Ukraine - Public expenditure review : restructuring government expenditures

Report No. 1611 2-UA Ukraine Public Expenditure Review Restructuring Government Expenditures June 25, 1997 Courntry Department IV Country Operations Division II Europe ancl Central Asia Region Document of the World Bank  UKRAINE PUBLIC EXPENDITURE REVIEW Restructuring Government Expenditures CURRENCY EQUIVALENTS (as of June 25, 1997) Currency Unit = Hryvnia 1 Hryvnia = US$ 1.857 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS FSU - Former Soviet Union GDP - Gross Domestic Product NBU - National Bank of Ukraine NIS - Newly Independent States OECD - Organization of Economic Cooperation and Development O&M - Operations and Maintenance UKRAINE - FISCAL YEAR January 1- December 31 Vice President: Johannes Linn, ECAVP Director: Basil G. Kavalsky, EC4DR Division Chief: Hafez Ghanem, Acting Division Chief, EC4C2  UKRAINE: PUBLIC EXPENDITURE REVIEW Restructuring Government Expenditures TABLE OF CONTENTS EXECUTIVE SUMMARY ...............................................................i 1. RESTRUCTURING GOVERNMENT IS CENTRAL TO T HE TRANSITION ......................1 2. CURRENT SPENDING WILL NEED TO BE CUT FURTHER ...................... .......................2 Government spending has already been reduced substantially ..................... ......................3 Budgetary arrears are rising and directed credit is still being used ................ .....................4 Relative to other countries the tax burden is high and public investment low ....................5 The cost of financing Ukraine's public deficit is high ........................................................7 A sustainable fiscal deficit is about 3 percent of GDP ........................................................9 Non-interest current spending will need to be cut by some 10 percent of GDP ......... ...... 12 3. EXPENDITURE ALLOCATIONS MUST REFLECT THE NEW ROLE OF THE GOVERNMENT ............................................................... 13 The government budget is starting to reflect new public expenditure priorities ......... ...... 13 The need to eliminate the employment and Chernobyl funds ..................... ...................... 15 The need to reform the pension system .............................. ................................ 18 Education: restructuring expenditures and increasing cost recovery ............. ................... 21 Health: A new role for government ....................... ....................................... 24 Financing of the coal sector restructuring ................................................ ............... 25 Government should limit its intervention in the gas sector ......................... ...................... 27 New approaches to public investment .......................... .................................... 28 4. PUBLIC ADMINISTRATION AND CIVIL SERVICE REFORM .................. ...................... 29 The need to lower the number of ministries and departments ........................................... 29 The need to improve the system of civil service pay and management ............ ................ 32 5. TOWARDS BETTER INTER-GOVERNMENTAL FISCAL RELATIONS ........... .............. 35 The system of expenditure assignment should be improved ........................ ..................... 35 Ukraine needs a new system of intergovernmental transfers ...................... ...................... 37 6. THE BUDGETARY IMPACT OF THE REPORT'S RECOMMENDATIONS .................... 39  TABLES Table 1: Fiscal adjustment is occurring gradually Table 2: Taxation and current spending are high relative to other countries Table 3: Money creation is major source of deficit financing Table 4: Estimating a sustainable deficit Table 5: Current spending will need to be cut Table 6: Distribution of the employment fund's expenditures Table 7: Distribution of Chernobyl fund expenditures Table 8: The distribution of education spending This report was written by Hafez Ghanem based upon inputs from: Ritu Anand (Intergovernmental Fiscal Relations), Mark Davis (Expenditure Projections), Thomas Hoopengardner (Social Protection and Health), Kathie Krumm (Intergovernmental Fiscal Relations), Laszlo Lovei (Energy), Mark Lundell (Agriculture), Michal Rutkowski (Education), and David Wood (Public Administration and Civil Service). The findings of this report are based upon several missions by the various contributors,. The first mission was in November 1995. A draft of this report was discussed with the Government of Ukraine in December 1996.  PUBLIC EXPENDITURE REVIEW Restructuring Public Expenditures in Ukraine Executive Summary I. Improvements in public expenditure policies are a central part of Ukraine's overall reform program. The aggregate level of public expenditures should be consistent with macro- stabilization targets. The allocation of spending also needs to be modified to reflect Government's new role in a market economy. Changes in the level and allocation of Government spending will have to be accompanied by administrative and civil service reforms to enhance the public sector's efficiency, and by changes in Ukraine's system of intergovernmental fiscal relations. Current Spending Should be Cut Further II. Ukraine has reduced its cash fiscal deficit from more than 23 percent of GDP in 1992 to around 3 percent in 1996. This was achieved mainly by cutting current expenditures from more than 54 percent of GDP in 1992 to less than 39 percent in 1996. Capital outlays were also cut drastically from more than 4 percent of GDP to around I percent. Thus, total Government expenditures were reduced by nearly 20 percent of GDP. Reductions in the cash deficit allowed a tightening of monetary policy and a sharp decline in monthly inflation from 70 percent in June 1993 to 0.1 percent in June 1996. Monthly Inflation: 1993-1996 100 90 80 80-- -- 70 - - - - - - - - - - 60 50 . 