Technical Note: Tax Expenditures Analysis in Ukraine 1 This note was prepared under the Parallel EC - World Bank Partnership Program for Europe and Central Asia through the Programmatic Single -Donor Trust Fund: EU Program for the Reform of Public Administration and Finances (EURoPAF) 2018 1 The report is prepared by the World Bank team comprising Svetlana Budagovskaya (Consultant), Inna Lunina (Consultant), and Oleksii Balabushko (Senior Public Finance Specialist) 1 Contents Executive Summary .........................................................................................................................3 1. Introduction .................................................................................................................................5 1.1. History of the Tax System in Ukraine ...................................................................................5 1.2. Recent Tax Legislation Reform .............................................................................................6 3. Tax Privileges and Tax Expenditures in Ukraine ........................................................................10 3.1. Legislative framework on tax privileges .............................................................................10 3.2. Review of tax expenditures ................................................................................................12 4. Personal Income Tax in Ukraine: Legislation, Tax Privileges and Tax Expenditures .................14 5. Simplified Tax System in Ukraine ..............................................................................................17 5.1 PIT Tax Expenditures based on Input-Output Data .............................................................22 5.2 PIT Tax Expenditures Based on Comparison between Entrepreneurs under STS and Regular System ..........................................................................................................................23 5.3 CIT Tax Expenditures Based on Comparison between Enterprises under STS and Regular System .......................................................................................................................................24 6. Approach to Measurement and Management of Tax Expenditures ........................................25 Personal Income Tax Expenditures .......................................................................................26 Corporate Income Tax Expenditures .....................................................................................27 VAT and excise .......................................................................................................................27 Practical considerations regarding methodology..................................................................28 6.2 Tax Expenditure Management ............................................................................................28 7. Findings and Next Steps in Development of the Tax Expenditure Framework. .......................31 Annex 1. Simplified Tax Regimes in 1999-2016.............................................................................33 Annex 2. List of deductions from personal income that lead and do not lead to budget losses (according to the Tax Code) ..........................................................................................................37 Annex 3. Documented expenses of individual entrepreneurs under regular tax system, share of annual income ...............................................................................................................................39 Annex 4. Effective rates for different income groups ...................................................................40 2 Executive Summary 1. The objective of this report is to assess tax expenditure management in Ukraine and provide recommendations on improving both quantification and management of tax expenditures going forward. The report also goes into more details on tax expenditures arising from the Personal Income Tax privileges and the Simplified Tax System. 2. The term “tax expenditures� was introduced in 1974, and first reports were prepared in the USA and Germany. Despite some nuances in approach to tax expenditure in different countries, there are some general provisions that all countries follow. First, a definition of tax expenditure explains the fact that there are some deviations from regular taxation that lead to budget revenue reduction. The most common types of tax expenditures are deductions or exemptions from any kind of taxable income, preferential tax rate imposed on specific group of taxpayers or industries, and deferral of tax liabilities. 3. Tax expenditures deliver economic or social support to groups or types of taxpayers, but are frequently subject to less scrutiny than direct spending programs . To shed light on tax expenditures and make support delivered through the tax system more transparent, many countries have chosen to systematically estimate the revenue foregone associated with tax expenditures and publish these figures. 4. The report is organized as follows. It starts with an overview and the history and current state of the tax system in Ukraine, and continues with the background on tax privileges and attempts by the government to estimate their fiscal impact. The report also provides detailed estimates of tax expenditure from the Personal Income Tax (PIT) and Simplified Tax System (STS), which are currently not performed by authorities. It also provides details of different approaches to quantifying tax expenditure by type of tax. It concludes with a summary of takeaways and key recommendations. 5. The analysis of tax privileges and tax expenditures shows that Ukraine does have some elements of a tax expenditure system, however, the tax expenditure framework is incomplete. Although the State Fiscal Service (SFS) produces estimates of tax privileges as budget losses, there are omissions and ambiguities in this process. There is no process to evaluate efficiency and effectiveness of granting tax exemptions or the impact of exemptions in terms of whether they achieve policy objectives. The PIT exemptions and privileges as well as those from the STS are completely omitted from revenue loss estimates. 6. In the case of the PIT in Ukraine, most of the tax privileges are provided to low income individuals - recipients of wages (so-called “social benefits�), at the same time the preferential rate for investment income creates a de facto regressive income taxation. In 2008, the wage income was taxed at an effective rate 17.29 percent, while investment income at 11.06 percent, and dividends and royalties at a mere 8.12 percent. The average annual income of taxpayers with non-wage income was several times higher than income of wage earners. 7. The Simplified Tax System, created to promote employment and support small businesses, has been gradually extended to higher income individuals and higher turnover entities. Revenue losses from the simplified system are estimated to be UAH 13.5 billion for PIT and addition UAH 1.5 billion for Corporate Income Tax (CIT) in 2016, comprising 0.7 percent of GDP. The number is likely larger as losses on VAT and other taxes have not been estimated. In 3 addition, the existence of the simplified tax system results in unequal taxation, with effective rates half or less of effective rates for taxpayers under a regular tax system. 8. In order to ensure the transparent and accountable budget process Ukraine needs to improve its tax expenditures framework, which will provide estimates of tax expenditures, and explain the purpose and rationale for granting tax privileges. Parliamentarians when making decisions regarding the budget should be aware about the amount of funds provided as tax expenditures. In addition, tax expenditures should be monitored regularly and assessed, as is done for direct budget financing. 9. The key recommendations include: a. Develop the tax expenditure framework with elaboration of “benchmark tax system� taking into account the experience of OECD countries and specific issues that should be addressed in Ukraine. b. Define tax expenditure in the legislation and incorporate PIT and STS into the tax expenditure framework. c. Start producing estimates for priority taxes (based on a need for reform and technical capacity of the government). Certain tax expenditures related to CIT and PIT could also feature in the first “wave� of estimates produced by Ukraine. d. Finally, start a comprehensive review of personal income taxation including PIT and simplified system to ensure efficient and fair taxation of the citizens of Ukraine. 4 1. Introduction 1.1. History of the Tax System in Ukraine 10. Since Ukraine’s independence in 1991, the Government of Ukraine (GoU) has made a number of efforts to design and reform the tax system of the country. Several laws were developed to regulate the institutional framework and the system of administration of specific taxes, including VAT, CIT, PIT, and other taxes. 11. The place and level of authority of the tax administration in the system of governance of Ukraine has been evolving since 1990. The Law “On State Tax Service in Ukraine� was adopted in 1990 and amended after Ukraine became independent. From its establishment, the State Tax Service has experienced multiple institutional stages summarized in Table 1. Table 1. Turbulent Evolution of the Tax Administration’s Organizational Framework 1990 The State Tax Service was created under the Ministry of Finance and consisted of the Main State Tax Inspection and local tax inspections at the regional and city levels. 1996 The status of the State Tax Service was enhanced: it was subordinated to the President of Ukraine2. According to the Decree, the State Tax Administration received the status of a central executive body. The subdivisions of the Ministry of Internal Affairs of Ukraine responsible for resisting the criminal concealment of tax revenues, were subordinated to the State Tax Administration of Ukraine. 2008 The State Tax Service became a central body of executive power coordinated by the Cabinet of Minister through the Minister of Finance. 2010 The State Tax Service was subordinated directly to the Minister of Finance. 2012 The State Tax Service and the Custom Service were united, and the Ministry of Revenues and Duties was created. 2014 The Ministry of Revenues and Duties was eliminated and the State Fiscal Service was established under the Minister of Finance. 12. A general institutional framework for taxation was developed during the 1990s. It was an important step forward for the country with no prior experience and culture of tax collection. At the same time, the system created in the 90s was a “police type� system, rather than “service type� tax administration. At that time, the tax system was characterized by tough enforcement of tax collection and, potentially, high corruption risks. The business community constantly complained about the wide-spread practice of informal fees (bribes) that increased 2 Decree of the President of Ukraine No. 760/96 dated August 22, 1996 "On the formation of the State Tax Administration of Ukraine and local state tax administrations" 5 the cost of doing business and decreased attractiveness of economy of Ukraine for foreign investors. 13. In the 1990s, the tax legal regime lacked stability and clarity of taxpayer rights and obligations. In the mid-nineties the work on the Tax Code started and several draft versions were prepared. However, despite long debates with the expert community and parliamentarians, none of them was adopted. At the same time, many legal amendments were introduced to regulate different taxes. In some cases, more than a hundred amendments were approved, thus complicating both tax administration and business activity. Moreover, the instability of tax legislation was a serious barrier for attraction of investment to the country. In 1998, the Decree of the President of Ukraine on Simplified Tax System (STS) was adopted to address high unemployment in the country due to the collapsing of state-owned enterprises, most of which served the military industry. Initially, the STS Decree was introduced for self- employed individuals and small enterprises. 1.2. Recent Tax Legislation Reform 14. Tax legislation was codified in 2010 and stopped regulation of tax provisions through sub-legal acts, but frequent legislative changes, including those regulating the Simplified Tax System, persisted. The adoption of the Tax Code did not stop a practice of amendments to tax legislation, although all of them were introduced exclusively through the amendments to the Tax Code. During 2010 – 2017, more than one hundred amendments were introduced, particularly, in 2012 – 13, in 2013 -18, in 2014 – 30, and in 2015 – 26 amendments. After 2010, many amendments were introduced into the section on STS, which was amended several times up to 2016. Initially, new rules for single tax payers were envisaged in a draft Tax Code in 2010. However, after the protests of single tax payers, who demanded to keep the system unchanged, it remained the same as it was introduced in 1998. At the same time, the Transition provisions indicated that new rules would be elaborated later, after discussions with small businesses. 