code) was to pull together a variety of off- 30 budget funds and revenues, and bring 25 them into the Consolidated Budget. PDG 20 Before the introduction of the Special of 15 % Fund, sector ministries were frequently 10 against the integration of off-budget 5 funds, arguing that without those 0 dedicated funds they would be unable to 2002 2003 2004 2005 fulfill their investment programs. As a Special Fund General fund consequence, the establishment of the special fund stipulated that the expenditures within this fund are to be Source: Ministry of Finance and State Treasury of Ukraine. financed by specially earmarked revenue sources.76 Overall, this consolidation brought more transparency to the budget (for example, the Special Fund has been fully integrated into the Single Treasury Account of the Treasury of Ukraine). 3.7 The relative size of the Special Fund has been declining slightly. The share of Special Fund expenditures in total expenditures fell from 22.8 percent in 2002 to 20.1 percent in 2005. This was essentially due to the fact that general budget expenditures grew faster than special fund expenditures. As 76Special budget fund expenditures are financed by earmarked revenue sources defined by the legislation. In 2005 over 70 percent of special fund revenues consisted of the following: (i) user fees for public services (39.2 percent), (ii) excise charges for domestically produced and imported oil products and vehicles (8 percent), (iii) extra charges to the tariff for electricity and heating (6.3 percent), (iv) duties on foreign exchange buying-selling operations (7.7 percent), and (v) receipts from sales of capital assets. 43 a share of GDP, Special Fund expenditures increased from 6.1 percent in 2002 to 7.2 percent in 2004, but fell to 6.4 percent GDP in 2005 (see Figure 3.2). 3.8 The Special Fund is particularly linked to financing of capital expenditures. Capital expenditures accounted for 43 percent of total special fund expenditures in 2005, being responsible for 67 percent of total capital spending. The Special Fund is a key source of resources for transport expenditures, which made up 17.4 percent of total special fund expenditures in 2005 (92.1 percent of total transport spending is financed through the special fund). 3.9 However, investments within the Special Fund are relatively under-executed. Executed expenditures from the Special Fund accounted for only 85 percent of the allocated amounts, while the figure for general fund expenditures is a much higher 97 percent. The difference is even higher for capital expenditures. The executed amount of capital expenditures from the Special Fund was only 80 percent of the funds allocated, as compared with 95 percent from the General Fund. 3.10 As the budget process improves, preserving the division between the General and Special Funds should lose its rationale; and consequently, further consolidation should be placed on the budget reform agenda. But since the Special Fund likely continues to serve a de facto role, by (somewhat) protecting resources for capital expenditures, particularly at the local level, the issue requires close and systemic scrutiny. Thus, consolidation should go hand in hand with a strengthening of the capital budgeting process (including capital transfers to local governments). C. ALLOCATION OF BUDGET EXPENDITURES: ECONOMIC CLASSIFICATION Current Expenditures 3.11 Current spending increased sharply in 2005. From 2001 to 2004 current expenditures in Ukraine represented a relatively stable share of GDP (see Figure 3.3). Their hike in 2005 (by 4 percentage points of GDP) boosted total expenditures to their highest level in the past five years. By international comparison, Ukraine's current (and total) public spending is higher than in countries with the same level of GDP, and at the same level as (or higher than) most EU accession countries. Moreover, Ukraine spends relatively less on interest payments than do most countries in the comparator sample. The sharp increase in recurrent (and total) public expenditures in 2005 was driven by increases in public wages, pension expenditures, and subsidies. All of these categories show sharp increases from 2004 to 2005. Figure 3.3: Current and Capital Expenditures in Ukraine and Selected Countries Current and Capital Expenditures in Ukraine (as percent of International Comparison of Recurrent and Capital GDP) Expenditures (as percent of GDP) 50 45 45 40 35 35 30 25 25 20 15 15 5 10 5 -5 ants ocix naint tpy yekr aiss dnal 0 mante kh Eg aibmol Vi Tu Ru lagutr Po 2001 2002 2003 2004 2005 zaaK Me gerA 50eniar Co 30ainam 40eniar 03niapS Po Ro Uk Uk Current expenditure Capital expenditure Current expenditure Capital expenditure Source: IMF, OECD, WB, Ministry of Finance; State Treasury of Ukraine; Bank Staff calculations. 44 The Hike in the Public Wage Bill 3.12 The wage bill registered a record high for Ukraine in 2005, reaching 8 percent of GDP. Increases in the minimum wage had a drastic effect on the public wage bill during 2005. The wage bill to GDP ratio may increase further to 8.4 percent of GDP in 2006, owing largely to the minimum wage increases and the decompression process in the wage structure (see Figure 3.4). Figure 3.4: Current and Capital Expenditures in Ukraine and Selected Countries Wage bill/GDP in Ukraine Wage bill/GDP ratio in selected countries 9.0 12 8.5 10 8 8.0 6 7.5 4 7.0 2 6.5 0 6.0 mante nat dna ocix naint yekr nia Vi 2002 2003 2004 2005 khsazaK aibmol Pol 40eniar yptgE Sp Me Co Uk gerA Tu 50eniar ainam Ro Uk Sources: IMF, OECD, WB regional fiscal dataset, Ministry of Finance; State Treasury of Ukraine. 3.13 The size of the wage bill needs to be carefully monitored to contain its further expansion. The growth in wage expenditures, in the absence of sector reforms leading to the improved productivity of public workers, and in an environment of economic slowdown, entails a risk of crowding out government operational and capital expenditures. Controlling the wage bill does not mean reduced wages for public workers. In fact, public wages may need to grow to be more competitive with the wages of other sectors of the economy. However, this implies that reforms need to be undertaken to achieve a streamlined and more productive public administration. 3.14 In order to maintain sustainable levels in the wage bill and yet pay competitive wages and increase productivity, the government needs to improve the efficiency of public sector programs and employment. Beyond social sector reforms which are needed in order to increase salaries of teachers and medical professionals, efforts are needed to improve the system of public administration. This will require a sustained effort that goes beyond drafting and approving legislation, and would focus on actually streamlining and implementing improvements in administration, public services and public employment.77 As the institutional systems and business processes are rationalized, and in parallel with a decompression of the wage scale so that highly qualified staff in the public sector receive a competitive salary (and are thus more likely to be retained), considerable attention should be given to developing personnel skills through effective in-service training systems. 77In this report and in most international usage "civil servants" refers to members of the formal state civil service, while public employees include civil servants and other public workers of the Consolidated Budget of Ukraine (for example, public sector teachers, doctors, non-professional staff). 45 3.15 Transparency in the pay system is important for creating incentives for civil servants and increasing efficiency. In past years, the basic salary made up only 30 percent of the total pay, while the rest (70 percent) was comprised of various pay increments and bonuses that are dependent on subjective and/or ad hoc factors.78 In March 2006, new regulation was approved to streamline the pay system in the country. Owing this regulation, the portion of the base salary in total remuneration has increased significantly to around 60 percent.79 Nevertheless, this report still cautions against having ad hoc remunerations in the system, particularly because non-cash benefits (which are often not costed-out) may provide more incentives for entering public service than official cash remuneration.80 Despite important improvements (such as the legislation commented on above), broad-based ownership for civil service reform needs to be reached by all levels of government. Experience and practical concerns suggest that if civil service reform is to be successful, it should be championed at the highest levels of government. 3.16 An increase in pay progression should be one of the central considerations in the continued effort to improve the pay system in Ukraine. The pay structure in the civil service is very compressed. The range of pay between the lowest and the highest ranks in the civil service (the decompression factor) is only about 3 (for base pay).81 In most OECD countries the decompression factor is in the range of 5 to 10, with an average of 7. When Ukraine's relatively low average salary levels are combined with the opportunities for rent seeking that come with higher grade positions, incentives for corruption become an acute issue. A significant increase in pay progression in Ukraine should be linked with cashing out most benefits and increasing the share of basic pay in the total remuneration. This would increase incentives for increased productivity. This can be financed through the restructuring of public sector employment consistent with operational efficiency. To achieve this goal the government needs to revise and streamline institutional procedures and develop a new, analytically underpinned, remuneration system. Pensions 3.17 The main driver behind the high growth of current (and total) expenditures is a rapid increase in pensions. The current level of pension expenditures is one of the highest in the world (see Figure 3.5), and is draining resources from other programs and uses. Along with the increasing need to cover the Pension Fund deficit (1.1 and 3.8 percent of GDP in 2004 and 2005, respectively), regular budget transfers to the Pension Fund grew to cover the gaps in resources generated by the expansionary spending policy in pension-related programs.82 Chapter 4 of this report provides a set of recommendations to improve the fiscal stance of the pension system and to generate sufficient savings for the successful implementation of the Government Pension Reform Strategy. 78 These factors include: the attitudes of superiors, the availability of vacancies (extra vacancies are obtained for topping up salaries since budget allocations are based, in part, on norms per position), and cash reserves for bonuses. 79This is just a rough estimation and more analysis is needed in the near future to determine the effect of the legislation more accurately. 80One example is the issue of assets in return for public service. For example, many civil servants are promised apartments if they serve for either a specified or an unspecified period of time. Apart from the lack of transparency of such arrangements, they create compromising situations for those involved. 81The new Government Resolution of March 9, 2006 essentially preserves the same pay progression. 82For example, this is to cover the gap created by the social insurance collection program in the agriculture sector. Agricultural producers pay the fixed agricultural tax (FAT), which substitutes for various taxes, including contributions to the social insurance funds. Before 2005, agricultural producers did not contribute to the Pension Fund and the Pension Fund losses were to be fully compensated from the budget. In 2005, agricultural producers started to pay 20 percent of the regular rate. The rate remains the same for 2006 and will gradually be increased to 40 percent in 2007 and to 100 percent of regular contributions in 2010 (the same rate as that for non-farm employees). 46 Figure 3.5: Pension Expenditures in Ukraine and Selected Countries Trend in Total Expenditures and Pension Expenditures 2003- Regional Comparison of Pension Expenditures (as % of GDP) 2005 (as percent of GDP) 20 18 45 16 40 Pension expenditures 14 35 12 30 10 Total expenditure 8 25 6 20 Linear (Pension 4 15 expenditures) 2 10 0 5 Linear (Total nat yra expenditure) ainem ainam 30a ainab aibmol ndaolP 0 Ar khsazaK ungH Ro ssiuR Al Co iaralguB 40eniar 50eniar Uk Uk 2003 2004 2005 Transfers to Pension Fund from the state budget (as percent Transfers to Pension Fund in 2005, % of GDP of GDP) 0.09 Conscripts 6 0.73 5 Social assistance to individuals not eligible for pensions and invalids/etc. Regular 4 transfer 0.21 Chornobyl victims 3 0.29 Fixed agriculture tax 2 Transfer to cover the 2.87 0.28 Other costs 1 deficit 0 Pension fund deficit 2003 2004 2005 Sources: IMF, OECD, WB regional fiscal dataset, Pension Fund of Ukraine. Utility Subsidies and Housing Allowances 3.18 Success in poverty reduction helps to contain expenditures on utility subsidies and housing allowances. As incomes have increased and poverty has fallen, subsidy expenditures for utilities have decreased as fewer households have sought assistance. This is a natural benefit of targeted social assistance programs; the energy price safety net is provided only to households whose utility expenditures are 20 percent or more of income, as evaluated through the program's administration. Nevertheless, the total program is still transferring about 1.4 percent of GDP in subsidies to vulnerable households, out of which about 0.8 percent are subsidies to the population for utilities. 3.19 With the rise in energy prices, and expected further increases (particularly on gas), the program on utility subsidies for households will increase its expenditures. In order to avoid an inefficient hike in subsidies, reforms such as better targeting to poorer population are urgent and necessary. These reforms also involve the integration of appropriate incentives in energy efficient use throughout the system. 3.20 Further increases aimed at cost-recovery tariffs across housing and communal services are recommended as a basis for efficiency in the choices of energy users, incentives to encourage service operators to invest in maintenance and new capital, and the overall preservation and operations of the system. In the light of natural gas price increases and the existing large quasi-fiscal transfer already represented by energy-related tariff structures, the National Energy Regulatory Commission has announced a 25 percent electricity tariff increase effective May 1, 2006. Further increases are expected throughout the next few years. This is a welcome step in the direction of cost-recovery and the efficiency of the system. 47 3.21 At the same time, moving tariffs toward cost-recovery will have a poverty impact, and the budget will need to factor in the financing requirements for targeted safety net programs. The payoffs for improved targeting and more efficient program administration will rise along with the costs of energy inputs. Research should be undertaken to estimate the potential poverty impact of energy price increases based on Ukraine's Household Budget Survey data. This has already been done for other countries in the region, such as Moldova, and is a particular area in which World Bank assistance may be useful. Initial estimates from consultants to the Ministry of Labor and Social Protection (MoLSP)83 indicate that a doubling of all utilities prices in 2006 would require UAH 8.6 billion to be spent on subsidies to the population for utilities, out of which UAH 2.5 billion would have to be allocated for targeted housing allowances. However, the same consultants indicated that if the government were to substitute privileges with a targeted housing subsidy for all groups of the population, the doubling of all utilities prices in 2006 would require only UAH 3.3 billion.84 Also, as is shown in the recent World Bank Poverty Study for Ukraine, utility subsidies, because of their urban/non-poor biases,85 are the most expensive means of reducing poverty, followed by pensions. According to these estimates, achieving a 1 percentage point reduction in poverty through utility subsidies would cost about 0.8 percent of GDP, whereas only 0.3 percent of GDP would be required to achieve the same reduction through poverty- targeted social assistance. Capital Expenditures 3.22 Capital expenditures in Ukraine are small and are falling, and an estimated one-third of these expenditures are actually recurrent subsidies. Despite an increase in total public spending, capital expenditures fell significantly in 2005 (see Figure 3.6). Total capital expenditures, as listed in the budget, represent 4.3 percent of GDP (they fell significantly from 6 percent in 2004). However, just over half of those expenditures (2.2 percent of GDP) are comprised of the category called "capital transfers to enterprises." Under this category, close to 65 percent are subsidies to SOEs, or transfers to spending units of the government (i.e., Ministry of Agriculture, Ministry of Energy) to support programs that in turn provide subsidies to various sectors. In addition, a large portion of these capital expenditures are significantly under-executed. All of these issues add up to the conclusion that public investments are given low priority by policy-makers. Yet every government program in memory has talked about the importance of investments (both public and private) to fostering growth in Ukraine. The remainder of this section focuses on the trends in and composition of capital expenditures in Ukraine. Chapter 5 is focused on examining the processes of planning, formulation, and allocation of capital expenditures, and provides recommendations for improving them. 83This information was provided by the Center for Social Development in March of 2006. 84Estimates are provided by a team of local experts based on simulations using the HHEIS data. 85The urban bias in utility subsidies is a consequence of the eligibility criterion that combines the utility cost as reported in the bills and reported or estimated income subject to major underestimation. In this way, households in areas with fewer utility services are less likely to qualify for the subsidy because of the lack of objective evidence about the cost of energy. Since 29 percent of the population uses solid fuel, mostly in rural areas, and since they have the highest poverty incidence, utility subsidies tend to exclude the poor. An analysis based on a proxy-means testing (PMT) simulation conducted by the Bank suggests that savings may be found, along with gains in poverty reduction, if utility subsidies were limited to households with a per capita equivalent income below the poverty line, based on PMT criteria, and excluded households comprised solely of working-age adults. 48 Figure 3.6: Composition of Capital Expenditures in 2002-2005 and Composition of Capital Transfers in 2005 (as Percent of GDP) Composition of capital expenditures in Ukraine, as percent of Composition of Capital Transfers to Spenidng Units and Enterprises GDP (as percent of GDP) 6 Other capital Transfers and transfers Transfer for the Subsidies for the State Roads Agency Agriculture sector --Infrastructure 5 0.37 (roads) , 0.63 Capital transfers to 4 enterprises (agencies, organizations) 3 Purchase of stocks and state reserves 2 Infrastructure Transfers and 1 and equipment Subsidies for the Energy sector Other transfers and (coal), 0.55 0 subsidies, 0.66 2002 2003 2004 2005 Source: WB staff estimates based on Ministry of Finance and State Treasury of Ukraine data. 3.23 Subsidies hidden as capital expenditures crowd out expenditures for infrastructure and equipment. More than half of the capital budget is spent on transfers to enterprises. Their share in total capital expenditures increased from 22.8 percent in 2002 to 51 percent in 2005, with the major swing between 2003 and 2004 (see Figure 3.6). Less than one-third of this category (capital transfers to enterprises) in 2005 is composed of actual investments, which go mainly to the State Roads Agency. In addition to the misclassification of some of these expenditures, most of them appear to have little justification relative to other resource-constrained programs in the budget. Moreover, they take up fiscal space that could be given to public growth-enhancing investments and/or tax rate cuts. Bank staff efforts to better understand these expenditures were stymied by a basic lack of information. This is an area in which comprehensive close scrutiny by the government would be useful, as significant costs savings may be found at little development cost to Ukraine.86 3.24 The actual level of public investments (in infrastructure / fixed capital) in Ukraine is small by international standards. Given the structure of the economy (almost one-quarter of Ukraine's exports are capital-intensive goods) and the large but deteriorating capital stock, capital spending in Ukraine should be expected to be higher than its current level. Ukraine lags behind EU member states and OECD countries in the level of public investments made over the past four years (see Figure 3.7). Figure 3.7: Ukraine Investments Are Well Below New EU Members and OECD Countries, 2002-05 4.5 4 New EU 3.5 Members Average 3 PDGfo 2.5 OECD Average % 2 sA 1.5 Ukraine 1 0.5 0 2002 2003 2004 2005 Source: OECD, Eurostat, State Treasury of Ukraine; Bank staff calculations. 3.25 In addition to being low, the budget provisions for infrastructure and equipment have persistently been under-executed. While the scope of under-execution was being reduced during 2003- 05, it still large considering the small size of the budget devoted to this spending category (see the detailed discussion in Chapter 5). 86Indeed, poorly designed subsidy programs create distortions that may actually reduce production in the sectors subsidized, let alone reducing net welfare overall in light of forgone better opportunity use of those funds. 49 3.26 The so-called development budget (investment program) for 2006, as in past years, shows a lack of clarity in Ukraine's strategy regarding growth-enhancing investments. The 2006 budget not only stipulates an overall decline in capital spending (to below 4 percent of GDP), it also exhibits a more acute bias toward capital transfers, which account for 58 percent of total allocated capital expenditures. One-third of the total increase in the development budget is represented by the increase in food reserves for the agriculture fund, the subsidies in interest rates for coal extraction loans, the subsidized loans for agriculture and the state guarantees for bonds to be issued for the state mortgage institution. Strategic and financially consistent planning in the energy sector in particular is becoming increasingly important, but has yet to emerge. 3.27 Procurement reform remains a lagging area of institutional change, and recent changes to the Procurement Law put the accountability and efficiency of the system in high jeopardy. Box 3.1 outlines the recent regression and highlights key steps to address the problem over the short run. The forthcoming Country Procurement Assessment Report prepared by the World Bank in coordination with the Government looks at this in much more detail, and outlines in much more detail both short-term and long-term problems and solutions for improving the procurement system. Box 3.1: Public Procurement Reform in Ukraine is Off Track Prior to the latest amendments the MoE Public Procurement Department had the internationally accepted functions appropriate to a government Authorized Agency (AA) in countries with a decentralized public procurement system. These functions included issuing by-laws, providing methodological guidance and support to procuring entities, approving non-competitive procedures, publishing public procurement bulletins, and complaints resolution. After the December 2005 Amendment, the functions of the Public Procurement Department have been diluted and assigned, in descending order of authority, to the Tender Chamber (an NGO), the Special Control Commission (SCC) under the Accounting Chamber, the Accounting Chamber, Parliament, the Anti-Monopoly Committee (AMC), and central executive bodies. The AMC has nominally become the AA, however its role in the complaints mechanism and authorization of non-competitive procedures has been reduced to recording of results. TC appears to be the de facto AA and most of its functions are those of an executive body and certainly are not consistent with that of an NGO. The TC has the right to authorize restricted tendering and single source procurement, issue opinions on complaints, propose improvements to public procurement legislation, and provide methodological guidance. The TC is a non-profit association of NGOs whose goals are to promote the public procurement system and improve its transparency and efficiency. However, there appears to be a close relationship of the TC management with a number of consulting companies in public procurement, including a single company which owns the website that was defined by the TC as the only acceptable one for placing mandatory procurement announcements on the Internet. The distribution of public procurement functions creates a conflict of interest between the responsibilities of the TC and any commercial interests its members may have, while the responsibility of the Accounting Chamber as the supreme audit institution is not consistent with its involvement in the execution of a process ­ this essentially means that there is no external audit for the procurement function. Also, the application of the law to state-owned enterprises (state share of more than 50 percent) is inconsistent with the objective that they operate in line with normal commercial practice. The recommendations to resolve the situation with public procurement in Ukraine are the following: · Revoke or substantially rework the December 2005 Amendment of the Public Procurement Law · Reconsider the role of the Tender Chamber in public procurement · Establish an Authorized Agency, which should be independent and accorded the responsibilities and rights normally placed with such a body · Prevent further development of a monopolized and privatized market for procurement services. 50 D. ALLOCATION OF BUDGET EXPENDITURES: FUNCTIONAL CLASSIFICATION Context 3.28 Table 3.2 presents general government expenditures in Ukraine by functional classification for the period 2002-05. This section starts with an overview of trends and issues concerning the major categories of social expenditures (social protection and assistance,87 health, education and social privileges), and then discusses the trends and issues with respect to public spending on economic activities (agriculture and energy). The section concludes with a brief analysis of the size and patterns of public expenditures aimed at the improvement of the business climate. Table 3.3 shows the recent expenditure trends for the broad functional classifications in the general budget. Table 3.3: General Government Expenditures by Function, as Percent of GDP, 2002-05 2002 2003 2004 2005 General public services 3.8 3.7 3.6 3.7 Defense 1.6 2 1.8 1.5 Public order and safety 2.2 2.2 2.3 2.5 Economic services 3.2 4.6 5.4 4.6 Environment protection 0.3 0.3 0.3 0.3 Housing & community services 0.6 0.7 0.8 0.9 Health affairs and services 3.3 3.6 3.5 3.7 Recreational, cultural, religious affairs 0.6 0.8 0.8 0.8 Education affairs and services 5.4 5.6 5.3 6.4 Social protection and social assistance 14.6 13.2 15.6 19.6 Total expenditure 35.6 36.7 39.4 44.0 Sources: Ministry of Finance and State Treasury of Ukraine; Bank staff calculations (and estimations for 2005). Social Protection and Social Assistance Expenditures 3.29 From a functional perspective, the increases in public expenditures between 2003 and 2005 have been dominated by the social sectors. Throughout the period in question, social expenditures (that is, expenditures on health, education, culture, social privileges, social protection and social assistance) represent the bulk of total expenditures, and have been increasing steadily. The highest increase was registered in 2005, which took spending in social sectors to a record high for the country, and to the highest levels in the region. 3.30 Social assistance transfers comprise a small and relatively stable share of total social protection expenditures; however, moderate savings could be found by better targeting. Social assistance transfers are represented mainly by scholarships, family transfers (child benefits), poverty targeted transfers, and unemployment benefits. In 2001, changes in legislation introduced some income- testing criteria for eligibility into these programs. These programs have a relatively low coverage of the population, and two programs--poverty-targeted transfers and family benefits--show a significant focus on low-income populations. Further savings could be achieved by limiting social assistance to social pensioners and families with many children to those whose actual income is below the poverty line on the basis of proxy means testing (PMT) criteria. Social and Occupational Privileges 3.31 Expenditure privileges are the rights of certain individuals to receive services and goods at discounted prices. The rate of the discount ranges from 50 to 100 percent. For example, those with disabilities as the result of war are eligible for free utilities (including gas, electricity, and hot and cold 87With the exception of pension expenditures, which are covered in Chapter 4. 51 water), regardless of the size of their homes or the number of people living there. Chernobyl victims, on the other hand, are eligible for a 50 percent discount. Telephone bills are discounted by 50 percent for several categories of retirees (for example, those retired from the military services, the fire-fighting services, the police, and other groups). The parents of deceased service personnel are eligible for a 50 percent discount for intercity travel by train, air, ship or bus (but not for intra-city travel), whereas several other categories of people are eligible for a discount of 100 percent for intra-city travel by streetcars, buses, trolley buses, metro systems, ferries, and commuter trains -- or if they live in rural areas, by intra- oblast buses. 3.32 It is estimated that actual public expenditures for privileges are equivalent to approximately 1.6 percent of Ukraine's GDP. But the total cost of these privileges, if they were fulfilled according to the law, is difficult to estimate. The consolidated 2006 budget provides nearly UAH 7.8 billion (US$ 1.55 billion equivalent).88 However, these are only the estimated costs explicitly financed through the budget. When entitled privileged persons execute a privilege (such as to get on a bus and not pay), any associated cost not explicitly covered by the budget becomes an implicit tax on the service provider. As the methods used to finance privileges are imperfect, with errors of overpayment and underpayment, the total cost of the privilege system in Ukraine is not actually known. Table 3.4 provides a breakdown of the budget allocations in 2006 for expenditure privileges, as well as an estimated value per recipient as explicitly financed. 3.33 There are 13 types of privileges for three categories of the population (see Table 3.4). The largest expenditure item is "Housing and Utility Services," costing close to UAH 3.5 billion or 44.3 percent of the total budget for privileges, followed by "Free and Discounted Purchase of Food Products" (UAH 1.4 billion or 18.5 percent of the budget) and "Sanatorium Treatment" (UAH 1.25 billion or 15.9 percent of the budget). These three largest items absorb 78.7 percent of the total privilege budgets. In 2006, additional privileges for individuals born around the Second World War were approved (i.e., privileges for the "children of the war"). The funding of these privileges could raise the spending on this category in 2007. Table 3.4: Type of Privileges and Budget Allocation for 2006 (in millions of UAH) Special Merit Social Privileges by type of services Occupation Based Characteristics Total Based Based Housing and utility services - 2,907.3 565.3 3,472.6 Communication services, installation of telephone and security and alarm system - 179.2 1.5 180.7 Public transport and baggage handling 21.9 549.7 181.8 753.4 Prescription medicines 192.4 70.4 - 262.8 Dental treatment and prosthesis - 174.6 - 174.6 Sanatorium treatment 5.7 1,112.3 128.2 1,246.2 Cars to drivers with disabilities - 84.4 - 84.4 Dwelling repairs - 13.1 - 13.1 Preferential/subsidized credits and loans 14.7 - 15.0 29.7 Free/discounted purchase of food products 1,445.4 - - 1,445.4 Compensations for special categories of individuals 115.4 - 2.6 118.0 Other - - 52.0 52.0 Total 1,795.5 5,091.0 946.4 7,832.9 Source: "Analysis of Special Privileges in Ukraine", background paper prepared by Anna Nechai. 88The cost estimate (UAH 7.8 billion) is based on the consolidated budget for 2006. An estimated GDP for 2006 of UAH 480 billion UAH has been used for the calculation. 52 3.34 Approximately one-quarter of the Ukrainian population enjoys some kind of privilege. Annex 3.1 summarizes the categories of privileged populations in Ukraine. The 58 different categories of privileged populations outlined in the Annex may be grouped into three major types: (i) those with special merits (e.g., accomplishment/recognition gained in conjunction with major historical and political events; approximately 760,000); (ii) those with certain social characteristics (approximately 10,500,000); and (iii) those with certain occupations (approximately 900,000). 3.35 In 2005, the Ministry of Labor and Social Policy (MoLSP) established a unified registry of privileged individuals.89 This was a major step forward and reflected the government's serious intent to reform the system of privileges. However, this unified registry is still incomplete because it covers only the second category of privileged populations (social characteristics based). The special merit based and occupation based categories are not entered in the unified registry. Their numbers can only be roughly estimated by cross-checking the registry of different service providers, not all of whom keep complete and audited records of the use of privileges. 3.36 Privileges are de facto administered by service providers. Privileges in the Ukrainian context are not direct cash subsidies to individuals and households. To exercise a privilege, an individual must first be certified by a government entity defined by a legal instrument that provides for a specific type of privilege. For example, a retired military serviceperson with disabilities must obtain a special certificate of eligibility for certain privileges. A teacher living and teaching in a rural area must obtain a certificate of her/his status from the local education department. 3.37 Once the certificate is obtained, the eligible individual must register with the service providers. For example, the widow of a deceased victim of the Chernobyl accident is eligible for a 50 percent discount in rent, hot/cold water, natural gas, electricity, garbage collection, wastewater disposal and telephone service. She will have to register with each of the service providers separately ­ there is no one-stop shop. Service providers, upon her registration, start billing her at a discounted price. 3.38 Service providers, not the population with the privileges, receive the public funds. In terms of the flow of funds, explicitly financed privileges take the form of advance payments to the service providers from the government. These service providers receive payments from either the central government or local governments, depending on the type of privilege. The amount is determined largely on the basis of the historical figures, namely, the actual amount of exercised privileges during the previous year. 3.39 As a result, the service providers may be either under-compensated or over-compensated by public funds. In the case of under-compensation, the service provider may attempt to recover the loss by raising tariffs and/or reducing the quality of services. Since many of the tariffs are fixed by regulation, such as those for utility providers, a reduced quality of services is often the default financing mechanism, typically through reducing maintenance costs and/or not making needed physical investments. In either case, the non-privileged users of the services and taxpayers are paying for the services received by privileged individuals. In the case of over-compensation, public funds end up as de facto subsidies to the service providers. 3.40 Mechanisms to see if service providers are under-compensated or over-compensated are either nonexistent, or do not function well. In cases where service providers are overcompensated, it is natural that their tracking may be weak or nonexistent (see Box 3.2). Furthermore, auditing systems are generally weak in Ukraine, and therefore it is difficult to ascertain whether the service providers are correctly declaring the cost of honoring privileges. 89Unified State Automated Register of Individuals Eligible for Privileges Based on Social Characteristics. 53 Box 3.2. An Example of Cost Tracking A pilot study was carried out by a private transport provider in one of Ukraine's largest cities. This firm was interested in monitoring the use of services by passengers with privileges. They installed electronic card readers in their vehicles, and provided card passes to the passengers with privileges. The study showed that the actual cost of honoring privileges was only 54 percent of the funds which this firm had received from public sources to cover the cost of privileges. Naturally, the experiment was discontinued. 3.41 The privilege system's built-in cost control mechanisms are weak. Service providers have practically no incentives to control the cost of privileges because they have guarantees for loss-recovery (either through public funds or increased tariffs) and they often do not receive strict audits. From the point of view of privileged persons, incentives to ration the use of privileges are practically non-existent, particularly when the discount rate is 100 percent. 3.42 The legal foundation for privileges is complex and makes reforming the system challenging. The legal framework for privileges consists of over 60 instruments (see Annex 3.1). There are 43 laws, two presidential decrees and 16 decrees of the Cabinet of Ministers that have entitled people to privileges, as well as decrees and normative acts issued by the Cabinet of Ministers and local authorities. Many of these legislative acts were established under the Soviet Union. However, after its independence in August 1991, Ukraine introduced 26 legislative acts and expanded the provision of privileges. This extremely complex legal framework grants various types of privileges to 58 different categories of persons. 3.43 According to the interpretation of the Constitutional Court of Ukraine, Article 22 of the Constitution prevents any reduction of the existing rights on the adoption of new social legislation.90 Unless this decision is adjusted, the reform of special merit-based privileges appears practically impossible. Means-testing, for example, apparently cannot be introduced for privileges under this category without violating the article. The Constitutional Court also made a judgment that limiting occupation-based privileges only to the "minimum subsistence" level (UAH 365 for 2003 and UAH 386.7 for 2004) -- a measure established with respect to the 2003 and 2004 state budgets -- was unconstitutional.91 For 2005 and 2006, the government replaced the minimum subsistence level based limitations with a salary cap, but this measure is also under threat of being declared unconstitutional. The fact that some privileges are essentially unfulfilled entitlements (e.g., invalids on a perpetual waiting list for a free car) appears not to have been considered on a constitutional basis. Privileges based on social characteristics are based on either laws or decrees of the President and/or the Cabinet of Ministers. It is constitutionally possible to eliminate these privileges, but political considerations make such reform unpopular in the absence of consultation and explanation, especially about who is actually paying the bills for the privilege recipients. 3.44 Confusion exists among privileges, employment benefits, social protection and loss/damage compensation. Existing sets of legislations and registries create confusion because they do not differentiate the purposes of providing privileges. It is possible that, owing to this confusion, debates over the system of privileges have been unnecessarily politically and emotionally charged. Moving forward, it 90 Article 22 declares: "Human and citizens' rights and freedoms affirmed by this Constitution are not exhaustive; Constitutional rights and freedoms are guaranteed and shall not be abolished; and the content and scope of existing rights and freedoms shall not be diminished in the adoption of new laws or in the amendment of laws that are in force." See http://www.rada.gov.ua/const/conengl.htm. 91 The 2003 and 2004 laws of the state budget established that privileges for selected categories of personnel would be provided: (i) within the budgetary allocations to their institutions; and (ii) only up to the gap between their income and the minimum subsistence level. 54 would be better if they were based on rational examination of the following: (i) the societal merits of providing certain benefits to certain group of the population, (ii) the form of benefit provision that would be most adequate, and (iii) whether the costs justify the perceived benefits on a welfare basis, given that all privileged recipients have to be financed by other service users, service providers and/or taxpayers. 3.45 Conceptually, the Ukrainian system of privileges consists of four different types of target populations. The first group includes those who have earned a distinguished status by having made positive contributions to the society in the past. About half of the categories under "Special Merit" and some under "Social Characteristics" (see Annex 3.1), namely, Heroes of Ukraine, Heroes of the Soviet Union and Heroes of the Socialist Labor, War/Military Veterans, and Labor Veterans would belong to this type. The second group includes those who have certain types of occupation that are considered to make positive contributions to the society at present. This group includes most of the categories under "Occupational Characteristics." Privileges for this group should be considered as employment benefits and provided within the context of employment contracts. This needs careful consideration in the context of overall public employment pay reform, as judges, for example, receive several privileges but may not receive salaries consistent with their responsibilities and purview. The third group includes those who are exposed and vulnerable to negative shocks (poverty, illness, etc.) at present and require protection. These include some categories under "Special Merit" and "Social Characteristics," including those with disabilities regardless of the cause, orphans, families with many children and certain types of pensioners/retirees. Consequently, privileges for this type of population have strong characteristics of social protection. Finally, the fourth group consists of those who sustained damage or losses in the past. Some are under "Special Merit" (those with disabilities as a result of war, Chernobyl victims Category 1) and others are under "Social Characteristics" (for example, Chernobyl victims Category II, pardoned people and their survivors, widow(ers) of military veterans, spouses of service persons missing in action and their children, and parents of deceased service persons). Privileges for this type of population should be regarded as loss/damage compensation. 