Information technology – one of Ukraine’s most promising sectors – stands to see certain taxes slashed in what lawmakers and government claim will foster growth for a sector seen as strategic for the national economy.
However, industry players and experts say that although the new legislation will boost profit margins for IT business owners, it failed to address the main issue of eliminating shadow employment, a step needed across Ukraine’s economy to fill depleting pension fund coffers.
Instead, parliament only July 6 reduced the corporate income and value added tax for software developers to 5 percent, down from 25 and 20 percent, respectively. Legislators also sought to cut personal income tax rates for employees working in the IT industry from 15 to 5 percent. The measure, included in a previous version of the legislation, was turned down by President Viktor Yanukovych.
Still missing from the legislation are measures which would cut Ukraine’s heavy payroll taxes, which keep the IT industry, as well as the nation’s economy overall, in the shadows. Keen not to pay payroll taxes in the 34-50 percent range, many employers in Ukraine pay the lion’s share of employee salaries under the table in envelopes. They only show a small portion of what is paid to tax officials.
The new IT industry legislation was backed strongly by billionaire Deputy Prime Minister Sergiy Tigipko, his wife who heads an IT industry investment group, as well lawmaker Viktor Yanukovych Jr., the president’s son. Yanukovych Sr. is expected to sign the legislation into law within weeks. The changes are to come into effect in 2013 and stay in force for the next 10 years.
While some industry insiders are cautiously optimistic. They unanimously point out that the new legislation completely overlooks the biggest headache they and most Ukrainian businesses face: a payroll tax that few claim they can afford to pay, which forces them to use two sets of accounting books.
Many analysts are also criticizing the IT law for introducing yet another set of industry-specific tax breaks. They point to more than a decade of experience in which industry specific tax breaks served more as loop holes that open doors for abuse, rather than efficient measures for attracting investment.
Experts say the tax collection and administration system need to undergo a complete overhaul to lessen corruption. The crucial need, they say, is to deal with the issue of social and pension taxes, the main components of the cumbersome payroll tax.
“Before you give some industry a huge cut from the budget pie [as tax preferences,] it would make much more sense to give them the fruit hanging much lower,” said Alexei Kredisov, managing partner in Ukraine for Ernst & Young, an international auditing and consulting firm. “Start with the banal improvement of the investment climate,” he added.
Despite all the challenges, Ukraine’s IT industry can immodestly be considered one of the nation’s most positive economic developments. With exports of outsourced work valued at approximately $1 billion yearly, Ukraine is considered the world’s fifth largest IT outsourcing destination.
The core expense burden that IT companies face lie in employee salaries and, therefore, corresponding payroll taxes.
“The main distinction of the IT sector is that around 80 percent of an [IT] product’s cost is comprised of salaries,” said Taras Vervega, vice president of Lviv-based SoftServe, one of Ukraine’s largest software development companies. Therefore, he says “adoption of this law with the changes that were made, shows that the government doesn’t quite understand the essence of support of the sector and what its main problems are.”
The reason for such a strong correlation between the cost of an IT product and labor costs is the comparatively higher salaries paid to programmers. According to Vervega, average salaries in the Ukrainian IT industry are about four times higher than the average salary in the country, reaching Hr 10,000-12,000 (up to 1,200 euros).
Consequently, salaries make the bulk of IT company expenses. High corporate social taxes of 34.7 percent combined with 15 percent personal income tax force many IT companies to look for ways to avoid paying all the fiscal dues. The use of shadow schemes is quite common. Often, salaries are paid in envelopes, or private entrepreneur contracts are used to avoid registering an employee as a staff member.
“Companies are forced to do so, because otherwise they would be uncompetitive on the market,” said Vervega.
He argues that a lower salary tax would make the system more transparent, boost the tax and pension fund collection base and, in turn, increase state budget revenues and pension fund contributions.
Bohdan Kupych, general manager of Kvazar-Micro, an international IT company with a large presence in Central and Eastern Europe, says the new law is “one step in the right direction,” but it’s far from enough.
“It’s not just tax [that’s the problem], it’s helping small businesses, helping entrepreneurs in the technology sphere,” he said. “[At the moment], many people choose to do that outside of the country. So they take the innovation outside and it doesn’t stay in Ukraine.”
Meanwhile, experts are skeptical about the very idea of giving tax benefits selectively.
Ildar Gazizullin, senior analyst at the International Centre for Policy Studies, a Kyiv-based think-tank, says similar practices of tax breaks in metallurgy and agriculture sectors proved to be mostly ineffective. Owners of businesses in both sectors failed to reinvest additional profits kept into modernization and upgrades.
Instead, according to Gazizullin, a thorough overhaul is needed to increase transparency of how the government is spending social taxes to incentivize both the employer and the employee to come out of the shadows and increase state revenues.
“Business doesn’t trust the government in how it uses collected money,” Gazizullin said. “Usually, cutting taxes is not a solution…You have to do more [reforms] than that.”
Kyiv Post staff writer Maryna Irkliyenko can be reached at [email protected].