15. The new wave of tax reforms started in 2014 but they have not delivered a simple and transparent tax system. During 2014-2016, several laws were drafted, some of which were submitted to the Parliament and adopted. The first law adopted by the Parliament in 20143 decreased the number of taxes from 22 to 9. Most of taxes and fees were not abolished, but some of them were simply consolidated into one payment. For example, the fee for special use of water resources, the fee for special use of forest resources, the fee for special use of radio frequency, and the payment for mineral resources were combined into one tax – “rent payment and payment for other natural resources usage�. The property tax included three taxes - a tax on immovable property other than the land plot, a transport tax and a payment for land. The Law also established a rate of 20 percent for passive income of physical persons, such as, dividends on shares and investment certificates that are paid by co-investment entities, and a rate of 5 percent for dividends on shares and corporate rights paid to residents who are payers of the profit tax. Some expenses are not eligible to be deducted in the calculation of the profit tax, specifically those that are not connected to economic activities (such as expenses for 3 Law of Ukraine “On Amendments to the Tax Code of Ukraine and certain legislative acts of Ukraine on tax reform� #71-VIII, dated December 28, 2014 6 receptions, presentations, leisure, advertising, fine payments, social contributions under private pension insurance and some others). According to the Law, such restriction was lifted for enterprises with annual income less or equal to UAH 20 million. 16. In 2016, the Government of Ukraine approved the Priority Action Plan for 20164, including actions on tax reform. To implement the Priority Action Plan, two Laws5 on amendments to the Tax Code were approved in the same year. The following amendments were introduced into tax legislation in 2016: • For the period 2017 - 2021 a zero percent rate was established for profit tax payers whose annual income does not exceed three million hryvnias, and the amount of monthly wages accrued to each employee for the reporting period is two minimum wages or more; • A flat tax rate of 18 percent was introduced for wages (instead of two rates of 15 and 20% in 2015), the same as for passive income of physical persons as dividends on shares, banking interest, and investment certificates that are paid by co-investment entities (in 2015 – 20%). For dividends on shares and corporate rights accrued by the profit tax payers the rate of 5 percent was retained; • A single social contribution (SSC) rate was reduced to 22 percent (instead of 36.76- 49.5% in 2015, depending on sector). The wage ceiling for the SSC calculation was increased from 17 to 25 of minimum wage. SSC includes payment to the Pension Fund and mandatory social insurance funds. It was introduced in 2011 and replaced four payments. 17. The plan also envisaged a transition from corporate profit tax to tax on retained earnings, but it was delayed amid concerns of the expert community and international organizations regarding revenue impact. The Law stipulated that the Cabinet of Ministers of Ukraine (CMU) should draft a law to replace the profit tax with the tax on retained earnings, and submit it to the Parliament of Ukraine. Although the draft Law was approved by the CMU in October 2017, and despite President’s declared readiness to submit it to the Parliament at the end of February 2018, the submission of the Law was delayed due to the negative opinion of IMF and World Bank experts. The main concern is a substantial decrease in budget revenues that creates a problem for macroeconomic stability, especially under the pressure of high-level state debt (currently almost 70% of GDP). 18. The conclusion, based on the experience of the past several years, is that the adoption of the Tax Code did not increase the stability of tax legislation. As a result, the tax system in Ukraine is quite fragmented and the legislation is cumbersome, creating difficulties for tax payers to comply with the tax legislation, as well as for tax experts to analyze it. 4 Resolution #418-r, dated May 27, 2016 5 Law of Ukraine #1797-VIII, dated December 21, 2016 “On introduction amendments to the Tax Code to improve the investment climate in Ukraine� and Law of Ukraine “On Amendments to the Tax Code of Ukraine and Certain Legislative Acts of Ukraine on Balancing Budget Revenues in 2016�, #909-VIII, dated December 24, 2015. Similar Laws as the latter one was approved in 2016, 2017 and most likely will be approved in 2018 as well. Such a practice violates a provision of the Tax Code on introduction of the amendments to tax legislation not later than 6 months before a forthcoming budget year. 7 2. Revenue Performance in Ukraine 2.1. Tax revenue: main taxes, their contribution to the budget and trends 19. During the last two decades, Ukraine has had a growing share of tax revenue as a percentage of GDP with VAT being a major revenue source. The share of VAT in consolidated budget revenues was stable and with over 36 percent in 2017. The VAT rate remained the same during that period: at the level of 20 percent. There were several attempts to replace the VAT with a sales tax because of issues with the administration of VAT refunds and alleged corruption around this process, although none of these were implemented. 20. At the same time, the tax regime in Ukraine is fragmented with a number of sectoral exemptions and Simplified Tax Regime undermining the level playing field in taxation. The details of the tax exemptions are discussed in the section 3 of the note. Figure 1. Revenue Performance in Ukraine 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 2011 2012 2013 2014 2015 2016 2017 PIT CIT VAT domestic goods (net of refund) VAT imported goods Source: State Treasury of Ukraine, State Statistics Committee, WB calculations 21. The corporate income tax (CIT) revenues have been declining mostly due to a gradual reduction in rates. The highest rate of 30 percent was established in 1998, then decreased to 25 percent in 2004, with subsequent decreases to 23 percent in 2011, 21 percent in 2012, and 19 percent in 2013. Finally, after the recent tax reform implemented in 2014, the CIT rates settled at the level of 18 percent. This led to the CIT share in the total tax revenues dropping from 27.1 to 9.3 percent between 1998 and 2016. Despite a stable rate of 18 percent during 2014 -2016, CIT revenue dropped from 10.7 percent in 2014 down to 7.7 percent of total tax revenues in 2015. This is likely attributed to (i) the extension of eligible expenditures that reduced taxable profit for medium-size enterprises with turnover less than UAH 20 million and (ii) the introduction of a zero rate for the small enterprises with turnover less than UAH 3 million (see section 1.2). 22. The Personal Income Tax (PIT) currently contributes more than 20 percent of the consolidated budget revenues. PIT rates changed several times (detailed information is presented below in the section on PIT). Currently the PIT rate is flat and stands at 18 percent. 2.2. Taxation under the Simplified Tax System 23. The Simplified Tax System (STS) was introduced in 1999 with the purpose to promote self-employment and create favorable conditions for small business, but it essentially created a parallel tax system in Ukraine. A single tax was introduced for individual entrepreneurs and 8 legal entities that met certain criteria. The role of the single tax as a contributor to the budget revenue is very low. The STS has been the subject of public discussion since its introduction. One disputable point is to what extent the STS is justified for legal entities, and if the STS is the best approach to support small businesses. Many countries opted for reduced tax rates or, in some cases, providing tax exemptions for a start-up period. This allows for maintaining unified reporting rules for all business entities. Currently, legal entities under the STS do not report their expenses, except for VAT payers. The existence of different types of tax returns and reporting forms complicates tax administration and creates opportunities for either splitting up business operations to meet STS requirements or minimizing tax obligations by using “individual entrepreneurs� instead of employees. 24. Agriculture is covered by the STS under criteria defined exclusively for this activity . Before 2010, agricultural producers enjoyed a fixed tax as a separate group of payers of a single tax. In 2015, the section on fixed tax in agriculture was eliminated in the Tax Code, and a separate group (group 4) was created for agricultural producers as single tax payers. In the report we will refer to it as Fixed Agricultural Tax (FAT) to underline the specificity of this tax (detailed information on FAT is presented in the Annex 1). 25. An agricultural producer may become a single tax payer of the fourth group if the share of the producer’s income from agricultural production to the total share of its income equals or exceeds 75 percent. The object of taxation for single tax payers in agriculture is the area of farmland, which should be dully registered. A single tax is a flat tax which replaced several taxes and duties including the profit and the land tax. Its rate depends on the type of land (arable land, hayfields, pastures, and others) and normative value of the farmland. In 2015 the normative value of land was substantially increased and the amount of the tax went up and became comparable with the tax amount paid by legal entities in other sectors, which belong to the third group of the STS. Although the contribution of FAT as percentage of GDP is equal to CIT of simplified taxpayers in 2016, the number of payers in agriculture was 4.5 times less than CIT payers of group 3(see Table 1). Table 2. CIT paid by agricultural producers and Group 3 single tax payers 2014 2015 2016 Number of taxpayers (thousand persons) Agriculture 41.3 32.7 34.2 CIT in Group #3 109.6 153.6 155.5 Tax paid (million UAH) by Agriculture 122.2 2,024.2 3,540.8 CIT in Group #3 1,533.0 2,206.1 3,299.8 Tax paid as % of total Agriculture 7 48 52 Group #3 93 52 48 Tax paid as % of GDP Agriculture 0.01 0.10 0.15 Group #3 0.10 0.11 0.14 26. State support of agricultural producers is not limited to the simplified tax regime, these producers benefit from other tax privileges and direct budget support. Until recently, agricultural producers enjoyed a special VAT regime, as well. It is not possible to make an accurate assessment of tax expenditures caused by FAT, as the detailed information on expenses, number of employees, and PIT paid by people working in the sector is not available. According to expert estimates, in 2014, the cost of exemptions from FAT reached 3.8 billion 9 UAH. In the same year, the costs from the VAT special regime were estimated at 14 billion UAH6. The special VAT regime was eliminated in 2016, eliminating a significant amount of tax expenditures. 3. Tax Privileges and Tax Expenditures in Ukraine 27. This section provides an overview of the legal framework regulating tax exemptions monitoring and reporting and analysis of the key data available from the official statistics on tax expenditures. The section also points at the key deficiencies of the tax expenditure framework, which could be addressed to ensure comprehensive monitoring and better management. 3.1. Legislative framework on tax privileges 28. Since 1997, all legal entities using tax privileges and exemptions are required to report them. Following the Resolution of Parliament, adopted in 19967, the Cabinet of Ministers of Ukraine developed mandatory financial statements on received tax exemptions by types of taxes and exemptions8. These statements should be completed by legal entities based on a unified template developed by the Ministry of Statistics (now - Sate Statistics Service). All information about tax exemptions should be collected by the State Tax Administration (now - State Fiscal Service). 29. The legislation at that time did not provide a definition of tax privileges or exemptions and the frequent changes to tax legislation complicated assessment of fiscal impact of tax privileges. The Budget Code adopted in 2001 introduced a term “budget revenue loss� and required a list of tax privileges with estimates of budget revenue losses as part of the annual budget submission. The list of the exemptions was not following international practice. For example, the State Tax Administration included a zero rate VAT on export, which is not recognized as a tax exemption according to the international practice. The absence of a clear definition of tax exemptions resulted in different assessments of the impact of tax exemptions and privileges on revenue, made by various actors. 