Three Errors That Will Turn the Rescue Plan for Ukraine's Economy Into a Disaster

Examined closely, the main measures proposed by the authors of the study-cum-program Ukrainian Economy of the Future are ruinous for our economy and lead straight to economic disaster.

The World Bank and the Kyiv School of Economics, commissioned by the government of Ukraine, have drawn up a forecast scenario under the promising title “Ukrainian Economy of the Future.” ZN.UA pointed out the document's flaws while it was still being drafted, arguing that the reshuffled government should not publish the study without a thorough reworking. It has been published all the same, which confirms that officials are perfectly content with it. In some respects—the analysis of the innovation ecosystem, for one—the work is genuinely thorough and offers sound recommendations (though it carefully ignores the pivotal role of the simplified tax system in the innovation sector). There is no point dwelling on those, however, because the macroeconomic foundation itself contains glaring errors that render everything else largely irrelevant.

Error one: invoking the experience of Central and Eastern Europe

The first error, one foreign advisers have been repeating since the 1990s, is using the countries of Central and Eastern Europe as a basis for comparison.

Start with the quality of institutions—a factor neglected thirty years ago because no one knew how to measure it. The study now includes a pile of charts illustrating Ukraine's dramatic lag in this area, and the work demonstrating the decisive contribution institutions make to economic growth has won a Nobel Prize. Yet the study draws no conclusions from any of it, beyond the familiar calls to fight corruption (an important problem, but not the main one) and to improve the rule of law through judicial reform. And in the optimistic scenario, reforms are somehow assumed to deliver results immediately, which is not how it works.

The rule of law is indeed the main problem: on this indicator, Ukraine sits somewhere between Bulgaria (the worst in the European Union) and… Afghanistan. Plainly, with the rule of law in that state and without a Confucian meritocracy to compensate, growth of 6 percent is impossible, as is joining the European Union. Yet the definitions of the rule of law—those in Encyclopaedia Britannica, say, or in the very World Bank indicator the authors draw on so heavily—make no mention of the court system at all, necessary though it is. The concept is in fact far broader and deeper, so establishing the rule of law requires the kind of comprehensive approach that once helped Georgia—the only post-Soviet country outside the Baltics to catch up with Bulgaria, at least, on this measure.

It is very strange, and very sad, that the World Bank, once a pioneer in the study of institutions, should so crudely disregard their central role. But Ukraine cannot be measured against the countries that joined the EU in the 2000s for a whole range of purely economic reasons either. Unlike during the industrial outsourcing boom of the 1990s, for instance, cheap industrial labor is now rapidly losing its advantages in the face of robotization. To say nothing of the security risks, which did not exist back then.

Error two: fiscal consolidation

The second error, potentially fatal in its consequences, is the call for fiscal consolidation, supposedly in the name of growth. The authors justify this by pointing to Ukraine's enormous public debt (formally above 100% of GDP) and citing the literature demonstrating how damaging that is for an economy. Their prescription, however, is to raise the tax burden further still—from the current 37 percent of GDP (already an extraordinary amount for a country with this quality of public administration, and higher than it was before the full-scale war) to 42–45 percent, while cutting social spending to 11 percent of GDP (roughly what is currently spent on pensions alone) or even less, which is simply unrealistic.

The only economies that have grown by even 3 percent a year under such a tax burden are in Scandinavia, with its exemplary institutions, the best in the world. Thirty years ago, back when the colleagues mentioned above worked there, the World Bank itself identified a profound and entirely valid regularity: high taxes are affordable for countries with high-quality governance. On top of that, there is a mass of literature demonstrating the depressive effect of taxes on economic growth, at least beyond a certain level (around 30% of GDP redistributed through public finances)—a level Ukraine was exceeding by a third or more prior to the full-scale war.

So if the effect of the proposed tax increases on the rate of economic growth were honestly accounted for, growth would in all likelihood turn out to fall to zero, if not below it. The model would then most probably fall apart, and the problem of repaying the debt would only deepen. The forecast rests, among other things, on assumptions that between 1.9 and 3.1 million migrants will return to Ukraine (i.e., practically everyone who left because of the war) and that foreign capital will flow in on a large scale. But how does that square with a proposal to impose one of the world's highest levels of taxation in a country whose institutions are well below average in quality (and cannot be improved quickly)?

This means the task of repaying the debt, as the study describes it, simply cannot be accomplished by Ukraine's own efforts. No more, incidentally, than the task of defending the country against an enemy whose economy is twelve times the size of ours and whose military spending amounts to roughly our entire GDP excluding grants. Everyone would like Ukraine to become financially self-sufficient, of course, but that is possible only if there are fundamental changes on the other side of our northern and eastern borders, or a generation from now, in the event of an “economic miracle.” And one of the preconditions for such a miracle is, in turn, low taxes. For creditors, easing the pressure now—however politically unpopular that may be in their own countries—is the better long-term bet, if it means ending up with a strong, self-sufficient economy next door, one with a large market and the capacity to service its debts.