3.46 Past attempts to address this problem have not been successful or sustainable. But over the years progress has been made in understanding the problem and proposing some aspects of a solution. Looking ahead there are opportunities for success through a comprehensive and stepwise process of measures, including consultation with the public as various actions are taken. Assuming that the decisions of the Constitutional Court would not be reconsidered, the following strategy might present a workable solution: (a) The grandfathering of existing privileges could be secured. With Article 22 of the Constitution, and with political pressures, it would be difficult to eliminate or reduce the benefits provided to the existing privileged population. Consequently, any reform effort in the future could be based on the principle that the benefits to the existing population with privileges would not be subject to future reform in most cases. At the same time, there should be a clear commitment not to introduce new, un-targeted privileges outside the social assistance framework. (b) There should be a clear separation of the purpose of providing the privileged benefits at the outset, and then the legal framework and record-keeping systems should be reorganized accordingly, to establish clear eligibility criteria. As part of this task, the Single Automated Register of Individuals Eligible for Privileges should be made comprehensive and operational. As discussed above, the current system of privileges (the legal framework and registries) does not provide a framework for debating the societal merit of providing special benefits to selected groups, or the form that these benefits should take. At minimum, work-related benefits should be provided only within the framework of employment contracts. And those benefits with strong social protection characteristics should be provided and administered within the legal and administrative framework of social protection, with clear eligibility criteria. 55 (c) The flow of funds should be shifted from "government to service providers" to "government to beneficiaries," while avoiding the provision of in-kind compensations. As discussed above, the current flow of funds provides little or no incentives for expenditure rationalization. Shifting the flow of funds to the beneficiaries, possibly with a ceiling on the total combined benefit amount, is likely to result in a more efficient spending of public resources. (d) If the shifting of the flow of funds is too difficult to accomplish in the short term, a system could be adopted in which service providers were compensated only on the basis of the service actually provided; the system would be evaluated by periodic sample-based audits. As discussed above, service providers may be over-compensated or under-compensated. For metered services (such as gas, electricity, and water), determining the amount of compensation to the service provider should be straightforward. For transport services and sanatorium use, the government could provide beneficiaries with vouchers of a certain cash value, and the service provider could be compensated on the basis of the vouchers surrendered. In any case, it would be important to audit service providers to ensure that compensation is aligned with costs. Education Expenditures 3.47 Education expenditures increased to 6.4 percent of GDP in 2005, after recovering from relatively low levels during the period of economic contraction. As is seen in Figure 3.8, the level of educational spending in Ukraine is the highest in the selected sample of countries (except for Portugal) and is similar to that in Poland, Latvia and Lithuania. These figures exclude side-payments (in cash and/or in kind) by parents to teachers and education institutions. Thus, the overall expenditures as a ratio of GDP are higher Figure 3.8: Education Expenditures in Ukraine and Selected Countries, % GDP Education expenditure composition (by level) as percent of Education expenditures, as percent of GDP GDP 8 7 7 6 0.7 6 0.6 5 0.5 0.5 5 1.9 Other 4 4 1.7 1.8 1.7 Higher education 0.4 Vocational-technical education 3 3 0.3 0.3 0.3 General secondary education Pre-school education 2 2 2.7 1 2.2 2.3 2.2 1 0 04 05 ni l 0.6 0.7 ry 0.6 0.6 0 ainam natshk Russia nei nei Spa urkeyT Poland tviaaL Ro za 2002 2003 2004 2005 Ka kraU kraU ortugaP ruslaeB ungaH ithuaniaL Sources: IMF, OECD, WB regional fiscal dataset, Ministry of Finance and State Treasury of Ukraine. 3.48 The increase in educational current expenditures was not accompanied by increases in their capital component. The large and increasing share of the budget spent on wages and utility expenditures leaves little room for other education-enhancing inputs such as textbooks and other goods and services. Recurrent spending represents about 90 percent of total education expenditures from the state budget and an even higher share of local budget expenditures (the shares vary by local government). Allocations for instructional materials and teacher training, which are essential to ensure quality of learning, are severely limited. Moreover, investments in the maintenance and repair of educational facilities are desperately needed, and the share of capital outlays in total education spending is low and declining. 3.49 Ukraine shows signs of inefficient operations in the provision of education. The average student/teacher ratio is close to 11, one of the lowest levels in Eastern Europe. On top of that, the non- teaching to teaching staff ratio is high at 2 for pre-schools and general education schools. Together, these 56 employment ratios are a clear sign of inefficiency. When this information is combined with the average salary of teachers, which is 83 percent of the official average salary in the economy at a point in Ukraine's history when human capital development is absolutely crucial, it becomes clear that employment and pay changes need to be part of Ukraine's education reform program. Extremely low student/teacher ratios, low levels of the utilization of educational facilities, and overall overstaffing are obstacles to efficient spending in this area. One of Ukraine's comparative advantages is its highly and broadly educated population. The development and implementation of an education reform program within a realistic priority allocation of financial resources appears to be a crucial area for the enhancing of Ukraine's human capital competitiveness. 3.50 Some of the inefficiencies seem to arise from dysfunctional links among financing, administration, and regulation in the education sector. Fiscal decentralization has brought about several positive changes. However, this reform is incomplete, and there are several obstacles that impede the realization of its benefits.92 In the education sector, owing to the Ministry's guidelines on norms and staffing needs, and to the large network of facilities, local governments have rigid budgets that are mostly hijacked by recurrent spending on wages, salaries, and heating. This perpetuates the inefficiency. The second phase of the PFR is intended to focus on this issue and related issues in more detail. Health Expenditures 3.51 Public health expenditures as a share of GDP are moderate by international standards. Public financing for the health sector has increased marginally since 2002 and reached 3.7 percent of GDP in 2005 (see Figure 3.9). Private spending (formal and informal out-of-pocket expenditure) is high; estimates suggest that it may be as high as formal expenditures.93 Thus, total health expenditure at least in the range of 5-6 percent of GDP, and is thus comparable to other countries of the same income level in the region. The relatively high share of out-of-pocket expenditures, however, suggests the existence of financial barriers in accessing health care, especially for lower income groups. Figure 3.9: Health Expenditures in Ukraine and Selected Countries, 2002-05 Health expenditure trends and composition in Ukraine (as Health expenditures in Ukarine and Selected Countries (as percent of GDP) percent of GDP) 4.0 Other 9 3.5 0.4 0.4 8 0.3 0.5 0.2 7 3.0 0.2 0.2 0.2 Preventive and 6 2.5 anti-pandemic institutions 5 and activities 2.0 4 2.6 2.5 2.6 Hospitals and 2.3 3 1.5 sanatoriums 2 1.0 1 Polyclinics, 0 0.5 ambulatories, first-aid, na aiss nia yra iav 0.4 0.4 0.5 0.5 emergency ainam dnal Sp eykr ugaltr sural ng Lat 0.0 Ru Po Tu 2002 2003 2004 2005 zakhstaK 40eniar 50eniar Ro Po Be Hu huaniatiL Uk Uk Sources: IMF, OECD, WB regional fiscal dataset, Ministry of Finance and State Treasury of Ukraine. 3.52 Inefficiencies in the provision of health are acute. Ukraine inherited an extensive hospital infrastructure and staffing system. Most of the limited resources are being spent on staff salaries and utilities (on average, between 80-90 percent). This leaves little room for needed supplies, adequate 92In particular, the fiscal and administrative aspects of the intergovernmental fiscal framework and sector regulations do not provide the right incentives for raising official revenue collection at the local level for performing the same tasks (namely, producing the same outputs) with fewer resources (in terms of staffing and network). 93These include informal payments to professional health staff, self-provision of supplies and medicines and in some cases equipment, and the excess opportunity cost of under-utilized real-estate and other assets. 57 equipment, maintenance, and repairs to deteriorated infrastructure. The Ukrainian health care system is hospital centered, which consumes over 70 percent of public health spending. The number of hospital beds per 100 000 population is 716; this is 30 percent over the EU-10 average. The average length of stay (ALOS) in Ukrainian hospitals is 12.3 days (one of the highest in the region) compared with 7.5 for the EU-10 in 2003. This suggests considerable overcapacity in the hospital sector and significant efficiency gains to be made from preventive medicine and the adoption of modern ambulatory care based treatment modes. It is worth noting that the value of real estate, especially in city centers, and other freed up resources stemming from downsizing and improving health facilities could be indirectly used to finance the reform and improved delivery of health services. 3.53 Incentives in the current health financing system are not yet geared towards efficiency. The public health financing system is fragmented, combining funding on different levels of local government with vertical programs between local and national budgets and national institutions funded by the state budget. Providers are mostly paid by norm-based line-item budgets, which do not motivate cost-saving measures or improvements in service delivery. 3.54 In recent years the equalization formula in the intergovernmental fiscal system has been backsliding, with the reconsideration of input-based norms. In the 2000 budget, a first stage intergovernmental reform was introduced that integrated objective criteria for financial allocation based on local incomes and demographics. However, starting in 2004, health expenditure allocations again began to be dispensed on the basis of input, as opposed to output-based norms (for example, number of hospitals, number of hospital beds). The second phase PFR will therefore focus in more detail on this and related issues. Agriculture Expenditures 3.55 Expenditures on agriculture have been increasing as a share of total spending and as a percent of GDP. In 2005, fiscal support to agriculture, including tax expenditures, reached 2.5 percent of GDP, as compared to 1.8 percent in 2002. The share of expenditures on agriculture in total spending increased from 6.7 percent to 8.6 percent during this period and accounted for almost a quarter of all budget spending on economic activities in 2005. The 2006 budget allocates about 2.3 percent of GDP to agriculture. Actual support to agriculture is even higher if non-fiscal support measures are taken into account.94 3.56 International comparisons suggest that Ukraine's fiscal support to agriculture is high. The share of agricultural expenditures (including tax expenditures) in GDP (adjusted by the size of agriculture) in Ukraine is above most middle-income countries and even higher than in some high income countries such as Australia (see Table 3.5). An interesting benchmark in this area is Brazil. This country increased its agricultural exports from US$6 billion in 1993 to US$17 billion in 2003, mainly by exporting more agri-food of high quality at competitive prices, but with low support and subsidies from the government.95 94 In addition to explicit budget measures, agriculture is supported by, at least, the following: (i) import tariffs; (ii) sugar quota, (iii) support of grain prices through pledge and intervention purchases, (iv) benefits from the low interest rate for machinery leased from UkrAgroLeasing, and (v) agreements with supply companies to provide fuel and fertilizers at lower than market prices. The annual value of these subsidies is estimated to have been at least UAH 1 billion on average during 2000-05 and around UAH 2 billion in 2005 alone. 95 According to Tangermann, OECD Work on Agricultural Policies in Brazil, China, India and South Africa, in the Presentation at the Rural Week of the World Bank, 2006, the gross agricultural output in Brazil almost doubled between 1989 and 2003, while the farm support level during 2000-03 was a low 3 percent of the farm gross income and 0.7 percent of GDP. 58 Table 3.5: International Comparison of Expenditures in Agriculture Countries Agriculture Public expenditures for Public expenditures for Sector Value agriculture (including tax agriculture as percent of GDP- added to GDP expenditures) a percent of GDP Adjusted for the size of agriculture in the country A C C/A Ukraine (total fiscal expenditures, including 11.60% 2.10% 0.18 VAT expenditures) Higher-income countries Australia 3.00% 0.31% 0.1 Canada 2.30% 0.51% 0.22 EU 2.30% 0.65% 0.28 USA 1.60% 0.73% 0.46 Middle-income countries Turkey 13.00% 2.00% 0.15 Mexico 4.00% 0.70% 0.18 Venezuela 5.00% 0.50% 0.12 China 15.00% 1.20% 0.08 Brazil 9.30% 0.70% 0.08 Sources: OECD (2004), World Bank (2005) and Tangermann (2006). 3.57 During the period 2000-05, fiscal support to agriculture was increasingly dominated by subsidies, including plain budget subsidies and tax expenditures -- the latter concentrated particularly in the VAT system (see Chapter 2).96 In 2005, total agricultural subsidies increased to 1.7 percent of GDP from 0.7 percent in 2000. Subsidies financed from both VAT and budget expenditures supported inputs and production, especially for livestock production and meat and milk processing. The share of subsidies in total budget spending on agriculture was 55 percent in 2005 and is expected to increase to 60 percent in 2006 (see Figure 3.10). Input subsidies were used to lower the costs of selected inputs (for example, fertilizers, machinery and credit) and of farm labor, through the financing of Pension Fund compensations as a result of the Fixed Agricultural Tax (FAT).97 Figure 3.10: Composition of Budget Expenditures on Agriculture, 2002-06 100% 80% 60% 40% 20% 0% 2002 2003 2004 2005 2006 Production Subsidies Input Subsidies Growth-enchancing investments Source: WB staff calculations on Ministry of Finance and Ministry of Agriculture data. 3.58 Despite the significant public expenditures received, the Ukrainian agricultural sector performs below its potential. In 2005, the output of the large agricultural enterprises was only 30 percent of the level in 1990, despite the fact that they operate on around 70 percent of total agricultural land. The agricultural production level is extremely dependent on weather conditions because of the lack 96Chapter 2 (section E) provides a detailed discussion of the inefficiencies and inequities generated by VAT expenditures for the agriculture sector in Ukraine. 97See Chapter 2 for a discussion of the Fixed Agricultural Tax. 59 of modern farm production technologies and poor farm management. Crop yields and livestock productivity remain low, and around 50 percent of large agricultural enterprises are loss-making. Indeed, 15 years into the transition, Ukrainian agriculture still faces numerous structural challenges. 3.59 Subsidies have had little impact on agricultural efficiency. Most subsidies have suffered from unequal in-year allocations, and lack of transparency in the eligibility criteria and the selection processes. The efficiency of both budget allocations and VAT expenditures continues to be judged by the government through observed changes in nominal output or input use, while the level of attention to changes in agricultural productivity and farm incomes, as a result of specific government programs, remains low. In the end, most subsidies are encouraging the higher production of targeted products or increasing the use of subsidized inputs, but they are not necessarily supporting the investments that are urgently needed to increase farm competitiveness. 3.60 Public spending on agriculture takes place in an environment in which subsidies and regulations offset each other. As described in the joint study by the World Bank and OECD, taking various administrative and trade distortions into consideration, total market price support was negative in Ukraine - farm-gate prices are typically depressed below reference border prices.98 As a result, the significant public transfers from the budget to the farms merely compensate farmers for these low prices, which are significantly the result of government policies. Border policies and behind the border policies are the key factors depressing agricultural prices and squeezing farm profitability. Policy measures at the border, such as the export taxes on oilseeds and live cattle, directly reduce farm-gate prices. In addition, ad hoc domestic market interventions, such as controls on prices and margins for grain, meat and other products, restrict inter-oblast movements of agricultural commodities, raise marketing costs, reduce competition, increase transaction costs, and discourage private investment. Investment and entrepreneurial incentives, combined with support services, land reform and a further opening of input and output markets, are the factors which can most effectively lead to sustainable productivity and output increases. Figure 3.11: Comparison of Costs of Trading Grain in Ukraine and Germany, 1999 and 2005 100 90 Risk premium and trader margins 80 ecrip 70 rtop Marketing Costs 60 ex BOFfot 50 40 Losses cenerP 30 20 Farm-gate price 10 0 Ukraine 1999 Germany 1999 Ukraine 2005 Germany 2005 Source: WB staff calculations on Ministry of Finance and Ministry of Agriculture data. 3.61 The program of interest rate subsidization through the budget should be phased out. During 2002-04, the budget for this program was relatively moderate, on average UAH 120 million, but it increased to UAH 350 million in 2005. Under the 2006 budget, UAH 260 million (or 0.06 percent of GDP) will be allocated for this program. The program should be replaced by a set of measures to reduce the risks of crediting agriculture, to improve the agricultural collateral base, and to increase the capacities 98World Bank and OECD, "Achieving Ukraine's Agricultural Potential: Stimulating Agricultural Growth and Improving Rural Life, OECD and the ESCCD", Europe and Central Asia Region, the World Bank, 2004. 60 of farmers, through training and consultancy, to increase access to credit from commercial banks on commercial terms. 3.62 The programs intended to ease farmers' access to agricultural machinery failed to accelerate the technical modernization of the agricultural sector. Over the years, the government has allocated substantial budget resources to programs aimed at increasing the supply of domestic machinery and reducing the costs of this machinery to farmers through a state financial leasing company which is itself subsidized (UkrAgroLeasing),99 since is partially compensated for machinery costs from the budget, and since it has been given exclusive rights to seize all farm equipment for which credits were defaulted and state guarantees called.100 Two of these agricultural machinery programs alone cost the budget almost 0.1 percent of GDP (UAH 1.4 billion) during 2002-05 and accounted for 18 percent of total input subsidies. Despite the greater supply of domestically manufactured agricultural machinery and equipment, farmers continue to purchase foreign machinery because of its better price-quality characteristics (e.g., more efficient fuel usage). Financial leasing through UkrAgroLeasing has not functioned well, and arrears for purchases of foreign machinery have mounted, reflecting the essential failure of the program. 3.63 To capture agriculture's full growth potential, the government faces three key policy challenges. First, it needs to create the conditions for an investment enabling environment in agriculture. Second, it needs to shift away from market-distorting measures that undermine the long-run competitiveness of the sector and focus its fiscal resources on resolving the structural constraints faced by agriculture and rural areas. And third, it should improve the quality of growth-enhancing support programs to meet the evolving needs of private agriculture and the food processing sector. 3.64 Currently, the share of growth-enhancing investments in total budget expenditures is small and is not performing well owing to lack of attention. The share of growth-enhancing investments in total budget spending on agriculture increased somewhat in 2005 from the low level in 2004, but it did not recover to the levels of 2003-04. The 2006 budget stipulates a reduction in the share of growth- enhancing investments. At the same time, their impact (especially for investments in agricultural education and training, research and development, crop selection and livestock breeding, and the public food safety and quality system) was very moderate, reflecting weaknesses in the way in which these potentially important support programs were being financed, managed and implemented. 3.65 Policymakers in Ukraine should focus on improving the effectiveness and also the nature of public spending on agriculture rather than on increasing its level. There is a strong justification for public spending to overcome policy and institutional challenges and to stimulate agricultural growth. Cross-country evidence suggests that public expenditures on growth-enhancing programs such as agricultural research and development, extension services, education, rural infrastructure, food safety, and rural development ­ are among the most important drivers of agricultural growth and competitiveness. Moreover, supporting agriculture through growth-enhancing investments is fully compliant with the WTO.101 3.66 Thus, the government's support to agriculture should shift away from the current fiscal subsidies and towards competitiveness-enhancing programs. As subsidies are phased out, the fiscal savings can be reinvested in the provision of investment support and public goods in order to ease the sector's structural problems and enhance rural development. In doing this, the budget could save up to 1 99For example, UkrAgroLeasing was given exclusive rights to seize and lease all agricultural equipment purchased in the 1990s with a state guarantee on which 90 percent of the borrowers defaulted and on which the state guarantee was called. 100A more effective approach would have been for the Ministry of Finance to hold a tender or auction for the right to cease and resell, or lease, these machines. 101These types of investments fit within the so-called "Green Box," and do not figure into distortion support calculations. 61 percent of GDP, even while increasing its support to such growth-enhancing investments as R&D, disease control, and WTO readiness programs. The Energy Sector 3.67 Budget expenditures on the energy sector have declined but still remain substantial. After the continuing increase both in nominal terms and as a share of GDP during 2002-04, expenditures on the energy sector fell in 2005 by 0.4 percentage points (a 14 percent decline) to less than 1 percent of GDP. 3.68 Very little is spent on research and development in the sector. Over a long period, explicit budget expenditures for the energy sector were mainly concentrated in the coal industry, whose share in total budget expenditures for the energy sector was as high as 98 percent (in 2002). Starting from 2003, the construction of power plants became another competing priority for state support, taking 15 percent of total budget outlays for the energy sector in 2005. About 1 percent of the energy sector budget outlays have been allocated for R&D. 3.69 Budget expenditures for the sector have been dominated by subsidies to the coal industry. Over the years, the overwhelming bulk of these subsidies has gone to three categories: (i) restructuring or mine closures and the associated mitigation of the social and environmental impacts of these closures (on average, about a quarter of the total during 2002-05); (ii) production support or partial coverage of the gap between prices and production costs (on average, 30 percent in total during 2002-05); and (iii) technical re-equipment or broadly defined "investments" (on average, about 40 percent in total during 2002-05). 3.70 The government should clarify the fact that the subsidy scheme is temporary and will be phased out as the coal sector is allowed to make a transition to a pricing structure that reflects the true economic value of the coal it produces. The current system of allocating subsidies to cover losses arises from the difference between the regulated price for coal and production costs. This creates a perverse incentive to incur (or at least to declare) greater losses in the expectation of receiving a larger subsidy in compensation. At minimum, this deters efficient investments (such as investments to reduce energy input costs), while the lack of a contractual agreement between the subsidy recipients and the provider exemplifies the absence of accountability for the use of funds and its poor results-orientation. In addition, maintaining low prices for steam coal hinders the adjustment of power tariffs. The price for steam coal does not reflect the actual value of the coal. The primary reason for this is to avoid putting pressure on power tariffs, which are highly sensitive to the cost of the fuel used to produce the power. 3.71 Moreover, the coal subsidies need to be re-evaluated in the context of the prices of alternative energy sources. As prices of other sources of energy such as gas go up, coal production acquires a price advantage and producers will increase their profitability. Consequently, the subsidies to this sub-sector should be phased-out rapidly. With this trend in energy prices there is no remaining rationale for budget support to this sector. Moreover, SOEs and companies with partial State ownership in this sector should be subject to higher standards of management, transparency, and financial discipline. 3.72 The protracted process of mine closures adds to the final costs of closure and contributes to social tension. The overall mine closure process in recent years has been almost at a standstill, although privatization of viable mines has accelerated. There continues to be significant financing from the budget which is absorbed by recurring costs at the mines under the slow closure process (the wages of the workers engaged in the closure process which account for about one-third of the recurrent costs, 62 electricity costs, etc.) and by components that have little or nothing to do with the mine closure process per se, such as the provision of free household coal to former workers.102 3.73 Investment subsidies do not contribute effectively to efficient coal production. The bulk of the subsidies for technical re-equipment (investment) is allocated for relatively routine repair and replacement, and dispersed among a large number of recipients. Investment subsidies, if they are to be preserved, should be linked to capital budgets, submitted by the mining companies and approved by the government. This would increase the prospects for funds to be allocated to the investments with the highest returns. 3.74 Quasi-fiscal activities (QFA) in the energy sector have declined but are still large and are driven primarily by price-based cross-subsidies. The implicit costs of QFA in the energy sector fell from 7.4 percent of GDP in 2001 to 4.3 percent in 2005, mainly because of improvements in payment discipline and the eradication of the barter trade. Mis-pricing, however, especially in the gas sector, remains the main contributing factor. QFA because of mis-pricing in the gas sector, increased from 2 percent of GDP in 2002 to 2.8 percent in 2005. This is the most conservative estimate, using an average price of independent gas traders in Ukraine as a benchmark. The calculations, where the regional market price is taken as the benchmark, yield to significantly higher estimates and much stronger growth, from 4.4 percent of GDP in 2002 to 8.3 percent in 2005. 103 3.75 Looking ahead, unless energy prices are allowed to move along with input costs as the natural gas price rises, QFA will rise with it. At an import price of US$95 per 1,000 cubic meters of natural gas, it has been estimated that Naftagaz alone will incur losses as high as US$1.5 billion per year. QFA frequently finds its way back to future budgets, representing contingent liabilities. This occurs through the accumulation of the tax arrears of energy providers, through the reduced value of state-owned energy companies at their time of privatization, through debt incurrence taken on by the state (often a pre- requisite for privatization when the debts are larger than the value of the rest of the enterprises), or through supplier debts to other countries taken on by the state. All of these types of contingent liabilities have resulted in budget allocations or debt incurrence by Ukraine in the past (for example, the US$1.4 billion worth of bonds that Ukraine issued to Russia as payment for the energy arrears of Naftogaz, or the leasing of Sevastopol ports to Russia, which was a deal struck with implicit debt repayment built into the annual rent calculations). The implementation of a comprehensive energy sector reform will necessarily incur budget liabilities in the future (such as budget participation in the debt restructuring settlements needed to complete power sector privatization). It is safe to say that the longer this comprehensive reform is delayed, the larger these liabilities will be when they are finally addressed. As noted above, the steps being taken and planned in 2006 to raise energy tariffs are needed, and more attention will be needed in the years to come to assure that implicit cross subsidization and/or under-priced energy-based services are curtailed. 3.76 To ease the fiscal burden of support to the energy sector, the government should undertake a comprehensive reform of the sector aimed at improving its governance, increasing its transparency and reducing its vulnerability. Box 3.3 summarizes some key recommendations from that body of work.104 102For example, more than a quarter of total mine closure subsidies in Donetsk Oblast in 2005 were subsidies for household coal. See Ukraine: Coal Sector Update, World Bank, April 2005. 103More details can be found in Poltavets, "Subsidies and Quasi-fiscal Activities in the Energy Sector of Ukraine," Background paper for the PER, 2006. 104Detailed discussion and recommendations of energy sector reform can be found at www.worldbank.org.ua 63 Box 3.3: Roadmap for Energy Sector Reform ­ Summary Recommendations · Maintain hard budget constraints on energy producers, intermediate energy suppliers and consumers to encourage them to improve efficiency, modernize capital, and reduce energy dependency. · Eliminate cross-subsidization of energy tariffs and bring them to full cost recovery, including needed investment costs. · Implement the Law on Debt Restructuring of the Energy Sector and adopt a strategic plan for further restructuring, ownership transformation and private sector participation in the energy sector. · Improve corporate governance and foster the commercialization of majority state-owned energy companies based on transparent performance targets contracted with the corporate management and supervised by independent boards. · Foster competition in coal and electricity supply through further market opening and gradual liberalization of the wholesale electricity trade. · Strengthen the financial and administrative independence of the energy regulator (NERC) and gradually introduce the main regulatory principles governing the EU gas and electricity markets. Source: World Bank 2005, Taking the Next Steps in Energy Sector Reform. Investment Climate Expenditures 3.77 Expenditures in the areas related to the investment climate are growing, but they remain small. These expenditures are related to the creation of fair conditions for the functioning of various product and factor markets ­ their absence represents binding constraints to Ukraine's growth and movement toward EU harmonization. They are important if Ukraine is to experience the benefits of WTO accession, and they are especially important for transition economies where some of the markets are non-existent or at an embryonic stage. To give some examples, expenditures on labor regulations and oversight represented a very small and stagnant share of GDP (0.02 percent) during 2002-05. Spending on the judicial authorities increased from 0.4 to 0.5 percent of GDP during the same period (see Figure 3.12). The strengthening of the judicial systems is one of the most important investments the state can make to improve the investment climate. Annex 3.2 provides more details about the judicial budget, issues in this area, and the proposed expenditure and investment program for the future. Figure 3.12: Expenditures on the Investment Climate, % GDP Investment climate 0.6 PD 0.5 Labor regulationand Gfo 0.4 oversight 0.3 Judicial authorities % 0.2 0.1 (inter) 0.02 0.02 0.02 0.02 0.0 2002 2003 2004 2005 Source: WB staff calculations on Ministry of Finance and State Treasury of Ukraine data. 3.78 In addition to being small in size, some important programs that support the creation of market institutions are not financed at all in practice. For example, programs such as "Increasing Transparency and Accountability of Public Sector and Strengthening Property Rights" received only 1.6 percent of the amount that it was allocated in the 2005 budget. Another example is the severe under- execution of various programs aimed at developing financial markets at the national and sub-national levels (national depository development ­ 5.2 percent of the allocated amounts); municipal credit market 64 development ­ 5.7 percent; establishment of the information and analytical system of financial bodies ­ 14.7 percent). The government spends large amounts of public resources on various subsidization programs (namely, subsidized interest rates), justifying this by the underdevelopment of well-functioning credit markets. To break this vicious circle, more resources should be devoted to market-promoting programs while, at the same time, market and incentive distorting programs are phased out. 3.79 Part of the explanation for the low level of the allocation of investment programs to enhance the investment climate may actually represent decisions made by the Cabinet of Ministers and/or the Ministry of Finance regarding design flaws in some of these programs. It takes time to redesign such programs, to build consensus, and to issue decisions to correct perceived problems.105 These programs should conform to the government's development policy program of improving the investment climate through the creation and the effective functioning of market-supporting institutions. Another explanation may be that program administrators are not able to implement programs according to the path originally envisaged (or the path presented at budget formation time in order to attract financial allocations). In either case, progress can be made by more carefully integrating the growth program represented by government development policy programs (such as the Development Policy Program supported by the World Bank) into the budget formulation process and consulting extensively with the Verkhovna Rada about both the allocations needed and the design of programs that those allocations are meant to support. E. SUMMARY OF RECOMMENDATIONS 3.80 The following options for reform and recommendation should be considered: (a) The public wage bill growth should be contained while the wage scale is decompressed. The public wage bill should be kept below 8 percent of GDP - the 2005 level. A decompression of civil service wages is necessary, but, to avoid an increase in wage spending and align worker incentives with program objectives, this policy should be coupled with the rationalization of positions in the civil service system (this would also allow more competitive salaries per position). To achieve these goals the government needs to revise and streamline institutional procedures and develop a new analytically underpinned remuneration system. Transparency in the pay system is important for creating positive incentives for, and improving the efficiency of, civil servants. (b) A comprehensive and systemic reform of the systems of social assistance and social privileges is recommended. In its current design, these systems are non-transparent, costly and convoluted. They are ultimately an inefficient method of achieving the goals they appear to be pursuing. Up to 1 percent of GDP could be saved (without hurting needy recipients) through three related sets of measures: (i) phase out spa/sanatorium and telephone benefits; (ii) tighten the eligibility requirements for utilities subsidies, housing allowances, and other smaller social assistance programs and replace them with programs using proxy means testing (PMT)); (iii) target properly Chernobyl benefits, which are currently too often abused. Moreover, the introduction of new privileges outside the existing social assistance system should be avoided. 105The allocation for the development of the National Depository of Ukraine (NDU) is a good example here. Ukraine already has an effective depository owned by securities market participants. The idea for the NDU to take over this business is not consistent with the government's development program. To address this problem, efforts are currently ongoing to support a merger of these institutions, with the state share reduced at least to a minority blocking share. While this debate and reform is under way, it would not make sense to spend significant levels of allocated state funds on further NDU development. 65 (c) The government should undertake a thorough review of subsidies in the energy sector (including those masked as capital transfers to enterprises). Cutting subsidies is essential to bring more efficiency to the budget. Subsidies in the energy sector have perpetuated inefficient energy use. The government should enforce financial discipline on the energy companies (including energy SOEs to avoid transfers to cover losses) while phasing-out under-pricing and cross-subsidization. This should be done in tandem with completing the coal sector restructuring and quickly phasing out coal subsidies. Moreover, the coal subsidies need to be re-evaluated in the context of prices of alternative energy sources. As prices of other sources of energy (e.g., gas) go up, coal production acquires a price advantage and producers will increase profitability, which also slashes any remaining rationale for budget support to this sector. Roughly 0.6 percent of GDP in expenditure savings could be achieved by implementing coal sector reform while phasing out inefficient subsidies (and transfers to cover losses) to this sector. (d) Other subsidies in the category of "capital transfers" should also be curtailed, including those related to the continual re-capitalizing of state-owned financial institutions. Up to 0.6 percent of GDP in savings could be achieved by eliminating the most inefficient subsidies in this area and other smaller sectors supported by the budget (excluding agriculture). (e) Government support to agriculture is necessary but needs to be shifted from the current inefficient fiscal subsidies to competitiveness-enhancing programs, compliant with WTO requirements. Just by implementing the government proposal for the new VAT system for agriculture up to 1 percent of GDP could be saved in tax expenditures (the total savings would range from 0 to 1 percent of GDP depending on a variety of factors).106 Also, in the short term, up to 0.4 percent of GDP in expenditure savings could be achieved by cutting the most inefficient production subsidies (such as financing for livestock production, horticulture, wine grapes, and support to private farms) and the most inefficient input subsidies (including the funding for leasing through the UkrAgroLeasing)107 (f) The government should make greater investments to support investment climate- supporting institutions (within the government). A portion of the savings from the elimination of market-distortive subsidization programs should be directed for these purposes. (g) Total expenditures in health and education are at somewhat reasonable levels compared internationally, however, attention should be given to make spending within the sectors more efficient. In particularly, fiscal space is needed to allow for capital investments in these sectors. The second phase of the Public Finance Review will examine these issues in detail from the sectoral perspective and within the framework of the intergovernmental fiscal and administrative relations in Ukraine. (h) Further budget consolidation should be put on the agenda. Preserving the division of the Consolidated Budget in its General and Special Funds no longer has a clear rationale. This budget reform should be preceded by the strengthening of capital budgeting (including capital budgeting and capital transfers to local governments). Further budget consolidation would increase budget management efficiency and might well help to improve the implementation of public investment programs. 106These factors include the cost and input structure of farmers and their patterns of consumption after the reform. 107A comprehensive discussion of these subsidies is presented in the background paper "Improving the Agricultural Fiscal Policy in Ukraine" prepared for this report. 66 F. CONCLUSION 3.81 The analysis in this chapter shows that in Ukraine's public spending there is the scope and the need for better allocation efficiency, for better use of allocated funds, and for a reduction in the overall size of public spending (to below 39 percent of GDP in the medium term). Significant expenditure savings can be achieved by rationalizing and phasing out inefficient and poorly targeted programs. Moreover, part of the savings obtained may be used to finance the government's reform agenda and to increase the low level of capital investments (prioritizing reallocation to productive investments). This amount includes the savings that could be achieved on the pension system, which are examined in the next chapter of this report. 