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Ukraine can't pull out of vicious circle without conducting fiscal reform

Author : Oleksiy Kushch

In the future, Ukraine should move to the postindustrial phase of development, where the tertiary sector of the economy will dominate in the form of services, medicine, education and science. But as the example of the United States and Trump’s new industrialization has shown, a prerequisite for the functioning of the tertiary sector is the presence of a competitive industrial core (20-30% of GDP)
11:02, 18 June 2019

National Bank of Ukraine

Ukraine will have to face several key challenges soon: the repayment of foreign debts and the restructuring of the economy. At first glance, these are quite diverse tasks, but only for a superficial examination. Our government recently introduced the concept of managing the sovereign debt of the country. Among the main messages, we hear that external, currency debt will be replaced by an internal one in hryvnias. More expensive and short debt with the help of refinancing will be replaced by a long and cheap. So far this is only a set of contradictory phrases because hryvnia debt is a priori shorter and more expensive than external one (if we are talking about real market issues). At the same time, the simplification of the nature of the Ukrainian economy, the flattening of its relief and the loss of the global value chains by Ukraine, including the strengthening of the raw material character of our exports, will make it impossible for us to achieve a positive trade balance in the foreseeable future. Everything is also logical here: selling cheap raw materials and semi-finished products on the international markets and buying more expensive consumer goods with a high level of added value, as well as even more expensive investment goods (means of production), we cannot a priori expect a positive trade balance, and imports will always exceed exports (for example, you can calculate how much grain you need to sell on the foreign market in order to ensure the purchase of one locomotive and the composition of the grain-carrier cars that transport the same grain). In addition, the capitalization of the economy, the so-called internal asset multiplier directly depends on its sectoral structure. If this is a commodity paradigm, (the model that has developed in Ukraine in recent years), then the dynamics of our growth will be forever tied to the indicators of world commodity markets, and the periods of growth will be replaced by deeper periods of decline. In addition, such an economy is not interesting for foreign investors, who expect a three to fivefold multiplication of the value of their assets over a five-year investment cycle.

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Nobel laureate Paul Krugman created a realistic theory of international trade, which says that developed countries dominate due to the fact that their large technological corporations win the competition, saving on the scale, and developing countries lose this fight, even with cheap labor. Thus, developing countries need to temporarily restrict imports and stimulate the development of domestic production, and, as they become more competitive, gradually remove customs barriers. They did this in Japan, South Korea, Singapore, China, and Taiwan. In addition, there is Krugman's positive theory, which is that the state should stimulate those industries that lead to the emergence of new sub-sectors of economy, as happened in Japan when the development of metallurgy contributed to the emergence of engineering. The production of final goods is a dead end.

What can the developmental imbalances like ours lead to? Until 1960, the economy of Somalia was ahead of the quality parameters of South Korea. But the latter, thanks to a stake on the development of a creative and innovative economy (although independent industrial policy was implemented before), managed to break out of the vicious circle of absolute advantages in the form of cheap labor and agriculture, while Somalia continues to search for them in such an exciting occupation, as the "catching" of foreign tankers.

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But systemic economic reforms require significant financial resources, primarily foreign and domestic investments, as well as credit resources since the same example of China,  shows that without credit leverage, you cannot launch a new industrial core. Investments are simply not enough, and they, at best, make up to 40% of the total financing needs.

In the future, Ukraine should move to the postindustrial phase of development, where the tertiary sector of the economy will dominate in the form of services, medicine, education, and science. But as the example of the United States and Trump’s new industrialization has shown, a prerequisite for the functioning of the tertiary sector is the presence of a competitive industrial core (20-30% of GDP). In simple words, in order to spend money in cafes, cinemas, hairdressers and teach children, part of the population must be engaged in the real sector of the economy.