30 10 I.-- -- -------- C 20 400 --- --8 i_ __---- --e- ---- o) 0) III. This important adjustment effort is still insufficient, as indicated by the massive build-up of budgetary arrears. The deficit targets are being maintained by means of cash management rather than taking the underlying structural fiscal measures. Whereas the cash deficit in 1996 was around 3 percent of GDP, the commitments deficit was more than 7 percent of GDP-- implying a rise in arrears of some 4 percent of GDP. By early July Government owed its workers about two months wages on average, or 1 percent of annual GDP; and owed gas companies more than US $550 million--3 percent of GDP. As of October I it owed the power sector more than US $200 million--another 1 percent of annual GDP. Arrears to workers are  ii bound to affect support for Government's economic policies, and arrears to gas and power companies, as well as other suppliers, makes it difficult to implement structural reforms based on commercialization and privatization. Hence, it seems clear that budgetary processes need improvement to avoid further arrears accumulation. IV. Non-interest current spending may have to be reduced by as much as another 10 percentage points of GDP over the medium term in order to achieve a sustainable deficit of some 3 percent of GDP. To avoid an acceleration of inflation or an uncontrolled build-up of foreign debt, Ukraine's fiscal deficit over the next few years should not exceed the 1996 cash deficit. This would require a sharp cut in planned current expenditures for four reasons: (1) the Government should lower "committed" expenditures to the level of "cash" expenditures in order to stop the build-up of arrears; (2) Ukraine's high tax burden (some 35 percent of GDP) will probably decline as a result of privatization and tax reform; (3) capital expenditures which are now only 1 percent of GDP will need to be raised to levels consistent with a growth target of about 5 percent a year; and (4) the Government's interest obligations are increasing. Expenditure Allocations Must Reflect the New Role of Government V. Spending cuts, needed to enhance macro-stability and lay the foundations for sustainable growth, must be done in a manner that would support the change in the role of Government-- from producer and provider of goods and services to a facilitator of private activities. The main reduction in expenditures between 1992 and 1994 was in the area of "National Economy", which are industrial and commercial expenditures that should be left to the private sector. National Economy's share of total spending fell from nearly 40 percent in 1992 to 5 percent in 1996. Thus, the structure of spending is starting to reflect Government's new priorities: the provision of public goods and social protection. Expenditures on the National Economy should be cut further. But even if they are pushed to zero, the resulting decline in spending would be less than 2.5 percent of GDP. More will be needed. The Changing Allocation of Spending 1992-96 (percent of total spending) 45% 40% 35% 30% Ii 25% 20% 15%in9 2 0Y O/Cti 4 19961 10% 0% L co a.z VI. The Government's decision to eliminate the Employment Fund and reduce the size of the Chernobyl Fund is a good step in the direction of expenditure rationalization. It could allow for  iii a reduction in the payroll tax from 52 to 38 percent--a cut of over 2 percent of GDP--which should help bring about economic growth and encourage the expansion of formal employment. The efficiency of the two funds in providing protection to those in need is very low, which means that the social loss from this policy change will be minimal. In 1995 the Employment Fund spent more than 67 percent of its budget on salaries and administration, and more than 11 percent went into training and retraining programs of doubtful benefits. It should be replaced by a system of severance pay by enterprises that shed labor. The Chernobyl Fund's objectives--to absorb the human and environmental costs of the Chernobyl nuclear disaster--are laudable. But it is not achieving them, and its operations lack transparency. Protection for Chernobyl victims should be a high priority expenditure, financed by the general budget and managed by the social ministries and departments--that have greater experience in implementing programs and projects, and have tested systems of budgetary control. VII. Ukraine's public pension system, which costs 10 percent of GDP, is in deep crisis. Moreover, its problems are structural and will not be simply resolved by a resumption of growth. The number of pensioners today exceeds the number of contributors by 20 percent, and if present demographic trends continue and the structure of the labor market remains unchanged this figure could rise to 44 percent by the year 2030. Reforms should aim at increasing the number of contributors relative to pensioners. Workers who are now operating in the shadow economy should be encouraged to join the formal sector and start contributing to the Pension Fund. This could be achieved by introducing a fully-funded pension system, so as to create a direct link between contributions and pensions. Thus contributions will not be viewed as a tax on labor that discourages formal employment. Concomitantly there is a need to keep people from retiring early; by raising the retirement age or by introducing a pensions formula that provides an incentive for working after 60. VIII. Restructuring education and health expenditures and increasing cost recovery is key to improving the allocation of public spending. A first priority in education is to refocus expenditures towards general education, which currently only receives 59 percent of the education budget, and away from