30. In 2004, the Ministry of Finance (MoF) drafted a methodology entitled “The Method for Calculation of Losses of Revenues of the State Budget of Ukraine and local budgets due introduction of tax exemptions� (hereafter – “Method�), which has never been formally approved by the MoF or Cabinet and deviated from good practice. The “Method� provided a definition of tax privileges, defined which kind of tax benefits the Ministry did not consider as a tax privileges (namely, special tax regime in agriculture, simplified tax system and others), clarified what kind of tax privileges are not budget losses for the main types of taxes (CIT, VAT, Land tax, Excise and Custom duties), and proposed a method to calculate budget revenue losses based on reported data (ex post) and to forecast budget revenue losses (ex-ante) at the stage of budget planning. Tax exemptions identified under the Method did not include a single tax, fixed tax, fixed agricultural tax, and special VAT regime on farming, forestry and fishery activities as exemptions9 even though each of these provide for a privileged taxation regime 6 https://voxukraine.org/en/impact-of-the-agricultural-tax-exemptions-on-the-sector-productivity-en/ 7 Resolution #327/96-VR dated July 12, 1996 8 Ministry of Statistics Order #376, dated December 23,1996 9 So-called “special regime of VAT in agriculture� that was canceled in 2016 10 based on characteristics of taxpayers. The MoF used the methodology to compile the table on tax exemptions as the budget losses at least till 2010-2012. Currently, it seems that the “Method� is not used in a systematic way. 31. Frequent changes of tax legislation complicated assessing revenue impact of tax exemptions. The Ministry of Finance’s estimates done at the beginning of the budget process could be adjusted because of amendments to the tax bills during the budget year. Although, in accordance with the current legislation any changes in tax policy that introduce tax privileges should be adopted by the Parliament not later than six months before the beginning of a budget year, in practice these tax exemptions can be introduced even after budget adoption. Besides, even if initially a tax privilege is introduced for one year, it might be extended for the following budget years. The most remarkable example is tax privileges in agriculture (so-called special regime for VAT) which was introduced in 2001 for one year only, and then prolonged for the next year. Afterwards, the Parliament extended regularly this special regime to 2007, until it was finally eliminated in 2016. 32. In 2010 a definition of a “tax privilege (benefit)� was finally introduced in the Tax Code. In Article 30 of Section 1, “tax privilege� was defined as “an exemption of taxpayers from payment of taxes and duties, or reduced payment of taxes and duties, stipulated in the legislation�. The basis for granting tax benefits are: characteristics of a certain group of taxpayers; type of their activity; object of taxation; or the nature and social significance of the taxpayer’s costs. Tax benefits are provided as tax rebates that reduce the tax base before taxation, reduction of tax liabilities after the tax is accrued, reduction of rates, or tax exemption. The definition of tax benefit did not include such internationally recognized privileges as “deferred tax liabilities� or “write offs�. Although, in accordance with the definition, accelerated amortization could be considered as a privilege, it is not included in the list of tax exemptions prepared by the State Fiscal Service. 33. Since 2013 the SFS started issuing two reference books on tax exemptions. One reference book (RB1) contains tax exemptions that are budget losses. Another reference book (RB2) contains exemptions that do not lead to budget losses or cannot be assessed due the absence of an adequate methodology. Some of the tax exemptions migrate from one book to another without any explanation. For example, the tax privilege on CIT provided for all international treaties (code 11020025) was moved from RB1 to RB2 in 2015. In Reference Books dated April 1, 2017 (#82/1 and #82/2), the same tax exemption (i.e., incomes of non- residents in the form of interest on loans and financial credits granted to residents under certain conditions are taxed under rate of 5 percent) was presented in both Books under different codes (11020369 and 11020383, accordingly). In the next quarter this exemption was presented in RB1 only (as an exemption that leads to budget losses). 34. The current categorization of tax privileges in RB1 and RB2 has flaws. There are several examples in land tax where a tax privilege that is considered as leading to budget losses and reported in RB1 does not actually lead to budget losses, and vice versa. Some of them are presented below: • In 2016, the tax privilege for state-owned enterprises (code 18010508) is not considered as creating a budget loss. This was not the case as the tax privilege granted to state-owned enterprises does reduce revenue to the budget in the same manner as tax privilege for a private company. • In 2014, tax privileges provided to preschools (code 18050079) and secondary schools (code 18050080), regardless of their ownership and sources of financing, 11 were considered as budget losses. However, the impact of these benefits on budget revenues depends on the sources of financing. In case of budget financing of such institutions, there is no loss of budget revenues (the need to pay land tax by such institutions would require an increase in the amount of their budget financing for a corresponding amount, which would then be transferred back to the budget); • In 2015 and 2016, tax privileges provided to institutions of culture, science, education and health care, which are fully financed by the state or local budgets (codes 18010511, 18010550, 18010551, 18010552, 18010553, 18010554), were considered as budget losses. But as in the previous example, when financed from the state or local budgets, the need to pay a tax by these institutions means that budget financing should be increased by the amount of the tax and then the tax amount would be transferred back to the budget. Thus, there is no loss of budget revenues. • Another example is transactions related to the housing sales (a privilege with code 14060423 presented in RB1). The developer is exempt from taxation if he builds so-called affordable housing or housing financed with budgetary funds. Otherwise, the first sale should be subject to taxation. All following sales provided by intermediaries are exempt from taxation. In fact, three different cases are combined under one privilege, but each having a different impact on the budget revenues. In case of resale, there is no creation of value added; therefore, there is no budget losses. If a developer builds houses using only budget funds there is no budget losses, as well, since VAT is included in the housing costs and developer should transfer this tax to the budget. But if a developer builds houses (so-called affordable housing) using sources others than budget funds the budget losses exist. 3.2. Review of tax expenditures 35. While data on tax expenditures is not complete, it still allows to monitor tax privileges and tax exemptions for specific taxes. During 2003-2006, the government made efforts to reduce tax expenditures from 8.89 to 1.03 percent of GDP. It was mostly done through the elimination of sector exemptions. Starting in 2008, this tendency changed and tax privileges went up first to 3.09 in 2009, and then climbing to 3.43 and 4.52 percent of GDP in 2010 and 2011 respectively). The increase of tax expenditures in 2011 may be explained by the introduction of several sector exemptions (particularly in the energy sector) in the Tax Code (Section on Transitional Provisions). 36. Tax expenditures have been declining since 2013 as presented in Table 3. Table 3. Tax Expenditures in 2013 – 2016, % of GDP Taxes\Years 2013 2014 2015 2016 CIT 0.36 0.29 0.012 0.012 VAT 1.72 1.69 2.54 0.96 Land Tax 0.04 0.04 n/a n/a Property Tax* n/a n/a 0.19 0.22 Excise 0.21 0.08 0.04 0.07 TOTAL 2.34 2.09 2.78 1.27 12 Source: WB Calculations based on SFS and Ministry of Finance data. * Under Tax Reform in 2014 Land Tax was eliminated and included into Property Tax 37. The decline in tax expenditures could be attributed to the elimination of several privileges on CIT, VAT and Land/Property Tax, as well as to the overall decrease in the tax base due to the economic downturn. The CIT privileges were reduced the most: instead of 36 privileges in 2014 only 6 remained in 2016. For the same period, the number of privileges on VAT was reduced from 40 to 37, and for Land (Property) tax from 19 to 13. Figure 2. Total tax expenditure declines from 2.34 to 1.27% of GDP between 2013 and 2016 3 2.5 2 1.5 1 0.5 0 2013 2014 2015 2016 38. VAT remains a tax with major exemptions in terms of their number and share of GDP. The decrease in VAT tax expenditures in 2016 is explained by amendments to the special tax regime in agriculture. In 2016 agricultural firms could keep only 50% of VAT (instead of 100%, as before) on their accounts, and in 2017 the special regime was eliminated completely. The most privileges are provided to agriculture and pharmaceutical and medical sector. The five major privileges on VAT accounted for 77% of total privileges provided for this tax in 2016 (Table 4). Table 4. Share of Five Major VAT exemptions, % of VAT privileges to total amount Privilege Code 2014 2015 2016 Agriculture 14010450, 14010451, 14010452, 68.58 79.27 35.96 14010453 Pharmaceutical and 14010437, 14010438, 14010508, 8.48 7.59 21.91 Medical Equipment 14010509,14010510 Education 14010404 6.10 3.89 10.35 Health Care 14010409 2.55 1.85 5.58 Publishing 14010435 2.27 1.26 3.29 Source: WB calculation based on STS data 39. While the tax expenditures for VAT, CIT, Land tax and Excise taxes are calculated as budget losses and presented by the SFS in its quarterly and annual reports, the privileges on PIT or Simplified Tax Regime are not covered. As far as Simplified Tax Regime is concerned, it is not considered as a tax privilege at all and, therefore, is not part of the tax expenditures calculation. However, tax privileges for PIT and simplified taxation create budget losses. To define the scope of the issue these budget losses were assessed in the next section of the report. 13 4. Personal Income Tax in Ukraine: Legislation, Tax Privileges and Tax Expenditures 40. This section provides an overview of the design of the PIT and attempts to estimate tax expenditures related to different exemptions and privileges granted under this tax in the absence of the official data on tax expenditure in PIT. The PIT was introduced in 1991 with Laws of Ukraine "On Taxation System" and "On Income Tax from Citizens of Ukraine, Foreign Citizens and Stateless Persons"10. At that time, a progressive personal income tax (PIT) scale was introduced, but the tax rates varied significantly in the early years. In 1993, a Decree of the Cabinet of Ministers of Ukraine11 established uniform tax rates for different types of income and categories of taxpayers. From 1993 till 2003 a progressive rate scale was in place (10, 15, 20, 30 and 40 percent; from December 1, 1993 to October 1994 the maximum rate was 90%). A term “a tax on personal income� was introduced in 1997. 41. In 2004, a new law regulating PIT was adopted that introduced a flat PIT rate.12 Initially, a flat tax rate of 13 percent was introduced, it was increased up to 15 percent in 2007- 2010. The procedure of the tax base calculation was changed as follows: i) taxable income was reduced by the amount of contributions to the compulsory social insurance funds (Pension Fund, Unemployment Insurance Fund, Social Security Fund for temporary disability, Social Insurance Fund for occupational accidents and occupational diseases); and ii) the use of a non- taxable minimum of income was abolished and a system of social benefits was introduced. 42. The approach to income taxation has shifted several times between progressive and flat rate regimes. After adoption of the Tax Code in 2010, the PIT tax rates changed several times. In 2011-2014 two rates of 15 and 17 percent were applied for wages and other payments under civil law contracts – for incomes below 10 minimum wages and above 10 minimum wages, accordingly. In 2015 the rate for incomes above 10 minimum wages was increased to 20 percent. In 2016 a flat rate of 18 percent was introduced which has remained up to now. 43. The rates for passive income of individuals varied depending on type of income, and has changed practically every year. For instance, dividends on shares (investment certificates) of joint investment institutions varied from 5 percent before August 2014 to 15 percent after August 2014, 20 percent in 2015 and 18 percent in 2016. The same rates were applied to interest on income paid by a company that manages assets of joint investment institutions, and interest on mortgage securities. Interest earnings on bank deposits were not taxed until August 2014 and then they were taxed the same as dividends. So, all rates for different types of passive income were gradually increased and currently are equal to the PIT rate (18 percent). However, dividends are not taxable if they are reinvested in authorized capital and proportions of shares for each holder remains unchanged. 