Raising taxes. How government is trying to mobilize Ukrainian economy

Western partners are increasingly urging Ukraine to rely on its own resources. While at the beginning of the year, Ukraine managed to finance its budget expenditures the old-fashioned way (full-fledged aid from the European Union and the United States mostly covered non-military government spending), in mid-summer the government admitted that it had serious problems financing defense spending throughout the year.

As a result, on July 18, the Cabinet of Ministers submitted a bill to the Verkhovna Rada to raise taxes on individuals and businesses. The government's goal is to raise an additional 500 billion hryvnias ($12.2 billion) for the security and defense sector, of which 125 billion hryvnias ($3 billion) is to be raised by raising military levy rates, expanding its scope, and introducing new excise taxes.

"The war has been going on for three years now and requires an average of 5.6 billion hryvnias ($136.5 million) every day," Finance Minister Sergii Marchenko explained the logic of the draft law in his column.

The increase in the military budget is connected with the increased mobilization of men liable for military service, which is a rather expensive business. At the beginning of the year, when the scale of the mobilization campaign was only being discussed, the head of the Rada Budget Committee, Roksolana Pidlasa, estimated the cost of this initiative at 700 billion hryvnias ($17.1 billion), providing for the mobilization of 400,000-500,000 people liable for military service.

In addition to recruiting more men and women to serve in the Defense Forces, the government must also finance the implementation of military tasks this year. In a recent interview with the British newspaper Guardian, Armed Forces Commander-in-Chief Oleksandr Syrskyi stated that Ukraine has a work plan with goals in Crimea. Later, President Volodymyr Zelenskyy supported Syrskyi's ideas, saying: "Ukraine has the strength to achieve its goals."

No matter how the hostilities unfold in the coming months, Zelenskyy plans to present a plan for achieving sustainable peace by the end of November. This means that the Defense Forces will require more and more spending as long as the president's peace initiatives yield at least some results.

This all costs money. While raising taxes to ensure stable funding for the Defense Forces is hardly controversial, the government's proposed method of doing so has led to heated debate.

"Playing with the military levy? There is a lot of discussion here," says Oleksandr Parashchiy, head of the analytical department at Concorde Capital. But he adds: "If innovations do not kill business, then it is strange to complain about higher taxes."

"For the second year in a row, the Ministry of Finance has been planning on the assumption that active hostilities will end by the middle of the year, but this is not happening," says Dmytro Boyarchuk, executive director of the Case Ukraine think tank.

How deep will the hand of the Ministry of Finance reach?

The current budget mobilization began when the government was forced to advance $6 billion in the first months of 2024 to purchase the necessary weapons and equipment from the subsequent periods.

"The reason was delays in the delivery of weapons promised by our partners," the Ministry of Finance explained.

And off it went. The excise tax on fuel is raised from September 1, and this figure will continue to grow until 2028. The Verkhovna Rada supported this step.

The government then asked the legislature to raise excise taxes on alcohol, with a similar plan for tobacco excise taxes. The parliament also agreed to this.

The Cabinet explained both moves as necessary to comply with EU excise regulations. However, these measures do not come close to covering the need for an additional 500 billion hryvnias for defense.

The first stage of raising excise taxes to the European level could bring in only 16.9 billion hryvnias ($411.9 million) by the end of the year. Therefore, the Cabinet of Ministers has gone further and now wants the Verkhovna Rada to support the following tax increases:

• Increasing the military levy rate from 1.5% to 5%.
• Introduction of a military levy for legal entities in the amount of 1% of turnover (this includes legal entities that pay income tax and single tax payers of the third and fourth groups).
• Introduction of a military military for sole proprietors who are single tax payers of the first, second and fourth groups in the amount of 5% of two minimum wages per month (an additional payment of 800 hryvnias ($19.50) will be required).
• Setting the military levy for sole proprietors that are single tax payers of the third group at 1% of income.
• Military levy at a rate of 5% of the value of transactions of individuals and legal entities with precious metals.
• Military levy at the rate of 30% of the value of jewelry sold.
• Military levy of 15% on the first registration of passenger cars.
• Military levy at the rate of 5% on the sale of real estate.
• Military levy for mobile operators in the amount of 5% of the cost of services.
• Monthly advance payments of income tax for companies selling fuel at the rate of 0.5 of the minimum wage per 1 cubic meter of fuel storage tanks.
• Excise tax on sweet soda at the rate of EUR 0.1 per liter.
• VAT for imported goods priced over EUR 45 and up to EUR 150.

This year, the Ministry of Finance wants to raise 125 billion hryvnias ($3 billion) through these instruments, and next year - 342 billion ($8.3 billion). Minister Sergii Marchenko urged MPs to adopt these tax changes: "I am counting on your support and determination. This initiative must go through the full procedure: it will be considered in committees and in two readings in the Verkhovna Rada."

