Ukraine's budget crisis: Government seeks funds for defense

In the third year of the full-scale invasion, Ukraine's state budget problems are coming to the forefront and becoming a key challenge for the government. The generous international aid programs, without which Ukraine's budget is now unimaginable, are becoming harder to secure. Each new dollar and euro is increasingly difficult to obtain, and the mobilization of internal resources is limited and divides the political class: the government has one vision, the lawmakers another, and the International Monetary Fund has its own.

A consensus was initially reached only on the main decision—to increase defense spending in this year's state budget by 500 billion hryvnias ($12.1 billion). On September 3, the Verkhovna Rada voted for this in the first reading, but it is already clear that these budget changes will need to be adjusted, as a decision on funding sources must also be made.

There is no consensus on where to find the 500 billion hryvnias ($12.1 billion) needed by the end of the year. To find such a sum, Ukraine will have to raise taxes (there are several options for how to do this). However, there are opponents of this idea—they argue that additional funds can be found by cleaning up customs from corruption or increasing the sale of government bonds.

The Ministry of Finance has passed the ball to the Verkhovna Rada's financial committee, which has begun consulting with businesses and the expert community. Meanwhile, the Ministry of Defense needs additional funds to pay combat bonuses to the military for September.

"Obviously, the war will last longer and continue next year. This will have its consequences—budget expenditures will increase, and hopes for a quick recovery will have to be postponed," said Gavin Gray, the IMF mission chief for Ukraine, at the end of August. "Some increase in tax rates, unfortunately, is necessary."

"The 2024 budget was initially planned optimistically, with the expectation that hostilities would end by mid-year," explains Dmytro Boyarchuk, economist and executive director of the expert organization CASE Ukraine.

This year, the financial situation is quite dire due to the not-so-successful counteroffensive in the summer. In 2023, amid expectations of military success, we were flooded with money.Dmytro Boyarchuk, economist and executive director of the expert organization CASE Ukraine

Impassable thickets of tax reform

After giving 301 votes to increase defense spending by 500 billion hryvnias ($12.1 billion), on the same day, September 3, the Verkhovna Rada did not find the necessary 226 votes to raise taxes.

Even a significantly simplified version of the tax reform from the parliament's financial committee gathered only 224 votes.

The decision not to support the tax law is absolutely illogical and harmful to the state. Especially since these same lawmakers supported the budget project, which provides for the use of funds collected through tax increases. A very sad political bipolar disorder. The European Solidarity party applauded the failure of the law, rejoicing in the lack of funds for the army.Danil Getmantsev, head of the financial committee of the Verkhovna Rada

However, the leader of European Solidarity, Petro Poroshenko, speaking from the rostrum of the Rada, explained that he does not understand why the bill on increased defense spending, which the legislators supported, did not include all the necessary fiscal decisions. Therefore, his faction did not vote for a separate document on these fiscal decisions.

So, what do we have? The Ministry of Defense, in response to a request from hromadske, stated that it expects an additional 373.7 billion hryvnias ($9.1 billion) this year, of which 333 billion ($8.1 billion) will go to cover the needs of the Ukrainian Armed Forces. These funds are needed by the Ministry by September 20—for payments to military personnel.

"We will vote again on tax changes," says Roksolana Pidlasa, a member of parliament and head of the budget committee of the Verkhovna Rada.

As can be seen from public communication, there are certain expectations that the shortened procedure for raising taxes will not only be supported by the Rada but also signed by the president.Grigory Kukuruza, partner at the expert organization Ukraine Economic Outlook

However, the discussion about raising taxes is not easy, despite the obvious need to finance additional defense expenditures.

Initially, the Ministry of Finance proposed a whole package of tax changes that would raise 125 billion hryvnias ($3 billion) this year alone. One of the main ideas of this bill was to introduce a military levy for legal entities at a rate of 1% of turnover. This idea met with strong opposition from the business community, as such a fiscal burden, along with others, proved too great.

Businesses communicated their position to the representatives of the financial committee during meetings, and the committee decided to listen.

"The Ministry of Finance is detached from reality. The position of the fiscal authorities—that they take what they need and do not ask anyone—is not normal," believes economist Dmytro Boyarchuk. "The parliament acted normally, listening to the businesses. Because the fiscal authorities not only want to take more but also complicate tax administration, as the military levy alone is a huge pile of papers."