pre-schools, vocational, and higher education. Another problem with the education budget is that more than 25 percent of it is in fact financing welfare programs. Examples of social welfare expenditures that are hidden in the education budget include student stipends and food for needy students. There is also a need to reduce overstaffing: there are currently two non-teaching personnel for each teacher in Ukrainian schools, and at 13.5, the student-teacher ratio is among the lowest in the world. There is room for increased cost recovery at the tertiary level, and for meals, books, and other services. At the same time, action is needed now to change the role of Government in the health sector by focusing on the provision of primary care; and by building a capacity for quality and safety control for vaccines and pharmaceuticals, while leaving their production, importation and distribution to the private sector. IX. Public expenditures in the energy sector also must be reallocated. Government should stop spending on the gas sector and should ensure adequate financing for coal mine closures. The repeated accumulation of external payments arrears on gas imports is a threat to macro- stability and creditworthiness. Despite a Government decision not to renew payments guarantees for gas imports, financial discipline in the sector has not been improved. By the third quarter of 1996 external arrears on payments for gas supplies amounted to about US $1 billion. It appears that Government's announcements about not providing guarantees are not credible. The time has  iv now come for Government to get out of the gas market altogether and refrain from intervening in commercial relations between suppliers and their customers. It should provide the legal and regulatory frameworks for the efficient functioning of the gas market, and stop financing any new public investments in gas. X. The coal sector restructuring program is an example of the special role of Government during the transition. The large number of workers involved (300-400 thousand people could lose their jobs) and their geographic concentration implies that normal restructuring mechanisms are insufficient. The social costs will be high and mine closures will have important external effects in the Donbass region where the coal industry is a main source of employment. That is why Government has a legitimate role to play and most of the cost of restructuring the coal sector should be covered by the budget. However, it is important to channel support in a way that minimizes the risk of distorting production and investment decisions. This can be achieved if budgetary support is limited to expenditures that have a public goods character, e.g. ensuring that mine closures are done in an environmentally sound manner and that there are sufficient safety nets to protect displaced workers. Institutional Reforms are Urgently Needed XI. Redefining the role of Government and restructuring its expenditures involves new responsibilities and functions for the state administration. This requires an effective institutional framework for policy formulation and coordination. It also requires a professional civil service to implement governmental policy and an effective framework for intergovernmental fiscal relations. XII. The number of ministries and departments in Ukraine is too large and their size is too small, which is a serious hindrance to effective policy formulation and implementation. There are 70 central bodies of executive power--two or three timres the number of Ministries in a typical OECD country. The average ministry has 3,200 staff, as compared to 43,400 in France and 19,300 in the UK. Bureaucratic fragmentation also extends to the structure of ministries and departments; e.g. the Ministry of Agriculture with 650 staff has 34 separate departments. Coordinating the work of all those ministries and departments is very difficult, and there are many instances of overlapping responsibilities. There is considerable scope for reducing the number of ministries and departments in Ukraine. Many departments have missions that are incompatible with the role of government in a market economy--e.g. the departments for food industry or construction--and should be eliminated. There may be also benefits from consolidating some ministries--e.g. in most OECD countries the ministries of economy and finance are consolidated. XIII. Efficient public service delivery will also require improvements in the system of civil service pay and management. The civil service pay schedule needs to be raised and decompressed to reflect market conditions, and civil servants should be provided with necessary physical resources. Real civil service salaries fell by 40 percent between 1991 and 1995, with the sharpest decline affecting more senior staff whose salaries and benefits fell by 60 percent in real terms during that period. Moreover, civil servants suffer from an extreme shortage of physical resources--e.g. basic office equipment, transportation and accommodation-- needed to carry out their work. The current vicious circle of low pay and poor performance must be  v converted into a virtuous circle of higher pay for increased output. Enhanced productivity may be achieved by a combination of measures, including: revised departmental mandates; clear performance standards; the introduction of a management information system; training; improvements in the system of personnel management; and measures to eliminate corruption. The ratio of Average Civil Service Wages to Per Capita GDP 7.0 6.0 - 1 _ 4.0 m*USeries1 3 0 _mIm_ 20 _fl * - 2.0 _-_ _ 1.0 111|1 0 n <: <5o Z z (n0 w < w D O. 0 XIV. Local governments are responsible for nearly 30 percent of budgetary spending in Ukraine. That is why efforts to improve the efficiency of public services and reallocate