67 68 4. GETTING PENSION REFORM BACK ON TRACK A. INTRODUCTION 4.1 The Pay-As-You-Go (PAYG) pension system in Ukraine encompasses a variety of problems that threaten its fiscal sustainability. These problems range from poorly designed features on both the revenue and expenditure sides of the system, to such threats as an aging population (by 2055 there will be 1 worker in Ukraine for every 1.42 pensioners). In 2003 the government enacted legislation with the objective of reforming the system by adding to it a second fully funded mandatory pillar, and a third, voluntary, and private fully funded pillar. While the core legislation was approved, the envisioned full reform was not implemented owing to the fact that its institutional and administrative underpinnings were not ready for implementation. Moreover, increasing expenditures and record deficits in the system in 2004 and 2005 put the implementation of the multi-pillar system on hold. In the last two years there has also been considerable activity in terms of adjustments of certain features of the system. Some of these adjustments have been driven by electoral promises such as the September 2004 measure to increase the minimum pension, which was one of the main factors responsible for the growing deficit. Yet, as a result of recent increases, the PAYG system represents one of the highest transfer levels in the world as a share of GDP (see Table 4.1). After the presidential election, the government started to face this tension, and in March 2005 certain measures were implemented to control pension payments. These efforts were positive for the system's balance (i.e., reduced expenditures from an expected 17 percent of GDP to 15.3 of GDP in 2005) but they did not avoid the overall hike in pension payments and the deficit that year. Nevertheless, their positive effect on the pension system will continue in the following years. Table 4.1: Overall Pension Expenditures as Percent of GDP: An International Comparison Country As percent of GDP Country As percent of GDP Cyprus 8 Austria 14.5 Czech Republic 7.8 Belgium 10 Estonia 6.9 Denmark 10.5 Hungary 6 Finland 11.3 Latvia 9.8 France 12.1 Lithuania 5.3 Germany 11.8 Malta 5.4 Greece 12.6 Poland 10.8 Ireland 4.6 Slovak R. 7.9 Italy 13.8 Slovenia 13.2 Netherlands 7.9 Bulgaria 9.1 Portugal 9.8 Romania 6.4 Spain 9.4 EU new and accession 8 EU pre-2004 10.4 Ukraine 2003 9.2 Ukraine 2004 11.4 Ukraine 2005 15.3 Note: Ukraine figures include pension payments for government employees Sources: EU and OECD. 4.2 At the beginning of 2006 additional measures were approved to control pension expenditures. These measures are likely to succeed in reducing the ratio of pension expenditures to GDP, at least during 2006.108 Almost in tandem, the Government of Ukraine launched its Strategy for Pension System 108For example, instead of an increase up front in the minimum pension benefits at the beginning of the year, the minimum pensions would gradually reach the minimum subsistence level by December 2006. This chapter provides an analysis of these measures in section D. 69 Development. The general precepts of this strategy are commendable as they are geared to control expenditures and increase collection efficiency in payroll taxes in order to implement the long-awaited reform. The analysis and fiscal impact estimation of the expenditure-reducing measures introduced recently and the measures envisaged by the government's Strategy show that they a have positive impact on the system's balance. 4.3 However, the fiscal impact estimation of the government's strategy also shows that the measures planned, while positive, are not sufficient to bring sufficient savings to the system to allow a fiscally smooth introduction of the second pillar (in 2008 or 2009) and to allow a rate reduction in the high marginal rates of the payroll taxes (social insurance contributions).109 In order to move the system onto a long-term path of fiscal sustainability while reducing the high marginal burden of the contributions, as originally envisaged, additional savings measures are recommended, including the following: · Increase the retirement age for women from 55 to 60 years, with an increase of 6 months per year (completed by 2017) starting in 2007. This measure would save an average of 0.32 percent of GDP annually, starting from 0.1 percent in 2007 and increasing to 0.7 percent by 2015. As life expectancy continues to grow, the retirement age for men and women would need to be further increased. · Lengthen the required contribution period for eligibility for a full minimum pension to 30 and 35 years for women and men, respectively.110 This measure would save an average of 0.17 percent of GDP annually, starting from 0.1 percent in 2008 and increasing to 0.2 percent by 2015. · Suspend the increase in pension benefits up to the subsistence minimum if the pensioner continues to work.111 This measure would save an average of 0.49 percent of GDP annually, starting from 0.5 percent in 2007 and decreasing to 0.4 percent by 2015. · Replace the minimum pension with means tested benefits for any pensioner whose family's per capita income falls below the minimum subsistence level.112 Only low income pensioners whose household income is below the notional amount of the "subsistence minimum" should receive the automatic increase. This measure would save an average of 0.33 percent of GDP annually, starting from 0.4 percent in 2007 and decreasing to 0.3 percent by 2015. · Introduce a regular contribution rate for those taxed under the simplified tax system (STS). This measure would save 0.1 percent of GDP annually from 2007 to 2015. 4.4 This chapter analyzes the recent developments in the Ukrainian pension system, and the current PAYG system parameters. It provides estimates of the fiscal impact of the newly announced government strategy for pension reform. It suggests concrete additional reform options to enhance the medium-term and long-term sustainability of Ukraine's pension system, and provides a detailed estimation of the fiscal savings that could be achieved. The analysis in this chapter is based on simulations generated by the Ukrainian Pension Simulation Model developed in collaboration by the Government of Ukraine, the 109Currently, the employer's contribution alone is around 37.5 percent of the wage. Together with the employee's contribution this rate reaches around 40 percent (although there is a rate variation depending on the employee's type of work--see Chapter 2). 110 Currently, the required minimum service period for a full minimum pension is 20 and 25 years for women and men, respectively. The minimum pension for shorter service periods is prorated. For every additional year of service the minimum pension is increased by 1 percent of the pension calculated by the formula, which also raises the equity issue. Extending the minimum service period for the full minimum pension to 30 and 35 years and prorating it for shorter service periods would be more equitable and cost effective. 111Working pensioners are currently entitled to the minimum pension regardless of the labor income they earn. This measure would entitle them only to the regular pension calculated with the pension formula as long as they continue to earn labor income. 112 The increase in the minimum pension currently occurs automatically up to the level of the "subsistence minimum." The subsistence minimum is a notional amount set by the government each year in the annual budget. This amount is well above the minimum wage in Ukraine. 70 National Academy of Sciences of Ukraine, and the World Bank (see Annex 4.1 for a brief description of the model). B. THE UKRAINIAN PENSION SYSTEM: EVOLUTION, CURRENT ISSUES AND PLANNED REFORMS 4.5 Like many other countries in the region, Ukraine has a PAYG pension system with several problematic features. The Ukrainian system features a conventional defined benefit formula with generous replacement rates, low retirement ages (60 for men and 55 for women), the full old-age pension entitlement based on 20 years of service for women and 25 for men, and numerous special early retirement provisions.113 These characteristics have been particularly problematic considering the country's demographic trends (for example, the shrinking contribution base and the growing beneficiary population). In addition, the system's sustainability faces compliance difficulties on the revenue side, owing to the high contribution rates, perverse incentives in the tax system (for example, the option for individuals to be taxed under the STS with a considerably lower burden), and weak revenue administration.114 Box 4.1 provides a chronology of the pension system in Ukraine. Box 4.1: Chronology of Events and Milestones in the Ukrainian Pension System · 1991: First Pension Law enacted-- base of the Ukrainian system (among other features, aimed at providing generous replacement rates). · 1991-2005: Constant ad hoc adjustments of pension benefits made to cope with growing dependency ratio. · 2003: New pension legislation enacted, setting the stage for a comprehensive reform based on a multi-pillar system. It also introduces changes in the current system (i.e., first pillar). · 2003-2004: Several parametric changes to the first pillar implemented. · 2004 (September): An increase in the minimum pension introduced prior to the 2004 presidential elections (this action would drive deficits up in 2004 and 2005). · 2004-2005: Pension payments hiked from 9.2 percent of GDP in 2003 to 11.4 percent of GDP in 2004. The year 2005 is a record high in pension expenditures (15.3 percent of GDP). As a consequence, deficits increased from 1 percent of GDP in 2004 to 3 percent in 2005. · 2005 (March): Amendments to the pension legislation introduced to control the negative fiscal outcomes. · 2005-2006: Additional measures introduced to control the deficits (changes to indexation rules for pension benefits in 2005 and in 2006, instead of an up-front increase in the minimum pension benefits at the beginning of the year, the minimum pensions should gradually reach the minimum subsistence level by December 2006). · 2005 (December): The government's Strategy for Pension System Development is announced. Among other things, the Strategy envisages the elimination of the pension deficit by 2008 and the launching of the second fully funded pension pillar in 2009 or earlier if fiscal conditions allow. Moreover, it envisions the unification of several functions of the four insurance funds, and a single contribution. 113 A defined benefit scheme is a guarantee that the pension agency will pay a benefit based on a prescribed formula. The replacement rate is the value of a pension as a proportion of a worker's wage during a base period before retirement or the entire lifetime average wage. 114The issues and recommendations regarding social insurance contributions (payroll taxes) are discussed in detail in Chapter 2. This chapter links its discussion to issues and recommendations in that chapter and re-states some of key arguments. 71 4.6 Replacement rates were for many years lower than mandated before 2004. This took place over the years in order to adjust the system to the rapidly growing dependency ratio.115 The adjustment took place through the imposition of a maximum cap on pension benefits, which in turn eroded the value of pensions. In addition, ad hoc benefits adjustments for inflation, and other factors, were put in place. As a result, the system has paid low and almost flat benefits. 4.7 During 2003-04, legislation was enacted to reform the current system with a multi-pillar pension system. The rationale behind this pension reform was to replace an ill-performing system with one that would: (i) provide adequate pensions, including a minimum benefit; (ii) ensure a transparent and direct link between lifetime contributions and benefits; and (iii) diversify the sources of pension income between current social security contributions and accumulated savings. The new legislation called for the establishment of three pillars: the first and second pillars as mandatory, and the third pillar to be voluntary. The first pillar is financed on PAYG principles; the second and third pillars would be fully funded. Box 4.2 briefly describes the second pillar. Box 4.2: The Second Pillar of the Pension System, as Envisaged by the Approved Legislation The second pillar is envisaged as a fully funded component of the system. Ukraine chose to link the PAYG benefits to contributions through the German point system, as in Hungary, the Slovak Republic, Slovenia and Croatia. That is, the current total pension contribution rate (i.e., payroll tax rate) would be divided in two between the mandatory pillars: the upper 7 percentage points of the contribution would go to fund the second pillar, and the remaining 26.8 percentage points (approximate, as rates vary by type of work and industry-see Chapter 2) would continue to fund the current PAYG first pillar. The second pillar would include people below the cut-off ages of 45 for women and 50 for men. People aged 40-35 and younger, as well as new labor force entrants, would have to join the new multi- pillar system. Workers between the ages pf 40-35 and 50-45 would be given the choice of remaining in the first pillar only or of enrolling in the multi-pillar system, like younger workers. This decision should be made within one year following the year of the introduction of the second pillar. If the current proposal remains unchanged, Ukraine would have one of the largest second pillars in the region. The new legislation conditions the introduction of the second pillar on macro-fiscal and institutional reform triggers, including the following: (i) balancing out the pension system deficit, (ii) recording real GDP growth above two percent for 2 consecutive years prior to its introduction, (iii) establishing institutions for supervising the funded system, (iv) creating a voluntary pension funds market in the country, and (v) requiring that the minimum pension should not be lower than the minimum subsistence level. 4.8 While the second pillar is yet to be introduced, some parametric changes to the first pillar established in the 2003 Law were implemented in 2004. These changes include the following: (a) An increased benefit to those who delayed retirement, beginning with a 3 percent increase in pension benefits for one year of delay, to a total 85 percent increase for a 10-year delay. (b) Benefits are set as 1 percent of the wage (subject to pension) per each year of service (before this, the figure was 2.2 percent for men and 2.75 percent for women). (c) Indexation of the pension payment for inflation116 plus at least 20 percent of wage growth (previous indexations were made on an ad hoc basis). (d) A ceiling on the taxable wage (contribution) equal to seven times the average earnings, the previous ceiling was less than twice the average wage in the country. (e) Separation of work injury-related disability from other forms of disability. 115 The dependency ratio is the number persons receiving pension benefits (from a certain pension scheme) divided by the number of workers contributing to the same scheme at a certain point in time. 116 The part of the income below the subsistence minimum is subject to indexation for inflation, while the part of the income above the subsistence minimum is not compensated at all. 72 (f) Specification of disability benefits as a percentage of the projected old age benefit rather than as a percentage of salary. (g) Movement of the elderly not eligible for a labor pension from the PF to a social assistance system funded by the state. (h) An optional recalculation of pension benefits for those already retired in accordance with the new pension formula that has no maximum cap on the pension payment (benefits paid) (the previous law had a maximum pension payment ceiling of three minimum wages). 4.9 Some of these measures increased pension payments. As stated above, the new law allowed those already retired to have a recalculation with the new pension formula, which does not have a maximum cap on pension benefits (see [h] above).117 Owing to this recalculation, total pension expenditures in the first three quarters of 2004 jumped by around 20 percent. 4.10 Just two months preceding the presidential elections a significant increase in the minimum pension took place. All pension benefits that were lower than a notional amount established by law called "the subsistence minimum" were raised up to this threshold (which is above the minimum salary), which resulted in a hike in pension payments during the last quarter of 2004 and throughout 2005.118 More than 12 million Ukrainian pensioners started to receive benefits equal to this "subsistence minimum" amount.119 Prior to this change the ratio of minimum pension to average wage was 18 percent. The resulting minimum pension level after this change (49 percent) is high and is well above most observed levels in other countries (see Table 4.2). Table 4.2: Minimum Pension Levels in Comparison with Average Net Wage, in % Country Percent Country Percent Belgium 30 Canada 14 Czech Republic 12 Ireland 30 France 29 Japan 19 Hungary 21 Korea 30 Luxembourg 42 Netherlands 34 Spain 33 New Zealand 38 Switzerland 19 Norway 18 UK 15 US 19 Bulgaria 16 Latvia 33 Ukraine 49 Poland 25 Note: Most recent years. Source: World Bank. 4.11 As a consequence of these changes, pension expenditures in 2004 and 2005 increased drastically along with Pension Fund deficits. Pension payments increased from 9 percent of GDP in 2003 to 11.4 percent in 2004. This trend continued, reaching a record level of 15.3 percent of GDP in 2005. This high ratio, even by European standards, unavoidably led to increasing deficits that reached 3.3 in 2005 (see Table 4.3). This fiscal gap was ultimately covered by transfers from the state budget to the Pension Fund. 4.12 The negative fiscal outcomes of the minimum pension increase were partially addressed in March 2005 through amendments to the Law. These amendments included: (i) the partial abolishment 117The previous law had a maximum pension ceiling of three minimum wages. 118The concept of "subsistence minimum" is discussed in detail in Annex 4.2. The resolution adopted in September 2004 is CMU Resolution # 1215. 119For most low income earners (the bulk of the contributors) this represented up to 200 percent of the replacement ratio. 73 of the wage component in the minimum pension indexation120; (ii) the abolishment of the rule that allowed 1 percent of the minimum pension increment for each additional year of service above 20-25 years for women and men, respectively; and (iii) the abolishment of the rule that allowed increases in supplementary payments to special categories of pensioners based on the increase in the minimum pension. It is estimated that this measures created expenditure savings close to 1.5 percent of GDP. Table 4.3: Pension System Budget Outline, UAH billion, 2003-05 Year 2003 2004 2005 2006/1 Payroll tax revenues (including government employees) 22.8 31.4 42.8 49.4 Transfers to PFU from different sources, 2.1 6.2 22.9 Of which; State Budget, 1.9 6 22.6 18.5 Of which: regular transfer (1) 1.9 2.2 6.7 8 deficit coverage 0 3.8 15.9 10.5 Unemployment Fund 0.1 0.1 0.1 Work injury and occupational decease fund 0.1 0.1 0.1 Total PFU revenues 26.7 39.8 66.3 Total PFU expenditures 24.5 39.2 64.1 68.3 Deficit/Surplus, 0 3.2 13.7 8.3 Including carry-over for next fiscal year 2.2 0.6 2.2 2.1 Total PFU expenditures, % of GDP, 9.2 11.4 15.3 14.2 Deficit % of GDP 0 0.9 3.3 1.7 Note: In 2004 the state budget assumed full responsibility for financing special pension programs (e.g., special pensions for civil servants, social pensions for people who never worked, supplements to war and labor veterans, blood-donors, victims of political repression, inhabitants of mountainous areas, scientists, recipients of merit pensions, Chernobyl victims, servicemen and other allowances). 1/ This estimation is based on the macro projections discussed in Chapter 6 (under the conservative scenario). Sources: Ministry of Labor; Ministry of Finance. 4.13 The measures to create expenditure savings that were implemented in 2004 and 2005 (March) missed some critical issues. For example, these measures did not address the issue of the mandatory retirement age, which currently remains at 55 for women and 60 for men. These retirement ages are considerably lower than in EU and other OECD countries. Other issues that were left out include the following: (i) the lengthening of the minimum contribution period, which is currently very short in Ukraine;121 (ii) the inclusion in the regular system of the individual in the FAT and the STS; (iii) the treatment of working retirees; and (iv) several revenue related measures, as discussed in Chapter 2. 4.14 The government's strategy to move the pension reform forward will have a positive impact on the system's balance. With the objective of making the long envisaged (and approved) pension reform possible, in December 2005 the government adopted a policy plan called the "Strategy for Pension System Development for the period 2006-2016." This Strategy envisages the elimination of the pension deficits by 2008 and the launching of the second fully funded pension pillar in 2009, or earlier, if the 120 The original pension reform law envisaged the price adjustment of pensions and, in addition, increases in all benefits in payments by 20 percent of nominal wage growth recorded in the year preceding the adjustment (so-called wage adjustment coefficient). The partial wage adjustment introduced in 2005 means that (i) pensions are increased by the difference between inflation and wage adjustment coefficients, and (ii) pensions are subject to wage growth adjustment only when the inflation adjustment coefficient is lower than the above-mentioned wage adjustment coefficient. 121The minimum contribution period for becoming eligible for disability, survivors or reduced minimum pension is 5 years. 74 policy measures yield a stronger fiscal impact.122 In parallel, the President and the government expressed their vision of reducing payroll tax rates by about 20 percent over the medium term. Box 4.3 briefly describes the Strategy. Box 4.3: Main Features of the Government Strategy for Pension System Development The adoption of the Government Strategy is an important step towards reforming the pension system along the lines of the multi-pillar design. However, it contains general policy provisions only and does not specify changes to some pension system parameters. Key policy measures listed in the Strategy include the following: (i) the introduction of a single social insurance contribution payment; (ii) the strengthening of the link between pension level, length of service and contributions paid; (iii) the streamlining of the payment of pensions to working pensioners in relation to their labor incomes; (iv) the revision of the list of occupations eligible for early retirement; (v) the introduction of general pension system principles for the military and other professions for which the legislation does not stipulate the mandatory payment of contributions; (vi) the streamlining of the procedure for the indexation of pensions and their raising in accordance with average wage growth; (vii) the creation of an administrative system for the second pillar; (viii) the introduction of the second pension pillar; (ix) the stimulation of the payment of wages and pensions through banking institutions; (x) the introduction of norms to collective bargains and sector agreements on minimum contribution bases and the establishment of responsibility for noncompliance; (xi) the creation of a system for electronic reporting by employers on the insurance contributions payments; (xii) the revision of the retirement age in accordance with the increase in life expectancy after 2010; and (xiii) the transfer of early and privileged pensions from pay-as-you-go to a funded system. However, several specific details about the implementation of these policy measures have not been clearly stated in the Strategy. Moreover, the changes in some of the areas above, particularly in those related to the expenditure side, are very marginal and consequently would have a limited impact. 4.15 The majority of the suggested policy measures in the Strategy focus more on increasing pension revenues than on curbing the high pension expenditures.123 Most of the measures for improving revenue collection stated in that Strategy are geared in the right direction (see Chapter 2). However, only a few measures to reduce pension expenditures are articulated in that document. The most relevant reforms of that Strategy are analyzed and measured in terms of their fiscal impact in this chapter. 4.16 The aging population, coupled with early retirement, would continue to pose a risk to the fiscal sustainability of the system. It is essential for policymakers not only to take measures to reduce the short-term PAYG deficit, but also to enact comprehensive measures to prepare the pension system for unfavorable long-term demographic changes. Ukraine has a population that is already old and that is shrinking. Life expectancy is increasing and fertility rates are low. Along with the rest of Europe, Ukraine will experience a rapid aging of its population. The most evident effect on the pension system is the rise of the system's dependency ratio (already the highest among transition countries). The system dependency ratio in Ukraine is projected to increase further from 92 percent in 2005 to as high as 140 percent in 2050; this increase would also be fueled by the current generous early retirement provisions and by a significant drop in the number of active contributors (see Figure 4.1). 122Recently the government has been discussing the introduction of the second pillar in 2008, and it was agreed with the government that 2008 would be used for the pension system modeling in this report. 123However, none of the suggested revenue improving measures challenges the simplified tax regime, which allows small businesses and individuals to pay significantly lower contributions than in the regular system (see Chapter 2). 75 Figure 4.1: Old Age and System Dependency Ratios in the Absence of Reforms, 2005-75 160% 140% 120% 100% 80% 60% 40% 20% 0% 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 Old age dependency ratio System dependency ratio 2006 2025 2050 2075 Average lifetime at birth, men 62.3 66 70 72 Average lifetime at birth, women 73.5 76 80 82 Total fertility rate 1.15 1.5 1.85 1.85 C. ARTICULATING REFORM OPTIONS 4.17 With the introduction of the second pillar, contributions to the first pillar (PAYG) will be reduced, and thus further policy changes to this latter pillar are necessary to control expenditures. In Ukraine, a further reduction of pension expenditures is necessary to obtain a balanced PAYG and to offset the transition costs of the second pillar. There are a variety of measures that can achieve this reduction in the short, medium, and long terms; the most feasible of these are listed in Box 4.4. This section focuses on explaining what these policy changes are, what they imply, how the current features of Ukraine's pension system rank internationally, and why they are important for the system's sustainability. Then, the next section of this chapter (Section D) provides an estimation of the fiscal impact of key measures according to changes planned under the government's Strategy, and according to the recommendations of this report. While some of the reform options in Box 4.4 are depicted in the government's Strategy, the fiscal impact, as discussed and estimated in the next section, depends on the specifics of the measures (that is, when implementation starts, and how marginal or bold are the changes to the parameters that they address) Box 4.4: Outline of Selected Reform Options (parametric changes to save resources for the system) · Increasing the retirement age. · Lengthening the contribution period required to become eligible for a full minimum pension. · Suspending the increase of pension benefits to the subsistence minimum for working pensioners. · Tightening generous minimum pension eligibility criteria through better targeting (means testing of the minimum pension). · Eliminating or at least reducing early retirement entitlements and special pension privileges for certain occupational categories. · Requiring individuals currently under the STS to contribute at regular rates. · Indexing pension payments at the inflation rate. · Differentiating minimum pensions through increasing the benefits for years of contribution above 30 and 35 years for women and men, respectively. Increasing the Retirement Age 4.18 The pension system's retirement age is one of the most critical variables in determining system costs. It directly affects the number of years during which benefit payments are made and also the number of years during which workers make contributions. A higher retirement age also reduces the number of new pensioners and increases the labor force. The retirement ages in Ukraine are low by Western European, Central European and OECD standards. 76 4.19 Moreover, most of the Central European countries have increased their retirement ages to at least 62 for men and 57 for women as they have moved into the EU. In some cases they plan to increase their retirement ages further in order to ensure fiscal sustainability of their systems (see Table 4.4). In Ukraine, women can expect to receive pensions for almost 25 years after retirement (that is, based on life expectancy after retirement), while the normal period for benefits elsewhere is about 15 years. Thus, one of the least burdensome ways to bring the pension system to long-term balance is to raise the retirement age for women. Men, with their lower life expectancy and their already higher retirement ages, receive benefits for about 15-16 years on average. As life expectancy continues to rise, the retirement age for men should also increase. Table 4.4: Mandatory Retirement Age in Selected EU, CEE, OECD, and CIS Countries Country Male Female Country Male Female Albania 65 60 Austria 65 60 Croatia 65 60 Denmark 67 67 Republic of Cyprus 65 65 Finland 65 65 Estonia 63 63 France 60 60 Hungary 62 62 Germany 65 65 Lithuania 62.5 60 Greece 65 60 Macedonia 64 62 Ireland 65 65 Poland 65 60 Italy 65 60 Romania 65 60 Japan 65 65 Slovak R. 65 60 Norway 67 67 Slovenia 63 61 Portugal 65 65 Russia 60 55 Spain 65 65 Turkey 60 58 Sweden 65 65 Kazakhstan 63 58 Great Britain 65 60 Ukraine 60 55 USA 65 65 Source: World Bank. Lengthening the Contribution Period Required to Become Eligible for a Full Minimum Pension 4.20 The current required contribution period in Ukraine is short. The system requires a contribution period of 20 years for women and 25 years for men for eligibility for the full minimum pension benefit. The minimum pension for the longer service periods is increased by 1 percent of the pension as calculated by the formula, while those with shorter service periods are entitled to a prorated minimum pension benefit, which raises both cost and equity issues. This feature, although it is a candidate for reform, was not harming the system's finances significantly in the past when the guaranteed minimum pension benefit was set at low levels (for example, at 20 percent of the average wage). However, the increase in the minimum pension to the subsistence minimum level, which implied a rise in the minimum pension to 49 percent of the average wage in 2005 (or 120 percent of the minimum wage), made the short contribution period an important threat to pension system sustainability. The recommended policy at such high minimum pension replacement rates is to award them to those with the longest service periods (i.e., 30 and 35 years for women and men, respectively) and prorate them for those with shorter service periods. Suspending the Pension Benefits Increase if the Pensioner Continues to Work 4.21 Many countries suspend PAYG pension benefits for those who continue working. This policy is not in place in Ukraine. As much as 20 percent of pensioners report that they continue to work while receiving a pension, and the actual figures is likely to be even higher. Furthermore, Ukrainian working pensioners are qualified, like working contributors, to the increase of pensions to the minimum pension level. In the short and medium terms, the government should consider suspending this top-up increase to the subsistence minimum for working pensioners. Working pensioners' total income is almost always higher than the subsistence minimum. Moreover, the bulk of these pensioners are not in the lowest income and poverty brackets. Those that are, would be eligible for poverty targeted social assistance. In 77 fact, the use of the subsistence minimum as a basis for pension calculations affecting all pensioners mixes a social insurance issue with a social assistance issue. Poor pensioners should be targeted with social assistance programs, not through a wasteful and unfair increase in the overall pension system minimum. Targeting the Increase of Pension Benefits Up to the Subsistence Minimum 4.22 The large increase in the minimum pension has essentially eliminated the link between pension benefits and contributions. Owing to the increase in the minimum pension, the current system pays almost flat benefits (at the level of the subsistence minimum) for more than 95 percent of pensioners. The poverty reduction argument of this policy loses strength because of the complete lack of targeting. Moreover, it should be borne in mind that pensioners are not among the poorest in Ukraine according to Ukraine's Household Budget Survey. Through targeting (for example, means-testing), critical savings in the system could be achieved without curtailing the benefits of poorer recipients (see Box 4.5). Box 4.5: A Simple and Cost Effective Strategy to Target Pension Increase to Poor Pensioners The most efficient and cost-effective way to eliminate poverty within the pension system is to use means testing in order to target poor pensioners. Targeting could be introduced in the following manner. The recipients could be divided into four different groups. The first and largest group (one-fifth of pensioners), consists of pensioners living alone. For them a pension is most likely to be the primary source of income. The second group, comprising one- sixth of pensioners, are couples living together--a married couple normally receives two pension payments in its own right. The third group comprises multi-generational households with pensioners, in which no other member is a wage-earner (these households usually consist of pensioners, children and the disabled)--this is a very small group (around 1 percent). And the last group, representing almost 40 percent of Ukrainian households with pensioners, consists of multi-generational households in which at least one member of the household is a wage-earner. In this last group, it is important to note that the significance of a pension for household income depends upon the number of employed persons in the household, since household members usually pool resources. In light of these group compositions, the targeting would consist of automatically allowing the level of the minimum pension (at the subsistence level) to the first three groups. Only the last group should be means tested--which would save resources in carrying out means testing for the whole population of pensioners. 1/This targeted approach to the minimum pension increase would ensure compliance with Article 46 of the Constitution of Ukraine for all Ukrainian pensioners. Introducing Regular Contributions for Individuals under the STS 4.23 The STS is an obstacle to the expansion of the base of payroll taxes (pension contributions). The current law allows certain categories of workers, such as individuals taxed under the STS (and agricultural workers taxed under the FAT), to pay only a fixed amount of tax, a portion of which is remitted to the Pension Fund. But this fixed amount is several times smaller than the corresponding contribution under the regular tax system (see Chapter 2). To compensate the Pension Fund for this revenue loss, the budget makes a special transfer to the Pension Fund to cover the payments of individuals under these special tax regimes. In practice this is a subsidy, one that introduces inefficiencies and inequities into the tax system. While a step-wise phase-out of this scheme has been approved for agricultural workers under the FAT by 2010, contributions from individuals under the STS remain an 78 issue.124 Curtailing this subsidy for individuals under both special tax regimes would increase the system participation rate significantly (by around 7 percent in the next 10 years).125 D. FISCAL IMPACT OF RECENTLY IMPLEMENTED, PLANNED, AND ADDITIONAL RECOMMENDED REFORM OPTIONS Measures Introduced During the Period of 2005- 06 4.24 During 2005-06 several fiscal savings measures were introduced, and they are expected to have a strong impact on reducing pension deficits. The key factor influencing a favorable pattern is a tight indexation rule introduced by the 2005 Budget Law. In addition, in 2006 instead of an increase up front in the minimum pension benefits at the beginning of the year, the minimum pensions would gradually reach the minimum subsistence level by December 2006. The law introduces a quarterly indexation of the minimum pension starting from UAH 350 to be applied in the first quarter of 2006, rising to UAH 359 during the seond and third quarters, and to UAH 366 in the last quarter. Effectively, the minimum pension would be raised by 8 percent in 2006, some 10 percentage points below the expected nominal wage bill growth and 6 percentage points below the expected nominal GDP growth. 4.25 As a result, in 2006 pension expenditures are expected to drop further to around 14 percent of GDP. Table 4.5 shows a simulation of the potential impact of the measures introduced. These projections assume that no further changes in the current legislation would take place; it also assumes a constant system participation rate.126 As shown in Table 4.5, pension expenditures fall significantly through the projection period. Again, the key factor influencing a favorable pattern is the very tight indexation rule. However, this would take place only in the absence of policies geared to increase pensions. It also implies that the same indexation rule is applied each year. Due to the model specifications these estimates are quite sensible to the real wage growth dynamics.127 Table 4.5: Simulation of Pension Expenditures without Further Parametric Reforms, 2007-15 1/ 2007 2008 2009 2010 2011 2012 2013 2014 2015 Conservative Scenario Expenditures, as percent of GDP 13.5 13.0 12.6 12.2 12.0 11.7 11.5 11.3 11.0 Replacement rate, % 40 38 37 35 34 33 32 31 29 Base Case Scenario Expenditures, as percent of GDP 13.5 12.7 12.1 11.6 11.2 10.8 10.5 10.2 9.9 Replacement rate, % 38 36 34 32 30 28 27 26 24 1/Includes the impact of introducing regular contributions from payers of a fixed agricultural tax. During 2005-06 payers of a fixed agricultural tax were to pay 20 percent of the pension insurance contribution rate. Starting from 2007 this share will grow by 20 percent per year to reach 100 percent in 2010. The state budget took full responsibility for covering the difference and transfers the money to the PF through the Ministry of Agricultural Policy. 4.26 But without any further pension policy changes, the introduction of a second pillar in 2008 would keep the system in deficit until 2015. With the introduction of the second pillar, the annual revenue forgone to that funded scheme is around 1.3 percent of GDP in the first year. From there it grows steadily up to 2 percent of GDP by 2015. Pension savings generated by the current pension indexation policy will partially help offset the initial pension deficits caused by the loss of contribution revenues 124The gradual introduction of regular contributions for agricultural businesses paying a fixed tax was initiated in 2005. 125The system participation rate is defined here as a share of contributors in active employment and gives combined information about coverage and compliance. 126Under a status quo scenario, system participation rate remains around the current level of 73 percent. 127See a description of the model in Annex 4.1. See a detailed discussion of the macro-scenarios' assumptions used for this report in Chapter 6. 79 diverted to the second pillar. However, during the period 2007-15, a significant part of the financing gap would still have to be covered by the government by the cutting of public spending elsewhere, through public debt issuance, and/or though increasing the burden of taxpayers. Fiscal Impact of Planned Measures of the Government's Strategy 4.27 This section evaluates the fiscal impact of the three savings measures of the government's Strategy.128 (a) The increase in the retirement age for women to 60 at the rate of 6 months per year, starting in 2010. (b) The introduction of the indexation of all pension benefits in payment status by 20 percent of the nominal wage growth. (c) The suspension of the increase in pension benefits up to the subsistence minimum for working pensioners (starting in 2007), and the payment of only the formula part of the benefit. 4.28 The expected fiscal impact of these three policy measures envisaged under the government's Strategy is the creation of savings that are, on average, 0.42 percent of GDP annually for the period 2007-15. The cumulative savings for that period are close to 3.8 percent of GDP (under the conservative macro scenario). The savings start at 0.2 percent of GDP in 2007 and increase up to 0.6 percent of GDP in 2015. These savings vary slightly between the two sets of macro scenarios (see Table 4.6). Table 4.6: Fiscal Savings Under the Government's Strategy, 2007-15 2007 2008 2009 2010 2011 2012 2013 2014 2015 2007-2015 (cumulative) Conservative Scenario Savings, as % of GDP 0.2 0.3 0.3 0.4 0.4 0.5 0.5 0.6 0.6 3.8 Base Case Scenario Savings, as % of GDP 0.2 0.2 0.3 0.4 0.4 0.5 0.5 0.7 0.8 3.9 4.29 The savings generated by policy changes under the government's Strategy are not sufficient to offset the pension system deficits in the long run and to allow a rate reduction in payroll taxes. The government Strategy addresses the weaknesses of the current system only partially. The savings generated by the expenditure side elements of this strategy are necessary and positive but are not sufficient to bring long-run sustainability to the pension system. For example, these measures would not be sufficient to serve as a counterweight to the decline in the replacement rate in the long run. Moreover, they would not provide enough fiscal space to allow a payroll tax reduction as planned by the government's administration. Fiscal Impact of Recommended Reform Options (measures to create fiscal savings) 4.30 Additional measures/reforms are necessary to bring the needed savings to the pension system. The government should consider the following concrete parametric reforms to the PAYG system (first pillar): 128The introduction of the second pillar with a 7 percent contribution rate in 2008 is assumed. These estimations also assume a cut-off age for second pillar participants of 50 for men and 45 for women. 