In the midst of their amazing work fighting off a Russian assault, the Ukrainian government has found the time to reform their tax system. Glorious indeed!
Some people might question their priorities, but it makes sense to put the tax system onto a war footing, like the rest of the country.
There is a famous precedent – the British PAYE system (for deducting tax from employee wages, paying it straight to the Treasury without the employees even seeing it) was created as we were facing the Nazis in the Second World War, allowing the government to collect more tax, more quickly, more certainly and more cheaply.
But there are questions about whether PAYE was the best system – either for the war or to rebuild the post-war economy. Has 2022 Ukraine done better than 1940s Britain?
There are three parts to Ukraine’s reform (based on an unofficial translation of the announcement):
- business profits tax and VAT have been abolished, and replaced by a 2% turnover tax;
- for small businesses the tax will be voluntary;
- alongside the tax reform is a radical regulatory reform – business regulations are all abolished.
The regulatory reform is definitely a good thing. Regulations prevent new businesses from being formed, and restrict existing businesses so that they produce less, at a higher cost, than they would otherwise be able to do. The pronouncement says that the government will “cancel all checks for all businesses…so that the cities can live”, and instead businesses will simply have to operate “within the law”. With permits, restrictions, regulation and government forms abolished, businesses can operate within a simple rule of law rather than an overbearing bureaucracy.
That will help keep their wartime economy functioning as well as it can, and will give the best chance of rebuilding and starting new businesses to encourage a fast recovery after the war. I hope there is a Hero of the Ukraine medal for whichever government official thought of this – a functioning economy is an even stronger service to the country than destroying an enemy tank.
The tax reform also is a good emergency measure for during the war. It is simple and allows businesses to concentrate on maintaining production and supplies in almost impossibly difficult times. But my enthusiasm is not quite as great.
Making the tax voluntary for small businesses is a generous emergency response that is unlikely to be continued once the war is over (although some sort of tax relief for small businesses should probably continue).
Abolishing the profits tax is also good; we know that they result in less investment, less company formation, lower growth, and ultimately a smaller economy and fewer (or less well paid) job opportunities.
But although I like low, simple taxes, a turnover tax can cause problems. It is not necessarily the best way to run a war economy, and it is certainly not the best long-term way to rebuild the economy after the war.
The first problem with a turnover tax is that its impact depends on the profitability of the business. For a business with a 20% profit margin – so that 20% of its turnover is profit – a 2% turnover tax is only a small problem. But for a business with a 5% profit margin, a 2% turnover tax would take out two fifths of its profit. And for a business with a 1% profit margin, a 2% turnover tax is disastrous.
In reality many businesses would pass a turnover tax on to their customers, by increasing their prices (which they can probably do without too much loss of sales, because all their competitors will be doing the same), and in this case the increased prices should mostly be cancelled out by the abolition of VAT.
However, even then it is possible for a low margin business to have to pay more tax under a 2% turnover tax than a 20% VAT, because VAT effectively allows you to deduct the VAT paid by your suppliers. For that reason, even in war, I would have considered keeping VAT, perhaps at a reduced rate, but with the option for small and medium sized businesses to pay a 2% turnover tax instead.
But the bigger problem with a turnover tax will come after the war.
A turnover tax is known as a ‘cascade tax’ because, like a waterfall, it gets more dangerous the further it falls – the tax becomes more damaging the more layers of business it goes through, because each separate business in the supply chain is charged the turnover tax again, without the credit that VAT gives for the tax paid by the layer below.
This encourages conglomerates, with one company doing everything, to reduce the tax bill, rather than outsourcing to lots of different suppliers. If one business does everything, from producing raw materials, then manufacturing, to selling the finished product, then there is only one lot of tax. But if components, for example, are bought in, there will be two lots of tax (on the producer and the seller), on what is ultimately the same money received from the end customer.
But modern businesses are more complex than that; it is very common for the raw materials to be produced by one company, then refined by a second company, then components to be made by a third, then the product to be assembled by a fourth, sold to a wholesaler as the fifth company in the chain, and then finally sold by a retailer as the sixth. Six companies in the chain, so six lots of turnover tax – and many supply chains are more complex than that.
The turnover tax therefore encourages businesses to try to do everything in-house, to reduce the number of layers in the supply chain and so reduce the number of times the tax is charged on the same ultimate product. And not just the main production, but all the ancillary business services as well— premises cleaning, accounting and other professional advice, transport, and many others—everything tends to be brought in-house to save tax.
That is usually inefficient, because one company is unlikely to be good at everything. It tends to have less innovation than when you have lots of different businesses each trying to improve their own little bit of the supply chain. And it damages small businesses, because they do not have the capacity to do everything themselves and so need to outsource—thus giving them a higher tax burden than a big company.
So Ukraine’s tax reforms have the right spirit: removing the burdens on businesses so that they can continue to produce and supply goods and services through these appallingly difficult times. But if they continue in the same way after the war, it risks damaging the recovery, particularly by restricting the formation of new, innovative, specialist smaller businesses.
A better plan would be to continue with a VAT, but a reformed one that is as low and simple as possible, and with the option of a turnover tax for small businesses who find VAT too complicated and would prefer a simpler, but less efficient, system. Any profits tax that is reintroduced should be as low and simple as possible, because we know that profits taxes are damaging to business growth and job creation.
I wish the Ukraine a speedy victory, and that they can soon make the Adam Smith toast to “peace and low taxes”.