expenditures must include an improvement in intergovernmental fiscal relations. Introducing a clear system of expenditure assignment that is linked to the availability of revenue is a priority in this area. In recent years the national Government assigned increased responsibilities to the regions. In particular, their share in expenditures on social protection rose from 30 percent in 1993 to 80 percent in 1995. But their revenue allocations did not rise commensurably. There are many instances of unfunded mandates--e.g., increasing teacher salaries without providing more resources to the localities. This practice of "shifting the deficit down" is partly responsible for rising local government arrears and should be stopped. XV. Oblasts, rayons and municipalities lack a stable revenue base, which discourages resource mobilization and budgetary savings. The Central Government continues to change every year the share of VAT--the largest single source of subnational finance--that oblasts are allowed to retain. The law only fixes a minimum of 20 percent of VAT collection that can be kept by the oblast. In the 1995 budget actual VAT shares ranged from 20 to 100 percent across oblasts. The government should consider adopting a stable "hybrid" system of local government finance which seeks to avoid the disadvantages inherent in either a fully centralized or a fully decentralized system. Local property and land taxes should be assigned locally, in particular to the second tier of government--rayons and municipalities. Local governments could also be allowed to "top-up" the personal income tax rates according to local preferences. In addition, a system whereby other taxes are pooled and then shared based on clear criteria will go a long way to providing revenue stability and the incentives to restructure which stem from it.   CHAPTER ONE RESTRUCTURING GOVERNMENT IS CENTRAL TO THE TRANSITION 1. Ukraine started its economic reform process much later than most other Newly Independent States (NIS).1 A radical break from past economic policies only occurred in mid- 1994. Since then important reforms have been put in place, covering the three key areas of stabilization, privatization and market liberalization. 2. Stabilization policies are starting to yield good results. Decreasing inflation is the clearest sign of success. The monthly inflation rate fell from more than 70 percent in June 1993 2 to 0.1 percent in June 1996. The exchange rate stabilized, and even appreciated during the second quarter of 1996. These developments allowed the Government to carry out monetary reform and to replace the temporary coupons by the new national currency, the Hryvnia, in September 1996. 3. Structural reforms are also on-going, but their impact on economic activity is still not felt. By February 1996 about half of small enterprises were privatized and the remainder is expected by end-1996. Mass privatization also accelerated--between January 1995 and June 1996 2,000 large and medium-sized enterprises were privatized. Actions were also taken to liberalize the economy--most domestic prices were freed, many import restrictions were removed and export quotas eliminated.3 Trade liberalization has had an impact on export performance, as export volumes to Western markets rose by about 20 percent in 1995. But overall economic activity appears to be declining, although at a slower rate, and real GDP fell by another 8-10 percent in 1996. This data should be interpreted carefully, however, because it does not include Ukraine's unofficial sector which, according to some estimates, may be as high as half of GDP.4 4. Adjustments ofpublic expenditure policies are a central part of Ukraine 's overall reform program. As the experience of Central Europe indicates, the transition to a market economy calls for a reinvention of Government. There is a need to control the aggregate level of public expenditures to ensure that it is consistent with stabilization objectives. High levels of spending and soaring fiscal deficits are usually associated with accelerating inflation and balance of payments problems. Hence, transition usually involves changes in the size of Government. Perhaps more importantly, the allocation of expenditures also needs to change to reflect the shift For a comparative perspective on Ukraine's transition efforts see the 1996 World Development Report "From to Plan to Market", pp.14 and 15. 2 The monthly inflation rate has risen to about 2 percent after the introduction of the new currency, but this is expected to be temporary. The pace of trade liberalization has been slow, and some impediments to trade--like quality certification for imports or reference prices for some exports--continue to exist. 4For a detailed discussion of Ukraine' s informal economy see "Kaufmann, Daniel and Aleksander Kaliberda (1995) "Integrating the Unofficial Economy into the Dynamics of Post-Socialist Economies: A Framework of Analysis and Evidence". Processed.  2 in Government's role from the prime economic agent to a facilitator of private sector activities. Government spending should support economic growth and provide social protection for the needy. This implies that spending priorities must be re-ordered to focus on those activities that cannot be carried out by the private sector--pure public goods. To succeed in this daunting task of reaching the right size of Government and changing its priorities, Govenmment must get its own house in order. There is a need to improve the way the public sector is managed and to reform fiscal relations between the different levels of Government. 