80 (a) Gradually raising the retirement age for women from 55 to 60 by 2017, with an increase of 6 months per year beginning in 2007. The government's Strategy also plans a reform on this front (i.e., increasing the retirement age for women to 60 only from 2010 at the rate of 6 months per year) but it is more marginal than the plan recommended here. (b) Extending the contribution period required to become eligible for a full minimum pension from the current 20-25 years to 30-35 years of service for women and men, respectively. (c) Suspending the automatic increase in pension benefits (up to the subsistence minimum) if the pensioner continues to work (this measure is also considered in the government's strategy). (d) Replacing the minimum pension with means tested benefits for any pensioner whose family's per capita income falls below the minimum subsistence level (e) Introducing regular contributions for all employees in the STS. 4.31 The measures suggested here generate more than three times the savings of the measures envisaged under the government's Strategy. The expected savings for the system of these recommended (additional) measures are, on average, 1.51 percent of GDP annually from 2007 to 2015. The cumulative savings for this period are close to 12.3 percent of GDP. The total savings start at 1.1 percent of GDP in 2007 and increase up to 1.7 percent of GDP in 2015 (see Table 4.7). Table 4.7: The Fiscal Impact (savings) of the Recommended Measures, 2007-15 1/ 2007 2008 2009 2010 2011 2012 2013 2014 2015 2007-2015 Savings generated by retirement age increase from 55 to 0.10 0.10 0.20 0.20 0.30 0.40 0.50 0.60 0.70 2.90 60 years by 2017, with an increase of 6 months per year beginning in 2007. Savings generated by lengthening the required 0.00 0.10 0.10 0.10 0.20 0.20 0.20 0.20 0.20 1.40 contribution period from the current 20/25 years to 30/35 years for women and men respectively. Savings generated by suspension of increase of pension 0.50 0.50 0.50 0.50 0.50 0.50 0.40 0.40 0.40 4.40 benefits up to subsistence minimum if pensioner continues to work. Savings through replacing minimum pension with means 0.40 0.40 0.40 0.30 0.30 0.30 0.30 0.30 0.30 3.00 tested benefits to any pensioner whose family's per capita income falls below the minimum subsistence level. Savings generated by introduction of minimum pension 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.60 contributions for employees under simplified tax regimes. Total savings 1.10 1.20 1.30 1.20 1.40 1.50 1.50 1.60 1.70 12.30 1/ Estimations using the "base case" macro scenario (see Chapter 6 for detailed assumptions of this macro scenario). 4.32 A rate reduction in contributions (payroll tax) would create large deficits if it is not coupled with the recommended savings measures in the system and parallel key reforms. As stated in Chapter 2, the rate reduction should be accompanied by several reforms geared to broadening the revenue base and improving compliance in order to avoid severe revenue losses, including the unification of function of the insurance funds under the PF (moving towards a single rate in the medium term), the reform in the simplified tax system, and an overall enhancement in coordination between the insurance funds and the STA. In addition, the government should consider a rate reduction after (or in parallel to) the introduction of the second pillar of the pension system (that is, when a stronger link between contributions and benefits is present). Figure 4.2 shows projections of the pension system balance under 81 two different scenarios. In one scenario, the recommended measures are not implemented and a 5 percent rate reduction is applied spread out over 5 years (1 percent each year from 2009 to 2013).129 This projection shows the larger deficits in the figure below. In the second scenario, the recommended measures are implemented and even a larger rate reduction (10 percent) is applied, also spread out over 5 years (2 percent each year from 2009 to 2013).130 In longer-term projections, this scenario shows surpluses in the system after 2015 even with that significant cut in the contribution rate. While these are two scenarios of many possible ones, they highlight the sensitivity of the pension balance to both the savings measures recommended and the rate reduction. Figure 4.2: Pension System Balance Estimations, 2006-15 (with and without recommended measures) 0.5 Pension System Balance 0 with recommended savings measures. Core Assummptions: Introduction of the second pillar in 2008; -0.5 Rate reduction of 2% annually from 2009 to 2013 PDGfo (total reduction 10%) -1 %sA Pension System Balance -1.5 without recommended savings measures. Core Assummptions: Introduction of the second pillar in 2008; Rate reduction of 1% -2 annually from 2009 to 2013 (total reduction 5%) -2.5 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Based on a projection of the Ukrainian Pension Model- developed in collaboration by the Government of Ukraine, the National Academy of Sciences of Ukraine, and the World Bank. E. CONCLUSION 4.33 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-run fiscal sustainability to the system. Consequently, additional savings, as recommended in this report, are urgently needed. The savings achieved through the recommended measures outgrow revenues passed on the funded second pillar, which allows a fiscally smoother transition. The savings also allow more fiscal space for a rate reduction in payroll taxes, which is a critical policy reform for Ukraine. Moreover, while the projections show that the system would be back in balance after 2015 (or as early as 2011 without rate reductions) policymakers need to think about the longer run (i.e. beyond 2015). The rising dependency ratio-- product of an aging population, low retirement age and numerous early retirement provisions-- poses a serious risk to the long-term sustainability of the system. The measures recommended here are geared to mitigate those risks. 4.34 Finally, the recommended reforms are geared to protect the poorer pensioners and are in line with international practices. Because targeting is involved in the measures suggested, the changes will protect poorer pensioners. The reforms presented are critical to a viable system for present and future retirees. Moreover, they follow the same path of reform implemented by countries with the same types of problems that have moved into EU (e.g., EU-8 countries), and other EU and OECD countries. 129 In addition to these assumptions, the assumptions of the "conservative" macroeconomic scenario are embedded in these projections. See Chapter 6 for the full set of assumptions and discussion of the scenarios depicted in this report. 130 In addition to these assumptions, the assumptions of the "base case" macroeconomic scenario are embedded in these projections. See Chapter 6 for the full set of assumptions and discussion of the scenarios depicted in this report. 82 5. STRENGTHENING CAPITAL BUDGETING IN UKRAINE A. INTRODUCTION 5.1 A strategy for finding fiscal space for public investments is incomplete without improving the capital budgeting process. Public investment is an important potential contributor to economic growth and to the achievement of Ukraine's development objectives. But 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 the expressed priorities (EU Action Plan). Significant efficiency gains (and best use of the fiscal space created) could be achieved by enhancing the processes of the planning, formulation, allocation, and supervision (including O&M) of capital expenditures. 5.2 In Ukraine, several components of the formal capital budgeting process are well structured and have some elements of good practice. For example, the line ministries and their programs are the unit of analysis for capital spending and select projects within their annual budget ceiling. Nevertheless, capital budgeting in Ukraine has also several weaknesses and is not well integrated into the overall budget process. This weakness is further compounded in investment programs funded by international donors, which are not fully integrated into the budget and implemented under a plethora of parallel systems of accounting, procurement and monitoring 5.3 The evaluation and screening of projects prior to selection is weak, the database of current assets or approved projects is inadequate, and the monitoring of project implementation is weak. This is partly due to a lack of coordination in functions between the Ministry of Economy (MoE) and the Ministry of Finance (MoF). In project planning, the major shortcomings are as follows: the absence of multi-year ceilings for both capital and recurrent spending; the absence of a central assets registry (including asset conditions) for planning maintenance and replacement spending; and the absence of strategic plans for line ministries. Capital project completion has also been a persistent problem and stems from the budgeting process, which favors the funding of new projects over ongoing projects. In addition, maintenance spending does not appear to be keeping pace with asset acquisition and maintenance requirements. There are also problems in the handling of capital budgeting at the sectoral ministries. The analytical capacity for project evaluation, internal controls, and project oversight in most ministries is poor. 5.4 Some key recommendations going forward include the following: (i) multi-year ceilings for total spending, line ministry spending (including capital and recurrent spending), and multi-year sector strategies/planning for all line ministries should be introduced; (ii) a database of current assets and their condition should be established for each line ministry; (iii) the MoF and MoE should more closely monitor capital project implementation during the year with line ministries, to assure that progress is being made and to identify and resolve any bottlenecks; (iv) the MoF and MoE should form a working group to review all aspects of capital budgeting from identification through completion and prepare a report on changes and improvements to the process; (v) the MoF should review current budget execution procedures for capital projects to review their adequacy and ensure that they are not contributing to the under-execution of capital spending; (vi) annual audits of internal control and internal audit processes in line ministries of capital project management should be conducted until performance improves; and (vii) donor assistance should be progressively integrated into government PFM systems requiring these 83 systems to be upgraded to conform with internationally accepted fiduciary standards while at the same time forcing donors to coordinate their assistance more effectively among each other and streamline their support with government priorities. 5.5 After reviewing the size of and trends in capital spending in Ukraine, this chapter considers some of the key elements of a robust capital asset management system and then uses this framework to provide an understanding of the current system in Ukraine. However, these issues are preceded by a discussion of the definitions that are required for a better understanding of the chapter. B. DEFINING CAPITAL 5.6 Governments around the world may define "capital" in different ways. Capital spending is generally about physical assets with a useful life of more than one year. But it also includes capital improvements or the rehabilitation of physical assets that enhance or extend the useful life of the asset (as distinct from repair or maintenance, which assures that the asset is functional for its planned life). Capital spending is sometimes equated with investment or development spending, where expenditures have benefits extending years into the future. Under this definition, governments may include physical assets for government use (for example, office buildings), physical assets of a public good nature that also enhance private sector development (for example, roads, water systems), and intangibles (for example, education, research). It can be quite difficult to distinguish between investment and non-investment expenditures, and if investment spending receives favored treatment in the annual budgeting process, nearly all spending, whether recurrent or not, will end up being classified as investment. Every government establishes some arbitrary cut-off point to distinguish capital from current expenditures. For budgeting purposes, the relevant distinction is between capital and current (or operating) expenditures. Current expenditures are purchases of assets to be consumed within one year, regardless of expenditure size. Small expenditures (for example, less than US$25,000) are current, regardless of useful life. 5.7 Ukraine's current Budget Law does not define capital in terms of monetary value. The 1996 Budget Law did require the budget to be divided between operating and development expenses, and development expenses were in turn said to include: (i) financing of production and non-production capital investments; (ii) financing of restructuring in the national economy; and (iii) subventions and other spending in conjunction with expanded production. The 2001 Budget Code eliminates this distinction, but does require the use of economic classification, including separately identifying capital expenditures, and does specify that local government capital budgets are for (i) repayment of the principal of debts (Crimea), (ii) capital investment, and (iii) autonomies' power authorities (Crimea).131 5.8 Ukraine uses the IMF 1996 Government Finance Statistics as the basis for its budget classification system. The 1996 GFS defines capital expenditure as follows: "Capital expenditure. Expenditure for acquisition of land, intangible assets, government stocks, and nonmilitary, nonfinancial assets, of more than a minimum value and to be used for more than one year in the process of production; also for capital grants. Capital expenditure is frequently separated (in some cases along with certain revenue) into a separate section or capital account of the budget or into an entirely separate budget for capital expenditure. That is, the capital budget. This separation may sometimes follow different criteria, however." While allowing intangible assets and government stocks, it does not standardize "minimal value," allowing countries to specify a value. 131The Budget Code of Ukraine. 2001, Art. 71. 84 5.9 In 2002, Ukraine changed its capital budgeting definitions to a "development" budget. According to MoF staff, this has resulted in a mixing of recurrent and capital spending in the development budget. Regardless of this, budget data prior to 2002 have not been re-estimated using post-2002 criteria, which resulted in data comparability problems. Box 5.1 presents the current Treasury Chart of Accounts definitions for capital. Box 5.1: Treasury Budget Classification Capital Expenditures (Code 2000): design, estimation, reconstruction, restoration, innovation and repair of buildings Basic Capital Acquisition (code 2100): capital goods with useful life over one year, and with a value over 1000 kopecks (UAH 10 or roughly $US 2). Includes housing, furniture, equipment, automobiles and other transportation. Code 2110 ­ equipment, for production and non-production, including transportation, computers, library books, cafeteria furniture, theatrical equipment, breeder cattle, plants for orchards or decorative use, non-military weapons Code 2120 - capital construction acquisition Code 2121 - building or acquisition of new facilities Code 2122 - building/acquisition of administrative objects Code 2123 ­ other Codes 2121-2123 includes equipment or material for construction Code 2130 ­ improvement repair. Classification entirely subject to discretion of manager and budget fund recipients. Includes subsystems such as sanitation, fire protection, etc. Code 2131 - expenditures for habitable housing Code 2132 ­ Administrative facility Code 2133 ­ other Code 2140 reconstruction and restoration. Excludes expenditures for state-owned enterprises, which are to be under capital transfers (code 2410) Code 2141 housing reconstruction Code 2141 administrative reconstruction Code 2143 other reconstruction Code 2144 Cultural, historical reconstruction Code 2200 - creation of government reserves Code 2300 - acquisition of land and intangible assets, includes patents, royalty payments, computer software licenses, other rights of use. Code 2400 - capital transfers. Grants and transfers, without obligation. Code 2410 capital transfers to enterprises, including higher education and scientific establishments Code 2420 - subnational transfers Code 2430 ­ transfers to public Code 2440 ­ capital transfers abroad Code 2450 ­ transfers to special funds Source: Treasury Chart of Accounts, September 30, 2005, No. 181, Kiev. 5.10 The important elements involved here are to have clear criteria and to use them consistently, and to ensure that the threshold value captures the type of capital spending that government and ministry management want to monitor. For Ukraine, the low threshold value means that "capital" spending is misleading and captures many small items, from office supplies and office furniture to roads and schools. Ukraine should re-examine its capital definition and consider revising it, or at least regularly differentiating between physical capital (and within physical capital, between spending above UAH 50,000 and below) and capital transfers. 85 C. CAPITAL EXPENDITURE TRENDS IN UKRAINE 5.11 In the mid to late 1990s, public investment in Ukraine was significantly reduced as part of the fiscal stabilization and transition to a market economy. A 1997 World Bank Public Investment Review (PIR)132 reported: "Public investment in Ukraine is low and has fallen dramatically in recent years. ..., falling from 4.6 percent (KBV55 trillion) of official GDP in 1994 to 1.3 percent (KBV1 06 trillion) in 1996."133 Both central and local government public investment declined in the mid-1990s. Of this, central government capital investment declined from 3.3 percent of GDP in 1994 to 0.9 percent in 1996, and local government capital spending declined from 1.3 percent of GDP to 0.4 percent over the same period. The 1997 PIR concluded that capital spending had borne a disproportionate reduction compared to recurrent expenditures, though noting that much of the capital spending was not consistent with a market economy. From 1997 through 2000, capital spending fell even further, from 0.6 percent of GDP in 1997 to 0.4 percent in 2000. A 2002 World Bank Public Expenditure Review noted that: "with less than 1 percent of GDP spent by the government on capital investment and maintenance, it would appear that Ukraine threatens its future growth potential by depleting its existing capital stock."134 5.12 Capital expenditures recovered between 2001 and 2004. Total capital spending rose from 3.1 percent of GDP in 2001 to 6 percent in 2004, and settled at 4.3 percent for 2005 (see Figure 5.1a). Most of the increase in total capital spending between 2002 and 2004 was devoted to spending on the economic functions of government. Smaller increases were given to health, utilities, the environment, culture, defense, and general public services. Capital spending declined for education, justice, and social protection. 5.13 However, within the post-2002 increases in total capital spending, most were in subsidies to enterprises, rather than fixed capital investment. Transfers to enterprises had an almost fourfold rise between 2001 and 2005, from 0.66 percent of GDP to 2.22 percent. For 2004 and 2005, transfers to enterprises comprised more than half of total capital spending (see Figure 5.1b) and only around one-third of these transfers went to actual fixed investments (mainly the transfer sent to the State Roads Agency). Figure 5.1 a-b: Capital Expenditure in Ukraine and its Composition, 2001-05 Composition of capital expenditures in Ukraine, as percent of GDP 6 Other capital transfers 7 6.0 5 6 PDGfo Capital 5 4.3 4.4 transfers to 4 enterprises (agencies, 4 organizations) 3.1 3.1 3 Purchase of % 3 stocks and state reserves 2 2 1 Infrastructure 1 and equipment 0 2001 2002 2003 2004 2005 0 2002 2003 2004 2005 Sources: Ministry of Finance; State Treasury of Ukraine; Bank staff calculations. 132"Ukraine Public Investment Review," May 30, 1997. The World Bank. Report No. 16399-UA, p. 3. 133 The definition of capital in use at that time under-estimated public capital investment by including asset rehabilitation expenses with maintenance (recurrent) expenses. However, at that time, investment included construction as well as expenditures on materials, equipment, social investments, and one-time expenditures on institution-building activities, which over-estimated capital spending. 134Ukraine Review of the Budget Process: A Public Expenditure and Institutional Review." The World Bank, March 8, 2002. Report No. 23356-UA. 86 5.14 Capital expenditures and fixed investments (within that category) fell in 2005. Despite the need to avoid further deterioration in the country's public infrastructure, and the pressing need for new infrastructure in energy and basic services, investments fell significantly in 2005. Ukraine spends comparatively less on capital investment than other countries in the region (see Table 5.1). Table 5.1: Public Capital Investments, Ukraine and Selected Countries Public Capital Investments (fixed) as percent of GDP, 2004 Kazakhstan 5.90 Hungary 5.50 Greece (1) 3.89 Poland 3.56 Romania (1) 3.50 Spain (1) 3.50 Armenia 3.40 Ukraine 2.76 Lithuania 1.8 (1) Data for 2003. Sources: IMF Government Finance Statistics; OECD; Ministry of Finance-Ukraine. D. ISSUES IN CAPITAL BUDGETING IN UKARINE Project Planning 5.15 The general process places emphasis on spending units as the primary point of integration for capital and recurrent spending, consistent with international good practice.135 Spending units also bear the primary responsibility for managing projects, assuring the completion and quality of workmanship, and subsequent maintenance and operation. 5.16 For the overall budget process, there are some known elements missing that the government is actively seeking to correct. For example, even though the budget guidelines are developed early in the process and approved by the Council of Ministers and the Rada, these are primarily economic projections and broad allocations between capital and recurrent spending for the budget year. They are not an overall fiscal policy position, with sector ceilings, over a multi-year horizon. As such, they tend to miss some of the strategic dimensions that the process could provide to public finances. 5.17 Multi-year sector ceilings, covering capital and recurrent spending, are absent in Ukraine's budgeting framework. International experience shows that multi-year spending ceilings are critical for providing a longer-term horizon for ministries and spending units to plan for capital and recurrent expenditures, which allows better planning and more productive spending. The picture is even worse for maintenance and operating costs, which lack any medium-term planning. Such planning is essential to enable the government to evaluate the affordability of new and existing capital assets. 5.18 Similarly, there are no multi-year sector strategies developed within the expenditure ceilings which might provide more strategic direction to sectoral investments. Sector strategies need to evaluate the different modes for delivering services and achieving sector objectives, each entailing a 135The Ministry of Finance has the overall responsibility for budget development, but, within the annual budget process, public investment project guidelines and approval are formally the responsibility of the Ministry of Economy. The general outline of the annual budget process is presented in Annex 5.1. 87 different mix of capital and labor. The mode of service delivery chosen will affect the capital investments needed. 5.19 The government is working on plans to require strategic planning for spending units. While valuable, these plans need to become an integral part of the budget process so as to inform spending decisions. Moreover, they need to be developed within the multi-year expenditure envelope provided by the overall fiscal policy. One of the most common shortcomings of strategic planning is undertaking it without any spending limits or realistic spending envelopes, making the plans unachievable or very abstract documents that cannot be used to guide management or finance decisions. 5.20 The MoE was built on the old State Planning Commission. It has frequently been reorganized, with each minister having his/her own vision of how it should be structured. The frequent reorganization has certainly played a part in inhibiting the development of the capital budget responsibilities that still remain with central organizations. 5.21 The Cabinet-approved "state targeted programs" arrangement contains too many programs and does not fit well with the program budget structure. An April 2004 law on state targeted programs established the new targeted programs framework. The MoE recently created a Targeted Programs Department to support the Cabinet of Ministers' task of approving a list of targeted programs. There are currently 246 such programs, and many were adopted prior to the introduction of program budgeting and may not fit strategically within the sector or programs today. The MoE was attempting to reduce the list this year by 30 programs, with an ultimate goal of no more than 30 highly important programs linked to the government's strategic priorities. Some of the programs that the MoE would like to discontinue are already in process, but the MoE analysis suggests that they are not economical or are no longer relevant and proposes canceling them. There are also projects on the list for which there is no financing, and the MoE proposes removing these from the list as well. Currently, targeted programs constitute less than 50 percent of total capital investment. Non-targeted programs are not directly addressed by the MoE capital investment processes, but would fall broadly under the MoE through the procurement process. 5.22 The MoE does have a database of capital projects covering central and local governments but does not have a complete inventory of capital assets and their condition. The existing database is not of completed projects but of proposed or ongoing projects, grouped by year of planned completion. The database is updated as an annual exercise, to enable the analysis and preparation of the list of approved projects. There are currently some 6,000-plus projects in the database. The specific procedures for preparing the project list change annually, but are viewed as transparent guidelines for spending units. The MoE reports that it is supposed to have a database of existing capital assets but that it does not at present. The MoE is also charged with monitoring the effectiveness and efficiency of capital investments, but it has not been able to undertake this task. Project Evaluation 5.23 Project evaluation prior to selection is weak. The evaluation and screening of projects prior to submission to the MoE and MOF, and prior to final selection, do not follow a comprehensive economic evaluation. Project feasibility assessment and overall project evaluation is performed unevenly within the line ministries. Guidelines for evaluation are established on paper, but they are more "procedural" steps than requirement for comprehensive cost-benefit analysis and evaluation. This situation stems in part from weaknesses in the analytical capabilities in the sectoral ministries. 88 5.24 Lack of precise project evaluation affects the efficiency of investments. Because of the lack of analytical capabilities in the sectoral ministries, projects submitted to the MoF and MoE may not be the most productive investments needed. This situation affects the efficiency of public spending. Moreover, the process of evaluation seems to be divorced from the country' strategic plans (EU Action Plan) and growth expectations. Project evaluation (through cost-benefit analysis) is a critical ingredient for attaining a higher level of productive public investments (Box 5.2 presents a summary of key aspects of a proper cost-benefit analysis for capital expenditures). Box 5.2: Cost Benefit Analysis -A Primer Cost-benefit analysis assesses the costs and benefits of a project and reduces them to a common denominator. If benefits exceed costs--both expressed in terms of present value-then the project is acceptable; if not, the project is rejected. Benefits are defined relative to their effect on the fundamental objectives while costs are defined relative to their opportunity cost, which is the benefit forgone by not using these resources in the best alternative use. By doing so, cost-benefit analysis seeks to ensure that no alternative use of the resources consumed by the project would secure a better result from the perspective of a country's objectives. Thus, if X, defines the benefit from the project in year t, C defines the cost today, r is the discount rate, and n the number of years that the project is expected to deliver benefits, then in very simple terms, a project is selected if: X /( 1 + r ) - C > 0 t t Economic analysis is similar in form to financial analysis in that both assess the profit of an investment. The concept of a financial profit, however, is different from that of a social profit of economic analysis. The former identifies the money profit accruing to the project-operating entity whereas the latter measures the effect of the project on the fundamental economic and social objectives. These different concepts are reflected in the different items considered to be costs and benefits and in their valuation. Thus, a money payment made for wages is by definition a financial cost, but it will be an economic cost only to the extent that the use of labor in this project implies some sacrifice elsewhere in the economy with respect to output and other objectives. Conversely, if the project has an economic cost which does not involve a financial flow--for example, because of environmental costs--this does not constitute a financial cost. Economic costs and benefits are measured by "shadow prices" which may approximate market prices in well functioning market systems. However, imperfect markets-like those characterizing transition economies-typically reflect a divergence between them. The key requirements for social cost-benefit analysis are: (i) specification of the costs and benefits; (ii) valuation of costs and benefits; (iii) choice and formulation of constraints; (iv) treatment of risk and uncertainty; (v) choice of the rate of interest for discounting future costs and benefits; and (vi) choice of a decision rule for accepting or rejecting projects. Source: Lyn Squire and Herman van der Tak, 1975, Economic Analysis of Projects, Baltimore and London--in the World Bank report "Russia: Towards Improving the Efficiency of Public Expenditures" (2001) 5.25 There is also a lack of enforcement over project evaluation. While a control of "procedural" steps is present in the system, the quality control over project evaluation is patchy within the Ministries of Economy and Finance. Moreover, since some projects are presented at the last minute in the budget process (with the support of Rada members), they lose the possibility of any conscientious evaluation. Selection of Projects and Allocations 5.26 As noted above, selection is not heavily based on project evaluation or other specific criteria. A law is being drafted to allocate budget funds to projects that are 75 percent complete, to try to complete them. This is in response to the problem of skewed allocation of resources to new projects instead of the continued financing of ongoing projects. The following list shows how central budget funds were allocated to programs during 2001-03, together with their rate of completion: · 51 percent of central budget funds for centralized capital investments were allocated to finance construction with a completion rate of less than 50 percent · 21 percent of funds were allocated for the projects with a completion rate of 50-80 percent 89 · 28 percent of funds were allocated for the projects with the completion rate of more than 80 percent. 5.27 The situation was slightly better in the case of local budgets. In particular, during 2001-03, the structure of the local budget funds allocated to centralized fixed capital investments was the following: · 33 percent of funds were allocated for the projects with a completion rate of less than 50 percent · 12 percent of funds were allocated for the projects with a completion rate of 50-80 percent · 55 percent of funds were allocated for the projects with a completion rate of more than 80 percent. 5.28 The Rada's interest in capital budgets is high and often results in prioritizing new projects over the completion of ongoing projects. According to MoE staff, the Rada Deputies pay close attention to the list of proposed capital projects and have extensive debates on the issues. Whereas limited funds could be allocated to completing ongoing projects, the extensive debates often result in emphasis being placed on new projects of greater interest to the Deputies. Deputies tend to favor such projects as the extension of natural gas lines to new villages, or schools and health clinics (with a view to having a school or clinic in every settlement, irrespective of economy or efficiency). 5.29 The Rada's priorities do influence allocation. In 2002, 93 percent of the projects proposed by the executive bodies were approved by the Parliament in the budget (though only 80 percent were actually funded by the MoF and MoE). For 2004, 98 percent of the projects proposed by the executive were approved by the Rada, and the Rada further increased the number of projects by 10 percent. (It should be noted that while not formally proposed by the executive, the new projects added by the Rada are subject to negotiation and the ultimate approval of the MoF and the government.) Rada increases were, in order of magnitude, for housing projects (25 percent increase), economic activity (22 percent), the environment (13 percent), and health care (11 percent). E. ISSUES ON PROJECT EXECUTION, CAPITAL ASSET CONDITION, AND MAINTENANCE Project Execution 5.30 The 1997 PIR indicated that Ukraine had problems with project completion. At that time, there were some 60,000 unfinished projects. A sample of 146 projects that received funding in 1996 for "production" and physical infrastructure found that half of the projects had implementation periods over 7 years and one-quarter had implementation periods over 10 years. 5.31 There remain significant problems with project completion. KRU, a centralized internal audit body, reviewed all construction projects financed by public funds for 2001-03, finding a 30 percent increase in uncompleted projects. 5.32 Management and internal controls at the ministries are weak for project oversight, and central agency monitoring does not occur. It appears that payments are being made for the completion of work without any assurance that the work is completed and is of acceptable quality. For individual types of projects, physical implementation rates varied from 100 percent for the construction and renovation of bridges to 7 percent for wastewater treatment facilities (see Table 5.2). The project's physical implementation rates do not match with financial execution. While 100 percent of bridge construction was completed, only 90 percent of funds were expended over this period (possibly cost 90 savings, or, if cash re-allocated, possibly arrears). For wastewater treatment, physical implementation was only 7 percent of the planned levels, but expenditures were at 76 percent of the budgeted levels. Table 5.2: Capital Project Physical Completion and Financial Expenditure, 2001-03 Program Unit of Measure Physical Expenditures Completion (%) (%) Gasification of rural area Km 48 71 Construction of gas pipelines Km 50 74 Housing thous. sq. m 72 75 Schools Places 34 72 Hospitals Places 20 83 Day care hospitals Visits 26 85 Water pipes Km 27 71 Wastewater Treatment plant thous. cubic m per day 7 76 Underground Km 66 98 Reconstruction and construction of administrative buildings thous. sq. m 69 83 Repair and restoration works Units 80 90 Construction and renovation of bridges thous. running meters 100 90 Source: Audit Report, KRU, 2004. 5.33 Regarding execution, procurement price targets are set using project normatives prior to tendering. The normatives are developed by construction industry groups, covering labor and materials. The price target is a maximum price. There is no shortage of bidders for contracts, and the price is always at the maximum, suggesting that prices are in fact too high. The MoF would like a truly competitive bidding process, and they expect to get more value (e.g., for the same annual budget). 5.34 Problems are also reported in financing capital spending. In roads, for example, there are numerous change orders during construction which escalate the project cost. Moreover, there are seasonal construction patterns for roads, with work beginning in the spring. By autumn, roads have been completed, the Roads Agency provides a signature of completion, and there is a large spike in payments. Earmarked revenues for roads, on the other hand, are more evenly distributed throughout the year. For 2006 the problem may have been solved, with 100 percent of the revenues for roads being earmarked for the Roads Agency, up from 70 percent. 5.35 The KRU report identified several sources of poor performance: · In the course of the annual budgetary process the executive does not pay due attention to the completion of the previous capital investments projects at the time of launching new projects. · Planning and analysis in budget preparation are weak, and are based on insufficient data and information on the project completion indicators, problematic projects, and current fixed assets. . · There are costs increases owing to additional expenses incurred to avoid the deterioration of suspended projects, as well as to facilities not meeting client needs and requiring further expenses to correct existing problems. · Insufficient control and oversight has resulted in some unlawful use of funds (5 percent of investments funds in 2003-04), of which less than 1 percent was attributed to scope of work or cost inflation). While the KRU report was conducted before the interim Treasury system was operational in 2004, and a Treasury system might help with some of the mismatch between payments and project 91 implementation rates, the bulk of the responsibility for managing projects and certifying completion rests with budget users. 5.36 Problems with capital implementation are further indicated by the under-execution of capital spending. The MoF data for 2003-05 show significant under-execution of capital acquisition and renovation accounts (see Figure 5.2). Execution improved somewhat from 2003 to 2004, but deteriorated again in 2005 for both capital acquisition and renovation. Figure 5.2: Capital Expenditure: Under-executed Accounts, 2003-05 0.00 t -5.00 -10.00 budge %-15.00 -20.00 -25.00 2003 2004 2005 2003 2004 2005 Capital construction (acquisition) Capital renovation Sources: Ministry of Finance; State Treasury of Ukraine; Bank staff calculations. Capital Asset Condition and Maintenance 5.37 Rather than examining only funding, it is important to examine other aspects of capital spending performance, such as the condition of facilities and the adequacy of maintenance spending. These are important inputs and outputs of the capital budgeting process and they affect both decision- making and the efficiency of capital spending. 5.38 At present Ukraine has no central or sector ministry registry of current assets and their physical condition. The MoE does not have an inventory of existing assets and their condition. Individual sector ministries should have these inventories, but Bank staff were unable to obtain such information from Transport or through Economy. The only data available were from the MoF, and they included only data on the year that the asset entered service and depreciation (see Table 5.3). According to a 2005 ECORYS Transport Sector Review, the most recent data on the condition of the road network were collected in 1997.136 Table 5.3: Residual Book Value as a Share of Initial Book Value of State Owned and Communal Owned Fixed Assets in Selected Sectors in 2003 (in %) Sector State Ownership Municipal Ownership Government services 72.9 49.3 Education 37.8 50.3 Health care and social assistance 50.7 46.1 Source: State Committee on Statistics of Ukraine. 5.39 For three functions--government services, health, and education--the depreciation information suggests a mixed picture: administrative facilities are relatively new, while education and health facilities are older. 136"Transport Sector Review Ukraine," ECORYS. 2005. 92 · Administrative facilities at the central government level seem relatively new, with a high current book value, while municipal administrative facilities are older and may be in need of additional financing in the near future. · For education facilities, little residual book value remains, suggesting older facilities that may need more significant investment in repairs and replacement. Centrally owned education facilities have a lower residual value than municipal education facilities, which suggests that the local governments have invested more recently in facilities, and the central government may require future investments in this area. · Health facilities are at 50 percent of the residual book value, suggesting that they are roughly half-way through their useful life, and some investment may be required in the medium term. 5.40 As depreciation and years of service are relatively crude measures, telling more about a facility's age than its current condition, they are not a satisfactory way to estimate maintenance costs or the need for various types of capital investment. The absence of better data in this area raises serious questions: namely, whether more investment in a sector is justified, or whether the investment would be properly maintained and would serve its full useful life. 5.41 Maintenance spending does not appear to be keeping pace with asset acquisition and maintenance. Given the increases in fixed capital spending in recent years, as well as the fact that some facilities (health, education) are at a half-way point in their useful life, annual total maintenance spending should be increasing to accommodate new facilities and the repair of existing assets. However, total maintenance spending has been decreasing as a percent of GDP, from 0.33 percent in 2003 to 0.28 percent in 2005. 5.42 Actual 2004 spending on maintenance was below the budgeted levels, with a budget execution rate of 87.6 percent for central government. Local budgets showed better execution rates at 97.8 percent of budgeted amounts. It is not clear whether the under-spending was due to: (i) the weather or related conditions outside of agency control; (ii) the reallocation of maintenance funds for other purposes (by the spending ministries, MoF, Treasury); or (iii) the poor planning and management of maintenance projects. 