In the end, the financial committee of the Rada fundamentally changed the government's bill, removing the norm on the military levy from the turnover for legal entities. The lawmakers proposed:

• to increase the rate of the military levy for individuals from 1.5% to 5%;
• to establish a military levy for sole proprietors (third-group taxpayers) at the level of 1%;
• for sole proprietors of the first, second, and fourth groups to pay a military levy of 10% of the minimum wage.

All these additional burdens are to apply only until December 31 of the year when martial law is lifted.

Such a tax reform was much more appealing to businesses, although its potential is quite small. Unlike the government's plans to accumulate 125 billion hryvnias ($3 billion) through tax increases, the new version could bring in only 30 billion ($729 million). Instead, it was planned to issue more government bonds—in the amount of 216 billion hryvnias ($5.2 billion), not 160 billion ($3.9 billion) as planned by the government.

An additional 25.5 billion hryvnias ($619 million) were planned to be saved by reducing the expenditures of the general and special funds of the state budget (including taking 11.2 billion hryvnias ($272 million) from the Ministry of Strategic Industries—these are actually funds from the tax on the income of individuals-military personnel), and taxes and fees—to over-fulfill by 100 billion hryvnias ($2.4 billion), while the government planned 76 billion ($1.8 billion).

Such a significantly softened package of financial decisions did not find the necessary support in the session hall of the Verkhovna Rada. What’s next?

Next, we will propose to the Verkhovna Rada to vote again in the first reading on the bill to raise taxes. I do not think there will be significant changes, except for the addition of a tax on the superprofits of banks. I am convinced that the majority of lawmakers will make the right conclusions and approve this decision vital for the state.Danil Getmantsev, head of the financial committee of the Verkhovna Rada

And then the IMF intervened, further complicating the process.

Noticing that the parliamentarians had not found a common solution to raise taxes, the fund proposed to increase the main tax of the Ukrainian financial system—the value-added tax. This decision was communicated by representatives of the IMF during a meeting with the Ukrainian Ministry of Finance and the National Bank at the beginning of September.

Should the VAT be increased? Economist and executive director of CASE Ukraine Dmytro Boyarchuk believes it should. "If you have dragged the situation to the brink, you need to find a solution in the least painful way—that is, raise the VAT," says the expert. "This is a socially just tax, collected evenly from the entire economy."

According to the calculations of CASE Ukraine, a VAT rate of 25% instead of the current 20% would be an acceptable solution, although the National Bank may not be fond of it, as this decision stimulates inflation, i.e., price growth. But even increasing the VAT rate to 23% could bring in an additional 125 billion hryvnias ($3 billion), which is also not bad.

So, the lawmakers will have to think again about how much money they want to collect for the Defense Forces through tax increases—and go to the hall, vote, and send it for the president's signature. All this must be done by September 20, otherwise, the fighters may be left without combat payments.

"Even if political competition does not allow [the Rada] to meet the September 20 deadline, in one of the options, the funds will be directed to the Ministry of Defense, and salaries will be paid. Most likely, they will be redistributed from other programs, even without indirect emission through the refinancing of state banks for the purchase of government domestic bonds," says economist Grigory Kukuruza.

Can tax increases be avoided altogether? In my opinion, no. The question is only the final size of the increase. Our partners—including the IMF—require this step from us. We may not like it, but one of the key tracks for partners is the growth of our self-financing level. Specifically, for communicating with their voters about the expediency of aid to Ukraine.Grigory Kukuruza, partner at the expert organization Ukraine Economic Outlook

Curing the budget deficit with the devaluation of the hryvnia

The next complication in attempts to reform the Ukrainian system of public finances to finance defense and all other budget expenditures this year and next is the IMF's idea to lower the key policy rate of the National Bank of Ukraine from the current 13% and devalue the hryvnia.

Discussions on this topic remain largely non-public, but the Western press, such as the Bloomberg agency, writes about them.

The NBU's rate of 13% is significantly higher than the inflation rate of 5.4%, so the IMF sees room for its reduction. By keeping the rate so high, the NBU wanted to make hryvnia deposits attractive, which banks could invest in government bonds, earning expected money.