5. This report presents an analysis of public expenditure policies in Ukraine and their role in the transition to a market economy. It addresses four questions: * what level of public spending would be sustainable over the medium-term? * what key issues should be addressed when re-ordering public spending priorities? * how could public administration be improved? * how should fiscal responsibilities be divided between the center and the regions? The answers to these questions should help develop a comprehensive program for public expenditure reform that aims at "right-sizing" Government, redefining its role and improving its efficiency. CHAPTER TWO CURRENT SPENDING WILL NEED TO BE CUT FURTHER 6. The brunt of future fiscal adjustment will have to be borne by non-interest current spending. Macro-economic policies in Ukraine have focused on controlling the cash fiscal deficit to limit money creation and reduce inflation. The cash deficit has been cut dramatically over the last few years to around 3 percent of GDP in 1996. But commitments have not been reduced commensurably, and the deficit in 1996 on a commitments basis was more than 7 percent of GDP. As a result, budgetary arrears to workers, pensioners, the energy sector, and other suppliers have been rising rapidly. Hence, Government's first objective should be to cut committed expenditures to the same level as cash expenditures to stop arrears build-up. The second objective should be to ensure that the level of committed expenditures is sustainable. Projections presented below indicate that in order to reduce annual inflation to single digits and to stabilize the stock of debt relative to GDP, future fiscal deficits will have to be held at around 3 percent of GDP. It is likely that the tax burden in Ukraine will decrease, while interest obligations and public investment will rise. Therefore, non-interest current spending may need to be cut by as much as 10 percent of GDP over the medium term.  3 Government Spending Has Already Been Reduced Substantially 7. Ukraine has reduced its primary (before interest) cash fiscal deficitfrom more than 23 percent of GDP in 1992 to around l.5 percent in 1996. This was achieved mainly by cutting cufrent expenditures on the "national economy" from nearly 24 percent of GDP in 1992 to less than 2 percent in 1996 (table 1). These are essentially expenditures in support of productive activities, such as industry and mining, that are usually financed by the private sector in a market economy. Capital outlays were also cut drastically from more than 4 percent of GDP to around I percent. Expenditures on health, education and social protection were maintained as a share of GDP. Thus, total Government cash expenditures were reduced by nearly 20 percent of GDP. Table 1: Fiscal Adjustment is Occuring Gradually (percent of GDP) 1992 1993 1994 1995 1996 Revenue 34.19% 42.57% 44.33% 38.96% 36.47% Income taxes 8.55% 11.49% 15.57% 12.20% 9.97% Payroll Taxes 12.52% 10.81% 10.20% 9.86% 9.84% VAT and Excises 10.93% 13.51% 12.93% 9.33% 8.44% Others 2.19% 6.76% 5.63% 7.56% 8.22% Noninterest Current Spending 54.27% 52.03% 48.64% 39.20% 36.81% Pension Fund 7.16% 8.11% 7.83% 7.78% 8.00% Chernobyl Fund 2.19% 1.35% 2.02% 1.79% 1.84% Other Social Benefits 3.18% 4.05% 1.76% 1.98% 3.78% Subsidies 3.98% 8.11% 4.40% 3.00% 2.46% Education 4.57% 4.73% 5.45% 5.54% 5.12% Health 3.58% 4.05% 4.93% 4.80% 4.33% Administration and Justice 1.39% 2.03% 2.64% 2.68% 2.71% Defense 2.19% 2.03% 1.85% 1.95% 1.63% National Economy 23.66% 15.54% 15.39% 3.57% 1.96% Others 2.39% 2.03% 2.37% 6.10% 4.97% Interest Due 0.00% 0.00% 1.14% 1.57% 1.54% Domestic 0.00% -0.20% 0.53% 0.11% 0.63% Foreign 0.00% 0.20% 0.62% 1.45% 0.91% Capital Expenditures 4.17% 2.70% 3.78% 2.61% 1.12% Total Expenditures 58.45% 54.73% 53.56% 43.38% 39.47% Extrabudgetary Funds 0. 99% 2.03% 106% -0.43% -0.01% Overall Budget Balance -23.26% 410.14% -8.18% -4.86% -3.00% Govenment Saving -19.09% -7.43% -4.40% -2.25% -1.89% Primary Budget Balance -23.26% -10.14% -7.04% -3.29% -1.46% 8. The real decline in expenditures is much greater than what is indicated by ratios to GDP. Real GDP has been shrinking rapidly since 1990. Hence, even maintaining the share of  4 expenditures to GDP constant entailed a substantial reduction in the level of real spending. In real terms, total government spending in 1996 was less than a third of its level in 1992. This implies that some important social expenditures on health, education and pensions--which even increased slightly as a proportion of GDP--have actually fallen dramatically in real terms. Real spending on education, health and pensions has declined by 47, 51 and 48 percent between 1992 and 1996. Budgetary Arrears are Rising and Directed Credit is Still Being Used 9. The rapid build-up of budgetary arrears indicates that the important adjustment effort of the last two years is insufficient. The fiscal deficit targets are often being maintained by means of cash management rather than taking the underlying structural fiscal measures. Experience with the 1996 budget demonstrates this point. The 1996 budget approved by Parliament in March of 1996 was untenable. It over-estimated revenues and inflated expenditures. It also approved a deficit that was too high, and therefore inconsistent with the monetary program and inflation targets. The Government tried to limit the cash deficit to 3 percent of GDP by freezing the equivalent of 0.5 percent of GDP of capital expenditure appropriations. But this was not enough. Revenues during the first months of the year fell short of budgeted amounts. Thus, cash spending had to be further restrained and arrears were built up. This experience indicates that the budgetary process needs improvement, and that further planned cuts in expenditures will probably be inevitable. 10. Arrears are reaching disturbing levels. It is estimated that the fiscal deficit on a commitment basis in 1996 was around 7 percent of GDP, as compared to a cash deficit of 3 percent. That is, budgetary arrears are rising by some 4 percent of GDP. By early July Government owed its workers about two months wages on average-- I percent of annual GDP. Pensioners are also being paid late. This situation is bound to affect political support for the economic reform process. 