Ukraine’s Desperate Search for War Funding Hits Local Budgets

Yves here. I have a post underway on Ukraine’s economy and this post launched, with some new, germane sightings. I thought it would be useful to provide this information first, since it provides useful breadcrumbs.

The short thesis of my post underway is that conditions in Ukraine are worse, likely markedly worse, than the Western press would have you believe, and the withdrawal/substantial reduction of external support will have a cliff effect. Note that given the source, the article below contains admissions against interest (as in Ukraine has tried in its messaging to present an image of strength and inevitable success).

If readers can send me links to relevant articles in the foreign language press to yves-at-nakedcapitalism-dot-com, it would be helpful, since English language/Anglosphere reporting is thin.

By Yurii Gaidai, a senior economist at the Centre for Economic Strategy, a Ukrainian non-governmental research body. Originally published at openDemocracy

Ukraine is preparing to roll out its second wartime budget. Faced with an existential threat from one of the world’s largest military forces, the country has dramatically increased its military spending. As a result, every other hryvnia from the Ukrainian budget is now spent on defence.

But Ukraine is in a vulnerable position: the country is heavily reliant on external funding.

According to estimates by the Centre for Economic Strategy, the Kyiv-based think-tank where I work, Ukraine’s total funding needs for 2024 will amount to roughly £43.6bn – to cover its budget deficit and debt repayments.

A fifth of this is expected to be sourced domestically via Ukrainian government bonds. The remaining 81% is anticipated to come from external sources, including a mixture of loans and grants from the US, EU, IMF and other creditors.

But as of now, neither the EU nor the US has confirmed the exact amount of financial support it will give Ukraine for 2024.

If external funding is not secured, Ukraine may have to consider monetary financing – the direct transfer of central bank funds to the state, usually by the purchase of government bonds.

This is a strategy it was forced to employ until late 2022, but has managed to avoid since. Monetary financing means creating additional money, which is not matched by an increase in a country’s economic output, usually resulting in higher inflation and interest rates. And if the situation does not improve, there is a tangible risk of a collapse of the Ukrainian public finance system.

Thus, in its desperate search for additional sources to finance the country’s resistance, the Ukrainian government has been exploring various options for funding defence needs and the production of weapons.

Measures taken so far include revoking most tax breaks initially introduced to support Ukrainian businesses at the onset of the Russian invasion, increased taxes on banks’ income, and a significant reduction in non-essential state-funded expenses.

But one particularly stark and controversial measure is the Ukrainian government’s plan to tap into local community budgets.

Officials have proposed transferring the income tax local authorities receive from Ukrainian military personnel into a centralised defence fund. The Russian invasion led to a significant increase in the size of Ukraine’s defence forces, up to a million service personnel – who all pay income tax on their wages to local authorities. Now this tax income could be set to pay for drones and other munitions.

The move could cut across the successes of Ukraine’s decentralisation reform, which has been one of its most impactful. This 2014 initiative transferred powers and funding from the central state level to local city and village authorities – known as hromadas, or communities. This shift brought local authorities closer to citizens, incentivising more responsive public services for citizens and businesses and making local government more accountable.

The decision has met resistance from many hromadas themselves as well as some Ukrainian MPs. They argue that the larger revenues give hromadas greater flexibility in addressing the needs of internally displaced citizens, which are often not promptly dealt with by central government, as well as additional defence costs such as some drones and vehicles. Yet local authorities used less than 20 billion hryvnia (£450m) on military expenditure for the first eight months of 2023.

The primary funding source for Ukrainian local budgets is personal income tax, 64% of which is allocated to the hromadas where Ukrainian taxpayers’ employers are registered. However, many large employers are registered in major cities like Kyiv, which exacerbates regional economic disparities. It also creates a gap between where taxes are paid, where services are delivered and where voters are represented, partially neutralising the positive effects of decentralisation.

To mitigate this, wealthier communities are obliged to transfer a share of their “excess” revenue back to the state budget, which then redistributes these funds to economically weaker communities through subsidies. Kyiv, being a hub for business registrations, receives only 40% of personal income tax.

Since the invasion, local authorities where military personnel are stationed have received a windfall in income tax revenue. (Ukrainian soldiers have had increased salaries that significantly exceed the national average.) These funds have helped offset the loss of tax revenues caused by the Russian invasion in 2022.

Meanwhile, as hromadas’ spending has largely been limited to critical expenditure, local budgets have started accumulating substantial surpluses. For the first eight months of this year, the overall surplus reached nearly 96.5 billion hryvnia (about £2.2bn), comparable to the state budget’s monthly tax revenues. Income tax revenues of local budgets from military personnel over the same period reached 67.8 billion hryvnia (just over £1.5bn).

Yet these military income tax revenues are distributed unevenly, as they depend on the place of registration of military units. The situation also creates incentives for unjustified changes of registration address of military units, likely in exchange for informal agreements on financial support by local authorities. Researchers at the Kyiv School of Economics identified over 60 such cases since April 2022.

Ukraine’s Ministry of Finance argues that, overall, local budgets will remain in aggregate surplus even without these military-related revenues. To offset the loss of income for less economically developed hromadas that had relied on military income tax before 2022, the subsidies mentioned above will continue to be provided, along with a further 33.4 billion hryvnia (£750m) in direct grants.

Public sentiment is also a factor. In major cities like Kyiv and Odesa, citizens have actively protested against non-critical and inefficient spending like the reconstruction of streets or beautification, demanding that funds be redirected to military needs.

In an attempt to find a compromise, the Ukrainian parliament’s budget committee proposed that 10% of military income tax be transferred to military units for urgent or unplanned expenses. But this proposal failed to gain parliamentary support last week, and the draft law has been sent back for further changes ahead of another reading in parliament.

The search for additional defence funding – and for a compromise between the needs of local government and the state – continues.