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Bigger is Better

Kyiv says its new tax code will snuff out corruption, but small business owners say they will be the real victims.

by Ksenia Korzun 21 February 2011

KYIV | Maria Gorpinich came out into the cold of this city’s Independence Square in November to protest a massive overhaul of Ukraine’s tax code and to fight for the survival of her business.

 

Gorpinich owns a small law firm, which she said could be on the verge of closing as the new tax laws make it unprofitable for larger companies to use her services. Specifically, the laws would prohibit corporations from writing off expenses for some services, including legal and consulting.

 

“I may have to close my business because some clients have refused to continue working with me,” she said.

 

The lawyer was one of about 200,000 people who turned out in Independence Square that day, but despite their efforts, less than two months later, on 1 January, a new tax code went into effect that could restructure the entire economy. It effectively squeezes small businesses in favor of large, manufacturing-heavy concerns.

 

Kyiv said the new package of laws, and the 2011 budget that rests on it, are among the conditions for Ukraine to receive the next tranche of a $1.6 billion loan from the IMF. It also pulls together the tax code into one place instead of having relevant rules and laws scattered throughout the country’s regulations and civil and criminal codes.

 

In addition to forbidding deductions for the costs of some services entirely, the new code disallows write-offs for goods and services purchased from businesses that use the country’s flat tax system, which almost all of the country’s small businesses do. It also raises the flat tax – a monthly sum that businesses pay that is not based on their earnings – and the amount that small businesses must contribute to the national pension fund.

 

On the other hand, the code gives a 10-year tax holiday to new businesses in light industry, shipbuilding, aircraft construction, and hotels.

 

Most small businesses will either have to pass the increased costs on to their customers or move to the more complicated and expensive regular tax system, which exacts a percentage of a company’s earnings.

 

The government says the changes will bring in an additional 66 million hryvnia (6.1 million euros) in tax revenues. Analysts aligned with critics of the new laws, however, predict they will put about 100,000 people out of work.


In a survey conducted in December, 5 percent of respondents said the new tax code was fair and 71 percent unfair.

 

Anatoly Kinakh, a former prime minister who heads the Ukrainian Union of Industrialists and Entrepreneurs, said the changes could snuff out small businesses and threaten the country’s economic recovery.

 

"Such an approach is unacceptable, especially in times of crisis, when countries everywhere are using entrepreneurship as a very effective way to get people employed," Kinakh said.  

 

Another critic of the new laws is Natalia Korolevskaya, an opposition lawmaker who chairs parliament’s industrial and regulatory policy committee. She said the changes put more pressure – not less, as supporters claim – on businesses, noting that some types of companies are no longer allowed to use the flat tax system. That list includes law firms, real estate agencies, wholesale traders, post and telecommunications, accountants, and retail Internet traders, many of which are small businesses.

 

A report by Korolevskaya’s committee said small businesses account for a shrinking percentage of the country’s GDP. In 2010 their share fell to 10 percent, from 16 percent the year before. Those figures compare with more than 50 percent in many EU countries, the United States, and China.

 

As of 1 January, Ukraine had more than 3 million self-employed entrepreneurs.  

 

Kyiv is trying to create factory workers out of some of those people. During talks last year on the changes, a deputy prime minister said Ukrainians needed to return to the factories and mines, although the mining business in Ukraine is a shadow of its former self.


The theme of a "return" of labor to the “real economy” was picked up by Prime Minister Mykola Azarov. He said the flat tax system was a compromise by the government in the late 1990s because there were not enough jobs to go around. Although Ukraine’s unemployment rate stood at around 8 percent in January, Azarov promised "decent jobs" with "decent wages" in the manufacturing sector of the future.  

 

That is a promise that Kyiv cannot keep, said Oleg Minor, head of the Union of Private Entrepreneurs. "They are expecting us to go to the plants. But where are they going to find that many jobs? There aren’t enough factories in the country. A certain number of entrepreneurs will de-register and become unemployed. And instead of getting additional tax income, the government will have to pay those people unemployment benefits."

 

One of those entrepreneurs who might have to de-register is Nadezhda Vasilchenko, who owns a children’s shoe store. "The idea is obviously to imbalance the tax system to favor large businesses. But small business is the backbone of the economy, and if the tax pressure gets too intense, it will either freeze up or go into the shadow economy,” Vasilchenko said. Unregistered and untaxed transactions are widely estimated to account for up to half of Ukraine’s economy.

 

Kyiv aims to stamp out a common tax avoidance scheme that exploits the flat-tax system used by most smaller companies. A large company pays a small company, supposedly for services. The small company keeps part of the fee and hands back some of it to the large company. In this way, the large company deducts from its taxes more than it actually paid, and the small company pockets the cash, whether it performed any services or not, without any effect on its tax bill.

 

JUST CAUSE

 

Dmytro Boyarchuk, executive director of the CASE Ukraine Center for Social and Economic Research, said the overall impact of the tax code would be neutral or negative for small businesses.  

 

“I think the government made a conscious decision to put micro-businesses in a vulnerable position. However, as far as I know, this solution is supported by some Western experts, because it makes everyone pay the same taxes,” Boyarchuk said. “I think the state simply hoped that the tax code would bring business out of the shadows and everybody would be paying taxes. However, many will not survive the tax burden, that's all.”

 

But Boyarchuk said Kyiv seems not to have considered that small businesses pay indirect taxes as well, including customs and excise, “and reducing the number of private entrepreneurs invariably leads to a reduction in payment of those taxes, too.”

 

Deputy Prime Minister Sergei Tigipko said many small business owners are protesting the changes because they operate under the table. Kyiv argues that the flat tax system has fed an epidemic of tax avoidance.

 

He noted that the government has streamlined the tax structure, reducing the number of state levies from 29 to 19, and local taxes from 14 to four.

 

Vitaly Homutynnik, chairman of parliament’s taxation committee and a member of the ruling Party of Regions, told parliament that the new laws will smoke out the huge proceeds that go untaxed every year. "Forty percent of GDP is now in the shadow economy. By a simple calculation, 30 percent should go into the budget, which means 270 to 300 billion hryvnia of additional income for the budget if that happens.”

 

The changes also give sweeping new powers to tax inspectors, allowing them to seize property without a court order and to conduct unannounced audits. That would be a welcome change, critics say, if the tax inspectors themselves were not notorious for corruption.

 

During a November forum for potential investors from Belgium, Prime Minister Azarov said the new tax code was the most liberal in Europe. And the European Business Association, the largest association of foreign investors in the country, noted that the country’s tax rates are low compared with other European countries.

 

More important than the rates, however, is consistency, the association’s executive director, Anna Derevyanko, said. "Sometimes the entrepreneur doesn’t need a decrease in the tax rates. The most important thing is not to be going in different directions all the time after having checked and being given the OK to start to work and grow your business.” She said a streamlined tax system could make the shadow economy less attractive. “Any businessman, if it’s a normal, healthy person, is going to find it much more profitable to work above board, by the rules, than to hide from the authorities, or to spend a lot of money to ‘optimize’ their tax obligations."

Ksenia Korzun is a journalist in Kyiv. Photo of tax protesters in Kyvi in November 2010 by Ilya Dobrych/Creative Commons.

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