44. Tax rates on dividends on shares and corporate rights which were paid to individuals by resident firms remained unchanged (5 percent) during 2014-2016, and far below most EU countries. It is appropriate to note that holders of such shares and corporate rights are usually wealthy people whose income is significantly higher even if comparing with the sufficiently high income of the hired employees. This policy of low taxes on dividends benefit the richest segment of Ukrainian population. The EU countries have been increasingly moving away from 10 Laws of Ukraine #1251-XII dated June 25, 1991 and #1306-XII dated July 5, 1991, accordingly 11 Decree of the Cabinet of Ministers of Ukraine "On income tax from citizens" (# 13-92 dated 26 December, 1992, entered into force in 1993 and acted (with amendments and additions until the end of 2003) 12 Law of Ukraine “On personal income tax� # 889-IV dated May 22, 2003, came into effect in 2004 14 taxing dividends at a lower rate, including Austria (rate of 27.5 percent) and Estonia (20 percent). Some others still have a special rate for dividends, but not nearly as low as in Ukraine. For example, Poland taxes dividends at 19 percent flat rate. Table 5. Effective tax rate for different types of income of individuals in 2014-2016 Wages Investme Dividends Income Income from Rental and nt and from the the sale of lease income royalties sale of real movable income estate assets 2014 Amount of income, billion 446.32 2.7 27.24 28.3 9.91 15.29 UAH Number of individuals who 13.51 0.01 0.25 0.14 0.13 3.68 received such income, million persons Amount of tax paid, billion 60.3 0.02 1.39 0.6 0.04 2.28 UAH Effective rate, % 13.51 0.74 5.10 2.12 0.40 14.91 Average annual income per person, thousand UAH 33.04 270.00 108.96 202.14 76.23 4.15 2015 Amount of income, billion 487.13 1.51 13.99 33.74 10.80 22.06 UAH Number of individuals who 12.1 0.01 0.18 0.15 0.12 3.78 received such income, million persons Amount of tax paid, billion 70.0 0.05 1.26 0.71 0.04 3.4 UAH Effective rate, % 14.37 3.31 9.01 2.10 0.37 15.41 Average annual income per person, thousand UAH 40.26 151.00 77.72 224.93 90.00 5.84 2016 Amount of income, billion 597.22 1.99 18.96 40.86 1.66 31.50 UAH Number of individuals who 11.75 0.01 0.20 0.18 0.02 3.96 received such income, million persons Amount of tax paid, billion 103.25 0.22 1.54 0.92 0.03 5.67 UAH Effective rate, % 17.29 11.06 8.12 2.25 1.81 18.00 Average annual income per person, thousand UAH 50.83 199.00 94.80 227.00 83.00 7.95 45. The effective tax rate for a limited number of taxpayers with a relatively high- income level was significantly lower than for wage recipients despite some reduction in this gap during 2014-16. In 2014, at the standard tax rates of 15 and 17%, the effective tax rate on income in the form of wages was 13.51% and the average annual level of taxpayers was 33,000 UAH. At the same time, the effective tax rate for investment income was 0.74% and its average annual level was 270,000 UAH, while the tax on income in the form of dividends and royalties was 5.1 % for taxpayers with an average annual level of income of 108,960 UAH. In general, in 2014, for the recipients of investment income, the effective tax rate was 18.2 times lower than for the recipients of wages, while on average, investment income was 8.2 15 times higher than the income from wages. In 2015, after cancelation of some of tax privileges on investment income, this gap narrowed, but remained quite significant (with effective tax rate 4.3 times less and with average income of 3.7 times higher). In 2015, at the standard tax rates of 15 and 20%, the effective tax rate on income in the form of wages was 14.37%. At the same time, the effective tax rate on investment income was 3.31%, and the tax on income in the form of dividends and royalties was 9.01%. In 2016, with a standard tax rate of 18 percent and cancellation of benefits for some types of investment income and dividends, the effective tax rate on income in the form of wages was 17.29 %. At the same time, the effective tax rate on investment income was 11.06%, and the tax on income in the form of dividends and royalties was 8.12 %. Thus, the recipient of income in the form of dividends and royalties (on average, such taxpayers had income that was almost twice higher than income in the form of wages) pays a tax whose effective rate is 2.1 times lower than for a wage tax. In 2016, the recipients of dividends had the effective rate 2.1 times lower than the recipients of salary, while earning twice the income. 46. A share of income received by individuals is excluded from taxable income. These are personal income provided as a direct budget payment, such as, state financial aid to low income individuals, disabled people, pregnancy care, etc. The above types of income (aid) are paid from the budget of Ukraine or from the income of individuals after personal income tax is paid (for example, alimony), and therefore do not lead to budget losses. The exempt income also includes interest on government bonds for residents and non-residents, and income of non-residents from interest on bonds under State and municipal guarantee. Complete list of all types of income exempted from PIT is presented in the Annex 2. 47. There are tax privileges for PIT payers called “social benefits� given to low income individuals as deductions from the received income. As stipulated by the Tax Code, the social privilege applies only to wages and on condition that the amount of the monthly wage does not exceed the amount that is equal to the subsistence minimum (for working persons as of January 1 of the current year) multiplied by 1.4 and rounded up to UAH 10 (Table 6). Table 6. Social Tax Benefit for the Personal Income Tax Payers in 2011-2017 years Year Maximum wage Subsistence Size of benefit, Amount of tax social benefit, UAH that entitles minimum, UAH. % of 100 % 150% 200% individual to subsistence for taxpayers whose for single parents for the heroes of receive a tax minimum monthly wage does not and parents of Ukraine and the social benefit (% exceed 140% of the disabled children, USSR, former of the subsistence minimum (per child), widows prisoners of subsistence (for able-bodied people (widowers), concentration minimum), UAH. as of January 1 of the students, graduate camps, repressed, current year), as well as students, residents, blockades, persons for parents with two or adjuncts, disabled 1 raising 3 or more more children (for each and 2 groups, children (up to 18 child) people affected by years, per child) the Chernobyl disaster 2011 1320,00 941,00 50 470,50 705,75 941,00 2012 1500,00 1073,00 50 536,50 804,75 1073,00 2013 1610,00 1147,00 50 573,50 860,25 1147,00 2014 1710,00 1218,00 50 609,00 913,50 1218,00 2015 1710,00 1218,00 50 609,00 913,50 1218,00 2016 1930,00 1378,00 50 689,00 1033,50 1378,00 2017 2240,00 1600,00 50 800,00 1200,00 1600,00 16 48. In 2014, 44.3 percent of wage recipients used the right for tax social benefits. Their annual wage was up to 18,000 UAH and the share of income in the total wage accrued in Ukraine accounted for 14.1 percent. In 2016, the number of such taxpayers decreased to 38.8 percent, and their share in the total amount of wages was up to 9.7 percent. In 2014, the provision of social benefits reduced effective tax rates for the wage recipients with annual wage from UAH 18,000 to UAH 42,000 to 9.54 and 13.22 percent, respectively. In 2015, the rates were reduced to 10.12 and 13.25 percent and in 2016 the rates were up to 12.68 and 15.79 percent. The minimum standard tax rate in 2014 and 2015 was 15 percent and in 2016 there was a standard flat rate of 18 percent. 49. The second important type of tax privileges for individuals is tax rebate - a reduction in the taxable wages for the amount of documented costs, in particular, interest on a mortgage loan; charitable contributions; education costs; expenses for medical treatment; expenses for reproductive technologies; expenses for conversion of vehicles for the use of biofuels; or expenditure on affordable housing. The relevant part of the tax paid is refunded to taxpayer based on tax return data. 50. The analysis of granting of tax rebate shows that low income taxpayers do not apply for or benefit from these privileges. In 2016, in the group of people receiving the lowest wage (up to 18,000 UAH annually) only 0.4 percent of taxpayers received a refund of the taxes paid, whereas among the recipients of high wages (over 360,000 UAH annually) received 0.8 percent as a tax rebate or twice as much, while 2.4 percent of taxpayers with an annual average wage of 60-120,000 UAH received a tax rebate. However, in all income groups the share of taxpayers who used the right to tax rebate, is not high. 51. According to WB estimates, PIT related tax expenditures varied from 0.2 to 0.5 percent of GDP in 2014-2016. The result is based on the difference between tax that would be paid based on standard rates by income brackets (15-17 percent in 2014, 15-20 percent in 2015, 18 percent in 2016) and tax that actually was paid given the lower rates for dividends, royalties and investment income or social benefit deduction. Table 7. Tax Expenditures on PIT in 2014-2016 years, billion UAH Type of benefit\Years 2014 2015 2016 1 Social benefit 4.07 3.00 2.29 2 Investment income 0.44 0.25 0.14 3 Dividends/Royalty 3.24 1.54 1.87 4 Total 7.75 4.79 4.30 5 Total, % of GDP 0.49 0.24 0.18 Source: WB calculations based on standard tax rates 5. Simplified Tax System in Ukraine 52. This section focuses on the Simplified Tax System (STS), which establishes a separate tax regime for small businesses and potentially creates distortions in the tax system and leads to revenue losses. The STS which was introduced to reduce cost of compliance for small businesses, but gradually extended to higher income individuals and higher turnover entities. This section tried to provide estimates of the revenue implications of the STS for the budget. 17 53. The STS was introduced by the Decree of the President of Ukraine in 1998 13 to reduce unemployment and decrease the tax burden on small businesses. The criteria for participation the simplified system included: • For individual entrepreneurs, with turnover below UAH 500,000 (equivalent to US$147,058 in 1999, an exchange rate of UAH 3.4 for one US dollar) and less than 10 employees, including family members. • For legal entities, with turnover below UAH 1,000, 000, and less than 50 employees. The Decree defined boundary levels of rates for individuals from UAH 20 (around US$6 in 1999) to UAH 200, with local authorities choosing the rate within the boundaries. For legal entities, the level of rates was set at 6 percent of turnover for VAT payers and 10 percent of turnover for non-VAT-payers. Taxpayers in the simplified taxation system did not pay social security contributions as a separate payment, but 15 percent of the single tax was directed to the Social Insurance Fund and 42 percent to the Pension Fund. The balance was distributed between local and state budgets. 54. Over time, the STS encouraged behaviors that were unintended and used to minimize tax liabilities. The STS creates incentives for legal and illegal migration from the regular tax system, which generates revenue losses for the budget in all major taxes (PIT, VAT, and CIT); it distorts taxpayer behavior in inefficient ways for the economy, potentially lowering productivity in the economy (e.g., firms fragment their operations into smaller firms to meet the threshold, losing economies of scale; and production and sales are kept below thresholds hampering output growth); and it introduces substantial horizontal (and vertical) inequalities to the system (e.g., an individual working as a “consultant� under the STS may pay significantly lower taxes than an individual with the same type of job description at a firm and the same level of income under the regular income tax system. The most telling example is large stores, which may hire fewer individual workers (single tax payers) in order to avoid taxation under the regular system. 55. To address the abuse of the simplified tax system, an attempt to limit eligibility to participate was made while drafting the Tax Code in 2010, but it was unsuccessful. After protests of single tax payers who demanded to keep the System unchanged, a chapter devoted to the STS was excluded from the Code but there was indication in the Transition provisions that new rules would be elaborated later, after discussions with small businesses. 56. The STS has changed several times before arriving to the current state. In October 2011 the amendments to the Tax Code modified the STS and further reduced tax rates. The number of taxpayer groups was extended from 2 to 4, and rates for these groups were reduced to 3 and 5 percent (instead of previously effective 6 and 10 percent). In August 201214 (Law #5083-IV, dated 12.08.2012) the system was changed again, extending the STS from three tax payer groups to six. The turnover for the fifth and sixth groups was increased to 20,000,000 UAH. The fifth and sixth groups were the most contested part of the reform. Most experts noted that in fact an enterprise with 50 employees and high turnover were able to maintain regular bookkeeping and therefore could have functioned under the regular tax system. 13 Decree of the President of Ukraine #727/98 dated July 3, 1998. In 1999 the System was extended covering small businesses legal entities as well, in addition several economic activities should be excluded from the System, such as game business, trade in excisable goods, extraction and trade in precious metals and precious stones. (Decree of the President of Ukraine #727/99 dated July 28, 1999) starting 2005. 