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Successful developing countries tend to go through two basic phases. This is a two-period model of intertemporal limitation of external debt, developed in accordance with the Riccardo equivalence theory. The size of the external debt is determined by intertemporal restrictions. If the state gives priority to current consumption, and not to the future one, it “gets in debt” (the first period), forming a negative current account balance. During the second period, there is a sharp decline in domestic consumption amid an increase in exports. During the first stage, export-oriented sectors are created, including for credit funds, which help the country in the transition to the second stage to pay off external debts. The principle is quite simple: to carry out a restructuring of the economy and increase the level of value-added exports through credits. So did China and other successful developing countries. Ukraine, unlike these countries, used the first period in 2002-2014 for the usual consumption, and now it passes into the second period of repayment of foreign debts with significantly weakened export potential.

In this context, there are IMF mathematical models regarding cause-effect relationships in the process of forming external debt (50 countries over 36 years). There is an inverse relationship between the growth of net exports and net foreign assets. A 1% decrease in net foreign assets leads to an increase in exports by 0.7%, and an excess of investment inflows over outflows leads to an increase in export potential. Here are the correction factors: the export response to a positive change in inward investment flows in developing countries is 1.8 years. And the general streaming imbalance of external debt, caused by the said transformation of investments in the growth of export potential, levels off within 10-50 years.

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With regard to Ukraine, this means that in order to increase export potential by 31% per year, it is necessary to increase the net inflow of investments by at least 30%, and the stabilization of export flow indicators may occur no earlier than two years later, including the stabilization of flow indicators debt - no earlier than 10 years.

For the functioning of a "credit - structural reforms - economic growth - debt recovery" causal relationship, an internal element of stability is needed, which, on the one hand, will function as a safety lock in the event of a fall in world commodity prices (at the stage of incomplete structural changes in the economy). On the other hand, it will act as an additional source of funding from the state for these structural changes.

In commodity economies, such an element is export duties, which are accumulated in national reserve funds. We are talking about the taxation of commodities, and then semi-finished products.

Of the 768 billion UAH of tax revenues collected by the State Fiscal Service last year, export duties amounted to only 0.5 billion UAH. For a country, most of exports o which are raw materials and semi-finished products, this is a catastrophic indicator, showing that a substantial share of the raw material incomes of our economy is redistributed in favor of several beneficiaries of the largest financial and industrial groups in the country. In essence, this is a sentence to the entire fiscal system of the country, through which national income goes to offshore accounts, and Ukraine, with capital outflow of over $ 100 billion, entered the top ten countries with the highest rates of capital flight abroad.

Nowadays, exporters of raw materials in Ukraine have a “double mandate” of support: they do not pay export duties (with rare exceptions) and they also receive from the budget a refund of value added tax (the lion’s share of UAH 130 billion a year).

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A sharp change in the fiscal rules of the game can lead to a significant drop in exports and a deterioration in the country's balance of payments, not to mention a slowdown in economic growth.

That is why we need a long-term policy to change the direction of the basic tax and budgetary incentives.

For example, within five years, the state progressively reduces the level of VAT refunds to exporters of raw materials from 20% to 0% (4% per year). In parallel, there is an increase in export duty by 1% per year, so that by the end of the five-year plan it will be 5%, which can be coordinated with the free trade regime in the WTO. Reducing the level of VAT refunds should reduce the outflow of funds from the budget and increase its revenue side, and the introduction of export duties will make it possible to begin filling the national reserve fund. At first, it will be hundreds of millions of dollars, and then billions.

The above fiscal maneuver must necessarily occur simultaneously with a structural change in the national economy, when regulatory and fiscal instruments begin to stimulate the creation of industries for the processing of raw materials - first into semi-finished products, and then into final products with high added value. To do this, the reserve fund can be sent in the form of concessional loans to commodity companies that fall under the fiscal maneuver and are ready to expand vertically integrated structures along the line "raw materials - semi-finished products - finished products".

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State incentives should also be applied in the medium business segment in terms of developing non-traditional exports (thus Chile became the second largest exporter of salmon in the world after Norway).

The second “five-year plan” is the same fiscal maneuver, but this time not with raw materials, but with semi-finished products. The total period of tax reform will be ten years.

We need just a little: to find a political force in Ukraine, not lobbying the interests of oligarchic financial-industrial groups, and to ensure the continuity of management decisions on fiscal reform during two political cycles.

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