A major challenge for the architects of Ukraine’s new tax system is how to uncloak about 40 to 60 percent of the economy that avoids government regulation, taxation or observation each year.
The Economy Ministry estimates that 42 percent of the nation’s economy, or about $18 billion, was unaccounted for in the first six months of this year. In fact, since 2008, an average of 44.5 percent of the nation’s gross domestic product has gone unregistered, according to Friedrich Schneider, an economics professor at the Johannes Kepler University in Austria who has studied the phenomenon for more than a decade.
This equals $328 billion that will have escaped official detection in 2011-2015, when using GDP figures provided by Kyiv-based investment bank Dragon Capital. In his research, Schneider defines the shadow economy as “all market-based legal production of goods and services that are deliberately concealed from public authorities.”
Tetyana Tyshchuk of the Institute for Economics and Forecasting at the Ukrainian National Academy of Science, in her research, said that “white” and “shadow” economies “don’t exist as two parallel realities.”
For example, an employee may receive a portion of their salary legally and the rest in an envelope that avoids payroll taxes and pension fund deductions. Either way, the money gets spent on items that get taxed.
“The list of these chains, which consist of white and gray operations, may go and on,” Tyshchuk said.
Another factor of which policy makers should take notice, according to Schneider, is that certain aspects of Ukraine’s shadow economy are“welfare enhancing” for the economy.
“Underground production is a vital branch of the overall economy. A shadow economy produces added-value goods and services, which are as good as officially produced ones,” Schneider told the Kyiv Post. “What’s bad is that social security and the pension fund loses, but the man on the street benefits, many have second jobs in the informal sector like driving a taxi or selling homegrown produce.”
When measuring the value of goods and services produced in an industry, the raw materials or resource extraction industry remains the most concealed from government regulation, taxation or observation. These segments are “highly monopolized,” according to a report on the shadow economy published in December by the Economy Ministry. Source: Ministry of Economic Development and Trade of Ukraine
Businesses engaged in transactions involving foreign currency sometimes enter the shadow economy to avoid risks.
On a larger scale, undeclared work and illicit financial flows remain the principal problems. They include tax invasion, capital flight, money laundering, and misuse of budget revenues, according to the Kyiv-based International Center for Policy Studies.
Tyshchuk said the “most dangerous one is the shadow economy in the government sector…it is based on corruption and destroys our economy.”
For Natalia Osadcha, partner at Syutkin & Partners, the “non-transparent system of taxation and high tax rates are the root of all evil.”
Ukraine lost over $116 billion in 2004-2013 in “illicit cash flows,” averaging $11.6 billion a year, according to a December report by Global Financial Integrity, a non-profit group in Washington, D.C. that analyzes the movement of money. Some $1.1 billion of this was “hot” money, “essentially cash that has disappeared from the economy” that wasn’t registered with the central bank or another regulatory agency, according to Global Financial Integrity.
But more than 90 percent of the dirty money was due to what the group calls “misinvoicing,” when the value or volume of an export or import is misstated on an invoice. Weak customs enforcement and tools, combined with graft allows “criminals, corrupt government officials, and commercial tax evaders to shift vast amounts of money across international borders quickly, easily, and nearly always undetected,” the Global Financial Integrity reported stated.
Fraudulent value-added tax refund schemes also fall into this category.
“The same with VAT, it is illogical corrupted tax, the company pays it, and then tries to get it back for five years, what’s the point, no one knows; the word ‘corruption’ comes to mind,” Osadcha said.
Serhiy Kurchenko, widely believed to be a front man for ex-President Viktor Yanukovych, is accused of using similar fraudulent manipulation of invoices in the liquefied natural gas business, robbing state coffers of $2.2 billion. He has denied the allegations, describing himself as an “honest businessman.”
The continued opacity of the global financial system makes it easier to shift stolen assets on the receiving end. “The opacity reveals itself in many well-known ways: tax havens and secrecy jurisdictions, anonymous trusts and shell companies, bribery, and corruption,” according to Global Financial Integrity.
At the country of origin of illicit funds, “customs agencies should treat trade transactions involving a tax haven with the highest level of scrutiny,” reads the American report. “Governments should significantly boost their customs enforcement by equipping and training officers to better detect intentional misinvoicing of trade transactions, particularly through access to real-time world market pricing information at a detailed commodity level.”
Tax authorities in Ukraine estimated last year that cash payments for salaries total about $17 billion a year tax, with at least two million workers not appearing on any tax rolls. Moreover, “another five million report earning salaries that are below the minimum wage, which authorities say is a sign they are paid partly in cash,” according to Reuters.
Authorities are on to the problem.
The Kyiv Post counted 15 large-scale busts of money laundering centers this year by the Security Service of Ukraine, totaling $160 million. About half were allegedly used to finance Russian-backed separatists in eastern Ukraine.
State Fiscal Service chief Roman Nasirov said at a Nov. 12 briefing in Kyiv that 50 conversion centers were eliminated this year without providing financial figures. In addition, thanks to the government’s electronic administration of value-added tax, some $8 million each month is detected and registered that otherwise would have remained hidden.
There’s also a correlation between which industries are most in the shadows and the extent to which they are regulated, said Tatiana Ignatenko and Rodion Teslia of the Poberezhnyuk & Partners law firm.
“For example, in the retail sector, the rank of the shadow economy is 60 percent, the pharmaceutical industry is 40 percent in the shadow…It is worth noting that the aforementioned industries are considered to be the most over-regulated sectors of business in Ukraine,” the two lawyers wrote in comments to the Kyiv Post.
Twenty-five companies paid more than Hr 100 billion to state coffers in 2014. Some have even paid more in the first six months of this year than all of 2014, including state-owned energy giant Naftogaz Ukraine. Source: Ekonomichna Pravda
Solutions
What governments like Ukraine can capture quickly is illegal trade, according to Global Financial Integrity: “Curtailing even a small portion of these illicit flows would have a catalytic impact on a government’s ability to address the needs of its most vulnerable people.”
Perhaps the trickiest part is what economists call “tax morale” – or more precisely, the lack of it in Ukraine.
“Taxpayers are more heavily inclined to pay their taxes honestly if they get valuable public services in exchange,” Schneider said.
Ukraine’s government officials have historically shown they are not putting taxpayers’ money to good use. Until they do, much of Ukraine’s economy will remain in the shadows where tax evasion flourishes.