5.43 Estimates of maintenance costs by key spending units are based on technical norms and standards, some of which are developed by industry. Maintenance norms for the repair of buildings are a part of state construction norms, which are developed by the State Committee on Construction and Architecture.137 The State Committee on Housing and Community Services establishes maintenance norms for an adequate frequency of city road repairs. At least for transport, these norms have heavy industry involvement and may be too high. F. SOUND CAPITAL BUDGETING AND ASSET MANAGEMENT: A FRAMEWORK TO IMPROVE THESE PROCESSES 5.44 As noted in the introduction, good capital budgeting should be an integral component of a sound overall budgeting system. While some important elements of the process are specific to capital spending, a robust public finance system and budget process are as important to sound capital management as the capital budgeting elements themselves (see Box 5.3). 137Order of the State Committee for Construction, Architecture and Housing Policy, "On approval of rules for determining the cost of construction" (DBN D.1.1-1-2000). 93 Box 5.3: Sound Overall Public Financial Management (PFM) Process A country's budgetary process has three main objectives: (i) aggregate fiscal discipline - allowing budgets to be set consistent with a realistic macroeconomic framework and a sustainable fiscal program, and brought in on target; (ii) allocative efficiency - requiring that resource allocations reflect the policies and priorities of the government's program; and (iii) technical efficiency - requiring that resources are utilized efficiently and effectively towards the purpose for which they have been allocated. (Annex 5.3 sets out the features of effective PFM systems relative to these objectives) Additionally, five general principles of public finance have emerged over the years to guide developments in public expenditure systems.138 These following principles are important preconditions for an effective PFM system: (i) Comprehensiveness: all revenue and expenditure, and all government agencies, are included in the budget, and all government agencies are integrated into the public expenditure management system; (ii) Accuracy: actual transactions and flows are recorded; (iii) Regularity: the budget covers a defined period of time (for example, one year); (iv)Authoritativeness: spending is carried out only as authorized by law. (v) Transparency: information on spending is publicly available, on a timely basis, in an understandable or common format. If elements of these principles are missing, the PFM system cannot serve as an effective tool for establishing and managing policies, holding agencies accountable for results, and, more generally, managing the public sector. 5.45 Additionally, a sound overall public financial management system supports each element of the system, including capital spending. Good multi-year planning supports overall fiscal balance, with more stable spending patterns for ministries and programs and for their capital planning and execution. Good budget execution and procurement enable the timely, within-budget completion of projects (assuming good program and project management). Financial Management Information Systems support the financial and program management needs of the Cabinet of Ministers, Ministries of Finance and Economy, spending ministries and program managers (all budget users). 5.46 As Ukraine moves to deepen its program budgeting process, it can be conceptually useful to think of the program operations as a production function. That is, some mix of inputs is used to produce a good or service (intermediate or final) or achieve an objective. Inputs include total funding, staffing levels, equipment, and capital. Within total spending ceilings, ministries must decide what mix of programs best meets government objectives within their portfolio. And within programs, some decision must be taken on the best mix of inputs to meet program objectives. Capital planning and spending needs should be undertaken within this context. Capital spending is not an end in itself, but contributes towards a defined objective. Capital Budgeting Process 5.47 Within the overall budgeting process, robust capital budgeting elements need not be overly technical or sophisticated. To help orient the reader, Figure 5.3 presents nine key steps in a capital budgeting cycle, covering four phases. These distinct phases are: planning, budgeting, and implementation, and audit. The latter one is not commonly included in capital budgeting discussions but it is an important step in assuring process and information integrity. 138 Schick, Allen. 1999. A Contemporary Approach to Public Expenditure Management. World Bank Institute,1999. 94 Figure 5.3: Capital Budgeting Cyclet6yt 1. Assess 2. Project Asset identification Condition, (new or Update Asset replacement) Inventory (Planning) 9. Audit 3. Project Evaluation (Planning) 8. Monitoring 4. Project (Implementa- Ranking tion) (Planning) 7. 5. Financing Procurement Identification (Implemen- (Budgeting) tation) 6. Budget for Projects (Budgeting) 5.48 The planning phase is often considered the most important phase because of the long-lived nature of the assets. Whether it is undertaking government-wide strategic capital planning, ministry planning, or program planning, the planning exercise needs to be kept within the overall expenditure ceilings or envelopes to help ensure more realism in the planning process, and in a multi-year framework, to take into account the inter-temporal nature of decisions. Capital planning is not divorced from strategic planning. Where strategic planning sets the goals and objectives for government, ministries, and programs, then capital planning fits in as part of the consideration of the mix of capital and recurrent spending that best meets those needs within the available resources. The planning phase should provide the type of investments and the size/number of investments (if not the specific investments) needed. The process should be guided with proper project identification and economic evaluation (typically using cost- benefit analysis). 5.49 The budgeting phase entails selecting specific projects to include in the budget and may entail trade-offs between specific investments, given the available resources and the government's relative priorities. It includes identifying specific financing sources. 5.50 Implementation is self-explanatory and entails government monitoring and oversight of the work for quality, timelines, etc. The bulk of this work is in programs or ministries. Procurement is a critical step in the process, and care must be taken to ensure that costs do not rapidly escalate after contract signing, and that unit costs are within competitive ranges. 5.51 Regarding the audit phase, the ex post audit of financial and physical records helps to ensure that weaknesses in the process are identified and can be corrected. Table 5.4 provides more details on each step of the process shown in Figure 5.3. Table 5.4: Robust Capital Budget Process Details Phase Step Product Feature Responsible Agent Planning 1. Update Asset Inventory (including Condition assessment and Inventory Database centrally Inventory, Assess information on date facility maintenance cost history should maintained by Central Agent Asset Condition entered service, annual enable better estimation of (e.g., MoF Capital Budget maintenance and repair maintenance budget Office, Ministry of Economy costs, current condition, Capital Office, or Planning 95 Phase Step Product Feature Responsible Agent etc.) Ministry) Asset Condition Assessment performed by sector ministry specialists, contracted to third- party 2. Project Preliminary list of possible Identify need for rehabilitation Sector ministries identify Identification projects with cost or replacement of existing projects, cost estimates estimates facilities, as well as new Central agent prepares facilities guidelines, forms for use by Should be tied to sector strategy, sector ministries service objectives Valuable to prepare list within overall multi-year sector/ministry resource ceiling (capital and recurrent) 3. Project More detailed costing of More detailed project evaluation Sector ministry, using expert Evaluation projects should be done only for the top panels or contracting with For revenue producing priority projects of ministry and consulting engineers projects, estimates of government, projects likely to be Central agent prepares standard revenues funded guidelines, forms for use by Identification of possible Cost-benefit and rate of return sector ministries financing sources analysis can be undertaken, but MoF Budget Department needs this can be very expensive and to be involved in revenue time consuming, and may not estimates, evaluating the add value for many projects quality of the cost estimates 4. Project Ranking CIP/PIP Multi-year list of Approved Central Agent maintains Projects, ranked in priority approved project database, Should be started afresh (zero- prepares plan based) annually. No assumption Ranking can be done using that a project approved but formal project ranking sheets, unfunded last year is used by an inter-ministry automatically included in review panel Including citizens subsequent plans or budgets in panel adds credibility A public hearing can also adds credibility before final plan adoption Some governments submit CIP/PIP to legislature for review and approval before finalizing plan Budgeting 5. Financing Specific financing Options include general MoF Budget Department arrangements for proposals revenues, debt, user fees, Capital Budget Office to be included in the concessions, public-private budget partnerships (which have to be properly evaluated to avoid future liabilities for the state). Must reconcile with debt limits decided in debt strategy 6. Budget Include expenditures for In addition to displaying the MoF Budget Department projects in the budget, in expenditures with the Capital Budget Office sector/ministry appropriate ministry and program, the budget might include an annex of those CIP/PIP proposals included in the budget for information Implementation 7.Procurement Procurement plans should Responsible Ministry already have been developed for MoE Procurement Office may the projects to be included in the provide technical support, and budget, including a schedule of certainly would set standards, cash requirements for budget provide general guidance execution Procurement should follow good practices as defined in Procurement Law 8. Monitoring Regular monitoring of Financial progress can be Responsible Ministry physical and financial monitored through Treasury Central Agent progress in completion payments Treasury could require Physical progress should be tied assessment of physical progress 96 Phase Step Product Feature Responsible Agent to a database of on-going before making payment, and projects forward to capital database Audit 9. Audit Ex post assessment of Ministry internal audit bodies, Budget User internal audit financial records and required under the budget code, offices physical completion should monitor accuracy of KRU financial records and efficiency Accounting Chamber of operations KRU and the Accounting Chamber should periodically check on the effectiveness of internal audit and internal control processes 5.52 Capital budgeting processes can be extremely time-consuming and expensive if they are not properly designed. There is frequently a tendency to require elaborate studies and cost-benefit analyses for all proposed projects, regardless of importance, feasibility, likelihood of being adopted, etc. A better system would seek to use strategic planning and priority-setting to help screen ideas before the need for more detailed analysis. Much of the planning and budgeting process is a filtering process to arrive at an optimal set of investments with respect to the government objectives and available resources. 5.53 A foundation of a robust capital budgeting process is a good inventory of existing capital assets. Basic information needs to be readily available and up to date. The inventory should identify each asset, the ministry owning it, the program it supports, the date it entered service and its original construction cost, its annual maintenance and repair expense history, its current condition, its current replacement cost, and similar data. Current asset condition requires a simple but consistent framework for summarizing condition, and should be updated annually. 5.54 Asset condition assessment is likely to be the most labor-intensive task in the capital budget process, but is essential in order to know whether the asset is in need of replacement. The condition can be assessed by the owning agency/ministry, by a central agent (a central agent charged with the overall responsibility for capital budgeting or the budget generally, such as the Ministry of Economy's Capital Office, or the Ministry of Finance's Capital Budget Office), or through a contracted to a private firm or university. Roles and Responsibilities 5.55 The roles and responsibilities of the various actors in the budget process in Ukraine are clearly defined, but in practice some functions are not well coordinated between the MoF and the MoE. Generally, the MoF has overall responsibility for budget preparation, including setting guidelines for the process,139 reviewing all spending proposals for conformity with policy and other guidelines, deciding what to include in the budget,140 and also defining what constitutes capital, recurrent, and other economic classification categories.141 The MoE is responsible for providing guidance to spending units on capital project preparation, collecting proposed projects, maintaining a database of current capital assets and new and ongoing proposals, preparing the list of priority investment projects for the Council of Ministers, and monitoring project implementation. The MoF, as noted above, is responsible for defining annual spending limits including capital and recurrent spending divisions within ministries, defining capital spending, and deciding which individual projects to include in the budget. During budget execution, the MoF manages cash (via the Treasury), including cash allocations for ministries. 139Article 35 (1), Ukraine 2001 Budget Code. 140Article 36 (1), Ukraine 2001 Budget Code. 141Article 10 (1), Ukraine 2001 Budget Code. 97 5.56 Individual spending units are responsible for developing project proposals and managing capital projects. Generally, projects above UAH 15 million require the approval of the MoE and the Council of Ministers, and all projects require MoF approval for inclusion in the annual budget. The authority to approve capital spending is also clearly delineated. Larger projects require Cabinet of Ministers or Parliamentary approval, while smaller projects can be approved by spending units directly. Annex 5.2 presents the formal approval structure for capital projects. G. DONOR FINANCED PROJECTS AND INVESTMENTS 5.57 Donor funding is a potentially important source of financing for Ukraine, both for investment and for technical assistance to lay the institutional foundations of a well-functioning market economy. Donor funding (through grants and loans) excluding non-guaranteed lending by bilateral and multilateral financial institutions to private entities amounts on average to USD 1.5 billion annually. Approximately USD 1 billion are in loans for investments and budget support, and USD 500 million in technical assistance and grants. Around two thirds of current lending is for capital investment, the key focus of this section. In the following years these amounts are likely to increase 142, particularly through funding from the European Commission (EC), which may become a major donor in investments funding. 5.58 While overall the effect of external development assistance has been positive in Ukraine, the cost of preparing and implementing projects is high and delays are widespread. There is scope for significant efficiency improvements that would help achieve development objectives of projects better or faster, and reduce financial costs. There is also scope for exploiting more efficiently the synergies of the different forms of assistance provided by donors, and for greater emphasis on improving outcomes and results of external development assistance. Issues in Donor Financed Investments and Projects 5.59 Most investment projects are executed by recipient entities but under parallel structures not well integrated into regular government agencies. Investments funded through loans and grants are typically managed and executed through Project Implementation Units (PIUs). Moreover, in some cases donors also make direct payments to contractors (based on requests by the project executing agency and the loan agreements).143 PIUs are stand-alone units created within the recipient agencies to execute the projects. They are established with the objective of servicing the fiduciary requirements of donors (in areas such as financial management and procurement). However, research on development effectiveness increasingly argues against the use of parallel structures established outside of the regular, mainstream, organizational units in ministries and recipient agencies. Specifically, the emerging lessons of experience indicate that such structures do not necessarily facilitate execution, fail to build capacity in government 142 See Annex 5. 4 for details on most donors development assistance in Ukraine. Sources of external development assistance include international financial institutions (e.g., European Bank for Reconstruction and Development-EBRD, World Bank), other multilateral institutions (e.g., European Union-EU, United Nations-UN), and bilateral sources (e.g., Canada, Germany, Japan, Sweden, UK, USA). Forms of assistance include: (a) loans for investment projects and other specific activities; (b) budget support funding; and (c) technical assistance--generally own managed by the donors (d) in-kind assistance (such as equipment, training, scholarships). Development assistance is provided for a wide range of activities and sectors. For simplicity all international multilateral institutions and bilateral agencies are collectively referred to as "donors" in this report. 143 Technical assistance grants are usually donor executed and in many cases may be provided to non-government recipients. The recommendations of this section apply primarily to investment funding, although some have more general validity. 98 agencies that would over time improve capital budgeting and execution processes as a whole, and can undermine government ownership. 144 5.60 Only a portion of development assistance operates within the country's public financial management (PFM) system. Cash funding to the government and public sector entities is typically included in the annual budget and reported in budget execution reports.145 But the execution of these activities, other than budget support loans, typically follow special procedures that are different from the country's regular PFM system (e.g., treasury, payments, procurement, financial reporting, and auditing) In addition to potentially weakening internal control, ring fenced financial arrangements have contributed to implementation delays (see Box 5.3). Technical assistance and in-kind assistance to public entities are not reflected in the budget and budget execution reports, and operate fully outside the country's PFM system. Box 5.4: Issues with Special Arrangements for Financial Management in Donor-financed Investment Projects in Ukraine "Ring-fenced" or special arrangements outside of the country's public financial management (PFM) system have been instituted in many donor-financed investment projects implemented by recipient entities. These include aspects such as banking arrangements, payment procedures, procurement procedures, accounting and financial reporting, and auditing arrangements. Improvements in the country's PFM system over the past few years, the most notable one being the installation of a comprehensive treasury payment and accounting system (which now covers the entire Government), provide a platform for increased use of the country's PFM system. Yet, each project still has two different systems operating concurrently, based on the source of financing (i.e., there are separate systems for the government-financed and donor-financed portions of project expenditures). The dual system operates through all stages of the project financial management cycle ­ budgeting, payment authorization, funds flow and payments, accounting, reporting and auditing. This system is further complicated by various special procedures (e.g., tendering processes for Special Accounts, special authorizations by the Ministry of Finance for each payment, co-signature of the Ministry of Finance on each check) that have added complexities and delayed project implementation. An ad hoc reporting system with monthly reporting by project entities to the Ministry of Finance on project expenditures is used to obtain information for budget execution reporting. In several instances, the start-up of key project components is delayed due to the non-establishment of the special financial management systems. In some cases, these special arrangements diminish the internal control environment since regular checks and balances are substituted by ad hoc special controls. 5.61 Information on external development assistance flows is sketchy and incomplete. Consolidated information on total flows from external development assistance (commitments, inflows and expenditures) is not available. There is no single database that systematically captures and reports flows on all external development assistance.146 As noted above, significant parts of external development assistance operates outside the country's public financial management system, contributing to information problems. Information flows from donors on planned and actual flows are also weak. 144 For the latter, the possible exception might be self-contained PIUs. That is, when the creation of a new implementing agency is due to a new activity not previously present in the country. In such case, greater institutionalization is expected at later stages (e.g., staff will continue to stay after project completion). 145 That is, grants are included in revenues; loans are reflected under financing; expenditures from these sources (including related financing from the government's own sources) are reflected as expenditure line items for the sector concerned; and financing for specific activities/projects (e.g., investment projects) and expenditures from such financing are reflected in the Special Fund. 146 The Directorate for Coordination of International Technical Assistance (DCITA) of the Ministry of Economy maintains a database of technical assistance provided through grants. However, this does not cover all external development assistance, and is mainly restricted to donor commitments, and not inflows and utilization. It also includes only those projects/activities that are "registered" with the DITCA, a process that is not always systematically followed for all projects. 99 5.62 The procedures of project approval in Ukraine are complicated and time consuming (see Box 5.4). This not only substantially increases project preparation time, but makes it extremely difficult for the MoE and the MoF, and the implementing agencies to effectively plan budget expenditures under donor supported projects. Box 5.5: An Unusually Complicated Pipeline of Project Processing and Approval in Ukraine The project cycle, as currently designed, establishes a series of complex and repetitive reviews of project documentation for projects financed by international financial institutions (they are specified in Decree 1317 of 2001 amended in 2003). Any loan documentation is subject to successive, duplicative, and often lengthy reviews by: (i) The Cabinet of Ministers: at the initiation stage, before, and after negotiations (ii) The President's office: before negotiations, when authorization to negotiate is issued, before signing when authorization to sign legal agreement is issued and after donor approval, and before submission to the Parliament. (iii) The Ministry of Foreign Affairs: according to the law "On international treaties", this Ministry has been given up to 6 months to review the signed legal documents for individual donor projects prior to their submission to the President's office, instead of mandating this review only for agreements affecting Ukraine's membership status with the Bank and other IFIs). (iv) Various ministries, including the ones that are not involved in project preparation and implementation, are required to give their "no objection" (visa) to documents reviewed. As a result, any ministry can delay or even veto further processing of the project. 5.63 Donor financed projects and investments are not well integrated into the capital budgeting process. Most donor financed projects are prepared and approved outside the budget process. Moreover, owing to some of the complexities above-described they are not included in the government's pipeline of capital budgeting. This situation may be reducing significantly the efficiency of these funds through under-execution, poor targeting of government priorities, overlapping of projects, and weak government ownership. Thus, execution delays are often even more acute in donor funded investments than in government capital spending (see Section 5.2). Moreover, a number of projects never move beyond the preparation stage and are cancelled after significant time and funds have been spent in preparing them. This has efficiency implications, including the higher costs of maintaining un-finished projects, costs of asset deterioration, costs of maintaining project management structures throughout a long implementation cycle, and the opportunity costs of staff time, counterpart funds, and the donor funds themselves. 5.64 Despite recent efforts to improve donor coordination, there is still considerable overlap and a tendency for supply driven initiatives with only weak integration into the strategic priorities of the government. The availability of funding from multiple sources is potentially a great asset, if these resources are effectively complemented (e.g., some donors offer technical assistance funding to specifically aid the preparation and implementation of investments funded by other donors). However, making the most of these complementarities requires donors to align their strategic planning cycles with each other, to determine respective roles and responsibilities, and to harmonize their internal rules and procedures. Moreover, both coordination and targeting need to be aligned with the country's development strategy. These principles have been endorsed by all major donors in the Paris Declaration on Aid Effectiveness of March 2005 (see Box 5.5). But the implementation of the Declaration on the ground remains a challenge. 100 Box 5.6: Donor Commitments in the Paris Declaration (Some Excerpts) Donors have inter alia committed to: · Base their overall support on the country's national development strategies, institutions and procedures. · Draw conditions, wherever possible, from a partner's national development strategy. · Link funding to a single framework of conditions and/or a manageable set of indicators derived from the national development strategy. · Use country systems and procedures to the maximum extent possible, including on transparent partner government budget and accounting mechanisms. Where use of country systems is not feasible, donors have committed to establish additional safeguards and measures in ways that strengthen rather than undermine country systems and procedures · Avoid, to the maximum extent possible, creating dedicated structures for day-to-day management and implementation of aid-financed projects and programs. · Align their analytic and financial support with partners' capacity development objectives and strategies. · Implement, where feasible, common arrangements for planning, funding (e.g., joint funding arrangements), disbursement, monitoring, evaluation and reporting to government on donor activities and aid flows. · Provide reliable indicative commitments of aid over a multi-year framework and disburse aid in a timely and predictable fashion according to agreed schedules; · Provide timely, transparent, and comprehensive information on aid flows so as to enable partner authorities to present comprehensive budget reports to their legislatures and citizens. 5.65 Although some progress has been achieved, the use of country systems for donor finance investments is very limited. The recording of transactions in the budget is where most of the progress has been achieved, but coverage is not at 100 percent for all donor transactions. The reporting of execution has seen more limited progress, and therefore detailed reporting still relies on donor information. Almost no progress has been made in using core country systems, that is, the country's procurement systems for contracting and commitment of funds, the State Treasury for payment, the intergovernmental transfer system to finance local government projects, and the state auditing agency for control and auditing. It is clear, however, that progress on this issue depends both on the government's improvement of its PFM systems, and on donors working together and assisting the government to move forward in using improved country systems Recommendations to Facilitate (and Improve Effectiveness of) Donor-financed Investments 5.66 Record (and report) all external development assistance flows to the public sector in the budget. This implies bringing up to 100 percent the recording of donor financed transactions in the annual budget and their execution details in government internal control reports. The budget is a central instrument for translating government policies and priorities into operational activities and programs, and to ensure efficient resource allocation. Recording donors' flows into the budget and keeping track of its execution in regular internal reports is a first step towards fully aligning donor-financed activities with national priorities and goals. Better recording also requires the following: (i) timely provision of information by donors on planned and actual flows; (ii) alignment of donor programming cycles with the country's budget cycle; and (iii) timely recording and reporting of information. . In the short-term, achieving 100 percent recording of donor executed assistance in the budget may not be realistic, but the principle of transparency should nonetheless apply. 5.67 Establish a comprehensive information system on external development assistance. A comprehensive information system that would facilitate better monitoring, management and reporting of all external development activities should be established. The unified database should capture information and report on aspects such as pledges/planned commitments, actual commitments, inflows (donor disbursements), amounts contracted, and utilization (spending), as well as progress of project 101 preparation and implementation. This should cover all forms of assistance (loans and grants, cash or in- kind, executed by national entities or by the donor agencies), and include information on government guarantees (e.g., on loans to state-owned enterprises). This system could also provide information to track and monitor pending decisions and actions during project preparation and implementation. To avoid duplication, this should be linked to and draw on information from the country's public financial management system. 5.68 Integrate the planning of donor financed investments (and assistance) to the core capital budgeting process (and to the overall budget process). Bringing donor-financed activities into the budget formulation and approval processes would ensure that these are better discussed with and disseminated to a broad range of stakeholders (including legislators and citizens), thereby securing better support and ownership. It would also assist in better planning and allocation of resources. But this shift requires the streamlining of current procedures of planning, processing, and approval of projects (see recommendation below). 5.69 Simplify processing and approval of donor financed investments. Efforts should be made to simplify, streamline and eliminate duplicative reviews of the project documentation for approval, for projects financed by donors (see Box 5.6 for some suggestions for consideration). An inter-ministerial working group could be established to work together with donors to develop changes to government procedures (and as appropriate, to those of donors), including longer-term legislative and institutional changes, and roles and responsibilities of different agencies. That simplification effort would need to be matched, on the donors' side, by helping to synchronize project preparation with the budget cycle. Box 5.7: Synchronizing the Project Cycle with the Budget Process and Streamlining the Project Cycle: Suggestions for Ukraine All activities related to project identification, preparation, and appraisal could be carried out in a way that is synchronized with the budget cycle envisaged in the Budget Code. For that purpose, a new procedure would need to specify objective processing benchmarks (i.e., completed pre-appraisal or appraisal stage in the project cycle) based on which the responsible line ministry will be able to submit to the Ministry of Finance specific project budgeting proposal for inclusion in the budget Resolution (no later than May 15) or draft State Budget (no later than August 15). That would allow the Ministry of Finance to reflect such projects in the projection of the Budget for the next fiscal year. In order to make this happen, it would be necessary to introduce a number of other changes that will make project preparation shorter, simpler and more predictable, and with less duplicative approvals; the following changes should be considered: (a) Introducing of "one-stop-shop" authorization to negotiate and sign loan agreements: this would help to eliminate multiple decisions and streamline loan processing procedures. For example, when there are no substantial changes between proposed and agreed loan provisions during negotiations, a single Presidential decision could be used to authorize the head of an official delegation to negotiate the proposed loan agreement, sign the agreed minutes of negotiations and follow-up letter confirming results of negotiations, as well as to sign the loan agreement upon approval by the donor agency. (b) Setting a clear and reasonable timeframe for each of the steps in the project cycle: currently, many steps of the project cycle are not defined in terms of time needed; and the ones that are actually defined are not consistent across the various legal acts. (c) Revising of roles and responsibilities of all of ministries and agencies of government in the project cycle: that is, the roles of the concerned sector ministry, Ministry of Economy, Ministry of Finance, directly related ministries and other non-related ministries) need to be clearly defined. (d) Including the loans in all budget documents: having this as part of the annual budget (through its documents) means that parliamentary approval is provided through the budget approval process itself, thus eliminating the need for separate ratification through stand-alone laws by Verkhovna Rada. This is actually provisioned in the Budget Code. 102 5.70 Plan donor funding aligned with the country's strategy and on multi-year basis. Medium and longer term fiscal planning should similarly integrate resources from all sources--domestic sources and external development assistance. As national and sector medium-term fiscal/expenditure frameworks are further developed in Ukraine (as recommended in this report), planned external development assistance should be fully incorporated into such frameworks. On the donors' side this should involve ample coordination to harmonize and complement aid efficiently on multi-year basis. 5.71 Designate a single office to coordinate external development assistance activities. An integrated institutional arrangement (i.e., a single unit within the Ministry of Economy or the Ministry of Finance to coordinate all external development assistance (grants and loans, investments and technical assistance, cash or in-kind assistance) would help in better management and monitoring.147 This unit should take overall responsibility for formulating and implementing an aid management strategy to ensure that external development assistance is well aligned to country's strategies and priorities; the activities of the proposed unit should include the following: · Communicating country needs and priorities to donors, and assisting sector ministries to mobilize financing for their projects and programs. · Ensuring donor coordination and utilizing complementarities within and across sectors (e.g., between technical assistance and investment financing across donors). · Ensuring smooth and expeditious processing of donor-supported projects and activities. · Serving as a focal point in the government for contacts with donors. · Assisting sector ministries in working effectively with donor agencies. · Ensuring availability of timely and complete information on external development assistance. · Assessing utilization and effectiveness of external development assistance including results and outcomes. 5.72 Continue improving PFM systems to allow donor funding, in the near future, to be channeled and executed fully through budgetary institutions and controls. Progress on this issue lies heavily on the government's efforts to tackle PFM weaknesses, such as procurement systems. In the meantime, the following suggestions could be considered jointly with donors: · Facilitate more direct involvement of staff and management of the beneficiary agencies in project preparation and implementation in order to improve ownership and implementation. For example, project managers should be located within the concerned program unit of the ministry or implementing agency. The agencies' regular financial management and other relevant units should be part of the project, and be phased-in with more responsibilities, as responsibilities of existing PIU are phased-out. · Donors could phase-in the use of the country's (PFM) system, but supplemented, as needed, by additional arrangements in those areas where weaknesses in the country's PFM system pose fiduciary risks. Such additional measures could be progressively phased-out in sync with improvements in the country's PFM and procurement systems. Box 5.7 provides an illustration of what the target model could be. 147 The Ministry of Economy is currently responsible for overall coordination of international technical assistance and assistance from international financial institutions. Within the Ministry of Economy, different offices deal with issues relating to grants and loans: the Directorate for Coordination of International Technical Assistance (DCITA) of the Ministry of Economy deals with issues relating to international technical assistance (principally grant financing), and a separate unit deals with issues relating to physical investments and loans. An arrangement integrating these would appear more conducive to effective management and coordination. The Ministry of Finance manages external development assistance resource flows. Much of its focus currently appears to be on loans from international financial institutions; this should be extended to include other development assistance resources. Sector ministries should continue to have principal responsibility for formulation and implementation of projects and programs in their sectors. 103 Box 5.8: A Goal to be Pursued: Use of Country PFM Systems in Donor-financed Projects · Total project expenditures would be budgeted and included in the annual budget. · Donor disbursements would be made into the treasury (single treasury account). · Regular budget execution procedures (commitments, warrants, and payments) would be followed for projects implemented by ministries and similar agencies. · Payments would be made through the treasury system using the concerned sector ministry's or agency's treasury's regular payment verification and authorization procedures. · Given weaknesses in the country's procurement system, special procurement arrangements or supplements to the country`s procurement system will be needed for donor-financed projects/activities until improvements are made to the country's system. · The treasury would account for project expenditures using the government's regular chart of accounts. · The agency's regular financial reports would be the principal basis for financial reporting, with additional information provided with regard to any donor-specific requirements. · Government's regular internal control systems and procedures would apply. Donor-financed projects would also be subject to internal audit by the KRU. · Donor-financed projects would be subject to external audit by the country's supreme audit institution (the Accounting Chamber). While the capacity of the Accounting Chamber is being further developed, particularly in financial audits, this would be supplemented by external audit by an acceptable professional audit firm with agreed terms of reference. H. CONCLUSIONS AND GENERAL RECOMMENDATIONS 5.73 Some formal elements of the capital budgeting process are well structured and the process has some features of good practice. For example, the line ministries and their programs are the unit of analysis for capital spending, and must select projects that are within their annual budget ceiling and are subject to financing availability. 5.74 In project planning, the major shortcoming is the absence of multi-year ceilings, and strategies, for both capital and recurrent spending. Multi-year ceilings help the government, the MoF and line ministries clearly see the future implications of spending decisions ­ particularly for capital spending. Currently, capital projects are prepared and selected by line ministries and the MoE without any multi-year ceilings. Another shortcoming in planning is the absence of strategic plans for line ministries, which present multi-year objectives for the Ministry and its programs. Strategic plans ­ undertaken within realistic resource constraints ­ aid the MoF, MoE, and line ministries in evaluating current spending within the Ministry, its effectiveness with respect to government and ministry objectives, and potential for reallocation across programs or within programs to increase marginal productivity. The following recommendations should be implemented: · Introduce multi-year ceilings for total spending for line ministries (for capital and recurrent spending). The MoF should take the lead in this task. · Introduce multi-year sector strategies/planning within resource ceilings for all line ministries. This is part of effectively implementing a MTEF. The MoF and the Cabinet of Ministers should take the lead in this issue. 5.75 The planning process would also be improved if the MoE would create and maintain a database of existing capital assets and their condition. Ideally, each line ministry would have access to such a database (managed by MoE) and would use it in capital planning. The World Bank project on public finance modernization could support this effort. The following is recommended: 104 · Establish a database of current assets and their condition. The MoE should set the standards, and possibly collect the data centrally for analysis and monitoring, but line Ministries would have the obligation of updating the information. The database can be used by line ministries to monitor their own progress and by the MoF/MoE for assessing the adequacy of maintenance spending and the longer run affordability of additions to the capital stock. 