US$12 billion for war: when will the Ukrainian authorities raise taxes and what are the alternatives?

Unless the government raises taxes, the National Bank of Ukraine (NBU) will have to print hryvnias. What will the government choose? At the end of March 2022, during the period of shock following the onset of the full-scale invasion, Ukraine's parliament, the Verkhovna Rada, passed what may have been the largest package of tax breaks in its history.

The lawmakers' aim was to support businesses to ensure the availability of fuel, food on supermarket shelves, and vehicles at the front. Two years on, the state's tax policy has shifted dramatically. Supporting businesses still grappling with the aftermath of the war and energy supply issues is no longer a government priority.

Now, the primary objective of the finance departments is to fund Ukraine's defence forces by all means possible, including raising taxes.

Ukraine's government, the Cabinet of Ministers, has been putting off this unpopular decision for a long time. The government and parliament have only a few weeks left to vote through and implement all the necessary changes. Otherwise, the defence forces risk being left without funding in the middle of the active phase of the war with Russia.

The scale of military needs

"We need everything, we need a lot of it, and we need it yesterday." This is how officials in the government's financial and economic departments describe the needs of the Ukrainian defence forces during the war.

Although Ukraine's defence spending is up for the third year in a row, it still falls short of meeting even a tenth of the requirements outlined by the military to the Cabinet of Ministers. For example, when the 2024 budget was being drawn up, the General Staff asked the Ukrainian government for UAH 17 trillion (almost US£420 billion) in funding, only UAH 1.69 trillion (US£41.5 billion) of which was granted. The state's ability to meet its military needs is constrained.

First, Ukraine's economy has declined by nearly a third due to Russian aggression. Many large companies have lost production capacity or cannot now export their products. Profits have plummeted as a result - and tax payments to the national budget have dropped accordingly.

Secondly, Ukraine's survival depends on international financial aid, which is pouring in in unprecedented amounts. But the government cannot spend a single dollar or euro of this funding to finance the war. Ukraine has now reached the limit of its ability to finance its defence forces.

All domestic resources are being allocated to the war effort - including taxes, dividends from state-owned companies, and proceeds from domestic borrowing. But it still isn't enough. The government urgently needs to increase the defence budget by US£12 billion - nearly half a trillion hryvnias.

Parliament is expected to vote on the necessary budget changes in the next few weeks before going into recess. This isn't the first time that the Verkhovna Rada has increased defence spending. But this time, it has exhausted all possible sources of covering the additional expenditure within the existing tax system.

Where to find the money?

Ekonomichna Pravda (EP) sources in Ukraine's Finance Ministry say the government plans to cover the UAH 500 billion shortfall through domestic borrowing and higher taxes.

Each of these options comes with its own challenges. Ukraine has already reached the limit of its ability to raise funds on the domestic market. Banks, which are the largest investors in domestic government bonds (DGBs - Ukrainian T-bills), cannot significantly increase their investments in this asset class because of internal investment limits that require them to diversify their assets to remain financially sound.

And the more money banks invest in DGBs, the less they can lend, particularly to fund the development of energy facilities by businesses and individuals. In order to boost sales of DGBs, the Ukrainian government needs to enlist the help of the National Bank. The NBU has already facilitated investment in government debt by allowing banks to hold part of their reserves in government bonds.

The National Bank is now hinting it is ready to adopt similar administrative decisions. The second source of funding for additional defence spending is tax increases. This is not the first time the government has taken this step.

At the end of 2023, it decided to introduce a temporary higher rate of corporate profits tax for banks at 50%, which since 2024 has been reduced to 25% (compared to 18% for other legal entities). This time, the proposed tax hike will impact all Ukrainians, as the government is considering increasing the rates of value-added tax (VAT) and the military levy. EP sources in Ukraine's Finance Ministry and Parliamentary Tax and Budget Committees say the government is looking at raising the VAT rate from 20% to 22-23% and increasing the military levy from 1.5% to 5%, which will also affect sole traders.

A one percentage point rise in the VAT rate is expected to boost state revenues by 0.5% of GDP. This could bring in up to UAH 120 billion (US£2.9 billion) in additional revenues over the year. EP sources in the parliament believe that the increase in the military levy could bring in UAH 70 billion (US£1.7 billion).

The final version of the tax changes is still being discussed. It will likely include other measures. At the Ekonomichna Pravda Banking Forum, Danylo Hetmantsev, Chairman of the Ukrainian Parliament's Tax Committee, highlighted the necessity of evening out profits tax rates between banks and non-banking financial institutions such as financial or insurance companies.