Regarding the exchange rate of the national currency, the hryvnia has already devalued by more than 10% since October 2023, when there was a significant escalation of hostilities in Donetsk Oblast. The central bank does not want the devaluation to become deeper, as it has been spending resources to ensure the "managed flexibility" of the hryvnia exchange rate, boasting that even with the actual support of the exchange rate, the NBU's reserves in August increased by $5.1 billion, reaching $42.3 billion.

"The value of the hryvnia is clearly overstated; the dollar does not cost 41 hryvnias [because it costs more] if you look at the trade balance and subtract international financial support," says economist Dmytro Boyarchuk. "The devaluation of the hryvnia will bring additional revenue to the state budget, although it will somewhat increase the costs of servicing the currency debt."

"This is not beneficial for people—it is beneficial for public finances," concludes the economist.

As for financing pensions and salaries of civil servants, the situation is difficult, but it is unlikely to lead to non-fulfillment of obligations. "We have been living with weekly-biweekly planning for three years," notes Boyarchuk.

The difficult 2024—the path to the difficult 2025

The scale, complexity, and urgency of political discussions about how to manage the Ukrainian system of public finances so that it can finance the war and all aggregate expenditures indicate that Ukraine has entered a stage where the search for and finding additional funds is becoming critically important.

The complexity, intensity, and urgency of political discussions on managing Ukraine's state finances to fund the war and other expenses indicate that the country has entered a phase where finding additional funds is critical.

This mission will not end this year—the 2025 budget also looks challenging, and work on it has already begun. Prime Minister Denys Shmyhal noted that there is an unfunded gap of $15 billion in the civilian part of the 2025 state budget.

"The International Monetary Fund currently estimates the need for external financing in 2025 at $22.7 billion, but this gap may potentially need to be expanded by $12-15 billion," said Olha Zykova, Deputy Minister of Finance, at the end of August.

"For 2025, approximately $35 billion in external financing is needed," she added.

Currently, the announced commitments to support the Ukrainian state budget next year include:

• The Ukraine Facility fund from the EU: $12.5 billion;
• IMF: $1.8 billion;
• The rest of the financial support from abroad is subject to agreements, mainly around obtaining $50 billion from frozen Russian state assets.

The government is counting on funds from the profits of frozen Russian sovereign assets, with political commitments to provide credit taken on by the G7 countries.Danil Getmantsev, head of the financial committee of the Verkhovna Rada

"Our goal is to obtain all $300 billion of frozen assets. The first step is to work on getting $50 billion from our partners as the first contribution, grant, considering the future full confiscation of the full amount," said Prime Minister Shmyhal.

"Our official estimate of the required financing for 2025 remains $35 billion. This is significantly lower than for 2023-2024 ($42.5 billion and $43 billion, respectively)," said Grigory Kukuruza, an economist from Ukraine Economic Outlook. "Some colleagues suggest 'closing' the difference with the $50 billion package from G7. But another component of Ukraine's financing is weapons. These data are not disclosed, but according to estimates by the Kiel Institute, we receive about $40-50 billion a year in military supplies. Considering the uncertainty in this area, we are actually provided with funds until approximately the end of the first half of 2025."

However, some political parties in Germany and Austria are actively promoting the idea of reducing funding for Ukraine. Plans to reduce support volumes also exist within the German government. The likelihood of Kamala Harris winning the U.S. presidential election could delay the provision of frozen Russian funds to Ukraine, as the G7 will not rush to do so if they see no threat of Donald Trump coming to power.

The budget declaration of the Ukrainian government for 2025-2027 indicates that expenditures on security and defense in 2025 are planned at the level of 2.2 trillion hryvnias ($53.4 billion)—the same as in 2024, with an increase in defense expenditures by 500 billion hryvnias ($12.1 billion).

Meanwhile, the head of the budget committee of the Verkhovna Rada, Roksolana Pidlasa, said in an interview with hromadske: "I do not think that it will be such an amount. Defense expenditures [for the next year] will be planned exactly as much as the state has its own resources—taxes, fees, domestic government loan bonds, dividends, etc."

International partners have repeatedly reminded Ukraine of the need to become a self-sufficient country. But for this, taxes need to be raised this month, and then desperately fight for frozen Russian money.

What will happen if there are no successes in financial policy? "If there are sharp deteriorations, such as a decline in international financing, it will be necessary to transfer funds from local budgets to the state budget," says economist Grigory Kukuruza.