5.76 The recent addition of a Targeted Program process, with Cabinet of Ministers approval of a set of priority programs, is not well integrated into the budgeting process. It is not clear whether the Targeted Programs are true high-priority areas or are simply an accumulation of special projects. The projects seem to be selected by the Cabinet without reference to the available resources over a medium- term horizon, and may result in the selection of unrealistic projects that can never be funded. It is also not clear what role these programs play, as funds are not always allocated to these priorities. The following is recommended: · Improve the timing and integration of the Targeted Programs process into the annual budget process. In the medium term, they should be phased out and replaced by an integrated multiyear investment program. 5.77 The government urgently needs to strengthen project evaluation capabilities in the Ministries of Economy and Finance, and in all sectoral ministries. Under the leadership of the MoE, the following recommendations should be considered and implemented: · Assess the current analytical capabilities for project and program evaluation in line ministries. · Set a concrete strategy and training program to strengthen those capabilities. · Implement transparent and standard cost-benefit methodologies of evaluation. · Apply consistently and selectively (and across all line ministries) an enhanced cost-benefit analysis as part of the formal process of capital budgeting. · Strengthen the analytical capabilities to evaluate potential risks in Public Private Partnerships and privatization schemes in line ministries. · Establish proper economic evaluation as a key element of the project submission process to the MoE and MoF (to be quality controlled). · Enforce the use of economic project evaluation for capital expenditures in projects and programs submitted by sectoral ministries. This should be done by the MoE and the MoF in coordination. · Monitor (and audit) the quality of the evaluation performed in line ministries (in coordination with KRU). 5.78 Capital project completion rates and the under-execution of project funding are persistent problems requiring further attention and monitoring. In the World Bank Public Finance Modernization Project under development, a close review of current budget execution procedures for capital projects is required to assure that these procedures are not contributing to under-execution. The following is recommended: · Monitor jointly (between the MoF and the MoE) the progress made in capital projects during the year to ensure that work is progressing. Given the persistence of this problem, KRU should also annually audit a selection of capital projects, perhaps focusing on the poorest performing ministries, on the question of whether the ministry's internal control and audit processes are functioning for capital spending, and on the reasons for poor performance. Line ministries may require some support for capital project data collection and monitoring, and the World Bank public finance modernization program under preparation could be a useful vehicle for supporting this area. 105 5.79 The current division of responsibility between the MoF and the MoE is not in itself a problem. The MoE handles project preparation and evaluation from the standpoint of cost-benefit analysis and feasibility, as well as handling the identification of high priority areas for future investments. The MoF handles actual project financing, and the division of ceilings between capital and recurrent. This division is logical and can work, but it requires closer coordination between the MoF and the MoE. The following options are provided to strengthen that coordination: · Establish a formal structure of collaboration between the MoE and the MoF, with the oversight of the Cabinet of Ministers within the overall public financial management structure. · Coordinate functions on capital budgeting through the suggested working group. This working group should review all aspects from identification through completion. · Prepare a report on changes and improvements to the process (this could include someone from the Cabinet of Ministers). This should be the first assignment for the working group. 5.80 The management of donor-financed investments and projects needs revamping. The analysis shows that efforts need to be made by the government and the donor community in Ukraine to facilitate and improve aid effectiveness in the country. Moving forward, the following broad options for reform should be considered (by both the government and the donor community): · Bring up to 100 percent the recording of donor financed public sector transactions in the annual budget and their execution details in government internal control reports. In parallel, establish a comprehensive information reporting system of external assistance (including inflows and execution). In the short term, this does not apply to donor executed technical assistance, for which full integration into budget planning and reporting is not realistic, although the objective of maximum transparency should equally apply. · Integrate donor financed investments (and assistance) to the core capital budgeting process (and to the overall budget process) by streamlining the complex procedures of project processing and approval in the government, and by synchronizing project preparation to the budget cycle. · Plan donor funding aligned with the country's strategy and on a multi-year basis. This should be integrated with the multi-year planning recommended in this report for all public capital investments. On the donors' side this should involve further strengthening coordination to harmonize and complement aid efficiently. · Continue improving PFM systems to allow donor funding, in the near future, to be channeled and executed fully through budgetary institutions and controls. In the meantime the following suggestion could be considered: (i) facilitate more direct involvement of staff and management of the beneficiary agencies in project preparation and implementation in order to improve ownership and implementation; (ii) donors could phase-in the use of the country's (PFM) system, but supplemented, as needed, by additional arrangements in those areas where weaknesses in the country's PFM system pose fiduciary risks. 106 6. CREATINGAND ALLOCATING FISCAL SPACE WITHIN A CONSISTENT MACROECONOMIC FRAMEWORK A. INTRODUCTION 6.1 Fiscal space options need to be discussed within a consistent macroeconomic framework. When fiscal programs are not realistic regarding their resource constraints, tensions begin to arise which, if not addressed, can lead to fiscal crises and/or periods of stagnation. This chapter showcases an adding- up 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 that take place between investments and macro-fiscal variables. In particular, they illustrate the ways in which different policy packages are likely to affect economic outcomes. 6.2 The report presents two macroeconomic scenarios.148 The first, called the "base case" scenario, involves a path of the economy under a moderately fast and well-implemented reform package that includes a higher level of productive public investments, improved recurrent and capital spending, better revenue policy and administration, improved public finance management, and more efficient use of donor funding. As these factors are expected to go hand in hand with an improved business climate and the establishment of the basis for private participation in public infrastructure, the private sector is also expected to contribute relatively robustly to finance infrastructure. 6.3 The base case leaves considerable room for an upside scenario should all the recommendations made in this report be implemented and should the external environment remain favorable. In other words, there is indeed potential for a higher growth scenario in Ukraine (that is, well above 5 percent annual growth in the medium term). The rationale behind adopting a moderate base case scenario in this report (and a conservative lower case scenario as depicted below) is that it is much better to plan conservatively and efficiently, and benefit from a windfall, than to expect a windfall and find that available fiscal resources impose considerably higher constraints than had been envisaged. 6.4 The second scenario, denoted the "conservative" scenario, assumes relatively slow and uneven progress on reforms and a less optimistic response from the private sector to the policy mix. As a result, it assumes lower overall levels of investment (and less productive investments as capital budgeting reform is assumed to be slow). The chapter considers these scenarios in the context of fiscal space by exploring the likely tensions that will arise in both scenarios ­ the debt tension, and the macro- economic tension. However, before moving to scenario analysis, three key macroeconomic issues facing Ukraine today are discussed in more detail, since they play important roles in both of the economic scenarios outlined: (i) the likely trend of the current account balance, (ii) the likely impact of natural gas price increases, and (iii) exchange rate tensions. 148The RMSM-X (Revised Minimum Standard Model-Extended) is used for modeling the macro-framework in this report. This tool is an Excel-based simulation package for facilitating the forecasting, monitoring and analysis of financial flows of (developing) countries. It models the (demand side of the) economy by using an economy wide consistent flow-of-funds framework in which different agents are identified. More precisely, the basic model includes the National Accounts; Balance of Payments; (general) Government; Monetary Survey and the rest of the economy account. In addition to the above-mentioned sectors, the model forecasts detailed trade accounts and foreign debt flows and stocks. As such it can be used to produce a comprehensive outlook for a (developing) country. See RMSM-X User's Guide by DEC, mimeo. 107 B. KEY MACROECONOMIC CONSIDERATIONS The Current Account Balance 6.5 The macroeconomic framework presented here involves a typical inter-temporal dynamic of the current account balance related to investments and growth. A growing economy, with a deficit in productive capital, can often benefit from foreign savings to develop itself (at least at the early stages of a cycle, as assumed here). Thus, early in a growth cycle significant foreign exchange inflows (including FDI) tend to increase pressure on the exchange rate (toward appreciation) and put downward pressure on the current account balance. Since exchange rate pressures tend to slow exports, for such a policy to be successful across economic sectors (and social groups), it helps if the real exchange rate is initially under-valued, and in all cases it is important that a liberal economic policy program is in place to encourage the diversification and growth of exports, broad-based wealth generation, and ultimately, the growth of domestic absorption (investment and consumption) on a sustainable basis. In fact, many countries, and in particular the EU-8, experienced current account deficits during such a capital inflow period (see Figure 6.1). Starting with a depreciated currency after the 1998-99 financial crisis, and in the presence of hard budget constraints encouraged by the government, Ukraine was able to run large current account surpluses from 1999 as it benefited from a rapid increase in volumes of production (Ukraine had underutilized capacity) and exports of traditional goods (metals, chemicals, agro-processing, and light industry), which was further supported by favorable terms of trade. The task now is to broaden that base of growth, in particular through the diversification of exports and the sources of growth across the economy in general. Figure 6.1: Real GDP Growth and the Current Account Balance in the EU-8 (Average), 1992-2005 8 6 4 2 0 -2 -4 -6 -8 CAB, % GDP GDP, % -10 -12 2991 3991 4991 5991 6991 7991 8991 9991 0002 1002 2002 3002 4002 5002 Source: World Bank DDP and LDB 6.6 To achieve economic diversification, capital investments and imported business services will be in high demand. If these goods and services are put to productive use in an encouraging business environment, the strong growth of production and exports in the future would provide resources to repay debts that were accrued abroad during the current account deficit years. The Likely Impact of Gas Price Increases on Growth and Productivity 6.7 The recent gas price increase emphasizes the importance of having a sound macroeconomic, institutional, and structural reform program. Near term estimates of the impact of the rise in the recent natural gas import price to US$95 (from US$50) per 1,000 cubic meters show an approximate negative influence on GDP of 2 percent. The negative effect could also add 0.7 percent of GDP to the fiscal deficit and subtract up to 3 percent of GDP from the current account balance.149 In addition, future 149See World Bank Note (2006) on "The Impact of Higher Natural Gas and Oil Prices in Ukraine" (www.worldbank.org.ua). 108 price increases are likely. Thus, as the terms of trade continue to move against Ukraine, with increasing energy import costs, the country needs to exert a greater effort in pursuing a prudent and growth- promoting macro-fiscal program, coupled with an adequate business climate that can help to diversify the economy. 6.8 Estimates from the general equilibrium model of the Ministry of Economy suggest that a 12 percent reduction in energy intensity could fully offset the negative impact on GDP of the price increase.150 According to International Energy Agency and World Bank estimates, on a purchasing power parity basis, Ukraine consumes 3.6 times more energy than Germany per dollar equivalent of GDP, and on a dollar for dollar basis, 22 times more. There is ample room for Ukraine to reduce energy intensity, but doing so entails a cost. The government's own Energy Sector Strategy through the year 2030, about US$200 billion in capital investment (including both private and public) would be needed to implement it.151 While a comprehensive energy strategy is being implemented (which will take several years), a lot can be accomplished through behavioral changes. For example, an appropriate pricing of energy can induce its more rational use (including investments in energy efficiency). Too little of this has taken place to date owing in large part to the large cross-subsidization of energy costs. Costs have simply not been aligned with use, and as a result price signals have not been allowed to play their crucial role of directing resources towards their most efficient uses. Current quasi-fiscal activity from energy under-pricing alone totals about 4.3 percent of GDP. Without adjustment, these costs are borne by the energy providers (most of which are still state owned) and the budget itself, through the loss of asset value in state property, the accumulation of tax arrears, successful lobbies for tax privileges, debt restructuring, and/or other avenues. The tariff increases announced for 2006 are thus an important step in the right direction. 6.9 Shocks to input costs (such as those from higher natural gas prices) also mean that labor and capital productivity decrease. One of the key points about increasing investment (both public and private) is that labor productivity should go up as productive capital becomes more abundant. The concomitant investment in human capital, such as through higher quality education (and health) programs, would also improve productivity. However, as variable inputs become relatively more expensive (like energy), there is negative pressure on factor productivity.152 The Exchange Rate 6.10 The real exchange rate (RER) also plays a dynamic role. In a growing economy, labor productivity growth above the average world rates should determine the trend of the real exchange rate. In the context of an inter-temporal framework, real exchange rate adjustment also serves as a means of adjusting the savings-investments balance, including through its impact on the trade balance. Figure 6.2 shows the dynamics of the RER in several EU-8 countries. In total, these countries experienced real appreciation of their currencies from 1992 through 2005, ranging from 50 percent (the Slovak Republic) to 85 percent (the Czech Republic). Ukraine can be expected to follow a similar path in general over the medium term. 150This model was prepared and is currently operated for the Ministry of Economy by the Institute of Economic Research and Policy Consulting. This work was funded out of a grant of the Dutch Government for the implementation of the Programmatic Adjustment Loan Program, supported by the World Bank. 151The energy sector strategy is a good example of a program worth close scrutiny. The program envisages required investments of US$200 billion in the energy sector alone by 2030 to secure Ukraine's energy independence. The strategy, though, is to invest in the highest cost energy supply available to Ukraine ­ nuclear, while alternatively designed programs should be able to provide comparable results for a fraction of the cost. 152The reasoning is simple ­ productivity can be measured by the value of output divided by the value of an input. 109 Figure 6.2: The Real Effective Exchange Rates in Selected EU-8 Countries, 1992-2005 (index: 1992=1) 2 Czech Republic Hungary 1.8 Poland Slovak Republic 1.6 1.4 1.2 1 0.8 2991 3991 4991 5991 6991 7991 8991 9991 0002 1002 2002 3002 4002 5002 Source: World Bank (DDP). 6.11 Despite the medium-term real appreciation trend, temporary exchange rate corrections are possible as a response to external shocks or domestic crises. EU-8 countries went through short periods of depreciating exchange rates at different times. Nominal exchange rate flexibility serves to absorb the negative effects of the various shocks and helps economies to adjust with overall smaller output losses. A nominal depreciation early in the growth cycle could well help to spur export growth and put Ukraine on a higher growth path throughout the cycle. 6.12 Higher energy prices, combined with the fact that Ukraine's exports are relatively undiversified, underline the importance of keeping the real exchange rate competitive. If domestic goods and services become relatively more expensive than foreign goods and services, significant negative pressure will be placed on the trade balance.153 There is strong evidence from around the world that export-led growth is critical for emerging economies. Ukraine has experienced an appreciating real exchange rate coupled with an undiversified export boom dominated by the metals sector. On the whole, Ukraine's exports can be characterized as undiversified, poorly aligned with trading partners' supply chains, and of low level processing and value added.154 But Ukraine has the capacity to produce a range of goods and services which are in demand by the world's rich countries. It needs to match that capacity with new technology and with the design of products which meet modern tastes and standards, and it needs to find ways of accessing those markets. Better public institutions and improved investment will play an important role in this continuing transition. 6.13 After nearly five years of a de facto fixed exchange rate (in the presence of strong current account surpluses), in April 2005 the NBU allowed an appreciation of the UAH of 4.4 percent in nominal terms (from 5.28 UAH/USD to 5.05). The move was in response to speculative activities by fixed income investors, who viewed Ukraine's exchange rate as a one-way bet through which, in addition to an eventual appreciation, they could earn high interest rates on UAH-denominated government and corporate papers. The appreciation was necessary because the large capital account inflows could not be sterilized by the NBU, and thus were rapidly increasing money growth and inflationary pressures. Since then, the current account surplus has reduced and capital inflows have slowed significantly. C. APPLYING A MACRO-FRAMEWORK TO THE FISCAL SPACE EXERCISE 6.14 Within the full spectrum (distribution range) of possible developments, we present two consistent macroeconomic scenarios. The "base case" scenario tracks the path of the economy under the implementation of a moderately fast and well-implemented reform package. The "conservative case" describes basically a status quo policy scenario (slow and uneven reform) under slightly less favorable 153IMF (2006) "Ukraine: Gauging the Macroeconomic Effects of Higher Natural Gas Prices", staff note--forthcoming for publication. 154World Bank (2004). Ukraine Trade Policy Study. Report # 29684-UA. 110 external conditions. Neither a high case nor a low case is explicitly considered. However, as explained earlier, a high case could take place under a fast and fully implemented reform program coupled with favorable external conditions. On the other end, our "conservative case" does not assume drastic negative shocks to the economy that could lead to a low case. In other words, the scenarios presented here are a middle ground in the distribution of possible outcomes. 6.15 The macro forecasts are informed by Ukraine's capital investment needs. Several sector teams in the World Bank provided estimations of the main public capital needs facing Ukraine within the next 10 years. The total rough estimate is US$100 billion. The breakdown with explanations and specific assumptions is presented in Table 6.1. The figures presented in this table are merely a conservative estimate of potential investment needs in view of the EU Action Plan. These estimates also assume that the government embarks on a successful privatization program, improves and streamlines its regulatory capacity, and encourages private sector investment. Table 6.1: Estimates of Potential Investment Needs in Ukraine, 2006-15 Sector In Billions Description of USD Energy 30 This estimate includes investment in the coal sector (USS 5 billion), the gas and oil sectors (US 11 billion), and electricity (US$14 billion). That includes investment into pipelines, nuclear power, energy distribution, harmonization with EU Acquis and related investments to connect to the EU energy grid, and other investments. However, a large share of these investments could be transferred to the private sector if privatization takes off. Road Transport 5 This estimate mostly consists of road construction and repair over the next 5 years. Other transport investments are included in the "Other" category below. Housing and 14 Investment and rehabilitation needs of water supply and sanitation are US$7 billion through Community 2012. Water supply investments require 60% of that amount, and the remaining 40% is Services needed for the rehabilitation of sanitation systems. An additional US$7 billion is needed for district heating companies and retrofitting activities on the demand side. Agriculture and 9 The estimate includes land reform, food safety and standards reform, R&D, and some Land Reform infrastructure investments. Health, 6.5 The estimates for health and education are based on public capital investment in these Education, sectors as a share of GDP made by new EU member countries. Social Protection Environmental 15 This estimate is made under the assumption that environmental protection investment Protection would lag economic development. The total cost of EU legal approximation and industrial rehabilitation is estimated at US30 billion. Market 4 The estimate includes bringing state tax, judicial and customs systems up to European Supporting standards, as well as a range of more minor institutional development programs which Institutions Ukraine will need in order to benefit from WTO membership. Other 16.5 These include remaining items such as ports, airports, railways, ICT, waste management and are done based on cross-country comparisons of overall public investments. Total 100 Source: World Bank staff. 6.16 The fiscal policy assumptions feeding into the models incorporate, to different degrees, the findings and recommendations of this report. The base case scenario assumes the implementation of a substantial portion (though not all) of the recommendations of this report. It also assumes progress in a broad government program to improve public governance and the investment climate through the implementation of the EU Action Plan.155 On the expenditure side, it foresees the implementation of the recommended set of pension policy changes. It is assumed that the government will keep control of public consumption (including public wages), while gradually and moderately cutting inefficient subsidies, and streamlining the privileges system through better targeting. The tax policy reform called for in this report 155The Government's Development Policy Loan Program, supported by the World Bank, is designed to help the government along this path. 111 is assumed to be implemented. The conservative scenario assumes slow and uneven progress in fiscal policy. A detailed set of assumptions is displayed in Table 6.2. Table 6.2: Fiscal Policy Assumptions for the Macroeconomic Projections Base Case Conservative Case Revenue A shift in the composition of tax revenues takes place: the The budget relies even more heavily than policy shares of direct taxes--particularly payroll taxes--also currently on direct taxes as a source of funds. called social insurance contribution in this report, which Tax administration does not change tax labor and capital drops together with the share of non- significantly. No further curtailment of VAT tax revenues. At the same time, the share of the least tax expenditures takes place. The indirect distorting indirect (consumption) taxes (mainly VAT) goes taxes share in GDP drops. As revenue up. Per the recommendations in Chapter 2, tax pressures mount, direct tax rates have to go up administration core tasks (including reducing compliance starting in 2009-the easier administration of costs, comprehensive monitoring, targeted auditing, and this tax drives this outcome. WTO accession better coordination among collection agencies) are leads to less reliance on international trade as significantly strengthened. In addition, the unification of a source of tax revenue. There is also more functions of the four social insurance funds under the reliance on non-tax revenues. Pension Fund is rapidly implemented. Reforms in the Simplified Tax System allow base broadening. VAT tax expenditures, particularly in agriculture, are further curtailed. WTO accession leads to less reliance on international trade taxes. Pension Parametric changes (expenditure saving measures) take No further parametric reforms are policy place as recommended in Chapter 4. The second pillar is implemented. Second pillar is introduced in introduced in 2008. 2008 (see Chapter 4, Figure 4.2). Slow change On the collection side, the recommended changes in in unifying collection agencies and a 5 p.p. unifying collection agencies take place. Payroll taxes are rate reduction over 2009-2013 are assumed. reduced by 10 p.p. over 2009-2013 (assumed 2 p.p. annually). Other Safety net to protect the poor from the gas price increase is Safety net to protect the poor from the gas current phased in during 2006-2009 to a total of 1.2% of GDP and price increase is phased in during 2006-2009 transfers then declines to 0.5% of GDP as some households to a total of 1.4% of GDP and then declines to graduate from the system with the growth of incomes. In 0.7% of GDP as some households graduate parallel, the privileges system is streamlined to gradually from the system with the growth of incomes. save 1% of GDP in 2010-2015 (see Chapter 3 on the The privileges system is streamlined to expenditure saving summary of recommendations). gradually save 0.4% of GDP in 2010-2015. Investment The share of public investment in GDP grows from an The share of public investment in GDP is on average of 2.1% in 2005-2006 to an average 3.7% in average 2.2% of GDP throughout the 2007-2010 and to 4.3% of GDP in 2011-2015. In total, projection period (2006-15). In total, only US$40 billion of new public investments is made over US$10 billion of new public investments is 2006-2015 beyond the level of 2005. made over 2006-15, beyond the level of 2005. Capital As a significant share of these transfers is actually The transfers marginally decline over the transfers subsidies to enterprises, in line with the recommendations period by 0.2 p.p. to 2.2% of GDP. of Chapter 3, they are assumed to decrease over the projection period to 1.2% of GDP in 2015. Public Public consumption adjusts to a level of 15.2% of GDP in Public consumption stays at a level of 15.6% consumption 2007-2010 and then gradually declines to 14.9% of GDP in during the projection period. 2011. The wage bill declines only marginally, while its underlying composition is assumed to change as higher real wages and wage decomposition are accompanied by employment optimization measures. Non-wage consumption is assumed constant in 2006-2009, because improved efficiency is accompanied by a growing energy bill for the budget institutions. After the energy prices adjust, continued improved efficiency drives the total public consumption down. Subsidies In light of the recommendations of Chapter 3, it is assumed Subsidies marginally decline to 2% of GDP. that future budgets gradually decline in subsidies to 1.3% of GDP through 2015. Source: Bank staff. 112 6.17 The projections show that expenditure savings would allow the public sector to increase investments in the base case scenario by US$40 billion (over the projection period--and above the current level), while the rest would be undertaken by the private sector. As public investment, public-private partnerships and private investment are considered mutually reinforcing; in the base case private investment growth is projected as relatively stronger than in the conservative case. 6.18 In the conservative case, only around US$10 billion would be financed by the public sector, while private investment growth would be slower, leaving a significant gap between Ukraine's aspirations and its achievements. The continued inefficiencies in fiscal policy and implementation would not provide as much fiscal space, and the investments would need to be considerably smaller in order to have manageable deficits. Because the conservative case projects a continuation of a slow reform in public finances with only marginal changes, it foresees the public consumption share going up between 2006 and 2009 owing to a growing energy bill for budget institutions (and higher expenditures in energy subsidies to the population). The level of public investments is 2.2 percent of GDP throughout the projection period (almost at the current level), resulting in only US$10 billion of cumulative new investments over 2006-15. 6.19 In the base case, the revenue system relies more on indirect taxes (e.g., VAT and excise taxes). The important tax trends over the projection period include a decline of the share of direct taxes and non-tax revenues. The capacity of the tax administration and other revenues authorities is assumed to strengthen significantly, while reforms in the STS and VAT tax expenditures, would lead to base broadening (and higher compliance) (as discussed in Chapter 2). A major change is assumed to be achieved concerning payroll taxes, as the contribution rate to the Pension Fund is assumed to be reduced by a total of 10 percentage points between 2009 and 2013 (2 percentage points per year for 5 years). This would be financed mainly by the savings that could be created with the recommended parametric changes to the pension system. This also implies a moderate decline in the average tax burden in the economy, along with a significant spreading of that burden over agents participating in official economic activity. This would help eliminate the "penalty for being official" and would induce a reduction in shadow economy activity. Since the base case scenario is conservative regarding how much shadow activity may be reduced, GDP growth might be significantly higher if the tax reform and administrative modernization are well implemented. 6.20 In the conservative case, the revenue side would continue to rely on direct taxes and non-tax revenues as sources of funds. This is because it is assumed that the tax administration would not improve significantly (and tax expenditures would not be further curtailed). As a result, the government would be unable to maintain the share of revenues from consumption taxes. Since revenue pressures would mount, the budget would increasingly put out efforts to collect more direct taxes, which are easier to administer (but which are burdensome to labor and capital). The fiscal space created only allows a 5 percentage point reduction in the payroll tax rate between 2009 and 2013 (1 percentage point per year for 5 years). 113 Table 6.3: Projection of Macroeconomic Scenarios1/ Base-Case Conservative-Case 2006 av 2007-10 av 2011-15 2006 av 2007-10 av 2011-15 Real GDP, % growth 4.5 5.0 4.6 3.0 3.0 2.5 GDP per capita, USD 4244 3318 Consumption, % growth 7.3 3.1 3.7 5.9 1.5 1.7 Investment, % growth 8.5 9.7 5.1 3.8 4.1 2.8 private investment, % growth 8.4 6.9 5.2 2.7 4.0 2.8 Real wage, % growth 9.0 7.0 6.2 5.0 4.3 3.5 GDP deflator, % growth 12.3 8.6 5.4 13.8 10.8 9.0 Current Account Balance, % GDP -2.2 -4.3 -3.9 -2.3 -3.5 -1.9 Gross National Savings, % GDP 17.5 17.3 18.9 17.2 16.6 18.1 Int.Reserves, months of GFS imports 4.3 4.1 4.0 4.1 3.5 3.1 Budget Revenues, % GDP 41.0 39.0 35.8 40.9 39.4 38.6 tax revenues, % GDP 35.3 34.0 31.9 35.1 33.4 32.9 direct taxes, % GDP 22.9 21.5 18.7 22.9 21.8 22.2 indirect taxes, % GDP 12.4 12.5 13.2 12.3 11.5 10.6 non-tax revenues, % GDP 5.7 5.0 3.9 5.8 6.0 5.7 Budget Expenditures, % GDP 44.1 42.4 38.5 44.3 43.8 42.2 public consumption, % GDP 15.6 15.4 14.7 15.6 15.7 15.2 public investments, % GDP 2.1 3.7 4.3 2.0 2.2 2.2 capital transfers, % GDP 2.2 1.7 1.3 2.3 2.2 2.2 current transfers, % GDP 20.8 18.5 15.5 20.8 19.9 18.1 subsidies, % GDP 2.5 1.9 1.4 2.5 2.2 2.0 Fiscal Balance, % GDP -3.1 -3.3 -2.7 -3.4 -4.4 -3.6 external financing, % GDP 0.2 0.8 0.5 -0.1 0.8 0.5 domestic financing, % GDP 0.9 2.1 2.0 1.4 3.4 2.9 privatisation, % GDP 2.1 0.4 0.2 2.1 0.3 0.2 Direct Public Debt, % GDP 14.5 17.2 21.9 15.0 20.5 25.5 1/ These projections were carried out using the World Bank's RMSM-X model for macroeconomic accounting and forecasting. 6.21 In the base case scenario (with all the reforms and significant levels of investment), the government would manage to keep a fiscal deficit of 3 percent on average during 2006-15. New external borrowings would mainly just refinance repayments with 0.2-1.1 percent of GDP net increases annually. Privatization revenues would be an important source of financing over the medium term, though the exact timing of large scale privatizations is not explicitly assumed ­ rather, an average level of some 0.2-0.5 percent of GDP annually is spread over the next 10 years. Domestic financing would become the most important source of deficit financing. This follows the government's strategy of changing the structure of public debt towards a larger domestic share. 6.22 Also in the base case, medium-term growth of around 5 percent is accompanied by current account deficits, by inflation deceleration, and by a marginal increase in the public debt. After several years of sluggish investments, as capital stock grows, so would the capital intensity of production, fueling the growth of labor productivity above the dynamics of real GDP. It is assumed that this is complimented with a stronger national education program, which will be reviewed in more detail in PFR phase II. A combination of higher capital inflows, an increase in investment import demand, and more expensive gas imports (which among other factors will cause deterioration in the terms of trade), would push the current account into deficit by as much as 4 percent of GDP (with the NBU maintaining international reserves at a level of four weeks of imports). A controlled fiscal deficit with less aggressive recurrent spending, coupled with a neutral monetary policy, would help to gradually bring down the inflation to about 5 percent in five years. 114 6.23 The conservative scenario forecasts lower growth, smaller current account deficits and persistent inflation dynamics. Slow progress in structural and tax reforms, combined with low public investments, would not lead to a substantial pick up of investment demand. As domestic investments and FDI would remain moderate, economic growth would remain at 2-3 percent over the medium term. Lower labor productivity allows for a smaller medium-term real exchange rate appreciation and continued low capital inflows. Though the current account deficits are projected as smaller compared to the base case, the NBU gradually loses the international reserves to a level of three months of imports. A looser fiscal stance (3.9 percent of GDP on average in 2006-15) with a substantial recurrent expenditure component would contribute to a more extended period of double-digit inflation. 6.24 While both scenarios imply an advance in economic development, the conservative case is disappointing in its representation of opportunities lost. Important quantitative and qualitative differences exist. What probably matters most is that in the base case per capita GDP in US dollars is estimated at around US$4,200 on average between 2011 and 2015, while it is estimated to be 20 percent lower in the conservative scenario for the same period of time (see Table 6.3). As a base for moving beyond 2015, the difference in GDP per capita in that year would be 23 percent. And as noted earlier, the changes of a high case outcome are significantly higher in the base case than in the conservative case. In the base case, the tax regime is more business-friendly with lower marginal rates and a broader base; and the expenditure envelope is both smaller and more efficient. In the base case, a better business climate and a better fiscal policy, holding much promise for the future, are reflected in the higher sovereign credit ratings and the lower costs of external borrowings. It is important to note that overall vulnerability and downside risks are lower in the base case. D. DEBT SUSTAINABILITY ANALYSIS Context 6.25 Debt sustainability analysis is an important part of the "adding-up" exercise. In order to decide how to finance capital investments and the reform program over the next years (i.e., choices regarding the level of deficits, financing between the public and private sector, and the public sector choices of deficit finance instruments), it is useful to project borrowing scenarios and observe the implied debt servicing costs to the budget, and the implications for the sustainability of the macroeconomic framework.156 The idea of this is straightforward - if fiscal authorities are not able to create the necessary fiscal space, any increase in investments (and other increases in spending or lower revenues due to slower growth) would generate higher deficits and possibly higher borrowing. While Ukraine has a relatively low debt to GDP ratio (18.7 percent as of 2005--which included 15.1 of GDP in direct public debt, and 3.6 of public guaranteed debt)157, a significant upward trend in this ratio would complicate the debt outlook, particularly in the presence of contingent liabilities. 156This report utilizes a new debt sustainability methodology developed by the World Bank (the Fiscal Sustainability Analysis model for middle income countries). The results are also inter-linked with the World Bank's standard macroeconomic model (RMSM-X). Moreover, recognizing the NBU's independence in Ukraine, and the fact that the NBU only indirectly finances budget deficits through primary T-bill purchases, we have adjusted the model to separate the central bank from the consolidated government. Also, for simplicity of the presentation, and in light of our focus on the government balance sheet, we do not consider sovereignty revenues in the analysis. 157As of 2005, public guaranteed debt (of 3.6 percent of GDP) included 1.6 percent of GDP in debt of the NBU to the IMF. 115 The Risk of Contingent Liabilities 6.26 Public contingent liabilities need to be included in the analysis, since a share of these liabilities may become explicit liabilities. A public contingent liability is a possible obligation arising from past events whose existence would only be confirmed by the occurrence of future events not wholly within the government's control. Contingent liabilities in the public sector may be explicit or implicit.158 Explicit contingent liabilities represent the government's explicit legal obligations to make a payment only if a particular event takes place. Implicit contingent liabilities are those that are not officially recognized until a failure occurs. For example, if a private bank fails, deposit insurance provided by the state would represent an explicit contingent liability. On the other hand, should a private bank be considered too important to be allowed to fail, the state might find it necessary to inject capital into that bank using public funds; that would be an implicit liability. Table 6.4 provides a breakdown of estimates of various types of contingent liabilities in Ukraine. 6.27 The largest component, 29.2 percent of GDP,159 corresponds to the so called "lost savings" in the USSR's Savings Bank, which is explained in some detail in Box 6.1. However, this deserves two clarifications: first, the "lost savings" are an implicit contingent liability160 not likely to become explicit debt all at once, but rather, if at all, throughout a long and structured process; Second, to date the fiscal authorities of Ukraine have been able to address this issue (i.e., lost savings) prudently, minimizing any impact on the budget and the economy. Table 6.4: Government Contingent Liabilities million UAH million US$ As % of GDP in 2005 Explicit contingent liabilities 22,748 4440.2 5.4 Guaranteed public debt 15,001 2,907 3.6 External 15,000 2,907 3.6 Domestic 1 0.2 0 Household deposits in Savings Bank 6,017 1,191 1.4 Household deposits in Ukreximbank 1,730 342 0.4 Implicit contingent liabilities 149,486 29,601 35.7 Lost savings of Soviet Union Sberbank 122,120 24,182 29.2 Naftogaz bonds /1 9,600 1,901 2.3 Naftogaz loans and credit lines /2 4,141 820 1.0 Kyiv municipal Eurobonds 3,030 600 0.7 Ukreximbank eurobonds 2,020 400 0.5 Energoatom bonds (UAH denominated) 500 99 0.1 Ukrainian railways bonds (UAH denominated) 500 99 0.1 Net arrears of energy companies after mutual offsetting /3 7,575 1,500 1.8 Total contingent liabilities 172,234 34,041 41.1 /1 Includes Eurobonds and bonds given to Gazprom as a means of debt restructuring. /2 This considers a US$220 million loan from the DEPFA Investment Bank and US$600 million from the Deutsche Bank. /3 This refers to the debt overhang that is expected to remain on state-owned power distribution companies after mutual offsetting between state-owned companies. This amount would need to be settled before privatizations, according to the Ministry of Fuel and Energy. Source: World Bank estimations. 