There is some consolation in the fact that the authors have overlooked at least two considerations that make the debt problem substantially less acute. Factor them in properly, and both the model's results and its recommendations would probably look very different.

First, the real debt is roughly a quarter lower than the nominal figure, because ERA and the entire €90 billion loan not yet disbursed will not have to be repaid out of Ukraine's budget: they are secured against the proceeds from frozen Russian assets or repayable only out of any future reparations. Several smaller loans have also been issued on what is effectively a non-repayable basis.

Second, debt does not hold back economic growth in itself, but through the budgetary burden of servicing it, and hence through taxes. In Ukraine's case, though, partners have provided funds at very low interest rates and with very long grace periods, so external debt creates only a moderate budgetary burden. The lion's share falls on payments on domestic debt, and more than two-thirds of those return to the budget as transfers of profit from the National Bank of Ukraine (which holds around a third of domestic government bonds) and the state banks (more than half again). Beyond that, given favorable conditions, this portion could be refinanced at lower rates, or converted into external debt and creditors persuaded to write off part of it—as Poland, which the study's authors mention more than once, did in the early 1990s.

The methods the authors propose for raising taxes look wholly detached from reality. There is a progressive personal income tax—something Ukraine has already tried twice and abandoned twice, because it never paid off; and the effective abolition of the simplified tax system, which the authors for some reason describe as “bringing the economy out of the shadows,” and from which they expect to gain an additional 3–5 percent of GDP in revenue. Even if every legal microbusiness suddenly started paying taxes under the general system, that would yield no more than 2 percent of GDP, against the current 1 percent. In reality, it is reasonable to assume it would react exactly as it did to the tax "reform" of Mykola Azarov, prime minister under Yanukovych—half of it would go into the shadows, and the effect on the budget would be zero at best.

Error three: “priority sectors of the economy” as a growth driver

The third error is support for “priority sectors” as growth points. The World Bank has been down this road before, backing industrial policy in Latin America and elsewhere. That ended in the debt crisis of the 1980s and the famous Washington Consensus adopted in its wake. The new generation appears to have forgotten the lesson. One can agree with the recommendation to prioritize clearing the way for exports from the sectors the authors consider most promising. But it is categorically unacceptable to encourage our government's fondness for protectionism and for spending taxpayers' money on stimulating the “domestic producer” in any form: that is exactly what international creditors got burned on in the 1960s and 1970s. Incidentally, this part of the study contains no costings at all, which is a pity: these are exactly the sort of expenditures that could be scrapped painlessly to save budget money.

There is an alternative. Ukraine can probably engineer an “economic miracle” of its own, much as it has already engineered a military-innovation one, but doing so requires creating favorable security, institutional and tax conditions for the economy, and above all for the innovation sector (not only IT).

The security issue has to be resolved first. If our partners are vehemently opposed to allowing “major upheavals” on Russian territory, then they, like us, will have to deal with a Russia that lays claim to greatness. Which means that keeping Ukraine stable will require them to dig deep and pay for the upkeep of a large professional “coalition of the willing” army—if not a purely Ukrainian one, then mostly Ukrainian. This will not be “aid to Ukraine, which is cutting its taxes”; it will be spending on their own security.

Instead of formal harmonization with the EU, all reforms should focus on creating the preconditions for a radical improvement in institutions, and above all on establishing the rule of law, as set out and argued in detail in a policy paper by CASE Ukraine. For European norms to work, after all, they need to rest on sufficiently well-rooted “European principles”; otherwise the result will be what happened with the general tax system, itself borrowed at the time from “best European practice.” So principles first, and only then norms, wherever those norms create room for discretion. Such norms (tax norms in particular) need to be deferred not merely until EU accession but beyond it, with a transition period. This is what Ukraine's negotiators should be insisting on above all. In the tax field specifically, including bringing the economy out of the shadows, the necessary reforms, together with fiscally responsible tax cuts, are set out in the Roadmap of the Economic Expert Platform.

And finally, the place of outdated sectoral policy should be taken by competitiveness policy. The study rightly notes that Ukraine's current competitive advantages in innovation (the only possible driver of growth in a post-industrial world) rest largely on the legacy of asymmetric development in the Soviet period, and that this legacy is melting away inexorably. This is precisely where the state needs to play an active role. The main thing, though, is to leave the simplified tax system alone—so far the only element of competitiveness policy that matters equally to every branch of the innovation sector, and not to IT alone.

All of this will plainly be hard to achieve. But at least this path leads to an attractive future—unlike the one described in the study.