On Spetember 28, the World Bank issued a new economic report on Ukraine’s public finances entitled "Creating Fiscal Space for Growth: A Public Finance Review." The Report concludes that Ukraine’s public sector is large and inefficient. Ukraine’s public spending in 2005 was 44 percent of GDP, but only 2.2 percent of GDP was spent on physical capital investment by the public sector, the WB press office informs.

“ In order to make the public sector fit for the 21st century and a pillar of sustained growth, the government needs to reallocate spending from transfers and public consumption to public investment ”, says Martin Raiser, Economic Advisor in the World Bank Office in Ukraine.

The Report estimates that Ukraine needs to invest up to US$100 billion over the period 2006-2015. However, the World Bank cautions that Ukraine should increase public borrowing prudently to avoid crowding out private investment and creating macroeconomic tensions. Instead, the Report recommends to create fiscal space for faster economic growth by reducing wasteful spending on subsidies and untargeted transfers and by reforming the tax and social welfare system to increase incentives for individuals and firms to pay taxes.

“ Marginal tax rates, particularly on payroll, are high in Ukraine, but the tax burden is very unequally distributed. The government should create room for tax reductions through measures to close loopholes and eliminate exemptions, and encourage greater compliance by making the system simpler and fairer .”, explains Pablo Saavedra, an Economist with the World Bank and one of the key authors of the Report.

While encouraging greater public investment, the World Bank warns that the money risks being wasted unless the capital budgeting process is improved. Completion rates for both national and donor funded projects are very low, planning and monitoring inadequate and fiduciary management is weak. Without improved capacity for multi-year planning and budgeting of capital investments, the risk of wasteful public investments responding to political expediency rather than solid cost-benefit analysis is considerable, according to the authors of the Report.

Key recommendations of the Report

On the revenue side

•Reform the Simplified Tax System to restrict its use to true small businesses and individual entrepreneurs.
•Strengthen tax administration to ease registration, reduce compliance costs, establish a comprehensive monitoring system, and a penalty system that deters evasion but limits the scope for discretion.
•Introduce reform to the VAT for agriculture, as proposed by the government in December 2005, and address the issue of the double pass-through of VAT on gas imports within the context of an improved energy policy.
•Unify collection of all social security and pension contributions and move towards a unified payroll tax for all employees.
•While a reduction of payroll taxes is crucial to reduce the shadow economy and improve the business climate, it can only be done after laying the base for improved compliance, and in parallel with measures to bring the pension fund back into balance.
•Continue curtailing tax exemptions (and avoid re-introducing them in the Free Economic Zones or any other scheme)

On the expenditure side

•Increase the retirement age for women and tighten eligibility for minimum pensions to redress current imbalances in the Pay-As-You-Go pension system (I know we are recommending additional changes but in essence these are the most important ones – parametric changes means nothing to the general public); introduce the 2nd pillar of the pension system in 2008 to increase contributor incentives.
•Increase public wages prudently aiming for a stabilization, if not a decline, of the share of the public wage bill in GDP, allow relative wages of skilled employees in the public sector to rise, whilst reducing overall public sector employment.
•Improve the targeting of social privileges and social assistance to ensure it benefits those really in need. Large savings could be achieved by tightening eligibility criteria of social assistance programs that are abused–including subsidies for utilities.
•Shift support to agriculture from inefficient input and production subsidies towards competitiveness enhancing and WTO compliant programs.
•Phase out coal subsidies and reduce all other subsidies (including importantly through continued regulated energy price adjustments); maintain tight financial discipline on all state enterprises.

On the budget process

•Consolidate the budget by integrating the general and the special fund.
•Improve capital budget spending through (i) better, multi-year based planning; (ii) improved project evaluation skills in central and line ministries; (iii) improved monitoring and information systems; (iv) greater coordination between MoF and MoE and between both and the line ministries; (v) better and more substantial integration of donor funding into budget planning and execution.

” The growth dividend of a leaner and more efficient public sector could be in the order of 2 percent of GDP per annum or more ”, concludes Paul Bermingham, Country Director for Belarus, Moldova and Ukraine. “ The donor community has a key role to play but we must become better aligned with country systems and priorities and more efficient on both sides in project planning and execution .”

The Report will be discussed by a panel of experts on September 28, 2006, at 10 am in the Conference Hall of the National Bank of Ukraine.

The World Bank supports improvements in Ukraine’s public finances under its adjustment and development policy lending as well as investment projects to improve tax administration (ongoing), and the modernization of the public finance management system (under preparation).


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