11. It is difficult to enforce financial discipline--key to successful structural reforms-- when Government, who is the largest economic agent in Ukraine, is not paying its bills. Structural reforms are adversely affected by the arrears situation. For example, Government's efforts at reforming the power sector and creating a well-functioning electricity market are seriously hampered by arrears of budgetary organizations to the power companies--Hryvnia 358 million as of October 1, 1996. Ukraine's pension system is in need of far-reaching structural reforms (chapter 3), which would be delayed if budgetary organizations are unable to meet their obligations to the Pension Fund. 12. Payments indiscipline throughout the economy is aggravating the fiscal problem. Revenue shortfalls during the first half of 1996 were largely due to gas and oil taxes, which is a result of the continued weak payment discipline of energy consumers. Local and central government have increased their arrears to the gas companies by some IJS $330 million during the first half of 1996. In turn, the gas companies have sharply reduced their tax payments to the Central Government.  5 13. Domestic energy arrears translate into foreign arrears that have to date always been converted into Government debt, further worsening the fiscal situation and jeopardizing the country's creditworthiness. Rescheduling of interest debt and arrears on payments for gas deliveries from Russian and Turkmenistan exceeded US $700 million in 1994 and US $3,000 million in 1995. The cost of servicing this energy debt in 1996 is estimated at close to US $1,000 million, or about 6.5 percent of exports. New arrears to Russia and Turkmenistan for gas imports so far in 1996 are estimated by wholesalers at about US $1,000 million. Unless a solution to the payments discipline problem is implemented quickly, Ukraine would face very serious fiscal and balance of payments problems. 14. In addition to arrears, Government is using directed credit to supplement its own spending. For example, of the Hryvnia 580 million support package for the coal sector announced in May 1996, about 170 million are in the form of directed credit from commercial banks. The repayments of these credits are guaranteed by the budget. The fact that the Government has to resort to directed credit is an indication of the tightness of Ukraine's fiscal situation. Those types of operations also have two important drawbacks. First, they politicize bank management and discourage the development of an efficient system of financial intermediation. Second, they imply a future liability that is not properly budgeted. There is a high probability that the Government guarantee for those credits will be called, which will mean a direct future cost for the budget. It is as if the Government has borrowed from the banks, but the expenditure and the debt associated with it do not appear anywhere in the budget. Relative to Other Countries the Tax Burden is High and Public Investment Low 15. At 36 percent of GDP the tax burden in Ukraine appears quite high, especially relative to the country's income level (table 2). Experience in other FSU countries has been that as privatization and liberalization proceed revenue collection declines. It is relatively easier to collect taxes from captive public enterprises. As table 2 shows, FSU countries who have started reforming their economies before Ukraine have much lower tax to GDP ratios. For example, in Russia the tax burden is only around 21 percent of GDP, and in Lithuania it is just 19 percent. So far Ukraine has avoided a sharp fall in revenue, but some decline over the next two years is probable. This would put additional pressure on expenditures to maintain deficit targets and macroeconomic stability.  6 Table 2: Taxation and Current Spending are High Relative to Other Countries Country GDPcapita RevenuelGDP ExpendituireslGDP Public InvestmentlGDP Ukraine $ 1,910 36% 39% 1% Transition Economies Lithuania $ 1,350 19% 21% 1% Latvia $ 2,320 27% 29% 1% Poland $ 2,410 42% 45% 2% Russia $ 2,650 21% 28% 1% Czech Republic $ 3,200 41% 43% 5% Average $ 2,386 30% 33% 2% Other Middle Income Thailand $ 2,410 19% 15% 4% Malaysia $ 3,480 30% 26% 5% Chile $ 3,520 22% 21% 3% Greece $ 7,700 28% 36% 4% Korea $ 8,260 21% 19% 3% Average $ 5,074 24% 23% 4% High Income Portugal $ 9,320 34% 43% 5% Spain $ 13,440 33% 37% 3% France $ 23,420 41% 47% 3% Germany $ 25,580 32% 34% 2% USA $ 25,880 20% X 23% 1% Average $ 19,528 32% | 37% 3%Y 16. The existence of a large informal sector indicates the need for tax reform. If the widely accepted estimate that the shadow economy in Ukraine is around 40-50 percent of "official" GDP, then the average tax burden is only around 24-26 percent, which is comparable to other middle-income countries. But 67-70 percent of the economy is taxed at about 36 percent, while others operating in the shadows are not taxed at all. This is obviously a serious distortion. It is not surprising that the untaxed shadow economy is growing steadily while the formal sector is declining. 17. Tax reform should aim at expanding the tax base while lowering rates. It would be very difficult to widen the tax net while maintaining the current high rates. It may not be even desirable. The informal economy has been the only source of growth in Ukraine over the last 5 years, and an important source of jobs and income. Destroying the shadow economy by trying to introduce excessively high taxes or by trying to over-regulate it must be avoided. 