Ukraine Reforms Watch Update (February 3, 2015)

In general, the Ukrainian government is moving in the right direction, with varying success in implementing reforms due to some political and financial factors. We have the impression that the state authorities are trying to find a balance between decreasing the budget deficit and making progress in key reforms, which is why we would not expect major improvements this year. However, we believe that as soon as financing the deficit is out of the question (which implies some help from the IMF and other IFIs), the Ukrainian government can concentrate on meaningful reforms that would really change the system.

 

Tax reform 32%
Decentralization reform 30%
Judicial sector reform 26%
Economic policy reform   14%
Public sector reform 11%
Energy sector reform 10%
Anti-corruption reform 8%
Agricultural sector reform 5%
Law enforcement reform 4%
Financial sector reform 2%
Overall score 13%

Tax system reform

The Ukrainian parliament voted for most of the changes to the Tax Code, outlined by the Coalition Agreement, achieving some visible progress, but caved in to the government’s request to make some adjustments to balance the State Budget. The overall tax burden on enterprises and individuals should increase in 2015, with some improvements afterwards as the decrease in the tax on labor cost comes into effect (90% of enterprises will not be able to get a lower rate in 2015 due to special conditions set out by the new Tax Code). The easy explanation for this situation is that the government needs more money to finance the defense sector in the face of “clear and present” danger coming from Russia, which continues to support militants in Eastern Ukraine, and to support the public debt, which rose quickly in 2014, mostly due to the effect of the UAH devaluation.

 

 

Key changes to the tax system included the following items:

  • Higher tax burden for individuals: personal income tax is up to 20% from 17% on higher-incomes, and the wartime “military” tax of 2% of all passive incomes for individuals is extended for a year
  • Higher taxes for investors: all passive income (royalties, interest on deposits, capital gains etc.) is now taxed at a 20% rate (up from 15% for some income types). 
  • Royalty rates for gas production were left at 55% and 28% (for gas wells with depth less/more than 5,000 meters), which is quite high by international standards.
  • Overall amount of time for tax administration should decrease, as the amount of taxes is decreased from 22 to 11, and tax accounting was made closer to the financial accounting. However it will not bring the overall tax burden down too much.
  • Electronic VAT payment system will be implemented, although with a delay, and its expected impact on business is negative as firms would have to pay taxes in anticipation of future sales, which will increase working capital needs. Moreover, exporters of grain were stripped from the benefit of receiving VAT refunds from the government. 
  • A decrease in the Unified Social Tax (to 16% from 41%) cannot be utilized by business this year, as conditions include a 30% increase of salaries, average salary being higher than 3x minimum wages (UAH 3,600), and a 2.5x increase of the tax base, among other things. However, in 2016 the tax will be decreased for everyone (a coefficient of 0.6 implies a decrease to 24% from 41%), which is good news for the economy.

 

Decentralization reform

The decentralization reform seems to be moving with varying success, with the State diverting some of the funds from the local budgets, but granting them more rights and independence. Quite surprisingly, the new Budget Code seems to redirect more tax flows to the central government, rather than leaving them on the local level. Thus, 75% of personal income tax will be directed to local governments (compared to 100% before), which should (in theory) be compensated by 10% of transfers from corporate income tax staying on the local level (as opposed to 0% before), as well as a 2-5% tax on retail sales of excisable goods (tobacco, alcohol etc.), property taxes and fees for administrative services. However, the new legislation also gives more rights to local communities, and transfers the medical and educational expenses to the state level (they will be funded by state subventions). Moreover, the State has given the local communities the possibility to merge and form a new unit (as small settlements can range in population size from 100 persons to as much as 10,000 persons).

 

Judicial system reform

The reform of the judicial system is hindered by political frictions, but generally going at an acceptable pace. Two bills on judicial reform were passed by the Ukrainian parliament in their first reading on January 13, 2015. While being initiated by different parties and conflicting in some areas, the bills had some common ground: increased responsibility of judges, introduction of reattestation procedures and clear criteria for the qualification of judges. One of the bills also envisions electronic publication of all court rulings and monitoring of lifestyle and income of judges. We view the outlined changes as generally positive, and expect intense public discussion which should result in a combination of the proposed bills that will incorporate suggestions and propositions of the business and society.