158 See Polackova, H., Shatalov, S., and Zlaoui, L. (2000) "Managing Fiscal Risk in Bulgaria" (World Bank Policy Research Working Paper No. 2282) for a detailed explanation based on the case of Bulgaria. 159As the total value of these liabilities is hard to identify and estimate, we present an approximation based on the available information 160Based on the interpretation of the Budget Code of Ukraine this would not be considered a liability or a commitment based on a guarantee (Part 2, article 8). For this reason, and considering the background of this issue, the "lost savings" are considered in this analysis as an "implicit contingent liability". Also, this implicit contingent liability is linked to the State and not to the current state company called "Savings Bank." 116 6.28 This report presents a conservative subjective probability of contingent liabilities becoming explicit public debt. The probability of contingent liabilities coming due is assumed in this report at 50 percent for guaranteed debt and 30 percent for other contingent liabilities. The identified portion of liabilities accrued (and due for payment) is spread out evenly over the projection period. This is an inherently conservative estimate for the following reasons: (i) this report has probably not been able to identify all contingent liabilities; (ii) the Verkhonva Rada (by decree) has already made the "lost savings" of the former Soviet Union Sberbank a state liability (although it is not a liability of the Savings Bank as is often perceived by the public); (iii) in the past, about 85 percent of sovereign guarantee issuances have become explicit liabilities,161; and (iv) there is no assumption in the projections of accrual of contingent liabilities in the future. At the same time, it has to be recognized that the government has to date handled the issue of "lost savings" in a way that has minimized the costs on the current budget. Should such a policy be continued and be politically sustainable, the share of total contingent liabilities becoming explicit public debt may be lower than assumed in this report. Box 6.1: The Lost Savings of the Former Soviet Union (Sberbank) The so-called "lost savings" are deposits (savings accounts) of the population in the former Soviet Union Sberbank. These accounts were frozen and their deposits devalued during the hyperinflation of the early 1990s. Since then, while they have not been paid, the value of these savings has gone through a series of indexations approved by the Verkhovna Rada, thus representing an explicit contingent liability for the government. The total sum of the savings in 1992 constituted about 116.1 billion Soviet rubles. Given hyperinflation, accompanied by the necessity for introduction of the hryvna (UAH) in 1996, these savings deteriorated in value to about US$0.5 million (at market exchange rates). To address this issue, Law #537/96-BP was adopted in 1996, providing the framework for the lost savings repayment at an indexation rate of 1 Soviet ruble to UAH 1.05. As a result, the sum of compensation constituted UAH 124.19 billion. Through January 1, 2006, about UAH 2 billion has been paid to the account holders through the state budget (to obtain payments people have to follow a variety of procedures, such as mutual offsets of energy arrears ­ a practice which in itself may deteriorate energy payment discipline). That leaves UAH 122.12 billion (about US$24 billion) of the lost savings as pending implicit contingent liabilities. The contingent liability issue related to lost savings is important in the country. The Verkhovna Rada approved legislation which explicitly allocated this liability to the state, and some decision-makers made it clear that the "lost savings" issue should be resolved as part of the strategy to restructure the Savings Bank (this is because the Savings Bank, in the mind of the population, is connected to the lost savings, not because these lost savings are a liability of the Savings Bank). Examining the Debt Tension 6.29 The level of Ukraine's public debt is relatively low by international standards. Table 6.5 shows the state of Ukraine's public debt as of 2005 plus an estimate of its contingent liabilities. The direct public debt of Ukraine was 15.1 percent of GDP in 2005, two-thirds of which was external debt. In addition, guaranteed debt constituted 3.6 percent of GDP, including a 1.6 percent of GDP debt of the NBU to the IMF. By comparison, the average PPG indebtedness in the EU-8 was 28.6 percent of GDP in 2005. 161Although, this percentage is clearly on a rapid decline, as the government has for the most part refrained from issuing state guarantees, and when they have been issued the proposed use of funds has been evaluated by the Ministry of Finance. Much more worrisome, however, are the implicit guarantees which have not received an explicit guarantee (such as the issuance of Naftogaz bonds, where despite the absence of an explicit guarantee, many investors have indicated that they would expect the state to bail out Naftogaz if it were to be under threat of defaulting on the bonds). 117 Table 6.5: Public Debt and Estimated Contingent Liabilities as of 2005 UAH million US$ million % GDP (2005) Direct public debt 63,145 12,504 15.1 external 43,956 8,704 10.5 domestic 19,188 3,800 4.6 Guaranteed public debt 15,001 2,908 3.6 Other explicit contingent liabilities 7,748 1,534 1.8 Implicit contingent liabilities 149,486 29,601 35.7 Sources: MoF; World Bank estimates. 6.30 Without considering contingent liabilities, Ukraine appears to have plenty of room for public borrowing. Figure 6.3 depicts the results of a debt sustainability analysis linked to the macroeconomic scenarios discussed above (see Annex 6.1 for more detailed projections). In the base case, the level of direct public debt remains under control and grows by only 8 percent of GDP over 2006- 15 (to 21.7 percent of GDP). It is noteworthy that if the goal would be to keep the debt ratio stable (with the base case assumptions), fiscal policy should be aimed at a primary deficit of 0.7 percent of GDP. Under the conservative scenario, public debt picks up more rapidly, by 10 percent of GDP over the projection period, reaching 25 percent of GDP in 2015. 6.31 But if the government indeed takes on some of the contingent liabilities, debt levels would pick up quickly. In the projections, it is assumed that the government ends up having to repay 50 percent of guaranteed debt and 30 percent of the estimated contingent liabilities during 2006-15. To avoid pointing to any particular year, we smooth this amount (UAH 54.7 billion) equally throughout the projection period, assigning 10 percent each year (with appropriate adjustment by the GDP deflator). The recognition of contingent liabilities is assumed to drive up the domestic real interest rate by 3 percentage points annually. As a result, the public debt ratio more than doubles in 10 years, climbing to 40 percent of GDP in 2015. The implications of assuming higher levels of contingent liabilities are clear­ in an extreme case, where 100 percent of the liabilities and 100 percent of the contingent liabilities were to be covered (using our spreading out approach), the debt to GDP ratio would climb to 57 percent of GDP in 2015. This is not an unreal situation given the relatively conservative nature of our contingent liability estimates, and given that these estimates do not take into account downside economic shocks which could have an impact on debt levels. The latter are discussed below. Figure 6.3: Public Debt Ratios under Different Macroeconomic Assumptions, 1999-2015 (% GDP) 50 45 40 35 30 25 20 15 10 Base Case Conservative Case 5 Base Case with recognition of some contingent liabilities 0 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 199 200 200 200 200 200 200 200 200 200 200 201 201 201 201 201 201 Sources: MoF; World Bank projections. 6.32 The debt ratios are quite sensitive to various shocks. Table 6.6 presents debt to GDP ratios projected for the last year of the projection period (2015) under different stress tests applied to the 118 economy. The results show that the ratio is most sensitive to the "sudden stop" situation where the economy stagnates for two years and then returns back to the base case scenario path, but with the level of public expenditures not adjusted to the shock. This generates higher fiscal deficits for the whole projection period and results in a public debt level of 58 percent of GDP by 2015 (or 35 percent above the base case projection). A one time 30 percent real depreciation leads to a 28 percent debt to GDP ratio (5 percent above the base case). A one time jump in other debt creating flows by 10 percent of GDP pushes the level of debt to 44 percent of GDP. A combination of the sudden stop to GDP growth, combined with a 30 percent real depreciation and a settlement of 75 percent of current contingent liabilities by the state, would lead to a public debt level of 78 percent of GDP by the end of the projection period. There is always a threat that a combination of negative factors could be sufficiently large to lead to debt and macroeconomic crisis. This type of scenario is not explicitly modeled here ­ it can best be avoided through consistent and responsible policy year in and year out, combined with careful reaction to negative shocks as they arise. Table 6.6: Public Debt Ratio in 2015 under Various Stress Tests (as Percent of GDP) As percent of GDP Base Case 23 Conservative Case 25.3 Recognition of some contingent liabilities (50 % of guaranteed debt and 30 %of the rest) 40.2 Real interest rate is at historical average plus two st.deviantions in 2006-07 36.2 Real GDP growth is at historical average minus two st.deviations in 2006-07 57.7 One time 30 percent real depreciation in 2006 28 10 percent of GDP increase in other debt-creating flows in 2006 43.7 Recognition of all contingent liabilities 57.1 Real GDP growth is at historical average minus two st.deviations in 2006-07; plus one time 30% real depreciation plus recognition of 75% of contingent liabilities 78.4 Source: World Bank staff estimates. Final Thoughts on Medium Term Fiscal Planning, Debt Sustainability and Debt Management 6.33 For Ukraine to make best use of its fiscal space, medium-term planning is essential. The base case showed that even implementing a portion of the reform measures advocated in this report Ukraine has room for an additional US$ 44 billion in public investment over the next 10 years. To make the best of this potential, and ensure that the fiscal space created by the suggested reforms to tax and expenditure policy is not wasted, Ukraine needs better strategic planning tools.. Some fiscal planning tools are already set in the budget regulation in Ukraine but are not applied fully in practice. Planning strategically and according to the country's objectives would be highly beneficial for Ukraine. This would help fiscal authorities to maintain discipline and spend wisely, supporting the growth of the country, particularly in these times of potential fiscal pressures. Moreover, it would increase transparency and trust in the government's management of public finances. 6.34 The debt sustainability analysis presented here shows that, while Ukraine has some room for public debt, it should be cautious about borrowing given its large contingent liabilities. Moreover, the results of this analysis reinforce the idea of finding fiscal space more actively within the budget as the most efficient and fiscally prudent way to move the reform agenda forward. 6.35 Debt management is another critical ingredient in reducing risk and debt servicing costs. Considering the critical role of sound debt management, this report also recommends the implementation of a medium-term debt management strategy. Currently, the discussion of the borrowing program is confined to the annual budget. Thus, the government could strengthen this area significantly. Box 6.2 presents a set of recommendations in this regard which were highlighted in the debt management 119 diagnostic conducted by the World Bank's Treasury Department in 2005.162 Clearly, any steps to reduce debt service costs and risk exposure of the Ministry of Finance would positively contribute to the creation of fiscal space. Box 6.2: Recommendations on Debt Management for Ukraine The following steps are recommended for Ukraine to design and implement a medium-term debt management strategy based on a systematic approach under different economic and financial assumptions. Currently, the discussion of the borrowing program is confined to the preparation of the annual Budget Law without any anchor on medium-term or long-term guidelines. As a first step to establish an explicit medium-term framework, it is recommended to formalize the existing implicit short-term debt strategy, including the parameters for managing rollover risk and possibly setting a target for the internal/external debt mix. 2. Strengthen the public debt legal framework in order to assure the accountability of the authorities in charge. Accountability can be strengthened by: (i) providing clear debt management objectives in the legislation, (ii) requesting the Ministry of Finance (MoF) to design a strategy for managing public debt, and (iii) requiring the MoF to report its performance versus the stated debt management objectives. 3. Revise and establish borrowing ceilings in net terms to give authorities the flexibility of using short-term funding when necessary. 4. Strengthen the analytical capabilities and institutional framework of the Directorate of Financial Policy and State Debt Management (DSDM) to assume the main role in developing and implementing a strategy for internal and external government borrowing, and for providing government guarantees and servicing government debt. 5. Further enhance coordination between the MoF and the NBU. 162 World Bank (2005) "Ukraine Public Debt Management and Domestic Debt Market Development." Needs Assessment Report. 120 ANNEX 1.1: Private Provision of Public Services163 Provision of public services can be carried out by Government, the private sector, or a mix of the two. In order to provide services that are currently state-run on a pure private basis, service providers need to be privatized. As far as service expansion is concerned, evidence suggests that in many cases the private sector does as well, or better, than public provision. Certainly, when fiscal space is not available within public finances for necessary investment and maintenance, private provision can help fill the gap. If well structure, private provision can also encourage financial discipline, cost recovery, improved productivity, and enhanced service quality. Public-private partnership (PPP) is a system in which a government service or private business venture is funded and operated through a partnership between government and one or more private sector companies. In some types of PPP (see Tables A1.1 and A1.2), the government uses tax revenue to provide capital for investment, with operations run jointly with the private sector or under contract. In other types, capital investment is made by the private sector on the strength of a contract with government. Government contributions to a PPP may in certain cases also be in kind. An appropriately designed and executed policy and legal framework are crucial for success of PPPs, and this requires political commitment and support for the program. It is important that policies stress that PPPs are being pursued to provide better services, not simply to attract private sector resources to supplement those that the government lacks. Policies can also provide clarity on other aspects (risk sharing, procurement, financing and the need for transparency). Although not all countries have developed specific new PPP legislation, nearly all PPP countries have felt it necessary to amend existing legislation, if only to clarify that public entities have the needed powers to contract out services under PPPs. In the UK, the Local Government Contracts Act was passed in 1997 to more clearly set out the ability of local governments to enter into PPP contracts and related arrangements. Ireland passed the State Authorities Act in 2002 which defined the possible range of PPPs that State Authorities could enter into, as well as the role of the Minister of Finance in providing directions to ministries aiming to enter into PPPs. In South Africa the national government developed new regulations under existing public financial management legislation to impose central government oversight and approval of PPPs being developed and signed by the provinces. PPPs have good potential as a method of building infrastructure. For example, a toll road was constructed in the US state of Virginia, financed by toll revenue bonds sold by a private corporation. This creative financing approach is why the Pocahontas Parkway could be built without a 15 year delay to assemble financing. Only $27 million of the Parkway's total $324 million price tag came from public funds. As the vast majority of the funding was raised through private bonds issuance, risk to both the localities and taxpayers were minimized. Another example is Chilean railway concession. The railway system deteriorated during the 1980s with freight volumes falling from 14.7 million tons in 1980 to 6.6 million tons in 1990. As the railroad was overstaffed and inefficient, the Government began a process of private sector participation. Under the plan, State railway Empresa Ferrocarril del Estado (EFE) was to continue to be responsible for infrastructure of the main network serving central Chile, while freight operations were vertically separated based on a European model. EFE retained a minority interest in the freight operating company and responsibility for passenger services. The primary Chilean railway concession, Fepasa, had a slow beginning, with numerous problems relating to labor and line rehabilitation. In particular there were a series of law suits from private operators who took the government company responsible for maintenance and investment in railroad tracks, as well as suits by the private companies running rail stock operations against each other regarding perceived anticompetitive practices. Traffic volume was 5.1 million tons in 1994 and did not reach or exceed that level again until 2001. However, these initial problems were eventually worked out, and by 2001 volume started to increase rapidly, reaching 7.3 million tons in 2003. Based on the success of the freight concessions, the Government now plans to concession the right to operate the company's passenger services to private firms as well. As the Chilean example suggests, PPPs have drawbacks and potential pitfalls. It is crucial that design issues are carefully thought out and that both the legal and regulatory framework are established, at least in parallel, with PPP provision. As another problematic example, in the 1990s many countries experienced problems with PPPs associated with currency mismatches between domestically denominated revenues and foreign currency debts. With 163This discussion was drawn from Deepak Lal "Private Provision of Public Goods and Services", and Policy Note Public Private Partnership in Infrastructure ­ Options for Kazakhstan, World Bank, 2005. 121 hindsight, many of the demand forecasts and risk assessments were overly optimistic. As a result, the annual investment flows into infrastructure began to decline, and many of the projects have been renegotiated or cancelled. To avoid pitfalls of PPS, projects must have strong cashflows. The legal and regulatory environment must be such that investors and creditors are sufficiently protected. The political environment must be such that there is popular support to PPP. And finally, PPPs must have access to financing at a reasonable tenor and price. Table A-1.1 Types of PPP Types/ Responsibility Asset O&M CAPEX Commercial Duration Sectors to consider Ownership risk (years) Performance based ­ urban Service Contract Public Public & road maintenance private Public Public 1-2 Road network maintenance Management Contract Public Private Public Public 3-5 Railways Lease Public Private Public Shared 8-15 Water Supply & Sewerage Concession Public Private Private Private 25-30 Electricity distribution BOT/BOO Private and Private Private Private 20-30 Electricity generation Public Urban ring roads National highways (with subsidy*) Divestiture Private or Private Private Private Indefinite (may be Private & limited by license) Public TableA-1.2: Main Forms and Potential Benefits of Private Infrastructure Options/Benefits to expertise t st from .n e Technical Managerial expertis Operating efficiency Investmen efficiency Investmen Responsiveness consumers Insulation political interventio Service contract Mgmt contract w/ fixed fee Mgmt contract w/ perform. Incentive Lease BOT Concession Divestiture Full achievement Partial achievement 122 ANNEX 2.1: Tax Structure: Taxes as Percent of Tax Revenue 2000 2001 2002 2003 2004 2005 TOTAL TAX REVENUES 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Indirect Taxes 30.39% 31.25% 32.55% 28.84% 29.53% 35.24% VAT 19.77% 18.17% 19.69% 15.42% 14.69% 23.06% Other taxes on goods and service 10.62% 13.08% 12.87% 13.42% 14.84% 12.18% Direct Taxes 69.61% 68.75% 67.45% 71.16% 70.47% 64.76% Personal Income tax 13.36% 15.40% 15.82% 16.55% 13.11% 11.82% Payroll taxes 24.15% 25.94% 26.21% 25.94% 28.81% 26.52% Enterprise Profit Tax (CIT) 16.12% 14.53% 13.73% 16.20% 16.03% 16.01% Taxes on international trade 3.27% 3.41% 3.46% 4.64% 5.03% 4.59% Property and land taxes 2.88% 2.84% 2.64% 2.49% 2.27% 1.85% Other direct taxes 9.84% 6.62% 5.59% 5.35% 5.23% 3.97% VAT efficiency ­Selected countries for 2004 VAT revenue Efficiency Standard rate as % of GDP Ratio (VAT collection as percentage of GDP / Standard rate Bulgaria 8.60% 43 20.00% Croatia 14.10% 64 22.00% Poland 7.90% 36 22.00% Ukraine 4.90% 25 20.00% EU-8 average 7.00% 37 18.80% CEE + Baltic countries 9.26% 46 20.25% 123 124 ANNEX 2.2: The VAT Stands as a Better Tax Compared to a Turnover Tax Issue VAT Turnover tax Distortions · Less distortion on economic choices with respect to · High distortion. This is the most distorting production technology by crediting taxes on inputs, type of sales tax. and avoids taxing exports by crediting taxes paid at · Cascading taxation effect (double taxation) prior stages. · Exports are taxed. · Creates incentives for vertical integration of firms (as "within firm" sales are not taxed) · High marginal tax on lower margin business. Issues of · Fraud detection is easier as it takes two to evade · It only takes one to evade. evasion (buyer and seller). · Under-reporting of sales is common and (detection of · Buyers and sellers (in theory) have conflicting more difficult to verify. fraud) interests-buyers want to overstate their purchases and sellers want to understate their sales. Administration · It requires a more sophisticated tax administration to · Easier to administrate--BUT the monitor and tackle fraud. administrative costs could rise with audits-as verification of reported turnover is difficult. Equity Many argue that, in general, consumption taxes are regressive, but to discuss equity impact it is necessary to look also at the incidence of expenditures. · Clearer distributional effect as VAT collects what is · Unclear distributional impact. economically equivalent to a single-stage sales tax by withholding tax at each stage of production. By doing so it achieves the goal of only taxing consumption. Expected level of VAT refunds for Ukraine -- based on the regression showcased in IMF working paper WP/05/218 Refunds = 0.16*Exports + 0.75*Growth + 0.19*Literacy +0.90*Range, where exports is the share of exports in GDP, growth is average GDP growth in the period, literacy is the literacy rate, and range is the difference between the lowest (non-zero) and highest VAT rates. (A number of dummy variables are included in the original equation, but none are applicable for Ukraine.) The estimated equation (adjusted R squared = 0.8826) 125 126 ANNEX 2.3: Methodologies to Estimate the "VAT GAP" The VAT gap is the difference between VAT actually collected and that potentially realizable if all consumption were in fact taxed at the stated rate, but considering exempted bases. Note that the VAT gap is not an estimate of VAT `evasion' but rather that combines both "evasion" and "erosion" in the form of legal reductions of the tax base through exemptions and zero-rating (other than for exports).164 Estimating the VAT GAP165 There is a variety of ways for estimating the "VAT gap", and they can be broadly classified in two groups: direct (also called bottom up approaches) and indirect methodologies (called top-down approaches). Direct methods are based on information gathered by the tax administrations through audits and other internal data. Indirect methods are based on information gathered from national accounts. While the estimated amounts through these methodologies are not exact point estimates, they are a good approximation for establishing a variety of collection and fraud benchmarks that can be used for monitoring in future periods of time. This information has allowed the tax administrations of several countries to monitor and tackle the fraud and evasion problems in a timely and efficient matter. The countries cited in this Annex have reduced fraud systematically during the last years through the use of these tools (and other), which have allowed them to perform better monitoring and allocate resources for auditing more efficiently. Indirect methodologies These are based on national accounts data and its comparison to actual collections. Within this category the production and the consumption methods are the most commonly used. The production method This method is based on information from national accounts and its desegregation (i.e., input-output tables). This method is extremely useful for establishing collection benchmarks by sector of the economy. In fact, its process of estimation is based on individual economic sector estimation of VAT gaps that at the end are added up to obtain the overall VAP gap for the economy. The VAT gap can be calculated from the difference of the potential or theoretical VAT collection (PVAT) minus actual VAT collections (AVAT) for a given year (or VAT GAP = PVAT- AVAT). The potential VAT collection (PVAT) is the sum of potential domestic VAT collection of all sectors of the economy (PDOM) plus the potential VAT collection in taxable imports (PIM). That is, PVAT = PDOM + PIM (1) More specifically, the potential VAT collection for each sector "i" of the economy (PVATi) is the result of the difference between debits for sales of goods and services in that sector (Di) minus the credits for purchases subjects to VAT used in the production of those goods and services in the same sector (Ci). This calculation can be expressed in the following way: PVATi = Di - Ci (2) 164Although direct methodologies as explained later in this Annex can depict with certain precision the amount on evasion and the type or nature of the evasion. 165The following methodologies draw on methods to estimate the VAT gap from Jorratt (1996); Cobas, Perelmuter, and Tedesco (2003); and Salim (2005) with adjustments. 127 Di = (GVPi - ESi - Ei)*r (3) Ci = [(ICi - ECi - CPEi)*r] +[(Ki + EKi + CPKi)*r] (4) Where GVPi is the gross value of production; ESi represents the VAT exempted sales; Ei represents exports of that sector; and r is the VAT rate applied. In addition, ICi is the spending in intermediate purchases; ECi represents intermediate purchases exempt of VAT; CPEi represents the purchases of goods and services used specifically for the production of goods and services that are exempt; Ki represents spending in intermediate investments; EKi is spending in intermediate investments exempt of VAT; and CPKi is spending in intermediate investments for the production of exempt goods and services. Note: If information is not available to estimate VAT exempted sales ESi as formulated in equation (3) above. Then the debits for sales of goods and services in a sector (Di) can be calculated using the "effective" VAT rate ( ), in the following way: Di = (GVPi - Ei)* (5) From the aggregations of the debits and credits of sector in the domestic economy we arrive to PDOM PDOM = ( Di...+ ..Dn) - (Ci....+ ..Cn) (6) The potential VAT collection on taxable imports (PIM), in its simplest way, can be represented by: PIM = (TI - IE)* r (7) Where TI are the total imports and IE are imports exempted of VAT. Of course, potential VAT collection on taxable imports can also be estimated by sector of the economy (i), so later can be added to the domestic potential collection of each sector (i) . This would create integrated (i.e., domestic + imports) collection benchmarks for each sector. PVATi = PDOMi + PIMi (8) The consumption method This method is used for estimating the overall VAT gap for the economy. It is based on the estimations of total final consumption of non-exempted goods and services, and the purchases of goods and services, and spending in investments that are utilized in the production of exempted goods and services. As before, the VAT gap is the difference between the potential VAT collection, as established through this methodology, minus actual collection for a given year. The estimation of potential VAT collection through the consumption method (PCVAT) has following procedure: PCVAT = (FCH * r) + (CIPN*r) + (CIE*r) + (IPE*r) FCH is the final consumption of households on non-exempted goods and services and it is calculated in the following way: FCH = FC-FE-UCA+CF. Where FC is final consumption of households; FE is final consumption of households of exempted goods and services; UCA is the final consumption of Ukrainian nationals abroad; and CF is consumptions by foreign nationals in Ukraine. CIPN is the consumption and investment of the public sector in non-exempted goods and services and it is calculated in the following way: CIPN = CIP-CIPE. Where CIP is consumption and investment of public sector; and CIPE is the consumption and investment of the public sector in exempted goods and services. 128 CIE is intermediate consumption of non-exempted goods and services used for the production of exempted goods and services. IPE is the investment in non-exempted goods used for the production of exempted goods and services. Direct methodologies (Bottom up approaches) Direct methodologies for estimating the VAT Gap are primarily based on the analysis of VAT declarations (and payments) and the results of random audits performed on those declarations. They help in the construction of VAT collection (and fraud) benchmarks by sector of the economy, type of tax payer, geographical location, and several other variables. In addition, they help to evaluate the nature of the collection problems (i.e., underreporting of sales, overstated purchases) and their relative size. The most commonly used methodologies for these estimations are the comparative analysis of audits and the so called "fix point" method. In the method of comparative analysis of audits, a representative random sample of taxpayers is surveyed and analyzed to estimate the value of underreported activities. The underreported activity for one tax payer (n) is the amount of VAT payment in the tax payer's declaration (and collected amount) minus the amount ought to be paid as determined by the audit. Once the underreported activity is added up for all the taxpayers in the sample (t) the total VAT Gap for that sample is obtained--and the results can be inferred for the whole population of taxpayers. This can be represented in the following way: VATGap = n=t(AL - DC) n=1 Where AL is the audited liability on VAT; and DC is the declared and collected amount of VAT from a tax payer. The process of sampling is relatively simple. A core principle is that the sample has to be purely random. This means that the audited taxpayers in the sample have to be selected for audits that were made randomly in the first place. In other words, audited taxpayers from "targeted" audits can not be included in this sampling process. The sample does no need to be very large. Even small samples can provide a good degree of confidence to estimate overall VAT gap.166 However, using larger samples this method can also produce benchmarks of collection by sector of the economy, by type of tax payer, and by geographical location. While rich information from past audits is required for getting more detailed results, this methodology is less complex and costly that it would appear. Estimate of VAT Revenue Loss, UK, 2001-02 Type of loss Size (as percent of VAT collections) Under-reporting of net liability owing to under-reported sales and over-stated 3.5-5.5 % purchases `Missing trader' fraud where firms buy goods tax-free from other EU countries, sell at 2.4-3.0 % VAT-inclusive prices and disappear without paying VAT Failure to register for VAT 0.6-0.7 % Avoidance schemes to be challenged by administration 3.5-4.2 % Total 9.9-14.2 % Moreover, this methodology allows for a detailed analysis of the nature of the problems generating losses of revenue (i.e., underreporting of sales, overstated purchases, avoidance schemes that could be challenged, and even "missing trader"). This can be done with larger samples by depicting the portion of revenue loss that corresponds to each type of fraud. This is a feature that indirect methods do not provide. The use of this type of estimation is common in the 166SIIC- Internal Revenue Service of Chile. 129 Chilean and the United Kingdom tax administrations, among many others. These revenue authorities perform periodically detailed analysis of the nature of problems that generate a VAT Gap and the relative size of them.167 In the "fix point method" a tax agent arrives at the tax payer place of business and performs a control of sales during a given period of time. The turnover during that period is later compared to declarations and payments made by the tax payer for similar periods of time in the past. After this is performed on a sample of taxpayers the summation of all estimated underreported activity is the VAT gap for that sample. Due to its characteristic of implementation, this methodology is limited to medium size companies that sell directly to the final consumer. Thus, the taxpayers considered for this type of exercise are mostly in the service, and retail/trade industries.168 Moreover, its results of VAT gap are limited to an approximation of the domestic VAT gap. 167 A detailed review of all the cases mentioned may be found in Bird and Gendron (2005). 168In some case wholesale firm can be considered if the volume of sales for a short period of time can be actually computed by the tax administration officer present. 130 ANNEX 2.4: The Relative Size of the Shadow Economy for Selected Countries, 1999/2000 Shadow Economy as Percent of Shadow Economy as Percent of GNP 1999/2000 Country GNP 1999/2000 Country Albania 33.4 Guatemala 51.5 Algeria 34.1 Honduras 49.6 Argentina 25.4 Hong Kong, China 16.6 Armenia 46.3 Hungary 25.1 Australia 14.3 India 23.1 Austria 10.2 Indonesia 19.4 Azerbaijan 60.6 Iran 18.9 Belarus 48.1 Israel 21.9 Belgium 23.2 Italy 27 Botswana 33.4 Kazakhstan 43.2 Brazil 39.8 Kenya 34.3 Bulgaria 36.9 Republic of Korea 27.5 Burkina Faso 38.4 Kyrgyz Republic 39.8 Cameroon 32.8 Latvia 39.9 Canada 16 Lebanon 34.1 Chile 19.8 Lithuania 30.3 China 13.1 Madagascar 39.6 Colombia 39.1 Malawi 40.3 Croatia 33.4 Mexico 30.1 Czech Republic 19.1 Moldova 45.1 Denmark 18.2 Mongolia 18.4 Georgia 67.3 Niger 41.9 Greece 28.6 Pakistan 36.8 Poland 27.6 Tunisia 38.4 Portugal 22.6 Turkey 32.1 Romania 34.4 Uganda 43.1 Russian Federation 46.1 Ukraine 52.2 Slovak Republic 18.9 Uruguay 51.1 Slovenia 27.1 Uzbekistan 34.1 South Africa 28.4 Venezuela 33.6 Spain 22.6 Vietnam 15.6 Sources: Schneider (2002) and Schneider and Enste (2002). 131 132 ANNEX 2.5: Equations of General Equilibrium Model Of central issue in current discussions of the payroll programs is the potential effect of payroll tax rate reductions on tax revenues. There are several ways of examining this issue. The simplest approach makes use of a simple accounting identity, in which tax revenues R are equal to the product of the tax rate t, the number of individuals subject to the payroll taxes N(t), and the value of the associated wage base W(t): R = t · N(t) · W(t). Both N(t) and W(t) are assumed to be functions of (among other things) the tax rate, to reflect the likelihood that changes in the tax rate affect the payroll tax base. The proportional change in revenues is then simply R/R = t/t + N/N + W/W, so that the proportional change in revenues equals the sum of the proportional changes in the individual components. Recognizing that the number of individuals and the value of the wage base each depends upon the tax rate, the proportional change in revenues can also be written as R/R = t/t (1 + N,t + W,t), where N,t is the elasticity of the number of taxpayers with respect to the duty rate and W, is the elasticity t of the wage base with respect to the rate. Both elasticities will be negative in value because a reduction in tax rates will increase both N and W. Now suppose that the payroll tax rates are reduced by, say, 50 percent. In the absence of any change in the tax base, payroll tax revenues would fall, also by 50 percent. However, conversations with numerous government officials suggest that both N(t) and W(t) will respond to the rate reductions. For example, if each variable increased by, say, 25 percent (or an elasticity in each case of -1/2), then overall revenues would be unchanged by the rate reduction. If the elasticities are greater than -1/2 (in absolute value), then revenues would actually increase. More generally, if the sum of the two elasticities exceeds - 1, then a rate reduction would increase tax revenues. The relevant issue then becomes the magnitude of the elasticities. There is no information on these elasticities. However, evidence for other types of responses in other countries suggests that elasticities in excess of 1/2 are extremely unlikely. A slightly more complicated framework generates the same conclusion. Suppose that the equilibrium level of some tax base (e.g., the wages of workers subject to the payroll taxes) depends upon the supply and the demand of this tax base. Then it is straightforward to show that the tax rate that maximizes the tax revenues collected from this tax base is: tRMaximum = (S ­ D)/(-D (1+ S)) where tRMaximum is the revenue-maximizing tax rate, S is the elasticity of supply of the tax base, and D is the elasticity of demand, where both elasticities are assumed to be constant, and where S 0 and D 0. Again, the crucial issue for the impact of any tax rate reduction is the magnitude of the elasticities. It is only when the elasticity of demand for the tax base exceeds -1 (in absolute value) that there is any chance that a reduction in tax rates will increase revenues. The general equilibrium model discussed earlier also gives the same conclusion. For reasonable values of the various elasticities, values that approximate estimates derived from empirical work on these 133 behavioral responses, it is never the case that a decrease in the tax rate on labor increases tax revenues. The typical result is that a reduction in the labor tax rate generates some increase labor in the taxed sector, but that this increase in labor (and the corresponding increase in labor tax revenues) is not nearly sufficient to offset the loss in revenues from the rate reduction. Indeed, for plausible values of the parameters, a reduction of, say, 10 percent in the labor tax rate reduces tax revenues in most scenarios by 5 to 9 percent. It is only when these elasticities (especially the elasticities of substitution between labor and capital in the various sectors and elasticities of demand) are extraordinarily high ­ and in excess of most elasticities estimated from empirical work ­ that revenue simulations give the result that a reduction in the labor tax rate increases labor tax revenues. Recall also that the stylized model assumes that labor (as well as capital) is perfectly mobile across the taxed sector, the legally untaxed sector, and the evasion sector. When factor mobility becomes less than perfect, the possibility that a reduction in the tax rate increases tax revenues becomes even less likely. The full set of equations for the stylized economy can be represented as follows (where ^ denotes the percentage change in the relevant variable): = EXX (PX -^PZ ) + EXY (^PY -^PZ ) ^ (1) ^X = EYX (PX -^PZ ) + EYY (^PY -^PZ ) ^ (2) ^Y ^ ^ (3) ^X = fK KX + fL LX ^ ^ ^ (4) Y = gK KY + gL LY (5) ^KX -^LX = sX (^r + TK - w - TL) ^ (6) ^KY -^LY = sY ( w - r ) ^ ^ (7) ^KZ -^LZ = sZ ( w -^r ) ^ (8) ^KX KX + ^KY KY + ^KZ KZ = 0 (9) ^LXLX +^LY LY +^LZ LZ = 0 (10) ^PX = fK(r + TK) + fL (w + TL) ^ ^ (11) ^PY = gK r + gL w ^ ^ (12) ^PZ = hK r + hL w ^ ^ (13) ^PZ = 0 where Eij is the compensated elasticity of demand for i with respect to a change in the price of good j, defined to be nonpositive (i,j = X,Y); Pi is the price of good i (i = X,Y,Z); r is the price of capital; w is the price of labor; fj is the initial share of factor j in sector X (j=K,L); gj is the initial share of factor j in sector Y (j=K,L); hj is the initial share of factor j in sector Z (j=K,L); si is the elasticity of substitution between capital and labor in sector i, defined to be nonpositive (i=X,Y,Z); and Tj is the tax on factor j in sector X (j=K,L). Equations (1) and (2) express the percentage change in compensated demand as a function of the percentage change in the relative product prices of X and Y, respectively. Equations (3) and (4) describe the change in output of X that results from changes in factor usage in the sector. Equations (5), (6), and (7) relate the change in factor proportions in the sectors to changes in relative factor prices via the elasticity of substitution in production. Equations (8) and (9) follow from the assumption of fixed factor supplies of capital and labor. Equations (10), (11), and (12) show the relationships between changes in factor prices (including taxes where appropriate) and the resulting changes in product prices. Equation 134 (13) defines the price of good Z as the numeraire. All physical units are chosen such that initial prices are unity. ^ ^ These equations constitute a thirteen-equation, thirteen-unknown system, where the unknowns are X , Y , KX , KY , KZ , LX , LY , ^LZ , PX , PY ,^PZ , r , and w . This system can be reduced by substitution ^ ^ ^ ^ ^ ^ ^ ^ ^ and then solved for the remaining unknowns by Cramer's Rule. Using dollars as the unit of currency for purposes of discussion, the size of sector X is assumed to equal $75, and this also equals the sum of the gross-of-tax income of capital and labor in the sector. Similarly, sector Y is assumed to equal $25; the legally untaxed sector Y is therefore 1/3 the size of the taxed sector. The amounts paid gross-of-tax to K and L in the taxed sector are assumed to equal $20 and $55, respectively, so that the shares of capital and labor in sector X (denoted fK and fL ) are assumed to equal fK =0.2667 and fL =0.7333. The amounts paid to K and L in sector Y are assumed to equal $5 and $20, respectively. The factors shares in sector Y (gK, gL) are therefore gK =0.2 and gL =0.8. Recall that units are chosen so that one unit of a factor is the amount that earns $1 net of taxes. Because capital and labor in sector Y are not taxed, there are 5 units of capital and 20 units of labor in the sector. For sector X, the number of units depends on the burden of taxation. We assume that total taxes equal 25 percent of output in sectors X and Y, with $8 of taxes coming from capital in sector X and $17 coming from labor in X. Because units of capital and labor are chosen so that one unit of a factor is the amount that earns $1 unit net of all taxes, there are 12 (=20-8) units of capital in X and 38 (=55-17) units of labor. This procedure also generates estimates of the tax rate on capital and labor. The tax rate is calculated by dividing the total taxes borne by the factor by its net-of-tax income. The tax rate on capital in sector X is 0.6667 (=$8/($12), while the tax rate on labor is 0.4474 (=$17/$38). Capital and labor in sector Y are untaxed.169 As for the hard-to-tax sector Z, we make two alternative assumptions about its size. We assume that sector Z equals either 25 percent of formal sector (X+Y) output, or $25, or that it equals 50 percent ($50) of formal sector output. In either case, we assume that this sector is highly labor-intensive, with factor shares for labor (hL) and capital (hK) of hL =0.9 and hK =0.1, respectively; the amounts of labor and capital therefore equal (22.5, 2.5) and (45, 5) in the two alternative scenarios. As discussed below, sensitivity analysis indicates that the excess burden estimates do not vary substantially with variations in the size of the sector. We assume various combinations of the elasticities of substitution between capital and labor (or si, i=X,Y,Z), from 0 to -1/2 to -1. As for the compensated elasticities of demand, we assume that the own- elasticities (EXX, EYY, EZZ) are equal to each other, and that the cross-elasticities of demand of Y and Z with respect to the price of the taxed good X are equal to one another. Together with the requirement of symmetry in compensated responses, these assumptions imply that choosing a value for EXX determines the values of the other elasticities. We assume that EXX equals -1/2 or -1. Variations in the elasticities of demand and of substitution have a more significant impact on the welfare cost estimates. 