However, since even such a significant tax increase is not enough to raise an additional 500 billion, the Ministry of Finance expects to make money this year on the following things as well:

• 75.8 billion hryvnias ($1.8 billion) - overfulfillment of the state budget revenue plan in the first half of 2024 (mainly due to the devaluation of the hryvnia);
• 65.7 billion hryvnias ($1.6 billion) in savings on public debt service after reaching an agreement with foreign creditors on July 22;
• 220.1 billion hryvnias ($5.4 billion) from the additional issue of domestic government bonds (however, in the amendments to the state budget, the Ministry of Finance still asks to take into account only 165 billion hryvnias ($4 billion) from the additional sale of domestic bonds).

This is the harsh reality of the Ukrainian public finance system in 2024. According to the National Bank, the state budget deficit this year will reach 23% of GDP, while in the European Union, a deficit of up to 3% of GDP is considered the norm. But war is war.

The Ministry of Defense alone needs an additional 373.7 billion hryvnias ($9.1 billion) this year, mainly to pay salaries to military personnel and provide one-time financial assistance in the event of the death or disability of Ukrainian defenders. The rest of the required 500 billion will be allocated to other law enforcement agencies: the Ministry of Internal Affairs, the Defense Intelligence of Ukraine, and the SBU Security Service of Ukraine.

"The additional need is about 500 billion hryvnias for 2024. All these funds are needed for the Armed Forces and to provide them with the necessary cash payments, as well as weapons, drones, equipment, medicines, and to build their own capacities for the production of weapons," the Ministry of Finance explained to hromadske.

Dmytro Boyarchuk, an economist at Case Ukraine, is not sure that the government's initiatives will help earn 500 billion for the country's defense budget this year. Think tanks' appeal to the Cabinet of Ministers expresses the same doubt, saying that the government's financial plans look questionable.

"Previously, we saw that foreign financing accounted for two-thirds of budget expenditures, and this year everything is much more modest," explains Concorde Capital's Paraschiy. "We need to show our foreign partners that we are improving our self-sufficiency, not relying on them alone.”

VAT or no VAT?

While the government's bill is being considered by the Verkhovna Rada, the debate is getting hotter and hotter.

As hromadske has learned, even the presidential party Servant of the People is somewhat critical of the ideas proposed by the Ministry of Finance. First, the political party expects the government to present the draft law to MPs separately, answer all questions, and take responsibility for the tax increase.

Secondly, the presidential party still wanted to increase the rate of the main budget-forming tax, VAT, from 20% to 24%, rather than raise a large number of other taxes and fees.

The VAT is a well-known tool for tax authorities and one they know how to administer, while new taxes, such as the excise tax on sweet soda, are problematic in terms of organizing their collection.

In the end, a VAT increase would still raise the price of goods, but citizens would have a choice - to buy familiar things at a higher price or to switch to cheaper analogs. But when the military levy for individuals is raised, there is no choice, and the family budget bears a heavier burden.

The Ministry of Finance, on the other hand, is worried that the VAT increase will hit pensioners and other vulnerable groups, so it prefers to impose additional taxes on the working population.

"It's hard to say what will be less painful for the economy, but I would still raise the VAT rate and some excise taxes," says investment analyst Oleksandr Parashchiy.

The experts interviewed agree that there is a very good alternative to the government's current ideas for filling the budget. For example, it is possible to once again resort to taxing bank profits at a higher rate. This measure both replenishes the budget and leaves the financial condition of the banking system in a normal state.

For example, in 2023, the tax rate on bank profits was 50%, but this year it was reduced to 25%. The advantage of such a tax is that it takes funds to the state budget from profit, i.e. the surplus of commercial activities, and not from income, which is still subject to various expenses.

So far, the Ministry of Finance continues to actively earn money for the budget from state-owned banks. This year, they have already transferred 36.1 billion hryvnias ($880 million) in income tax to the government, and another 11.1 billion hryvnias ($271 million) is expected by the end of 2024. They also paid dividends this year, amounting to 24.4 billion hryvnias ($595 million).

"As for sectoral taxes (car market, real estate, jewelry, sale of sweet drinks), there is some potential for growth in budget revenues, and we can move in this direction, but not sharply," Parashchiy said.

Different countries conduct tax reforms in different ways, depending on the government's objectives. However, if we compare Ukrainian fiscal policy with Western ones, it should be noted that Western economies set specific timeframes for tax innovations.

For example, the tax reform of US President Donald Trump, which he carried out in 2017, provided for a reduction in the tax burden by the end of 2025. Instead, the Ukrainian Ministry of Finance is planning higher taxes due to the need to finance the war, but is silent on the possibility of returning them to the previous level after the war is over.

The Ministry of Finance only states that the military levy, if increased, will remain in effect until a new parliamentary decision is made, and that the new excise taxes on tobacco, fuel, and sweet soda will remain in effect indefinitely.

