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How and why VAT fuels Ukraine’s shadow economy.

Is it possible to carry water in a sieve? Yes, but provided that for the same period of time more water gets into the sieve than flows from it. And this is not an allusion to Arthur Okun’s famous “leaky bucket” metaphor used to describe the state budget. No, we even carry water to the budget-bucket in a sieve, and then we pour precious water – taxpayers’ money – through the same sieve into the sand!

Frankly speaking,  it is this symbolic image that appears every time you start analyzing not only the figures given in the official reports of the state, but also slightly more comprehensive indicators that are not taken out of the context of our daily life, dynamics of existing trends and patterns.

The biggest sieve in our tax system is VAT. I have previously written about how it is harmful to the domestic economy. Obviously, not everything is obvious to everyone yet, so, I guess it is time to add new arguments.

VAT has the largest tax gaps among all taxes. What exactly is the reason for this is the topic of a separate extensive discussion, there is only a statement of facts here. A study by the HM Revenue&Сustoms notes that with the average value of the tax gap across the entire tax system of the country in 2018-2019 at 4.7% of potential tax revenues, the VAT gap was 7%. A study by European Commission tax experts points out that in 2018 the VAT gap with the EU (including the UK) reached EUR 140.04 billion, or an average of 11% of potential tax revenue across the EU. The range of values for each country is quite wide. The largest VAT gap was registered in Romania – 33.8% of potential tax revenues, and the smallest one was in Sweden – 0.7%. The document also notes that the recession caused by the coronavirus pandemic is expected to increase the VAT tax gap both due to falling incomes and purchasing power of citizens, and due to increased taxpayers’ opportunistic behavior. According to the study by EU experts, just as the gap in the 2008 recession widened from 12% to more than 16% on average in all EU countries in 2009, in 2021 this figure is expected to reach 13.7%.

 Interesting is the following fact. From our observations, the tax gap in relative terms is inversely related to the size of the average per capita income in the economy. That is, the smaller this income, the greater the tax gap. If we add the corresponding figures for Ukraine to the EU data, we will see a clear picture, which is presented in Fig. 1.
Figure 1. The relationship between GDP per person and the VAT tax gap

It should be noted that our estimates of the size of the tax gap, which were given above, are still quite modest. After all, let us recall what figures were announced by the head of the State Tax Service in the TV program “Freedom of Speech”: out of UAH 3 trillion of income per year in Ukraine, 1.2 trillion is spent on consumption. VAT is paid on these expenditures. But UAH 1.8 trillion is missing in a strange way. Is it allocated for savings? No, it isn’t. Based on official data of the NBU, the increase in deposits last year amounted to UAH 210 billion. In view of this, questions arise both to the model of VAT itself and to the efficiency of its administration system. It is obvious that a significant part of the funds allocated for consumption is not subject to taxation, so the size of the VAT tax gap at 30% of potential tax revenues for Ukraine is an absolutely realistic estimate. According to 2019 data, our estimates of the VAT gap on the basis of a comparison of State Tax Service’ data and the intersectoral balance of the State Statistics Service, are 25.6% of potential tax revenues, or about EUR 4.5 billion. For comparison: in absolute terms VAT gaps of EU countries are shown in Fig. 2. Let us remember that this huge gap is fueled by financial corruption, which in turn feeds political corruption with all the negative consequences of it! 

The revealed pattern – the poorer the country, the greater the VAT gap – is confirmed by other researchers who have prepared two important pieces of news for us: one good, one bad. The good news is that in reality, given the phenomenon of shadow consumption, VAT is converted from a regressive tax into a moderately progressive tax. But that is a small consolation for the vast majority of our compatriots. The bad news, which is especially relevant for Ukraine, is that the poorer consumer, the more consumption of goods and services on which taxes are not paid is in the structure of his/her consumption. It does not matter why, be it smuggling or shadow production. This is confirmed in this study based on empirical data from 31 countries. I doubt that the laws of gravity and common sense do not apply in Ukraine!

In view of this, I will not engage in “masochism” to remind our educated readers once again what the level of income per capita in Ukraine is compared to other countries in Europe or the world, how this discrepancy grows over time and what it means for state budget revenues.

The fact that VAT is a sieve is proved by the official statistical data of the State Tax Service of Ukraine, which should only be considered not in dynamics, but in comparison with other no less official indicators of the State Tax Service and the State Statistics Service. According to these data, the tax efficiency of VAT in terms of NACE industries varies in a fairly wide range.

 If the weighted average for the economy as a whole is 3.18% as of the third quarter of last year, the maximum value for the sector “state administration” is 15.9%, and the minimum is for “wholesale and retail trade”, only 1,5%. But if we compare these indicators with the indicators of the tax base, i.e. the share of value added created in each of the industries separately, we see an inverse relationship between the share of the VAT base in the economic structure and fiscal efficiency of the tax. In other words, the larger the tax base in each industry, the lower the tax efficiency of VAT (see Figure 3). Isn’t that weird! In my opinion, there should be no such high differentiation of tax efficiency by industry at all. Since the structure of the economy is a slow thing to change in the short and even medium term, I must assure you that in 2020 the picture did not change dramatically, even despite a slight increase in the fiscal efficiency of VAT.

Figure 3. The relationship between tax base and tax efficiency of VAT, 2019

After numbers and facts, there are some thoughts as always. VAT, like democracy, which works well only in mature societies, may be a good fiscal tool for an economy that is already quite rich and has a steady increase in its citizens’ welfare and a growing population. VAT is effective where a state, if does not control, then at least influences the course of socio-economic processes and successfully corrects market failures. At the same time, it is clear that VAT in its current form is a poor fiscal tool, in other words, a sieve for an economy with a de facto large shadow sector, falling real incomes, rising income inequality, a decline in population, including the working one, a long process of deindustrialization. It is a dangerous illusion to think that such problems in an anocratic state can be overcome by administrative methods. China can probably do it, but Ukraine can’t. The latest example of inability is the protest actions of entrepreneurs against the introduction of registrar of settlement operations (SOR). It was half a step forward and a step back. After all, it is not even marking time.

All this points to the fact that the limit of what is acceptable in taxes is not drawn by the Ukrainian state, even a democratic one, but by the society, the taxpayers. This is neither good nor bad. These are the realities of our lives. After all, no matter what progressive tax laws are approved, only society determines the degree of their legitimacy, which later manifests itself in the level of voluntary payment of taxes and the size of the shadow economy. This important nuance is constantly out of policy-makers’ view, moreover, it is ignored by all kinds of international advisers. They are interested in dry figures and structural benchmarks and our interest is a state with the human face. That is why a social compromise is really important here, and the state must take the first step forward.

We should take this for granted and go with it in future. Therefore, we have no alternative but to give fresh air to all taxpayers, both the mass consumer and entrepreneurs, given the obvious problems in the economy and taxation. What needs to be done for this is a matter of another challenging discussion!

Kostiantyn Shvabii, expert of the Growford Institute, professor, Doctor of Economics for Dzerkalo Tyzhnia.