169See Harberger (1962), Alm (1986), or Alm and Buckley (1998) for more discussion of this procedure. 135 136 ANNEX 2.6: Tax Systems for Small Businesses Country Type of System Comments/Description Albania Lumpsum tax or gross turnover A fixed tax for small businesses whose annual turnover is less than 2 tax million Lek; a 4% gross turnover tax for small business whose gross turnover is 2-8 million Lek Armenia Lumpsum tax For small-scale activities (e.g., hairdressers, gas stations, commercial fishing, and trading activities conducted in trading areas less than 30 square meters) Azerbaijan Gross turnover tax A 2% gross turnover tax when turnover is less than 300 times the minimum tax-exempt wage Belarus Lumpsum tax For stores that are single owned and that have total trading space less than 25 square meters Belgium Flat rate tax A forfeit scheme that applies for 3 years to small businesses based on profession for income below BF 10,000 Bulgaria Lumpsum tax For individuals in specific business sectors with an annual turnover less than 75,000 BGN Georgia Lumpsum tax For enterprises with turnover less than GEL 24,000 Greece Flat rate tax Applied to purchases and receipts Hungary Lumpsum tax Small entrepreneurs may chose an itemized presumptive tax in place of the individual income tax and the value-added tax Israel Flat rate tax For retail firms and artisans whose gross turnover is less than $4000 Kazakhstan Lumpsum tax or gross income A special regime based on a simplified tax return for individuals with tax no more than 15 employees and T 4.5 million gross income, or for legal persons with no more than 25 employees and T 9 million gross income Kosovo Lumpsum tax For any taxpayer other than an insurance company with gross receipts less than 15,000 DEM Kyrgyzstan Gross turnover tax A 5-10% gross turnover tax for small businesses with total revenue less than 3 millions soms, in lieu of all national taxes; a 4% monthly gross turnover tax for individual entrepreneurs Lithuania Presumptive tax Optional for firms with gross income less than 100,000 LTL Romania Gross income tax For small enterprises with no more than 10 employees and Euro 100,000 annual turnover Serbia Gross turnover tax; lumpsum A 2% tax on gross receipts for enterprises with no more than 50 tax employees, 8,000 average monthly gross wages, and average value of assets no more than 6,000 average monthly gross wages; a lumpsum tax for entrepreneurs Uruguay Flat rate tax A flat rate tax on turnover, for small businesses and professionals Uzbekistan Gross turnover tax; lumpsum A 3-5% tax (depending on location) on turnover, for wholesale trade tax firms, and a 7-10% tax (depending on location) on turnover, for public catering firms; a lumpsum tax for individual entrepreneurs with no legal entity Sources: Engleschalk (2004) and Bird and Wallace (2004). 137 138 ANNEX 3.1: Social Privileges in Ukraine Categories of Privileges Populations in Ukraine Special Merits Social Characteristics Occupational Characteristics (Approximately 760,000) (Approximately 10,500,000) (Approximately 900,000) · Heroes of Ukraine · War participants · Member of Parliament · Heroes of the Soviet · Chornobyl accident victims in Category II · Deputies of local radas Union · Pardoned* people and their survivors · Fire fighters · Heroes of Socialist Labor · Labor veterans · The military · Participants in combat · Individuals with status comparable to that · Militia personnel operations of war participants · Personnel and inspectors in Public · People with disabilities of · Families of people eligible for privileges Prosecutors' Offices Groups I, II, III as a result based on social and occupational of war · Court personnel characteristics · Chornobyl accident · Officials of the Customs Service · "Victims" of occupational activities and State Tax Administration victims, Category I · Honorary blood donors · Individuals with special · Culture and Education workers labor merits · Military veterans · Teachers working in rural areas · Children of war and retired teachers who worked · Veterans of the state fire fighting service and still reside in rural areas · Veterans of the Ministry of Defense, · Health and pharmacists residing in National Security Service, Ministry of rural areas Interior, other executive agencies and · Journalists military units · Personnel from anti-tuberculosis · Surviving spouses of military veterans facilities · Pensioners under special laws on · Specialists in plant protection occupational retirement (including former MPs) · Pensioners including retired inspectors of the Public Prosecutor's Office, retired agriculture workers, retired librarians · People with disabilities by occupational characteristics · People with disabilities (general disease) · People with disabilities from birth · Invalid of the military service · Widows(ers) of military veterans, Ministry of Interior veterans and their children · Spouses of service person missing in action and their children · Parents of deceased servicemen · Disabled survivors of firemen, militia, tax police, officers in the criminal and executive system · People who were forcibly relocated · Orphans · Families with many children *People who served in prison camps who have since been considered "rehabilitated" and pardoned. 139 Laws and Normative Acts that Regulate Privileges in Ukraine Laws 1. Law of Ukraine "On Prioritized Development of Rural Areas and Agro-Industrial Complex in the National Economy" # 400-XII dated October 17, 1990 2. Law of Ukraine "On Militia" # 565-XII dated December 20, 1990 3. Law of Ukraine "On Status and Social Protection of Chornobyl Accident Victims" # 796-XII dated February 28, 1991 4. Law of Ukraine "On Basic Principles of Social Security in Ukraine" dated 875-XII dated March 21, 1991 5. Law of Ukraine "On Vindication of Victims of Political Repression in Ukraine" # 962-XII dated April 17, 1991 6. Customs Code of Ukraine # 1970-XII dated December 12, 1991 7. Law of Ukraine "On Education" # 1060-XII dated May 23, 1991 8. Law of Ukraine "On Border Troops of Ukraine" # 1779-XII dated November 04, 1991 9. Law of Ukraine "On Public Prosecutor's Office" # 1789-XII dated November 05, 1991 10. Law of Ukraine "On Armed Force of Ukraine" # 1934-XII dated December 06, 1991 11. Law of Ukraine "On AIDS Prevention and Social Protection of the Population # 1972-XII dated December 1991 12. Law of Ukraine "On Farming" # 2009-XII dated December 20, 1991 13. Law of Ukraine "On Social and Legal Protection of the Military and Their Family Members" # 2011-XII dated December 20, 1991 14. Law of Ukraine "On Fundamentals of the Ukrainian Legislation on Culture" # 2117-XII dated February 14, 1992 15. Law of Ukraine "On National Security Service" # 2229-XII dated March 25, 1992 16. Law of Ukraine "On Ukrainian Ministry of Interior Troops" # 2225-XII dated March 26, 1992 17. Law of Ukraine "On Status of a People Deputy (Member of Parliament) of Ukraine" # 2790-XII dated November 17, 1992 18. Law of Ukraine "On Fundamentals of the Ukrainian Health Legislation" # 2801-XII dated November 19, 1992 19. Law of Ukraine "On Status of Judges" # 2862-XII dated December 15, 1992 20. Law of Ukraine "On Promoting Social Formation and Development of the Youth in Ukraine" # 2998-XII dated February 05, 1993 21. Law of Ukraine "On Status of War Veterans and Guarantees of Their Social Protection" # 3551-XII dated February 05, 1993 22. Law of Ukraine "On Basic Principles of Social Protection of Labor Veterans and Other Senior Individuals in Ukraine" # 3721-XII dated December 16, 1993 23. Law of Ukraine "On Physical Culture and Sport" # 3808-XII dated December 24, 1993 24. Law of Ukraine "On Civil Defense" # 2974-XII dated February 03, 1993 25. Law of Ukraine "On Public Service" # 3723-XII dated December 16, 1993 26. Law of Ukraine "On Firefighting Service" dated # 3745-XII dated December 17, 1993 27. Law of Ukraine "On Veterinary Medicine" # 2498-XII dated June 25, 1994 28. Law of Ukraine "On Libraries and Librarianship" # 32/95-BP dated January 27, 1995 29. Law of Ukraine "On Utilizing Nuclear Power and Radiation Safety" # 39/95-BP dated February 08, 1995 30. Law of Ukraine "On Status of Highland Populated Areas" # 56/95-BP dated February 15, 1995 31. Law of Ukraine "On Museums" # 249/95-BP dated June 25, 1995 32. Law of Ukraine "On Donation of Blood and Blood Components" # 239/95-BP dated June 23, 1995 33. Law of Ukraine "On Status of Military and Ministry of Interior Veterans and Their Social Protection" # 203/98-BP dated March 24, 1998 34. Law of Ukraine "On Plant Protection" # 180-XIV dated October 14, 1998 35. Law of Ukraine "On Presidential Elections" # 474-XIV dated March 05, 1999 36. Law of Ukraine "On Emergency Rescue Services" # 1281-XIV dated December 14, 1999 37. Law of Ukraine "On Perpetuating Victory in WWII" # 1684-III dated April 20, 2000 38. Law of Ukraine "On Out-of-School Education" # 1841-III dated June 22, 2000 39. Law of Ukraine "On Fighting Tuberculosis" # 2586-III dated July 05, 2001 40. Law of Ukraine "On Support of Mass Media and Social Protection of Journalists" # 3056-III dated February 07, 2002 41. Law of Ukraine "On Status of Local Deputies" # 93-IV dated July 11, 2002 140 42. Law of Ukraine "On Social Protection of Children of War" # 2195-IV dated November 18, 2004 43. Law of Ukraine "On 2006 State Budget of Ukraine" 44. Decree of the Verhovna Rada of Ukraine "On Logistics Support of Members of Parliament" # 122/94 dated July 26, 1994 Presidential Decrees 1. Presidential Decree "On Privileges to Heroes of Socialist Labor" # 492/93 dated October 28, 1993 2. Presidential Decree "On Privileges in Health Services to Children Who Had Chemical Toxic Alopecia" # 304/95 dated April 12, 1995 Acts of the Cabinet of Ministries of Ukraine 1. Decree of the Cabinet of Minister and Ukrainian Trade Unions Council "On Measure to Improve Living Standards of Handicapped People from Birth" 2. Decree of the Cabinet of Ministers of Ukraine "On Urgent Issues Related to Operation of Education-and- Foster Institutions" # 143 dated March 23, 1992 3. Decree of the Cabinet of Ministers of Ukraine "On Privileges to Heroes of the Soviet Union and Full Chevaliers of the Glory Order" # 37-93 dated April 23, 1993 4. Decree of the Cabinet of Ministers of Ukraine "On Free Travel by Public Transit for Pensioners" # 354 dated May 17, 1993 5. Decree of the Cabinet of Ministers of Ukraine "On Supplementary Social Guarantees to the Needy Families with Sick Children under Two" # 66 dated February 08, 1994 6. Decree of the Cabinet of Ministers of Ukraine "On Improving Upbringing, Education, Social Protection, and Financial Support of Children without Parental Care" # 226 dated April 05, 1994 7. Decree of the Cabinet of Ministers of Ukraine "On Extending the Effect of Cabinet of Ministers Decree # 254 dated May 17, 1993" # 555 dated August 16, 1994 8. Decree of the Cabinet of Ministers of Ukraine # 879 dated August 01, 1996 "On Setting Standards of Utility Services Consumption by Individuals Enjoying Privileges for Payment for these Services" as amended by Cabinet of Ministers Decrees # 479 dated May 22, 1997 and # 1964 dated December 17, 2003 9. Decree of the Cabinet of Ministers of Ukraine "On Rationalizing Free and Discounted Sale of Prescribed Medicine to Selected Categories of the Population undergoing Out-Patient Treatment" # 1303 dated August 17, 1998 10. Decree of the Cabinet of Ministers of Ukraine "On Approving the Regulation on Granting Low-Interest Long-Term Loans for Educational Purposes to Young People Regardless of Form of Study and Institutional Form of Universities" # 1303 dated August 17, 1998 11. Decree of the Cabinet of Ministers of Ukraine "On Arranging Meal for Selected Categories of Students of Secondary Education Institutions" # 856 dated June 19, 2002 12. Decree of the Cabinet of Ministers of Ukraine dated December 30, 1997 "On Approving the Rules for Providing Residential Water, Wastewater, and Heat Services" as Amended by Cabinet of Ministers Decrees # 450 dated May 06, 2001, # 1973 dated December 25, 2002, # 717 dated May 15, 2003 13. Decree of the Cabinet of Ministers of Ukraine dated July 26, 1999 "On Approving the Rules for Providing Residential Electricity Services" as amended by Cabinet of Ministers decrees # 1607 dated October 26, 2000, # 1275 dated September 26, 2001 14. Regulation on Distributing Pensions and Benefits through Recipients' Current Bank Accounts by Recipients' Approbation ­ approved by Cabinet of Ministers Decree # 1596 dated August 30, 1999 15. Instruction "On the Procedure of Granting, Funding, and Distributing Pensions and Benefits by Post Offices" registered with the Ministry of Justice of Ukraine on August 06, 1998, # 494/2934 16. Standards (of heat, water, and wastewater service consumption) set by the Council of Ministers of Autonomous Republic of Crimea, oblast, Kyiv and Sevastopol city state administrations and local executive authorities 141 142 ANNEX 3.2: Ukraine's Judicial System: Challenges and Plans for Improving Budget Funding170 Global studies indicate that determining the annual allocation of budget funding for the judicial system is generally a frustrating and contentious process given the independent nature of the Judicial Branch, split responsibilities and functions among justice sector institutions, and usually diffuse performance measurement and accountability mechanisms. Ukraine's challenges are similar, perhaps more complex, as new institutions are still being created and old ones are being reformed following the country's independence in 1991. The transition has altered the number and composition of budget entities and resources due to changes such as the creation of the constitutional court, the transfer of administration of justice responsibilities from the Executive Branch (Ministry of Justice) to the Judicial Branch through the setting up of State Judicial Administration (SJA) in 2003, the creation of the Judicial Council, establishment of Academy of Judges for training, and reorganization of MoJ and the bailiff service etc. SJA administration, which handles the bulk of the courts under the general direction of the Supreme Court, is undertaking improvements in budgeting and automating management. Ukraine's system of justice is financed out of the state (central) budget. In 2004, the budget allocation for the system of justice was about UAH 240 million. This equals about 0.7 % of the GDP or about 3.0% of the total amount of the state budget. In 2004, the overall share of the budget for the judicial system--a subset of the system of justice comprising judicial authority (courts) and State Judicial Administration responsible for administering the lower courts--was about 0.87 % of the total amount of the state budget (about UAH 692 million). Budget expenditures for judicial institutions are broken down in two main economic categories: (i) consumption expenditures which pertain to remuneration of staff, social protection and utility payments etc.; and (ii) development expenditures which pertain to capital expenditures, expenditures for studies, designs, purchase of land etc. Consumption expenditures, which are the biggest category, range from about 85 percent in SJA, about 50 percent in the Supreme Court and about 92 percent overall for the system of justice. Court budget per capita in Ukraine is about 2.31 Euros, compared with 4.62 in Russia, 0.8 in Moldova and 0.64 in Azerbaijan (CEPEJ 2002). In recent years the proportion of the overall budget for the system of justice in relation to total budget of Ukraine has generally remained the same (about 3 percent). But the individual allocation to sector institutions has experienced major shifts due to judicial reforms that have changed their functions and responsibilities. For example, MOJ administration budget was reduced by half when SJA was created and court administration functions were transferred to this new institution. Support to regional (oblast) courts was reduced to zero when functions were transferred to central judicial authorities such as the High Commercial Court. These changes have affected personnel that manage budgets and the development of automated financial management systems. The classification of indices of planned budgetary disbursements by economic classification has experienced changes in 2005, making a multi-year comparison of budgets cumbersome. Given that the system is in transition and has to address decades of underinvestment, mounting budgetary pressures warrant better financial planning and resource management. The process of moving towards an appropriate budget and financial management arrangement is underway. Three specific measures are contemplated by the authorities. One is to clarify the role and functions of different institutions that comprise the justice system. The second is to automate/upgrade financial management and budget management systems. The third is to improve the information base for planning and to link it with operational priorities at the central and regional SJA levels. SJA has undertaken bottom-up planning and budget preparation work for development and consumption expenditures. Resource management and its linkage with workload and other priorities of the courts is planned to be improved through a court mapping exercise that the Bank plans to support under the proposed judicial modernization support project. While contentions between sector institutions and between the Judicial and Executive Branches are not expected to be resolved anytime soon, incremental improvements towards good budgeting and linking budget with resource management will help overall performance and measurement mechanisms. 170By Waleed Malik (LCSPS) 143 144 ANNEX 4.1: A Brief Description of the Forecasting Models171 1. Overview Ukraine's pension system is entirely unique. In particular, the system's complex indexation mechanism, which increases the minimum pension at the rate of inflation, but increases higher pensions at a rate less than inflation, cannot be simulated using a standardized simulation model. For this reason, it is necessary to construct forecasting models that are tailored specifically to Ukraine's pension system. Prior to the Consultant's arrival in Kiev, the Ukraine Center for Social Reform had constructed a basic forecasting model for Ukraine. This model is an "average-person" model -- a model that estimates future cash flows of the pension system by calculating pensions for persons who earn the average wage and work for the average service period. While such a model is useful, Ukraine's indexation mechanism cannot be simulated with a high degree of accuracy using such a model. Rather, a "multi-person" model is required; that is, a model that estimates the cash flows of the pension system by calculating pensions for a representative sample of different types of individuals (e.g. individuals with low wage levels vs. individuals with high wage levels, individuals with low pension service vs. individuals with high pension service, etc.). Therefore, building upon the foundation of the first version of the model, the Consultant created a second version. The second version is a multi-person model rather than an average-person model, and is capable not only of simulating the current-law indexation mechanism, but is also capable of simulating a variety of changes to this mechanism. The following paragraphs provide an overview of the model's capabilities. 2 The Model's Basic Structure The Ukrainian Pension Simulation Model (UPSIM) is written in Excel / Visual Basic, and consists of three main components: an input matrix, an output matrix, and an "engine". The engine contains a visual basic computer program which, when activated, reads the input matrix, performs the calculations required to forecast the operation of the pension system, and then writes the results of the forecast to the output matrix. The input matrix is divided into three sections: data, assumptions and policies. The data section contains statistics that describe the current demographic and economic conditions of Ukraine, as well as the financial condition of the pension system in a particular "base year" (e.g. 2003). The assumption section contains economic and demographic assumptions that the user can adjust, and which are used to project the future development of GDP, wages, employment and the size and age-sex structure of the population. The policy section contains parameters that describe the rules governing the pension system, such as contribution rates, retirement ages, benefit formulae and pension indexation rules. The output file is divided into three sections: finance, head counts and pensions. The summary section contains key economic, demographic and pension system statistics for each year of the forecast. The finance section contains a detailed forecast of the pay-as-you-go system's revenue, expenditures and implicit pension debt. If the particular policy scenario involves a capitalized pillar, then the finance section will also display a forecast of the contributions, assets and distributions of the capitalized pillar. The pension section displays the projected entry172 and stock173 pensions for each year of the forecast. In addition to presenting pension averages computed across all pensioners, the pension section also displays pension averages for different sub-categories of pensioners defined by type of pension (old age, disability, or survivor), sex, and financing system (PAYGO defined benefit, PAYGO defined contribution, or capitalized defined contribution). 171This description was prepared by Patrick Wiese (Actuarial Consultant). 172An "entry" pension is defined as the pension awarded at time of retirement. 173A "stock" pension is defined as the average pension computed across both new entrants and those who were first awarded their pensions in prior years. 145 3 The Model's Capabilities UPSIM can forecast the impact of demographic and economic changes upon the operation of the existing PAYGO defined benefit system, and can also simulate a wide-range of policy reform options. The model has an unlimited time horizon, but is typically used to generate 70-year forecasts. Up to 100 sets of policies and assumptions can be neatly stored in the model's "library", and retrieved quickly when needed for a particular simulation. Similarly, up to 100 sets of output results can also be stored in the library. Thus, multiple simulations and sensitivity analyses can be performed rapidly and conveniently. The model can simulate the impact of the following types of reforms: 1. Retirement age increases. 2. Changes in contribution rates. 3. Changes to the indexation mechanism for the minimum pension. 4. Changes to the indexation mechanism for pensions above the minimum. 5. Changes to PAYGO defined benefit formulae. 6. Changes in the valuation of non-contributory years174. 7. The introduction of a notional defined contribution pillar. 8. The introduction of a capitalized defined contribution pillar. 9. Changes to the level of the minimum pension. 10. Changes to the service period required for the full minimum pension. 11. Application of the minimum solely at time of retirement, or each year until death. 12. Any combination of the reforms listed above. UPSIM can simulate fast-paced transitions in which the entire workforce is immediately placed in a new two-pillar system, slow-paced transitions in which only younger workers enter the new system, or medium-paced transitions in which a portion of the workforce initially enters the new system. The model can simulate any level of "accrued rights" valuation for workers entering a new system, ranging from the complete elimination of accrued rights to full credit for accrued rights. 4. The Model's Internal Algorithms UPSIM forecasts the operation of the pension system as a function of user-inputted parameters that describe expected economic and demographic changes. The model does not predict future economic growth, future mortality rates or future fertility rates. Rather, these values are exogenous inputs specified by the user. Therefore, the model could most accurately be described as an "actuarial" model rather than an "economic" model. The model's engine is subdivided into five primary components: a data input module, a demographic module, an economic module, a pension system module, and an output module. The data module is executed first and reads data describing the initial demographic, economic and pension system conditions for a particular base year. After this data is read, the model enters a "loop" which cycles forward in time from the base year to the final year of the projection. The demographic module, economic module and pension module are positioned inside of this loop, and are executed once for each year of the projection. Thus, the basic "skeleton" of the model is as follows: (1) Read Data Describing The Initial Conditions For Each Year From Base Year To Final Year Of Projection: (2) Demographic Module: Project population forward one year (3) Economic Module: Project GDP, wages and employment forward one year 174The Slovene pension system provides unemployed persons receiving cash benefits and women on maternity leave with service credit for periods in which they are not working. PRISM can simulate changes in this policy. 146 (4) Pension Module: Calculate revenues and expenditures for one year (5) Output Module: Write results to output file. Return To Step 2 The demographic module is executed once each year of the forecast, and uses user-inputted fertility rates, mortality rates and migration rates to project the size and age-sex structure of the population forward one year. Thus, each time the demographic module is executed, the population is projected forward in time from year "x" to year "x+1". Similarly, the economic module is executed once each year of the forecast, and calculates GDP, the average economy-wide wage, and the number of employed persons by age and sex. To calculate the number of employed, the population at each age and sex is multiplied by an age-sex specific labor force participation rate, and this product is then multiplied by one minus the age-sex specific unemployment rate. Labor force rates and unemployment rates are entered exogenously by the user. At the user's discretion, an option may be activated which partially endogenizes labor force rates to automatically estimate the impact of retirement age increases. In addition, the calculation of either wage growth or GDP growth (but not both simultaneously) can also be endogenized. In this case, the model uses a simple algorithm to ensure the harmonization of GDP growth, wage growth and employment growth. The pension module is executed after the execution of the economic module, and performs a complex chain of calculations necessary to calculate the revenues, expenditures, and pensions of the PAYGO system, as well as the contributions, assets, distributions and pensions of the capitalized pillar (if the particular policy scenario involves capitalization) 147 148 ANNEX 4.2: The Notion of Subsistence Minimum in Ukraine Article 45 of the Constitution determined the subsistence minimum as a reference point to secure living standards of Ukrainians. Starting from 2000 the subsistence minimum is annually set up by the Parliament before adoption of the State Budget Law and is supposed to follow the increase in CPI175. Actually, during 2001-2004, adjustment of subsistence minimum exceeded CPI growth. Ironically, the level of subsistence minimum at the year of its introduction was set almost at the level of average wage in the country. In contrast to the parliamentary decision the Government introduced the notion of secured subsistence minimum to bring its social commitments in conformity with available budget resources. For the first time the level of secured subsistence minimum has been established in 2001 as a basis for few types of social assistance.176 The minimum wage and pension were always significantly lower then the generous level of subsistence minimum. The minimum pensions were brought up to subsistence level during presidential election campaign in December 2004. Minimum wage is still to be ultimately set at this level by adoption of a new tariff scale, while social assistance is going to be paid based on the secured subsistence minimum. Hence, the current concept of subsistence minimum requires revision to bring it to the affordable level. Major Subsistence Minimum Ratios Year 2000 2001 2002 2003 2004 2005 2006 Subsistence minimum (SM), UAH 216.56 248.77 268.00 268.00 284.69 332.00 358.50 Min old-age pension benefit, UAH ... 58.00 86.90 91.80 102.82 332.00 358.50 % of SM - 22% 32% 34% 36% 100 100 Average pension, UAH 68.86 84.04 125.79 139.46 316.23 385.00 411.00 % of SM 32% 34% 47% 68% 111% 116% 115% Min wage, UAH 91.00 118.00 140/165 185.00 237.00 300.33 364.58 % of SM 42% 47% 52/62% 69% 83% 90% 102% Average wage, UAH 230.13 311.08 376.38 462.27 585.00 791.77 938.02 % of SM 106% 125% 140% 172% 205% 238% 262% Secured subsistence minimum, UAH - 65 80 80 80-115* 90-140 155 175The first level of subsistence minimum has been established in 2000 after the adoption of the Law on Subsistence Minimum in July 1999. 176These are assistance to families and poverty benefits. 149 150 ANNEX 5.1: Annual Budget Process in Ukraine March/April Preliminary macroeconomic forecast by MoE, NBU, and MoF in consultation, and estimate of revenue by the MoF April/May Expenditure limits set for key spending units. May Budget policy guidelines sent to Rada1/ June 1 Commencement of hearings on budget policy in the Rada Early June Expenditure guidelines and request for expenditure estimates issued by the MoF. End-June Estimates of recurrent and capital needs prepared by key spending units (and their subordinate units) in accordance with schedule set by MoF. August 15 Other laws that affect budget revenues or expenditures must be enacted before August 15 of the year that precedes the planned year. Mid-August Consolidated state budget prepared by MoF and submitted to government. September 15 Revised budget approved by government and submitted to Rada. Within five days after government approval, the Minister of Finance presents the budget to a plenary session of the Rada, accompanied by a report from the Budget Committee on compliance with the budget code and the policy guidelines--noncompliance could result in resubmission. October 1 or 6 Rada: first reading, no later than October 1 (or October 6 if a second submission by government required). November 3 Rada: second reading no later than November 3 (or 8). or 8 November 25 Rada: third reading no later than November 25. Should the budget law not be adopted, monthly state budget expenditures will be restricted to one-twelfth of the annual amount applied under the previous year's budget. December 1 Rada: adoption of the State Budget Law. December Regional and local authorities: approval of budgets taking into account transfers and other provisions approved by the Rada 1/Article 33 (3) 5) of the 2001 Ukrainian Budget Code requires the budget guidelines to include "capital expenditures as a share of State budget expenditures and high-priority purposes for the use of capital expenditures." Source: "Ukraine: Report on the Observance of Standards and Codes: Fiscal Transparency Module." IMF Country Report No. 04/98. IMF. April 2004, page 23. 151 152 ANNEX 5.2: Authority to Approve Capital Projects in Ukraine Approval Required Project Size -for productive investments -for non-productive investments Above UAH 15 m The CABINET OF MINISTERS upon For administrative buildings and sport submission of ministries, other regional construction, the CABINET OF bodies of executive power, Council of MINISTERS upon submission of ministries, Ministers of Crimea, oblast, Kyiv and other regional bodies of executive power, Sevastopol state administrations (requester) Council of Ministers of Crimea, oblast, upon agreement of the Ministry of Kyiv, and Sevastopol state administrations Economy. (requester) upon agreement of the Ministry of Economy. UAH 5 m - UAH 15 Ministries, other central bodies of executive For housing, utilities purposes, environment m power, Council of Ministers of Crimea, protection objects, health care, physical oblast, Kyiv, and Sevastopol state culture, science, education, culture and art, administrations (requester) upon agreement Ministries, other bodies of executive power, of the Ministry of Economy. Council of Ministers of Crimea, oblast, Kyiv, and Sevastopol state administrations (requester) upon agreement of the Ministry of Economy. Under UAH 15 m For the projects that start form well-boring, Ministries, other bodies of executive power, ordering of oil and gas deposits, connecting Council of Ministers of Crimea, oblast, them to active networks, mine investment Kyiv, and Sevastopol state administrations activities, forest protection activities etc. (requester) upon agreement of the Ministry Council of Ministers of Crimea, oblast, of Economy. Kyiv, and Sevastopol state administrations (requester) upon agreement of the Ministry of Economy. Under UAH 5 m Approved by the heads of the state-owned Approved by the heads of the state-owned entities upon agreement of supervisory entities upon agreement of bodies of higher executive bodies. level to which responsibility they belong. Investments that The CABINET OF MINISTERS upon attract foreign submission of ministries, other regional investments and executive power bodies, Council of loans guaranteed by Ministers of Crimea, oblast, Kyiv, and the CABINET OF Sevastopol state administrations (requester) MINISTERS upon agreement of the Ministry of Economy. Source: Order of the CMU #995 from 08.09.1997. 153 154 ANNEX 5.3: Criteria for Assessing the Effectiveness of the Budget Process Element Budget Formulation Features Budget Execution Features Aggregate Multiyear macro-fiscal framework used to set Commitment control system limits commitments Fiscal public revenue, expenditure and debt policy within to available resources, supporting avoidance of Discipline realistic economic framework, supporting arrears during retrenchment. anticipation of crises. Treasury cash management further supports The total budget envelope should be: matching of expenditures to revenues. (i) explicit and set prior to determining individual Treasury payment system and internal controls spending allocations; support proper payments. (ii) consistent with the broader macroeconomic Accounting system and Financial Management framework; and Information System (FMIS) support (iii) sustainable over the medium term. comprehensive, timely and accurate information Current policies, laws, and normatives and on spending and revenues for government and line programs reconciled in annual budget to assure ministry management. affordability. Fiscal and banking accounts regularly reconciled. New policies with expenditure or revenue Annual accounts closed in timely manner. implications adopted during year only if Debt management assures sustainable debt policy, affordable in medium-term framework, sources of timely issuance of debt for cash flow management financing identified, and supplemental budget and reaching the spending target. approved to finance within budget targets. Internal audit detects and corrects fraud, waste, Budget is comprehensive, accurate, annual, and abuse; assures integrity of financial authoritative, and transparent. information. External audit assures fairness and accuracy of financial reporting, effectiveness of internal audit and control systems. Allocative Expenditure allocations between and within Commitment and Treasury controls execute the Efficiency sectors are consistent with government policies budget as approved. and priorities. Formal, transparent procedures used to amend Sectoral ceilings set early in expenditure process budget if necessary. to encourage ministry prioritization. Frequency of FMIS reporting allows management Current policies, laws, and normatives and action to correct deviations from approved budget. programs reconciled in annual budget to assure prioritization of resource use, possible program restructuring. Resources are reallocated from lesser to higher priority programs and from less effective to more effective programs, across and within sectors. Technical Budget planning (within resource ceilings and Budget execution (commitment and cash controls) Efficiency supported via execution of budget as approved) limits critical expenditures, but supports flexible supports productivity improvements and resource use at program level (e.g., across non- management/program development. personnel economic classifications, with respect to Budget process supports analysis and review of seasonal spending patterns) for efficiency performance, structure, staffing and organization, (controls are not excessively detailed to prevent policy, normatives. management of program). Program classification structure within ministries FMIS supports program managers. supports focus on objectives, results. Civil service system supports quality public staff, Basic program performance information allows flexibility in reallocating staff resources, linking of resources with results, pressure for restructuring workforce. increased efficiency. Procurement system supports competitive, Program evaluation supports occasional review of efficient, timely contracting. program impact, effectiveness. Internal audit may identify options for improved economy and efficiency. 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Tess 10. 19. 16. 18. 22. 21. 27. 34. 20 .5 5 5 1 2. 0. 1. 6 1. 3 4 1 1 0 0. 0. 5. 6 2 2. .3 Stres.II .6 .0 .0 .3 .1 .2 .9 .6 0062 14 .98 .75 -0. -0. 41 43 -0. -0 .00 .30 -0. 5.0- -2. -2. .00 35 .06 7.5 1.1 7.5 1.1- .33 12 .42 .05 11 17 15 16 17 21 25 26 Analysis 4 1 raeY 6- dradnatS on .43 5.2 .63 1. 4.9 1.1 eviatiD 4 raeY alcir ega 7. 2.3 1 3.- .22 5.11 .541 6- Histo ervA 2015 1 5 6 05 15. 10. 4. .54- .52- .61 9 5 41. 43. .52- .60- .10- 4 3 0.- 0. .50- 9 1.- .61- .61- .00 0 0 2 2 2.- 36. 5. 4. .62 .05 2.5 5.8- 5 5 7 4 2. 13. 2. r).oatlfed 21. Sustainability 2001-, 159 20 4 6 6 ork 9.1 3.1 1.6 .15- .43- 3.3 1 4 5.3 8.3 .63- .62- .10 3 0.- 3.0 .72- 0 1.- .13- .13- 0.0 7 0 1.- 6.5 9.6 5 4. 1.21 0.5 8 4. 0.4- 1.2 0.9 7.2 7 6.2 ,etar GDPno ew 200 ster ed as 7 1 7 9 8 3 5 5 2 9 7 8 1 2 3 7 al (b Debt Fram indicated) 03 4.2 7.1 7. .83- .63- .10- 5.3 5.3 .72- .22- 2.0 0.- 0. .52- 0.- .80- .80- .00 0.- 8.6 3. 1. 4.9 .51 4.5 7.3- 3. 5. 2. 6.1 ,/3eron inte ty 20 Actu ootf od.ir 6 1 .4 .7 .2 7 6 .3 .6 3 3 .3 .3 7 9 1 3 7 ni gnier pes ionatlf 02 28. 19. 5.9 -2 -1 -1 35. 34. -0 -0 .01 0. 7.0 5.1- 0. -0 -0 0.0 0.- 79. 7.2 1. .25 4.3 5. 6.2 7.3 8.0 6.1 6.1: 15. 20 otherwise denif f =foi ouive incti pr es 0 7 3 Sustainabili .8 .8 .2 0 8 .5 .0 31. 20. 10. -6 -6 -0 33. 32. -5 -3 2.0 3.0- 6 0 9 9 5 4 0 8 0 thiw 0. 2.3- 5.2- .1 .1 -1 -1 .00 0. 93. 3. 1. 2.9 .68 3.5 .43- 2. 12. 2. 12. desa bt De unless, 0012 otiartb o.tiartb ofdneta modsuni GDP de Sector of ictse ANNEX blic ent m Pu:enairk perc n(I doten delanrtesessorg bt m) de cy mrtet- enrr cu orhssu . local )t odir odir pl, ofeu .U-- rcenep 70 pesu pesu bt GDPfot val de 20 arll bleaT ni iove iove rcenep do I, CP )tnecr 7002 d and pr prse ortcesc in an es ni ) nillaf pe ge xtte 6002 6002 bliup in .tear mit]) cenalab th geat an the ow ary / + imrp 11 chsuni ni,IPC +g1)( in nisnoiati ionsati sieitilbailtn mit])g+1)( gr + mret-gnol d rcenepyb t) dev [(1)/ )/[(1 dna cen me debir evd d 0062 inge - an;e edru 3/ / rat d GDPlaer f - bt per al in )tnecr 5/ dar 15 ardd ants nis i(sa (i muide ratt eas latinereffid 2/ ratet dengierof n ht (intbed 11)tnecr inegnahcsuni m pe 006-2 ants as m(no (nom owts owtsuni /6 ntocfotnecrep devir g=;tear of n teresni ati pe 50 de on owrg iotaice iestilibali tic es ni( metarlani ni,IPC scedsa(sieitilbail 20 57fo is noital devriedsi iotazit real; htwo nt tionsp btedcit mo by nt plue me ni owlfgnitaerc-tb es (n erag noi onti or ecirped interes nge mu mod bted inge erag ion bt av gnit infctise onitu thworg nali dte nai m t 14)+7+4(s erutidnep teartsertenilaer )3- av dereh .etarhtwo masu /gretar mod real (2 Ass ot .tb om public ribtn gr de GDP mon m ictse PDGlaer e)v detlafed( ntoce ati xerof eciatr ges no gn m goer ic =d co pl,ticif as fron m omrf swolfg in eg do ntiocroti an scaliF )t dexerof dep t) oricaltsih dna bl ,e /1 noedycnerru debr owlfg ex)t :sci stere teartsertenilaer ratet man int tiou omrf omrf onit predetaregnahcxelaer rate iclbupno on calirotsih at PDGlae ets as ndaci rcenep sofono is realt inesaercni denifed terest ratet rcenep dinepsyra soir atsie P pucitse buirtnocetartseret rattseret derotces bt ectos gr mofr ribtn morf reatc-tbed (nstp licp ch otiar /4 srla recei mifo nue need n(i onetartseret t)necr teresni in pe (in im seaC 3B,2Bfo inla ic realeduclnisel isno decitse intaerc- tsna blicup teresnino dytb co onit onit rcenep nom dom g=r;tear bt noit edifti no noti gnid vee dol.S.U ht cenaS ratt bl eco nali inlani resetni ni( gnitiocer veti st thworg incti real n ati es de ncing iot grow ivet us var Tes teres 03e GDfotne ng debt ign-cer dnae (ny nu ofsn real rateno prlaer rectise pusa abriav pl in GDP mo in notiubi fo dom ar ntr ichhwfO buirtnoC buirtnoC buirtnochichw Of zatiiatvirP gnioceR cluni, o-rt-tb mon tear mit noitanib de ioll croa n atilf of infla ecirped ht nse rcep =d terna d ublicP w/o w ge Co endireh duali finass bi M GDP o/ an Ch deiftinedI citifedy ar decita mirP veeR mirP tomuA buritnoC Ot Res licbuP in Gro Key Real eragevA monegarevA eragevA teartseretnilaeregarevA tioalfnI In ow Al US Gr A. nisegarevalaicrotsihriehttaeraslebairavyeK.1A seaB.2A Co. 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