14 Law #5083-IV, dated 12.08.2012 18 Nevertheless, the amendments to the STS had been approved by the Parliament and signed by the President. In 2015, a newly created group 3 from the combined groups 3, 4, 5 and 6 that had existed before 2015. This new taxpayer group 3 had a turnover ceiling up to 20,000,000 UAH and tax rate 2% for VAT payer and 4% for VAT non-payer, accordingly. Agricultural producers who were regulated in a separate chapter of the Tax Code were included as a group #4. In 2016, a ceiling for group 3 was reduced to 5,000,000 UAH and tax rates were increased to 3% and 5% for VAT payer and VAT non-payer, accordingly. Modifications of STS between years 2010-2016 are presented in Annex 1, while the current STS is presented in Table 8. Table 8. Simplified Tax System, 2018 Groups Eligible Taxpayers Hired Turnover Tax Base Tax Rate Tax Persons (Income) Code Articles 1 Individuals - 0 Not more Living Wage Up to 10% 291.4; entrepreneurs who do not than of living 293 use the labor of hired 300,000 wage persons, carry out UAH exclusively retail sales of goods from trading places in the markets and / or conduct economic activity in providing domestic services to the population15.1/ 2 Individuals - Up to 10 Not more Minimum Wage Up to 20% 291.4; entrepreneurs who carry than of 293 out economic activities in 1,500,000 minimum providing services, UAH wage including domestic ones, to single tax payers and / or population; production and / or sale of goods; restaurant activities16 3 Individuals - 0 Not more Income (turnover) 3% of 291.4; entrepreneurs who do not than income 293 have employees and (VAT 15 For domestic services provided by the first and second groups of single tax payers, the following types of services are understood: 1) custom made shoes manufacturing; 2) shoe repair services; 3) manufacturing of sewing products on an individual order; 4) manufacturing of leather goods on an individual order; 5) manufacturing of fur products according to individual orders; 6) manufacturing of underwear according to individual order; 7) manufacturing of textile products and textile haberdashery on an individual order; 8) manufacturing of headgear on an individual order; 9) additional services for production of products on an individual order; 10) clothes and household textile products repair services; 11) manufacturing and knitting of knitted products on an individual order; 12) repair services of knitted goods; 13) the manufacturing of carpets according to individual orders; 14) services on repair and restoration of carpets; 15) manufacturing of leather haberdashery and travel products on an individual order; 16) services on repair of leather haberdashery and travel products; 17) furniture production on an individual order; 18) services on repair, restoration and renovation of furniture;19) manufacturing of carpentry and joinery products on an individual order; 20) maintenance and repair of motor vehicles, motorcycles, scooters and mopeds customized; 21) services for the repair of radio and television and other audio and video equipment; 22) services on repair of electrical appliances and other household appliances; 23) clock repair services; 24) repair of bicycles; 25) maintenance and repair of musical instruments; 26) manufacture of metal products on an individual order; 27) services for the repair of other personal use, household goods and hardware; 28) manufacture of jewelry on an individual order; 29) services on repair of jewelry; 30) rental of personal and household goods; 31) services for performing photo works; 32) film processing services; 33) laundry, linen and other textile products services; 34) services on cleaning and dyeing of textile, knitted and fur products; 35) perfection of fur skins according to individual order; 36) hairdressing services; 37) ritual services; 38) services related to agriculture and forestry; 39) domestic servants; 40) premises cleaning services on an individual order. (Article 291.7) 16 Do not apply to individuals - entrepreneurs who provide intermediary services in the purchase, sale, lease and evaluation of real estate (group 70.31 KVED DK 009:2005.); as well as for those who are engaged in production, supply, sale of jewelry and household products from precious metals, precious stones, precious stones of organogenic origin and semi-precious stones. Such individuals- entrepreneurs belong exclusively to the third group of single tax payers if they meet requirements set for such a group. 19 legal entities of any For 5,000,000 payer), 5% organizational and legal individuals of income form with unlimited (VAT non- number of employees payer) Not more Not than 6% of limited for income legal 5,000,000 (VAT entities payer), 10% of income (non-VAT payer) 4 Agricultural commodity Normative Depends 291.4; producers with the share monetary value of on 292; of agricultural commodity one hectare of category 293.9 production is equal to or agricultural land (type) of exceeds 75 percent in the taking into account lands and previous tax (reporting) the indexation their year. coefficient location17 determined as of January 1 of the basic tax (reporting) year in accordance with the procedure established by Tax Code; and for water reservoirs - normative monetary value of arable land in the Autonomous Republic of Crimea or in the region, taking into account the indexation coefficient determined as of January 1 of the basic tax (reporting) year in accordance with the procedure established by the Tax Code. 17 For arable land, hayfields and pastures (except for arable land, hayfields and pastures located in the mountainous areas and Polissya territories, as well as agricultural lands under the closed soil conditions) – 0.95 (Article 293.9.1); for arable land, hayfields and pastures located in the mountainous areas and Polissya territories – 0.57 (Article 293.9.2); for perennial plantings (except perennial plantings located in the mountainous areas and Polissya territories) – 0.57 (Article 293.9.3); for perennial plantings located in the mountainous areas and Polissya territories – 0.19 (Article 293.9.4); for lands of the water reservoirs - 2.43 (Article 293.9.5); for agricultural lands under the closed soil conditions – 6.33 (Article 293.9.6). 20 57. Budget losses (tax expenditures) associated with STS could be assessed based on aggregate data on production and administrative data on taxpayers. This report uses the following approach: (1) make an assessment of revenues that would be received from STS’s taxpayers if they paid taxes under the regular tax system (for each group of STS’s taxpayers); (2) compare this assessment with the data on taxes paid by each group. 58. There is no methodology for tax expenditure assessment under the STS used by the State Fiscal Service or Ministry of Finance, but the difference between effective rates under the regular PIT and STS are significant. First, the STS is not considered as a tax exemption in the legislation. Second, the existing reporting for physical persons and legal entities of the STS15 does not allow estimating the losses accurately. However, the existence of such losses is obvious, and it is useful to make even their rough estimates to understand the scale of the problem. Table 9 presents effective rates under STS. Table 9. Effective rates for individuals-entrepreneurs under STS in 2014-2016, % Group\Year 2014 2015 2016 1 2.34 3.10 1.92 2 0.91 0.81 0.74 3 4.90 3.38 4.41 Source: WB Calculation based on State Fiscal Service data 59. The difficulty in assessing tax expenditures under STS is that only the taxpayers under the third group record expenses18. These expenses are recorded for the purpose of tax credit and VAT reimbursement, and can be used as a proxy for the purpose of tax expenditure estimation. To assess tax expenditures under PIT for taxpayers under the STS for individuals- entrepreneurs, the following aggregate tax returns’ data was used: a number of taxpayers, a unified tax paid under STS, and turnover for each group 1, 2, 3 in 2014, 2015 and 2016 years (group 5 existed only in 2014 and was not a subject of this estimation). Assessment of tax expenditure on tax returns is associated with the registered taxpayers. Besides, the hired employees should also be incorporated in the assessment. Information about hired employees is contained in the data form 1-DF. The aggregate data of Form 1-DF was requested from SFS but has not been received. In the absence of data, the assumption was made that all hired employees will pay taxes from minimum wage for appropriate year. 60. In the absence of the information on reported expenses two options are suggested to estimate expenses. The first option uses input-output table data; the second option uses the data on expenses recorded by individuals/entrepreneurs under the standard tax system. 18 STS taxpayers do not report on their expenses but all STS taxpayers – physical persons (1, 2 and 3 groups) keep records on their sales in a special book. The Ministry of Finance of Ukraine approves the sample of the book. In this book all types of received income (or returned income if any) are identified. The book is a document for State Fiscal Service that is responsible to “open� the book when a taxpayer starts to use it (checking page numeration, verification of the absence of damages etc.) and “close� the book when it is fi nished (no records can be done after the book’s closure). In other worlds the book should be registered in the SFS (in accordance with the Tax Code). A taxpayer should keep the book during three years after its closure. A taxpayer fills in tax return based on the book and submits tax return to the SFS quarterly. The purpose of the book is to record a turnover to monitor legislatively permitted ceiling. 21 5.1 PIT Tax Expenditures based on Input-Output Data 61. Expenses can be estimated using input-output table considering the economic activity code for each group of taxpayers under the STS. As far as groups two and three are concerned, an example of a basic activity in these groups may be wholesale, retail and catering business. It is more complicated to define the prevailing sector for the first group since taxpayers operating in a dozen sectors are registered there. In each tax return a taxpayer should identify an economic activity code for the business. Ideally, it would be possible to make accurate estimation if any economic activity code would be matched with appropriate turnover, but such information is not available. Due to that the same basic activity was chosen for the first group as for the second and third groups. 62. The estimates of business expenses under each group were made as follows. To define expenses for individuals of the first group, a share of inputs in final output for chosen activities is calculated. Since in the second and third group there are hired employees, the expenses for this group also includes wages. The difference between turnover and expenses is a “hypothetical� tax base that can be used to estimate an amount of the tax that would be paid by individuals – STS taxpayers if they were taxed under regular tax system. Share of interim product in final product for wholesale, retail and catering businesses is approximately 40-50 percent, and share of wages is 18 and 21 percent. For the first group a tax base is taken as 50 percent of turnover, and for the second and third groups a tax base is taken at 30 percent. 63. The estimated tax expenditures are made based on the assumption that the effective rates are the same as for individuals who are subject to the regular tax system with the same level of income. All hired employees will pay tax from the minimum salary based on the corresponding effective rate for minimum salary under regular system. Minimum wage is taken as of January 1 of each year. In fact, the tax base was higher in 2015 and 2016 because of a minimum wage increase within a year (in September in 2015 and in May and December in 2016). So, these estimates are rather conservative. Results of the assessment are presented in the Table 10. According to estimates, the total amount of tax expenditures over 2014-2016 years constituted 27.7 billion UAH, showing the growing trend from 5.35 billion to 13.50 billion within three years. The negative tax expenditure for a group 3 in the year 2014 could be explained by unreliable data on the number of employees. The 2014 data shows the same number of registered taxpayers but only half the number of employees in 2015, which is likely attributed to unregistered labor used by the group 4 taxpayers. Table 10. PIT tax expenditures estimates based on input-output data Groups Number of Number of Income, Tax paid, Tax paid at Tax Registered employees, declared, UAH million effective expenditure, Taxpayers, thousand UAH million rates, UAH UAH million thousand persons million persons Year 2014 1 184.2 0 10,100.0 235.9 667.6 431.7 2 570.4 363.6 161,300.0 1,460.2 6,813.3 5,395.4 3 284.2 58.8 72,000.0 3,528.2 3,041.3 -480.1 Total 1,038.8 422.4 242,400.0 5,224.3 10,522.2 5,347.0 Year 2015 1 145.1 0 8,600.0 266.5 569.8 303.3 2 515.4 382.9 197,500.0 1,598.4 8,555.7 7,004.5 3 285.4 108.5 144,400.0 4,879.8 6,402.7 1,536.3 22 Total 945.9 491.4 350,500.0 6744,7 15,528.1 8,844.0 Year 2016 1 164.2 0 11,800.0 226.3 931.6 705.3 2 617.0 439.7 234,500.0 1,735.7 12,606.7 10,947.8 3 372.6 162.2 189,500.0 8,364.5 10,187.5 1,851.4 Total 1,153.8 601.9 435,800.0 10,236.5 23,725.9 13,504.5 5.2 PIT Tax Expenditures Based on Comparison between Entrepreneurs under STS and Regular System 64. Another option is to calculate tax expenditures based on the assumption that individual STS payers have the same level of expenses as individual entrepreneurs under the regular tax system. The tax base is defined as a difference between declared income of STS tax payers and expenses documented by individual entrepreneurs under regular taxation for the same level of income. The documented expenses from tax returns were grouped by level of income (see Annex 3). For hired employees the assumptions for effective rates and wages remain the same as it was for calculation based on input-output data. 65. Estimates based on comparison between entrepreneurs under different tax regime are inconsistent with estimates based on input-output data and pose a question on accuracy of reporting, as income generated for owners of businesses under the regular regime is considerably lower than minimum wage. According to this assessment all businesses pay much more taxes under STS than they would pay under the regular tax system. However, such a result is dubious and may be explained by the overestimated documented