2. BROADENING THE TAX BASE AND IMPROVING COMPLIANCE, WITHOUT INCREASING THE TAX BURDEN

Transcription

1 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 , 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, TOTAL REVENUES VAT Other taxes on goods and services Taxes on international trade Personal Income tax Payroll taxes Enterprise Profit Tax (CIT) Property and land taxes Other taxes Total Tax Revenues Non-Tax Revenues 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

2 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 Context B. STRENGTHENING VAT POLICY AND ADMINISTRATION 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 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 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 Although 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. 33 As is argued later in this chapter, the potential outcomes of such a measure are unambiguously negative. 34 See, for example, the econometric analysis in T. Baunsgaard and M. Keen, IMF Working Paper No. WP/05/11, June Commonly, 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 VAT efficiency (or productivity) is the actual collection as a ratio of GDP, divided by the standard rate of the VAT in the country. 14

3 Table 2.2: VAT Collection as Percent of GDP, VAT Net collection VAT Gross collection Gross Domestic Imports Refunds Sources: Ministry of Finance; Ukraine State Tax Administration; Bank staff calculations 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 ( ): net domestic vs. imports VAT on imports as % of net VAT collection: An International comparison Net VAT Domestic (Gross domestic -Refunds) as % of total net VAT collection VAT on Imports as % of total net VAT collection. 70% 60% 50% 40% 30% 20% 10% 0 FY99 FY00 FY01 FY02 FY03 FY04 FY05 0% Sources: Data from MoF; Bank staff calculations; Ebrill et al. (2001). Albania Peru Philippines Russia Ukraine Georgia Zambia 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 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. 37 Roughly 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 Of 15

4 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 business 38, 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 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 The gas sector continues to be a problem for the VAT (the issue of the double passthrough). 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. 38 The level of VAT refund arrears was at UAH 3.3 billion (0.8 percent of GDP) as of August 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 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 Annex 2.2 contains a comparative table on the VAT and the turnover tax from a variety of different perspectives. 16

5 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 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, % 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, % 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 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. 40 This 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

6 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 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 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 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 41 While 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. 42 In 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

7 generated by legislative changes that expanded the base, but that increase was not necessarily a sign of better tax administration 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 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 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: international comparison Number of (man) hours spent by a company in a fiscal year filing taxes or related procedures (includes labor taxes) Bulgaria Mexico Moldova Poland Russian Federation Source: Doing Business Survey Ukraine OECD 0 Bulgaria Mexico Moldova Poland Russian Federation 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 Ukraine OECD 43 This 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. 44 The 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

8 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 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 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 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 enforcement of penalties 5. Better Audit Practices: More targeted, well informed, avoiding hassles for good taxpayers 7. The Ukrainian STA needs sufficient political support. 1. Better Registration Process: Fast, client friendly, but able to reject potential evaders 2. Reduction of Compliance Costs: Making taxes easier to pay 4. More efficient allocation of resources: Based on monitoring results 3. Better risk monitoring tools: Using benchmarks of collection and fraud (by sectors of the economy; by type of tax payers; by geographical regions) 45 In the United Kingdom, with 1.4 million registrants, only a few hundred cases a year go to prosecution. 46 These 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

9 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 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 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. 47 Section C of this chapter deals in more detail with reducing compliance costs through the eventual unification of insurance funds that collect payroll taxes. 21

10 (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 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 reallocating 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

11 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 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) 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 50 It 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). 51 Canada 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

12 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. Context C. PAYROLL TAXES 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 / / 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 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 52 While 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

13 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 Insurance Unemployment Insurance Temporary Disability Insurance (2) Industrial Accident Insurance. Employer (4) 37.5 Total Employee 1.0 /2.0 (1) / 1.0 (3) Total (*) 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 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 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 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

14 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 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 midrange 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 ( ). 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 The 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