 

Economic policy reform

The progress in the economic policy reform is significant, with a clear positive trend on the deregulation. On December 25, 2014, the Ukrainian parliament passed the bill on deregulation in its first reading. According to the bill, the Ukrainian law will be harmonized with the EU law in agriculture, production of organic agriculture goods, geological exploration, pipeline transportation, and building of oil and gas wells. In addition, administrative centers regulating different businesses will be liquidated, and their responsibilities will be transmitted to centers on providing administrative services that will be available on the local level. Last but not least, deadlines for some administrative services will be reduced, thus allowing for more efficient permitting. 

 

Public sector reform

The progress in the public sector reform is slow, most likely due to high level of corruption in the system, but generally going in the right direction. Recent initiatives in the public sector have been mostly related to the decrease in the overall number of public employees. While the Ukrainian government as a whole doesn’t plan to lay off more than 20% of all staff members, Ukraine’s Minister of Economy Aivaras Abromavicius declared that he is planning to reduce the number of staff by 50%, while retaining the general salary budget the same.

Moreover, some changes are being made in the law enforcement sector. Eka Zguladze, a native of Georgia, who was recently appointed on the position of Deputy Minister of Internal Affairs, announced that the Road Patrol Service will be reorganized completely, with first experimental changes being implemented in Kyiv city. The plan is to fire all employees and conduct an open contest to attract new people, who will then undergo a special training program and pass an exam.

 

Energy sector reforms

Ukraine continues to decrease its dependence on Russian supplies of gas, simultaneously increasing imports from the EU. Starting from February, it is expected that the country could import 40 mcm of gas daily from the EU as opposed to 31.5 mcm in January. Moreover, recently the state-owned Naftogaz Ukraine signed an agreement with Gaz-System to construct a 10 bcm gas pipeline between Ukraine and Poland, that will provide access to gas from LNG terminal in Klaipeda (Lithuania) currently under construction. Additionally, the government has removed subsidies to the coal industry in the State Budget for 2015, and is planning a gradual privatization of state-owned mines.

 

Anti-corruption reform

In our view, the anti-corruption reform is going slower than the current situation warrants. The Anti-Corruption Bureau, which should have been created (at least on paper) by January 25, 2015, still doesn’t have a Chairman (currently there are 18 candidates for the post, including some foreign citizens, and the selection procedure is planned to be finished by February 12, 2015). 

For now, there have been several high-profile cases of corruption and bribery, mostly connected with the imports of coal (Ukraine’s Attorney General Office declared that coal contracted from SAR was at an unjustifiably high price and poor quality, although this was later refuted by some participants of the case) and electricity (Ukraine’s PM Arseniy Yatsenyuk demanded an extensive investigation to be made into the imports of electricity from Russia as by some sources the contract had terms that were unbeneficial to the country). Additionally, some of the administrative workers in the MoD were caught on bribery charges. Thus, it seems to us that law enforcement tends to follow public attention, which is focused on “headline” topics such as national security and energy policy. More “boring” yet also vital issues related to social and infrastructure ministries remain neglected, in our view. 

 

Financial sector reform

There were some positive developments in the financial sector reform, but nothing that would significantly improve the system, in our view. The reason for this is that the financial sector was seriously affected by the crisis, and the authorities are mostly focused on “fighting fires” than on actual reforms. 

On New Year’s Eve the Ukrainian parliament approved a bill that will ease the process of recapitalization and acquisition/mergers of banks, which establishes clear terms for the consideration of documents by the NBU and the Antitrust Committee, and eliminates some of the previous requirements (such as the requirement to have a quorum to make a decision on the bank’s capitalization/reorganization). 

It is also worth noting that the National Bank of Ukraine has started the process of functional reorganization, eliminating unnecessary functions and developing a long-term monetary policy. The NBU also started improving transparency of the banking sector, recently publishing the information on banks that were refinanced by the regulator, and demanding that information about the final owners/beneficiaries is being published by the banks. 

However, the capital controls and FX restrictions still remain in place, which complicates any transfers of foreign currency to/from the country, and indirectly supports the existence of a “black” FX market. The only positive development in this sphere is the implementation of futures contracts on gold and the US dollar, which was long awaited by market participants. Currently the futures can be traded on the UX and the PFTS stock exchanges.