18. There is a growing consensus in Ukraine that payroll taxation is an important source of distortion. The high payroll tax--52 percent, including mandatory enterprise and worker contributions to the Pension Fund, Chernobyl Fund, Social Insurance Fund, and the Employment Fund--discourages the expansion of "official" employment, and explains why most new jobs are  7 in the shadow economy. This tax is an important source of revenue--revenue from payroll taxation is about 10 percent of GDP, or slightly less than a third of total revenue. Nevertheless, there is a consensus now that it should be cut, by around one-half in order to encourage employment. This could result in a revenue loss of as much as 5 percent of GDP. 19. Reducing tax rates must be accompanied by expenditure reductions. Institutional strengthening to improve tax collection is needed and should be carried out. This could be complemented by the introduction of presumptive taxation and other methods for widening the tax net. However, it may be unrealistic to expect that an expanding tax base will offset the impact of lower rates, especially in the short run. Hence, in order to maintain macro-economic stability while undertaking tax reforms there will be a need to further compress expenditures. 20. Public investment has been drastically reduced. At I percent of GDP, public investment in Ukraine is comparable to other FSU countries who had to cut investment to achieve macro- economic targets. However it is much lower than earlier reformers like Poland and the Czech Republic whose public investment rates are 2 and 5 percent, respectively; or other middle income countries such as Chile or Greece where public investment is 3 and 4 percent of GDP. 21. It therefore appears that future adjustment has to fall mainly on current spending. In fact, public investment will probably need to expand in the future. Naturally, there is also a need to analyze public investment carefully to ensure that only projects that produce pure public goods are financed, and that projects have an acceptable rate of return (chapter three). The Cost of Financing Ukraine's Public Deficit is High 22. The total public sector deficit is defined here to include the budget balance as well as the balance of the National Bank's (NBU) operations.3 This public sector deficit could be financed in three ways: printing money; borrowing from abroad (or running down foreign assets); and borrowing domestically (or reducing central bank and Government credit to the rest of the economy). Each of the three financing methods has its own limitations. Printing money at a rate that exceeds the public's demand for it would lead to inflation. Borrowing from abroad or running down foreign assets could help delay the inflationary effect of a public deficit. But excessive reliance on external borrowing could lead to a debt crisis; and a sharp fall in international reserves could result in capital flight and balance of payments problems. Finally, public sector domestic borrowing reduces the credit that would otherwise have been available to the private sector, raising interest rates and lowering private investment and growth.6 For a more analytical discussion and a country example of how to integrate the Central Bank's accounts in the discussion of public sector deficits see: Anand, Ritu and Sweder van Wijnbergen (1989) "Inflation and the Financing of Government Expenditure: An Introductory Analysis with an Application to Turkey" World Bank Economic Review 3, no I (January), pp. 17-38. 6For a more detailed exposition of the different methods of deficit financing see: Fischer, Stanley and William Easterly (1990) "The Economics of the Government Budget Constraint" The World Bank Research Observer, 5, no. 2 (July), pp. 127-42.  8 Table 3: Money Creation Is Major Source of Deficit Financing (percent of GDP) l_l 1993 1994 1995 1996 Total Public Sector Deficit -12.3% -6.8% -4.3% -3.0% of which budget -9.5% -8.2 % -4.9% -3.0% Net Foreign Financing -1.1% -1.8 % 1.0% 0.8% Net Domestic Financing -4.4% -2.6% -0.6% 0.5% Privatization Proceeds 0.0% 0.3% 0.1% 0.1% Money Creation 17.8% 11.0% 3.8% 1.6% 23. Money creation was the main source of deficitfinancing during 1992-96, but dependence on the printing press has declined as the Government started to stabilize the economy (table 3). The change in base money declined from nearly 18 percent of GDP in 1993 to about 4 percent in 1995 and an expected 1.6 percent in 1996. Rapid growth of base money led to high inflation and a dramatic decline in money demand, which in turn made it more difficult for Government to finance the deficit through money creation. As monthly inflation averaged about 39 percent in 1992 and 50 percent in 1993, the demand for money declined dramatically. Since they did not want to hold domestic currency whose value was falling rapidly, people found other ways of carrying out transactions and storing value, especially they started holding more foreign currency. The demand for domestic broad money collapsed and the ratio of M2 to GDP fell from more than 45 percent in 1992 to less than 10 percent in 1995. The fall in money demand means that money creation is more inflationary than before. Higher and higher inflation is required to finance the same level of real deficit through money creation. 24. Ukraine's experience in this area is similar to that of other countries in Europe and Latin America who resorted to massive money creation to finance fiscal deficits. It is widely accepted that because the demand for base money declines as the inflation rate rises, eventually the government's revenue from printing money (seignorage) reaches a maximum. After that maximum, faster growth rates for money lead to more inflation and less revenue. How much revenue should the government expect from money creation? Historical data show average rates of seignorage of some 1 percent of GDP in OECD countries and 2.5 percent in fast-growing low- and middle-income countries. 