However, even these changes may prove insufficient to cover the additional needs of Ukraine's defence forces for 2024. If the tax changes come into effect from early September, they will only bring in UAH 60-70 billion (US£1.4-1.7 billion) by the end of the year. "It's almost impossible to cover the rest of the half a trillion hryvnias by borrowing on the domestic market.

Unless money is issued this year, the numbers just don't add up," says a source close to the budget process. Other EP sources in the parliament also said that printing money in 2024 is a very likely scenario. The agreements with the IMF also envisage such a possibility, though only as a last resort and in limited amounts (UAH 40 billion or nearly US£984 million per quarter).

The last moment is upon us

The fact that Ukraine is short of UAH 400-500 billion (US£9.8-12.3 billion) for the war effort this year is not news.

Back in February, EP reported that defence spending was in need of a review and that the only way to meet defence needs is to raise the rates of basic taxes. The reason lies overseas. For six months, since October 2023, Ukraine has received no military aid from its key ally, the United States.

This has forced the Ukrainian government to spend money from the treasury to purchase weapons it had expected to receive free of charge. Since these purchases were not foreseen in the budget, the government spent the funds allocated for defence spending by the end of the year. This process is known as expenditure reallocation.

In early 2024, the government reallocated December expenditure, and later on, November and October expenditure too. EP sources in the Finance Ministry and the parliament say that as of early July, Ukraine is utilising funds earmarked for defence that were originally planned for September. So unless the budget is amended soon, the government could face a shortfall in funding to sustain the Armed Forces of Ukraine by early autumn.

Despite the urgent need to find resources to finance defence, the government has said very little about future changes to the budget and tax legislation. The reason for its silence is pragmatic: any such discussions could have hampered Ukraine's ability to successfully complete the fourth review of the IMF Extended Fund Facility and receive US£2.2 billion. In addition, an EP source in the Verkhovna Rada stressed that the government is reluctant to push tax changes through parliament without the support of President Volodymyr Zelenskyy's Office.

Be that as it may, the government has very little time left. It plans to first coordinate the relevant draft laws, changes to the budget, and tax increases with the IMF, which will be sending a mission to Kyiv in mid-July. If the President's Office approves the amendments, Parliament will have only two weeks left in its current session to pass the drafts in the first and second readings: one at the end of July and another at the end of August.

The Verkhovna Rada is not due to sit in between.

What are the alternatives?

On 13 June, during the G7 summit in Italy, the leaders of the Group of Seven countries made a political decision to provide Ukraine with a US£50bn loan secured by proceeds from frozen Russian assets, pledging that the first tranche of this amount would be disbursed to Ukraine in 2024. Unlike the international financial aid provided to Ukraine by its partners, these funds - or at least part of them - can be spent on the war. It would seem that this decision by Ukraine's partners could save Ukrainians from tax increases, but in practice, it's more complicated than that.

First, the G7 countries are a long way from developing and approving a mechanism for transferring the funds to Ukraine. Discussions are in progress, though Ukraine is not involved in them. Secondly, the Ukrainian authorities do not view the proceeds of frozen Russian assets as an additional resource that can be used to finance military and civilian needs, but rather as a substitute for American aid should the flow of arms and funds from the US diminish after the US presidential election.

"Various estimates show that Ukraine needs approximately US£100-US£150 billion in foreign aid (military and economic) annually. Even if we assume 100 billion, 50 billion will cover only half of what is needed and only for one year. This isn't sufficient for a long war," explains Yuriy Gorodnichenko, a professor at the University of California, Berkeley.

Therefore, the only alternative to raising taxes is to issue hryvnias, which seems unavoidable in 2024. The only question is the scale and the consequences for the solvency of each Ukrainian citizen. * * *

Changes to the tax legislation have been looming over Ukraine like a comet on a collision course with Earth. Just as in the film Don't Look Up, the Ukrainian government has attempted to pretend that the problem doesn't exist, with the country's prime minister even claiming that "the government is neither initiating nor discussing tax rises". The government appears to have believed that ignoring the problem would make it go away.

However, no miracle has happened, so now Ukrainians will have to face an emergency tax rise completely unprepared. No prizes for guessing how this will go down with business and the general public. Translation: Artem Yakymyshyn

Editing: Teresa Pearce