expenses rather than tax overpayment under STS. Data on tax base per person (see Table 11) shows that wage for each group of taxpayers, in some cases, is even less than minimum wage for reported period. Having the level of expenses as reported by individuals under the regular tax system, physical persons from group 1 would have 973 UAH per month in 2014 when the minimum wage was 1218. The calculated monthly wage for group 3 individuals is 1,837 per month that is a suspiciously low wage level to keep them in business. This report concludes that the income data is likely underreported. Table 11. PIT tax expenditures estimates based on documented expenses Groups Number of Number of Income, Tax paid, Tax base Tax paid TE, million registered hiring declared, million calculated based on UAH taxpayers, employees million UAH UAH based on expenses thousand , thousand documented including persons persons expenses per hired person in persons, annual terms, million thousand UAH UAH Year 2014 1 184.2 0 10,100.0 235.9 11.68 205.2 - 30.7 2 570.4 363.6 161,300.0 1,460.2 24.60 1,897.4 437.2 3 284.2 58.8 72,000.0 3,528.2 22.04 834.9 - 2,693.3 Total 1,038.8 422.4 242,400.0 5,224.3 - 2,286.7 Year 2015 1 145.1 0 8,600.0 266.5 10.96 161.0 - 105.5 23 2 515.4 382.9 197,500.0 1,598.4 34.87 2,428.6 830.2 3 285.4 108.5 144,400.0 4,879.8 46.04 1,855.9 - 2,993.9 Total 945.9 491.4 350,500.0 6744,7 - 2,269.3 Year 2016 1 164.2 0 11,800.0 226.3 13.39 276.8 50.5 2 617.0 439.7 234,500.0 1,735.7 37.25 3,705.5 1,969.8 3 372.6 162.2 189,500.0 8,364.5 49.84 3,135.3 - 5,229.2 Total 1,153.8 601.9 435,800.0 10,236.5 - 3,208.9 5.3 CIT Tax Expenditures Based on Comparison between Enterprises under STS and Regular System 66. Similar approach is used to assess expenses for legal entities under STS. The STS legal entities in the form of turnover tax replaces several taxes paid under standard taxation, particularly CIT, land, property and other taxes. The lack of information does not allow to account for all taxes, and the assumption is made that a single tax for legal entities replaces CIT. Because of that, for CIT “gross profit and mixed income� is taken as a tax base. Changes in the STS in 2015 do not allow direct comparison with 2014 data. so the assessment was made for 2015 and 2016 only. 67. The estimation of the tax expenditures has been done based on aggregated indicators on the number of taxpayers of the unified tax of the third group, the amounts of declared income and unified tax paid. This information was received from the SFS of Ukraine. Estimates of budget losses for legal entities of the third group are based on input-output tables of the respective years. A share of "gross profit, mixed income" in output by various types of economic activity (according to codes of economic activities - KVED) is taken as a tax base for CIT. Budget losses (tax expenditures) are the difference between estimates of corporate income tax that legal entities would pay under regular taxation and amounts of the single tax that was actually paid. The assessment of tax expenditures is made for two options: • The first option with the assumption that "wholesale, retail trade, repair of vehicle� and "catering" are the prevailing activities for the third group of legal entities. The share of "gross profit, mixed income" for these types of activities has been taken as a tax base. • The second option with the assumption that activities of legal entities under STS correspond to types of activities of micro-enterprises, according to statistical indicators published by State Statistics Service of Ukraine. In this case a tax base is defined as weighted average indicator defined based on turnover structure of micro enterprises. 68. The tax expenditures for legal entities of the third group of taxpayers amounted to 1.3- 2.3 billion UAH in 2015, and to 0.2-1.5 billion UAH in 2016. Table 12. Tax expenditures estimated for legal entities of third group STS, 2015-2016. Year Number of Declared Actua Effective Tax paid, Tax paid, TE, UAH TE, UAH Registered income, l tax rate, % UAH billion UAH billion billion billion Taxpayers- UAH paid, (actual) legal billion UAH (Option 1) (Option 2) (Option 1) (Option 2) entities, billio thousands n 2015 153.6 67.9 2.21 3.25 3.49 4.22 1.3 2.3 24 2016 155.5 66.0 3.30 5.00 3.49 4.76 0.2 1.5 69. The tax expenditure related to STS are within UAH 13 to 15 billion range suggesting non-negligible revenue losses and a need for in depth analysis of the STS. While the simplified regime for small taxpayers could still be justified from the point of view of encouraging compliance and minimizing burden on small taxpayers, the size of tax expenditures suggests at least monitoring them on a regular basis and potentially looking closer at how the design of the STS could be improved to ensure only truly small businesses benefit from it, while minimizing potential for abuse. 6. Approach to Measurement and Management of Tax Expenditures 70. This section provides an overview of different methods to estimate tax expenditures and some practices considerations on where Ukraine can focus its initial steps in measuring tax expenditures and evaluating their impact. Despite some nuances in approach to tax expenditure in different countries, there are some general provisions that all countries follow. First, a definition of tax expenditure explains the fact that there are some deviations from regular taxation that lead to budget revenue reduction. The most common types of tax expenditures are deductions or exemptions from any kind of taxable income, preferential tax rate imposed on specific group of taxpayers or industries, deferral of tax liabilities, etc. Tax expenditures in general terms are considered as a substitute to direct budget spending. From this point of view the important issue is to justify the advantage of tax expenditure against direct spending. In some cases, such a justification is connected to “market failure� and preferential taxation may be a better option to make an adjustment. 71. The most common methodology used to estimate the value of tax expenditures is referred to as the ‘revenue foregone’ method. This methodology is an ex post calculation of the tax that would have been payable if the tax concession were removed, assuming everything else remained unchanged, including taxpayer and economic behavior. There are some alternative ways to measure tax expenditures: a. Initial/static revenue loss (gain): measuring the reduction (increase) in tax revenues as a consequence of the introduction (abolition) of a tax expenditure, based upon the assumption of unchanged behaviour and unchanged revenues from other taxes. This method is very similar to the revenue foregone method but is an ex ante calculation rather than an ex post estimate. Based on the data available, the previous sections of the report use this methodology. b. Final/dynamic revenue loss (gain): measuring the reduction (increase) in tax revenues as a consequence of the introduction (abolition) of a tax expenditure, taking into account the change in behaviour and the effects on revenues from other taxes as a consequence of the introduction (abolition). Because estimates will greatly depend on expected changes in behaviour and interactions with other taxes, this method requires intimate knowledge of taxpayer behaviour. Estimates will only be as robust as the parameters (e.g., elasticities) used in the calculations. c. Outlay equivalence: measuring the direct expenditure that would be required in pre-tax terms to achieve the same after-tax effect on taxpayers’ incomes as 25 the tax expenditure if the direct expenditure or subsidy was made taxable in the hands of the recipient. 72. The revenue foregone method is by far the most common method used to estimate tax expenditures but there are some drawbacks to this method. This is because it is fairly intuitive to understand (and explain) but also because it is easier to compute than methods such as the dynamic revenue loss or the outlay equivalence method. The most important drawback is that each tax expenditure is estimated in isolation, without considering interactions between different tax expenditures or between the tax expenditure and the tax system in general. For a particular tax expenditure, revenue foregone estimates do not reflect the actual amount of revenues that would be raised if that tax expenditure were repealed, as it does not take into consideration behavioural effects. In addition, such a methodology does not account for the economic impact that the tax concessions may create and its corresponding impact on government revenues. For example, an increase in personal taxes resulting from the elimination of a tax concession available to individuals, will reduce the disposable income of the individuals impacted by the measure and may result in lower consumption and lower VAT revenues. This implies that tax expenditures estimates cannot be summed up as interactions would occur that would affect the estimates if multiple tax expenditures were removed or altered at the same time. It also implies that officials must be cautious to qualify affirmations relating to tax expenditure estimates so that decision-makers can interpret these estimates correctly. Personal Income Tax Expenditures 73. For income tax expenditures, the foregone revenues are often estimated using micro-simulation models that calculate tax revenues and income-tested entitlements (in the case of individuals) with and without a given tax expenditure for each taxpayer. These models generally optimize the tax situation of each taxpayer in the scenario where the measure under consideration is ‘removed’ by assuming that the taxpayer would use all available deductions or credits to offset a potential increase in taxes payable. 74. Micro-simulation models are essentially static tax calculators where the data used for the model is based on taxpayer data usually collected by the revenue administration. In the case of a very large population, a stratified sample of taxpayers can be constructed with each taxpayer in the sample being assigned a weight. Each tax expenditure accounts for changes in personal income tax as well as changes in income-tested entitlements when applicable. Tax expenditures whose costs cannot be estimated using micro-simulation models due to the complexity of these measures or the absence of individual tax return data are usually estimated using supplementary data obtained from the revenue or statistical agencies/departments. 75. The models for PIT frequently have the following data requirements. The models frequently contain data on the amount of personal taxes that each taxpayer pays under the status quo system (i.e. under the existing tax parameters such as the personal exemption, spousal exemption, etc.) and another dataset that re-estimates the total amount of taxes paid under an optional tax system. The difference between the amount of taxes paid under the optional and the status quo systems constitute the impact of the change to the tax parameter. 26 76. Such a model could be used to determine the cost of tax expenditures. To do so, the optional parameters associated to tax elements considered to be tax expenditures (e.g. the dependent exemption) can be set to zero and the amount of estimated additional taxes that would be generated from this change would determine the revenue forgone associated to the tax concession. The exercise can be repeated for every element of the system that are considered tax expenditures. Corporate Income Tax Expenditures 77. Micro-simulation models are also used extensively to estimate foregone revenues from corporate tax expenditures. These models simulate changes to corporate income taxes using corporation tax return data capture by the revenue or statistical agencies. The model calculates taxes payable based on existing tax provisions and then adjusted tax provisions, and usually take into account the availability of unused deductions and losses that could be used by corporations to minimize their tax liability under the adjusted tax scenario. The computation is done for every corporation in the database and the results are aggregated to determine the overall revenue gain from eliminating a tax concession. As is the case for personal income taxes, corporate income tax expenditures that can’t be estimated using a micro-simulation model can usually be estimated with supplementary data obtained from the revenue or statistical agencies, or from other government departments or industry association. VAT and excise 78. Tax expenditures related to the VAT arise from two sources: those arising from exemptions on imported supplies and those that arise from domestic sales. The former are usually fairly straightforward to estimate as long as data is available from the customs agencies. If this data is sufficiently disaggregated to map customs data (usually available by business on a commodity basis) to specific tax expenditures, an estimate can generally be obtained by simply summing the foregone VAT for each category of tax expenditure. This is also the case of foregone revenue from excise-related tax expenditures. Data on commodities imported exempt from excise can usually be mapped to the specific excise exemptions found in the Tax Code. Foregone revenue from the tax expenditure in this case is simply the value of the commodities exempted times the excise rate that would have applied had the tax expenditure not been in place. 