7 25. Foreign financing of the public sector is increasing and could eventually threaten Ukraine 's creditworthiness. Drawing down NBU's foreign reserves has been an important method of financing the consolidated public sector. NBU's net international reserves fell from around US$ 280 million in December 1994 to about -US$ 820 million in June 1996. Direct foreign financing of the budget has been limited, never exceeding 1 percent of GDP during 1993- 96. However, foreign borrowing, with government guarantees, has been used to finance public enterprises and especially to cover energy arrears. Thus, the stock of public and publicly See Fischer, Stanley (1982) "Seignorage and the Case for a National Money" Journal of Political Economy, 90, no.2 (April), pp. 295-313.  9 guaranteed debt which was zero at the time of independence is now more than 15 percent of GDP. 26. If the debt build-up continues at the same rate, Ukraine could face debt servicing problems. Loose fiscal policy and soft budget constraints imply lower public and private savings, and hence a larger current account deficit that is financed by foreign inflows.8 Public savings could be raised by reducing Government's expenditures and by increasing revenues. Private savings could be raised by improving payments discipline for enterprises and households, which would induce them to lower consumption. Unless reforms in the areas of fiscal policy and financial discipline are implemented, Ukraine's current account deficit is likely to remain at its present level of 4-5 percent of GDP. Without reforms foreign investment will not be forthcoming, because investors will not be convinced that macro-policies are sustainable. That is, the current account deficit would be mainly financed through foreign borrowing. Ukraine's debt indicators could worsen dramatically: the debt to GDP ratio could exceed 40 percent and the debt service ratio could exceed 25 percent by the year 2001. 27. Domestic borrowing is not an important source of deficitfinancing. The underdevelopment of the financial market limits the Government's ability to borrow directly from the nonbank public. Most of the increase in NBU's net domestic credit has been in credit to the Government, with some refinancing for the banks. Since the public sector deficit is defined here as the consolidation of the fiscal and NBU accounts, inter-public sector transfers do not appear in the data presented in table 3. Domestic financing of the consolidated deficit has been mostly negative since government has not been borrowing directly from the public or commercial banks and since NBU does refinance some of the banks. 28. Domestic financing of the budget is unlikely to increase by much in the future. It is true that the budget should increasingly rely on the sale of treasury bills and bonds to the public. But, on the other hand, NBU should start lending less to the budget and more to the rest of the economy to encourage the expansion of private activities. The share of NBU resources used to finance the budget in Ukraine is very high relative to other countries. In 1995 net credit to the Government was about 124 percent of total NBU assets. In Russia the comparable figure was 107 percent, in Poland 41 percent and in Latvia 8 percent. Ukraine's large fiscal deficits have been diverting resources away from private activities that are needed for growth and employment creation. A Sustainable Fiscal Deficit is About 3 percent of GDP 29. Whether a fiscal deficit is sustainable or not depends on its size and the rate of growth of the economy. Decisions on whether a deficit is sustainable are typically based on detailed macro-economic projections. It is necessary to analyze the path of the debt to GDP ratio based upon acceptable assumptions concerning money demand, the desired inflation rate, the real interest rate, and the growth rate of real GDP. If the analysis shows the debt to GDP ratio to be 8 The current account deficit could be viewed as the difference between saving and investment.  10 rising continuously then the fiscal deficit is not sustainable and a different target deficit is required. Macro-economic projections indicate that a sustainable fiscal deficit in Ukraine would be around the cash deficit expected in 1996--3 percent of GDP. As shown in table 4, this conclusion was reached by analyzing the three sources of deficit financing under the assumption that policy reforms would lead to a resumption of growth of real GDP at about 5 percent a year, and that inflation would fall to 25 percent a year in 1997 and 5 percent afterwards. 9 Table 4: Estimating a Sustainable Deficit (percent of GDP) 1996 1997-2000 I 0QI-2004 2005 Broad Money 11.2% 14.0% 22.0% 27.0% Base Money 5.7% 5.6% 7.3% 9.0% A. Change in Base Money 1.6% 0.8% 1.2% 1.4% Foreign Debt 15.2% 16.1% 18.2% 18.4% Change in Foreign Debt 0.0% 2.4% 2.0% 1.7% Change in Reserves -0.8% 0.9% 0.8% 0.4% B. Net Foreign Financing 0.8% 1.5% 1.2% 1.3% Change in NBU Credit to 0. 5% 0.3 0.5% 0.9% Gov. Domestic Borrowing 1.1% 1.1% 1.1% 1.1% C. Net Domestic Financing 0.6% 0.8% 0.6% 0.2% Sustainable Deficit (A+B+C) 3.0% 3.1% 3.0% 2.9% 30. Base money creation to finance the deficit was estimated under the assumption that the demand for money would stabilize in 1997 and then increase gradually, so that the ratio of broad money to GDP would reach 27 percent by 2005. Financial deepening would be associated with an increase in the money multiplier from 2 in 1997 to around 3 in 2005. Using the projections for M2 and the money multiplier an implied projection for base money is reached. As table 4 shows, deficit financing through money creation would initially be low, between 0.5 and 1.0 percent of GDP. Then it would rise to about 1.5 percent as money demand expands.