Life will become more expensive again

Whichever version of the tax reform is adopted – the government's or the lawmakers’ version with the VAT rate increase – will result in higher prices. The famous American financier John Cochrane once said: "Business never actually pays taxes. Corporate tax rates are simply passed on to the consumer."

The National Bank has already downgraded its own inflation forecast: this year it will be 8.5%, and in 2025 - 6.6%, although prices are currently growing at a rate of 4.8%.

"Some of the tax changes, such as the increase in the excise tax rate on tobacco products, were taken into account in the NBU's previous macroeconomic forecasts. Overall, we took into account changes in the excise policy in the July forecast," the regulator explained.

Thus, the increase in the excise tax rate on tobacco products and fuel, as well as the recalculation of excise taxes on alcoholic beverages from hryvnia to euros, will lead to an increase in inflation by about 0.4% compared to the April forecast.

In response to our inquiry, the Ministry of Finance stressed that the price increase is not only due to the increase in excise taxes, but is also determined by the balance of supply and demand, global energy and logistics prices. They also note the medical logic of reducing the consumption of harmful products.

The main inflationary concern is the taxation of companies with the military levy on turnover.

"The effects of the introduction of a 1% military levy on income from any activity of legal entities on inflation are an additional risk to the forecast. If this tax is introduced, and companies actively pass on additional costs to prices, it may accelerate inflation this year more significantly than envisaged in the baseline scenario of the July forecast," the NBU concludes.

They hope that businesses will not pass on the new taxes to consumers in full, but will agree to reduce their profits through lower margins.

"There will be fierce resistance to the turnover tax," predicts economist Dmytro Boyarchuk. "In addition, the registration of new sole proprietors may fall, because there are activities that depend on turnover. If the margin is low, then every percentage of turnover is very sensitive for them, so they need to do something."

However, industries that are subject to an additional fiscal burden (car and real estate sales, sales of sweet sodas, the jewelry market) should be able to withstand these measures.

"There will be a narrowing of demand, some players will be forced to leave, this is a natural development. But the industry and the market will not go away," says Boyarchuk.

"Businesses like to report on the funds transferred for defense and security needs, but with the tax increase, they will give less money to various volunteer programs – this is a serious consequence of the tax reform," adds Paraschiy of Concorde Capital.

As for the Ministry of Finance's plans to sell additional government bonds for at least 165 billion hryvnias ($4 billion), there are concerns here as well. For example, state-owned banks and state-owned companies can always be forced to invest their surplus funds in government debt securities through administrative means. As a last resort, the National Bank can also buy them.

However, for the sake of financial market stability, it would be better if the demand for government bonds were organic.

"If we are talking about a free market, we need to expand the range of its participants, including foreigners. But they need guarantees that they will be able to withdraw their funds from Ukraine," says investment analyst Oleksandr Parashchiy.

The Ministry of Finance has no doubt that they will be able to sell additional volumes of government bonds.

"According to the Ministry of Finance's calculations, the planned figures for additional government bonds reflect the potential capacity of the market and are absolutely realistic," the Ministry explains. "Individuals, in particular, are actively increasing the volume of purchases of government securities.”

Since the beginning of the full-scale war, citizens have increased the volume of purchases of government bonds by 2.5 times - to more than 63 billion hryvnias ($1.5 billion).

Finally, the state budget for this year envisages economic growth of 4.6%, while even the optimistic version of the NBU's forecast envisages only 3.7% growth. This may also affect the revenue side of the country's main financial document.

As for foreign financial assistance, the central bank says it still expects the pace of its receipt to continue. 

"The baseline scenario of the NBU's updated macroeconomic forecast assumes that Ukraine will continue to receive significant external financing: international partners are expected to provide about $38 billion in soft loans and grants in 2024," the regulator's press service said. "While in the first half of the year Ukraine received about $14 billion, the forecast for the second half of the year is $24 billion.”

The Ministry of Finance confirms the foreign aid figures: "This year, the need for external financing is $38 billion. Ukraine is expected to receive the funds in full. Our partners have given us their assurances. These funds are directed to the social and humanitarian spheres, i.e. non-military expenditures. There are no plans to revise the amount. The need for external support will continue next year."

Everyone get ready

The State Tax Service has already planned more than 3,300 inspections of companies and individual entrepreneurs this year. Accordingly, the implementation of the new fiscal rules will be closely monitored by regulators.

In anticipation of the tax reform, private businesses have already begun reporting a drop in profitability, and Ukrainians are buying new cars in droves to avoid overpaying for them after the new rules come into effect.

The Ministry of Finance is "attacking" the G7 to get it to quickly transfer the $50 billion loan secured by frozen Russian assets to Ukraine. Perhaps success in this area will allow the tax reform to be carried out in a simplified version.

However, the most important thing is to fulfill all financial obligations to the Ukrainian Defense Forces. While the methods of tax reform are debatable, the goal of such a measure is quite obvious and difficult to disagree with.

So now it's up to the Verkhovna Rada, which is likely to consider the tax increases in late August.