79. Conversely, estimating the tax expenditures arising from the non-application of VAT on domestic supplies is not straightforward, as this data cannot be captured on tax forms. This is because, unlike traditional retail sales taxes, the VAT is intended to apply only on supplies for final consumers. Hence, one needs data on exempt purchases as well as on exempt supplies and to know whether the supply was made to a final consumer or a business. That is, the revenue loss to be attributed to an exemption of VAT is determined not only by the value added imbedded in the sale price but also by the tax profile of the buyer. Revenue will be remitted to the government only if buyer is a final consumer of an intermediate exempt consumer. 80. Consequently, most governments use models based on a country’s Input-Output tables to estimate foregone revenue from VAT tax expenditures. Input-Output tables detail 27 the supply of the principal products by sector of the economy and the commodities used by these sectors to produce their respective outputs. Models built based on Input-Output tables hence consider intersectoral buying and selling associated with different goods and services, allowing researchers to “track� where the VAT is applied. Foregone revenue associated with the tax expenditure is the difference between the VAT that would be nondeductible under the supposed elimination of the exemption and the VAT that is nondeductible under the current tax legislation. Practical considerations regarding methodology 81. The methodologies used to estimate revenue foregone are highly dependent on the nature of the tax expenditure and the availability of data. Consequently, there is no universal “recipe� to estimate tax expenditures but rather broad guidelines based on what has been shown to work in other countries. For example, the value of certain tax expenditures can simply be inferred from administrative data because all the relevant information is on the tax form and the calculations used to determine taxes payable are straightforward. If once the calculations are done the taxpayer can indicate on the form that it is exempt from the tax for whatever valid reason, then the tax expenditure is simply the value of the tax not paid aggregated across all taxpayers in the same situation. But doing the same calculation for taxes that are more complicated and involve deductions and multiples rates will lead to biased results. This is why most countries use micro-simulation models (as discussed above). 82. The use of these models if not a “best practice� per se, as for example, some tax expenditures related to personal income tax could be estimated using simple calculations based on administrative data. The “best practice� is to ensure that all aspects of the tax expenditure at hand are considered (interactions, context, etc.), and most of the time this necessitates the use of micro-simulation models for personal income taxes. 83. When planning to begin estimating and evaluating tax expenditures, authorities need to be cognisant of the fact that this is an exercise that requires a significant investment in time and resources. Reports produced by countries like Canada and the U.S. are the result of many years of analysis with constant improvements as new tools and new data become available. Most countries’ tax system, like that of Ukraine, have numerous tax expenditures and while the ultimate goal is to put in place a system where all expenditures are estimated, in most cases restrictions in resources make it necessary to select a few measures with which to begin the process and put in place the proper framework. Which measures to select will depend on various factors such as the relative importance of tax expenditures and data availability. 6.2 Tax Expenditure Management 84. Regardless of the method chosen for tax expenditures calculation, the key issue is understanding the nature of tax expenditures as a substitute for budgetary funds. It means that tax expenditures should be justified in terms of their goal, costs, duration time and effectiveness. Other countries experience shows that the properly established tax expenditure framework is time consuming process that requires substantial resources. Because of this, it is a common practice to involve research centers or other independent bodies in calculating tax expenditures. 28 85. Another problem is the identification of a "reference" tax system as a system with equal treatment for all taxpayers. This system is called a "benchmark tax system" (sometimes “normative tax system�)19. If the calculation of tax expenditures can be delegated to different agencies, the definition of the benchmark system is purely an exercise for the authorities, who need to decide what constitutes a "benchmark system" for the country. One of the approaches is to treat the legislative tax system as a "benchmark system". Another approach suggests defining a benchmark system based on comprehensive income tax (Haig- Simon definition of income). In any case the approaches are not universal and depend on the country specifics and the decision taken by authorities. 86. Identification of “benchmarks� for the system and for particular types of taxes allows to estimate tax expenditures at during budget planning. In Ukraine there is a provision in legislation regarding assessment of the potential revenue losses due to introduction of tax privileges (elaboration of appropriate forecasts). However, these forecasts are not elaborated regularly and are done based on general trends of inflation rather than on analysis of main tendencies of economic activities. As the result forecasts are not accurate: the deviation from numbers in records is substantial (Table 13). Table 13. Data on Actual and Forecasted Tax Expenditures in 2010, 2013 and 2014 years, Billion UAH Tax\Year 2010 2013 2014 Actual Forecast Actual Forecast Actual Forecast Total 37.127 24.687 35.631 41.461 33.213 44.275 CIT 2.097 2.029 5.533 16.306 4.623 10.551 VAT 34.040 17.881 26.204 22.317 26.742 32.435 Source: Ministry of Finance and State Fiscal Service data 87. There are several key points that characterize international approaches to establishment of the tax expenditure framework. First of all is the need for definition of tax expenditures. In general, “tax expenditures� are defined in terms of some deviation from “benchmarks�. However, there is no common view what kind of tax privileges may be considered as part of the benchmark system. So, in the USA tax expenditures are defined as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability�20. “Special� is a key word in this definition. In fact, it means that not all tax privileges are tax expenditures. For example, such tax privileges as employers’ deductions for employee compensation or interest expenses, personal expenses and expenses on dependent are not considered as tax expenditures in the States, but as the appropriate way in measuring a taxpayer’s “ability to pay�. In general, most countries categorized tax privileges that reflect “ability to pay� as a part of benchmark system. However, it is a matter of judgment. For instance, tax privileges for families with 19 The Definition, Management, and Evaluation of Tax Expenditures and Tax Reliefs, Tax Administration Research Center, Technical Paper prepared for the National Audit Office, June 2014 20 The Congressional Budget Act of 1974 29 children also is introduced to address “ability to pay� but from another side this is a privilege to targeted taxpayers, therefore it can be considered as tax expenditure21. 88. In Germany the tax expenditure is defined as a type of tax concession leading to the budget revenue decrease. Currently the concept of tax privileges has been aligned with the concept of financial assistance and defined as special exceptions from regular tax norm introduced on economic and social reasons and leading to budget revenue reduction. Tax expenditures are considered as special provisions of the tax code such as exclusions, deductions, deferrals, credits, and tax rates that benefit specific activities or groups of taxpayers. 89. Since tax expenditures are part of budget expenditures, they need to be assessed at both planning and execution stages to ensure they are most cost-efficient method of achieving policy objective. This information is usually contained in the reports on tax expenditures. There is no single approach followed by all countries. However, all countries which report on tax expenditures do cost estimates for each of them and this is an important part of the reporting. 90. There are several good practices that could be considered in institutionalizing the tax expenditure management as part of the budgeting process. Ideally, all tax expenditures should be regularly and systematically reviewed, just like regular government expenditures. Ukraine may consider combining tax expenditure reviews with spending reviews that MoF is currently trying to develop to allow policy makers to holistically analyze government support to particular sectors, activities, regions, or agents. Otherwise, there is a risk of overlapping objectives and expenditures between different programs. The ultimate responsibility of the tax expenditure review is with the Ministry of Finance, although over time a joint responsibility with sectoral ministries could be considered in the case of sector-based exemptions. The following table shows the practices across different countries regarding tax expenditures integration into the budgeting process22. Table 14. Links between Tax Expenditure Analysis and Budgeting Process Country Link to the budget process Separate document Australia Part of the “subsidies report� of the budget submission to the legislature Austria An appendix to the budget Belgium Part of the budget submission Germany Portugal Part of the annual report that accompanies the annual budget project; presented to parliament by the government Brazil Informe de Beneficios Tributarios (Tax Expenditure Report) integrated with draft budget legislation Information attached to draft budget legislation Peru 21Choosing a Broad Base-Low Rate Approach to Taxation, OECD Tax Policy Studies, #19, 2010, p.71 22Villela, Luiz Arruda et al, Tax expenditures budgets : Concepts and challenges for implementation , IDB working paper series; 131 30 7. Findings and Next Steps in Development of the Tax Expenditure Framework. 91. The analysis of tax privileges and tax expenditures shows that there are some elements of a tax expenditure system in Ukraine helping report on the key tax exemptions’ impact; however, the tax expenditure framework is incomplete. Although the SFS produces estimates of tax privileges as budget losses there are omissions and ambiguities in this process. There is no process to evaluate efficiency and effectiveness of granting tax exemptions or the impact of exemptions in terms of achievement of policy objectives. 92. According to the internationally recognized approach, there are many steps which should be implemented to establish an appropriate tax expenditure framework. First, authorities should define what constitutes the benchmark tax system (defined in the paragraph 91) in Ukraine . So far there is no definition of tax expenditures in legislation. Also, the definition of tax privileges does not include internationally recognizable tax concessions as deferred tax liabilities and preferential taxation (special regime in agriculture, STS). 93. Categorization of tax privileges does not exist and there is no clarity how to separate the tax privileges as part of the normative system from those that can be considered as tax expenditures. Nevertheless, the SFS divides tax benefits into two Reference Books, depending on whether the tax concession results in budget losses or not. The rationale behind this division is not always clear, as well as methodology behind the analysis. Tax privileges for PIT taxpayers are not analyzed and assessed from the viewpoint of their impact on budget revenue. 94. The approach to estimation of tax expenditures is not clearly defined in Ukraine. Although the use of a specific method is not found in Ukrainian legislation, estimates made by the SFS show that they are similar to the "revenue forgone" method. First, tax privileges are measured as budget losses in the ex post calculation. Second, budget losses from a specific tax are calculated separately, not taking into account the interrelation with other taxes and taxpayer behavior. At the same there is no formal methodology underlying tax expenditures’ assessment. 95. The forecast of tax expenditures currently in place is not reliable. There is a provision in tax legislation that requires to forecast costs of tax privileges at the beginning of the budget process. Unfortunately, the method used for forecasting does not allow to get accurate estimates (item 3.1.8). Moreover, internationally applied methods (micro-simulation, NA and input-output tables) are not used for the tax privilege assessment in Ukraine. 96. There is no requirement for analysis of the rationale and impact of tax exemptions. In legislation there is no identification regarding the substitutional nature of budget and tax expenditures. Therefore, the legislation does not stipulate a purpose for tax privilege introduction, assessment to what extend the tax expenditure is better option than direct budget spending for achieving results. There is no assessment whether the result was achieved and what was a cost effectiveness of its achievement after the tax privilege was eliminated. 97. A properly developed tax expenditures framework helps increase transparency of the budget process. Some specific measures can be taken to achieve this objective. Quantified and properly justified tax expenditures should be considered as a part of budget process. When making budgetary decisions, Parliamentarians should be aware of the amount of funds provided as tax expenditures. In addition, the tax expenditures should be regularly monitored and assessed as any direct budget financing would be. 31 98. Based on the analysis and international experience, Ukraine should pursue the medium- term efforts on developing a tax expenditure framework based on the following key actions: 1. Start development of the tax expenditure system with elaboration of “benchmark tax system� taking into account the experiences of OECD countries and specific issues that should be addressed in Ukraine. General estimates of tax expenditures might be calculated as deviation from the benchmark system. 2. Define tax expenditures in the legislation. 3. Incorporate PIT and simplified tax system into the tax expenditures’ framework. 4. Choose and implement the method for assessment of tax expenditures by type of taxes and by type of concessions in line with international practice and country specifics as discussed in the section 6 of the report. 5. Certain tax expenditures related to corporate income taxes and personal income taxes could also feature in the first “wave� of estimates produced by Ukraine. While building a comprehensive micro-simulation model should become a medium-term goal, estimates could be produced in the short term on an ad hoc basis. Focusing on corporate income taxes has worked in the past for certain countries as the number of taxpayer is smaller than for personal income taxes and the largest corporations usually account for a very large percentage of tax revenue. For example, a small model based on administrative data could be built using a sample of corporations (selecting for example those above a certain revenue threshold). While this model would not enable the estimation of all corporate tax expenditures, it could provide reasonably accurate estimates for certain measures. It would also provide the team responsible for the estimates experience with modelling tax expenditures and would serve as the basis for the larger, more sophisticated model. 6. Improve integration of the tax expenditure analysis into the budgeting process. 99. At the same time, some specific recommendations can be proposed summarizing the analysis of PIT and STS regimes: 1. To elaborate an approach on PIT reform to avoid unfair distribution of tax benefits in favor of high-level income groups. 2. A separate study is needed to analyze alternatives to the existing STS options to support small business (tax-free start-up period, reduced rates, etc.). Reporting obligations should be unified to allow for a more accurate assessment of the price of small business support. This is also important to ensure level playing field for all taxpayers. 32 Annex 1. Simplified Tax Regimes in 1999-2016 Groups/Years Up to 2010-11 October, 2011- 2012 2013-2014 2015 2016 up to now (Decree 1998-99) Two Groups: 1. Individuals - 1.Individual entrepreneurs who 1.Individuals - 1.Individuals - entrepreneurs who do not use wage labor and carry entrepreneurs who do not entrepreneurs who do 1. Individuals do not use the labor out retail trade from market use the labor of hired not use the labor of of hired persons, places in the markets and / or persons, carry out hired persons, carry out Hired persons – carry out exclusively provide household services to exclusively retail sales of exclusively retail sales not more than 10 retail sales of goods the population goods from trading places of goods from trading (including family from trading places in the markets and / or places in the markets members); in the markets and / conduct economic activity and / or conduct Turnover – not or conduct economic Hired persons – 0; in providing household economic activity in more than activity in providing The annual income - not more services to population providing household 500,000 UAH; Tax than 150 thousand UAH; services to population rate – from 20 to Hired persons – 0; Tax rate - from 1% to 10% of the Hired persons – 0; 200 UAH Turnover – 150,000; minimum wage depending on Turnover - not more than Hired persons – 0; Tax rate – from 1% to the type of activity 300,000 UAH; Tax rate – up Turnover - not more 10% of minimum to 10% of minimum wage than 300,000 UAH; Tax wage rate – up to 10% of living wage 2. Individuals - 2. Individual entrepreneurs who 2. Individuals - 2. Individuals - entrepreneurs who provide services, including entrepreneurs who carry entrepreneurs who carry out economic household, payers of single tax out economic activities in carry out economic activities in providing and / or population, are providing services, including activities in providing services, including engaged in the production or domestic ones, to single tax services, including domestic ones, to trade of goods, activities in the payers and / or population; domestic ones, to single tax payers and restaurant industry. production and / or sale of single tax payers and / / or population; goods; restaurant activities or population; production and / or production and / or 33 sale of goods; Hired persons – up to 10; sale of goods; restaurant activities Hired persons - not more than Turnover - not more than restaurant activities 10 persons. 1,500,000 UAH, Tax rate – Hired persons – up to The annual income - not more up to 20% of minimum Hired persons – up to 10; Turnover than 1,000,000 UAH. wage 10; 1,000,000; Tax rate – Tax rate - from 2% to 20% of the Turnover - not more from 2% to 20% of minimum wage depending on than 1,500,000 UAH, minimum wage the type of activity. Tax rate – up to 20% of . minimum wage 3. Individuals 3. Individual entrepreneurs. 3. Individuals - Individuals - entrepreneurs who do not entrepreneurs who do Hired persons – 0/or use the labor of hired not use the labor of up to 20; Turnover – Hired persons - not more than persons/ or a number of hired persons/ or a 3,000,000; Tax rate – 20 persons; persons who are in number of persons who employment with them are are in employment 3% VAT payer, 5% - Annual income (turnover) - not not limited; and legal with them are not VAT non-payer (from more than 3,000,000 UAH. entities of any limited and legal turnover) Tax rate - from January 1, 2013 2. Legal Entities organizational and legal entities of any Hired persons – * - 3% (VAT payer) or 5% (VAT form (includes groups 3-6 organizational and legal not more than 50; Individuals or Legal non-payer) on income. existed before 2015) form Turnover not entities more than For individuals and legal For individuals 1,000,000; Tax 4. Hired persons – up entities rate – 6% VAT to 50; Turnover – Hired persons – 0: payers, 10% VAT 5,000,000; Tax rate - Hired persons – not limited; Turnover – 5,000,000; non-payers (from 3% VAT payer, 5% - Turnover – 20,000,000; Tax Tax rate – 3% (VAT turnover) VAT non-payer (from rate – 2% (VAT payer), 4% payer), 5% (VAT non- turnover) (VAT non-payer) payer) 34 For legal entities: Hired persons – not limited; Turnover –5,000,000; Tax rate – 6% (VAT payer), 10% (VAT non- payer) 4. Legal entities of any 4. Agricultural commodity 4. Agricultural organizational and legal form. producers in which the commodity producers share of agricultural in which the share of commodity production is agricultural commodity Hired persons - not more than equal to or exceeds 75 production is equal to percent in the previous tax or exceeds 75 percent 50; (reporting) year. in the previous tax Annual income (turnover) - not Tax rate - Normative (reporting) year. more than 5,000,000 UAH; monetary value of one Tax rate - Normative Tax rate - from January 1, 2013 hectare of agricultural land monetary value of one * - 3% (VAT payer) or 5% (VAT depending on category hectare of agricultural non-payer) from turnover (type) of land and location land depending on (coefficient specified for category (type) of land each type of land) and location (introduced instead of Fix (coefficient specified Agricultural Tax) for each type of land) 5. Individual entrepreneurs. Hired persons - not more than 20; Annual income - not more than 20,000,000 UAH; Tax rate - from January 1, 2013 - 7% (VAT payer) or 10% (VAT non-payer) from turnover 35 6. Legal entities of any organizational and legal form. Hired persons - not more than 50; Annual income - not more than 20,000,000 UAH. Tax rate - from January 1, 2013 - 7% (VAT payer) or 10% (VAT non-payer) from income. Fix Agricultural Defined Defined separately Included into Group #4 Eliminated, #4 Group is Tax separately introduced for agricultural producers (see above) 36 Annex 2. List of deductions from personal income that lead and do not lead to budget losses (according to the Tax Code) The list of incomes that are not included in taxable income and do not lead to losses of budget revenues (Tax Code of Ukraine Article 165): o various types of state financial aid, including housing subsidies, assistance to persons with disabilities, maternity payments, insurance payments from the budget and mandatory social insurance funds, from the Fund for the Social Protection of Persons with Disabilities (165.1.1); o financial assistance to servicemen who died fulfilling the military duty (165.1.1); o sums of state prizes and scholarships, which are awarded according to Laws, Resolutions of Verkhovna Rada, Decrees of the President (165.1.1); o sums of international awards to athletes-prize-winners of international competitions; o Academic payments from the State Budget to members of the Academy of Sciences (165.1.1); o payments to victims of Nazi persecutions or their heirs (from the budget of Ukraine or other sources under international treaties) (165.1.1); o financial aid to repressed or their heirs (from the budget of Ukraine or other sources under international treaties) (165.1.1); o monetary compensation for servicemen for housing (165.1.1); o payments to employees (and / or compensatory payments to family members) from the budget (within the average salary) called up for military service (165.1.1); o the cost of uniforms and food in accordance with the Law on Labor Protection (165.1.9); o the amount of compensation for damage resulting from the Chernobyl disaster (165.1.3); o alimony payable by court order or according to the Family Code (165.1.14); o the amount of money or property provision for conscripts that are paid out of the budget or by a budgetary institution (165.1.10), as well as charitable assistance, including international charitable organizations (165.1.56); o the amount of funds transferred to a taxpayer by an international financial organization (another financial organization of development programs) for the implementation of energy efficiency and energy conservation measures (165.1.57, 165.1.58). The list of incomes that are not included in the taxable income of individuals and lead to budget losses: o income of residents in the form of interest on government securities (issued by the central executive authority that ensures the formation and implementation of public financial policies) (165.1.2.). o incomes of non-residents in the form of interest on state securities or local bonds (sub-items 165.1.2); 37 o incomes of non-residents in the form of interest on securities for state or local guarantees (sub-items 165.1.2); o incomes of non-residents for loans to economic entities under state or local guarantees (sub-items 165.1.2); o investment income from operations with securities of the National Bank of Ukraine and government securities (issued by the central executive authority that ensures the formation and implementation of public financial policies) (165.1.52); o dividends reinvested for the purpose of increasing the authorized capital of the joint-stock company and at the same time the proportions of shareholders' participation in the statutory fund remain (165.1.18) 38 Annex 3. Documented expenses of individual entrepreneurs under regular tax system, share of annual income Taxpayers at the level of Independent professional Individuals – entrepreneurs total annual income, declared in tax annual activity taxpayers declarations, UAH 2014 2015 2016 2014 2015 2016 0-18000 39.5 40.0 n/a 78.7 71.8 66.7 18001-42000 57.0 55.6 54.3 81.1 81.5 96.1 42001-60000 66.4 64.1 60.4 84.7 83.5 83.0 60001-120000 62.2 63.1 62.5 88.1 87.5 86.5 120001-180000 57.8 67.8 59.6 91.3 90.9 90.2 180001-360000 53.3 55.9 56.5 93.4 93.1 92.5 360001-600000 50.8 51.1 53.4 94.8 94.4 94.0 600001-1200000 41.1 46.9 48.3 95.5 95.7 94.8 1200000-6000000 33.8 34.8 37.3 97.0 96.8 96.1 6000001 and more 22.8 16.9 26.2 97.8 97.8 97.6 39 Annex 4. Effective rates for different income groups Annual income, UAH 2014 2015 2016 Wages and Investment Dividends Wages and Investment Investment Wages and Investment Investment salaries of income and royalties salaries of income income salaries of income income servicemen servicemen servicemen 1-18000 9.54 9.55 6.89 10.12 12.47 10.50 12.68 9.89 10.76 18001-42000 13.22 7.62 5.67 13.25 11.20 14.73 15.79 12.69 12.05 42001-60000 14.17 12.52 5.72 14.25 8.25 15.57 17.63 9.35 11.55 60001-120000 14.08 10.14 6.07 14.44 8.15 13.66 17.92 7.42 11.26 120001-180000 14.17 5.09 5.97 14.78 4.89 12.12 17.96 5.47 10.50 180001-360000 14.92 4.68 5.91 15.89 5.19 10.61 17.96 4.07 9.71 360001-600000 15.69 2.67 5.72 17.41 3.88 9.76 17.94 5.45 10.65 600001-1200000 16.10 2.15 5.41 18.30 3.79 9.04 17.90 5.97 8.61 1200001-6000000 16.51 0.65 5.39 19.15 1.68 8.37 17.89 2.39 8.01 6000001 and up 16.52 0.33 5.33 19.52 5.02 7.76 17.83 15.05 7.89 Total 13.61 0.80 5.41 14.41 4.19 8.51 17.31 11.17 8.20 40