Shadow Economy Cannot Be Combated “in General”

Throughout last year, we heard certain officials make lofty statements about combating the shadow schemes of oligarchs instead of taking the much-needed vigorous and practical steps to improve the legal and normative system and remove the loopholes in it being used by shadow operators. Instead, there were attempts to exercise a hands-on and injunction-based management, which resulted in the economy sinking still deeper in the shadows. This is why this issue was put on the agenda of a special sitting of the National Security and Defense Council of Ukraine (NSDC).

By signing the decree, On the Decision of the National Security and Defense Council of Ukraine of January 25, 2001 On Measures to Bring the Economy Out of the Shadows, the president of Ukraine has once again drawn the attention of the executive branch to the problems of the shadow economy. The decree approved a comprehensive program called The Main Principles of Bringing Money Circulation Out of the Shadows, gave a number of instructions to the Cabinet of Ministers, and formed an Interdepartmental NSDC Commission for Financial Security. The decree, as our experts note, calls for the establishment of an effective mechanism to prevent the Ukrainian economy from slipping underground and help it become a part of civilized social life. In an interview with The Day, NSDC Deputy Secretary Trokhym KOVALCHUK comments on the presidential decree.

“Although decisions aimed at bringing the economy out of the shadows have also been made before, now there are apparent changes. Can we hope the fulfillment of this decree will help eradicate this dangerous phenomenon?”

“Let us change accents here a little. The presidential decree does not deal with ‘overcoming’ or ‘relentlessly combating’ the shadow economy or something of that kind. The decree is permeated with the same spirit as the Main Principles. So let me quote the latter to illustrate my words: ‘The attempts to restrict out-of-bank money circulation by administrative pressure alone on economic entities shows the need to employ a new strategy for taking the money circulation out of the shadows. This strategy envisages creating favorable conditions for money to circulate with the maximum possible account of the interests of the owners of such money.’

“As we see, the point is not in ‘combating’ or ‘overcoming.’ On the contrary, the document condemns the usual injunction-based methods whereby certain economic operations are either banned or allowed exclusively against the tough standards supposedly drafted by punitive authorities. Our state is beginning to really master the main paradigm of a market economy: the latter is the domain of free subjects guided by their own egoistic or, if you like, profit-seeking interests rather than by abstract ideals. This was stressed by market theory founder Adam Smith 300 years ago: people act the way each of them, not anybody else, finds it profitable. An old woman hawking cigarettes on the street, who has never read Smith, still follows his instructions: do what is profitable to you personally. Economic operations hide in the shadows only when it is profitable, so the question is not to discontinue or overcome but to bring them into the light by legalizing them.”

“Then may I put the question in another way: if this shadowization is profitable for at least a part of our citizens, meets their interests, and the state does not see it necessary to overcome it, is there any sense in bringing it into the light, let alone combating, it?”

“The point is that the paradigm itself provides for some restriction of economic freedom if somebody’s actions harm others. In essence, the chief problem of statehood and power has been the same for millennia: how to realize the natural aspiration of man for freedom and to keep not infringe on the interests of others. There is an apt phrase that everyone is free to swing his arms, but this freedom ends at his neighbors nose. In other words, the state must act to defend, not infringe, on the individual’s interests.”

“In some cases, defending the interests of some objectively requires restraining the interests of others, so there is not and cannot be any common algorithm for all anti-shadow measures.”

“The decree calls for a mechanism to ensure mutual cooperation among thousands of state-run and non-governmental organizations and promote changes in the behavior of millions of people. All this is only aimed at one major aspect of economic activity: it is of paramount importance today to make all accounts, without exceptions openly through legal banking institutions. It is not the question of state control over the clauses of commercial contracts, prices, and amounts, forbidding individuals to possess foreign currency, and so on. The question is that all these operations should be carried out through the banking system and reflected in financial and statistical bookkeeping and accounts.”

“Incidentally, it may seem strange to citizens of the developed countries that this requirement should be an item of a state-sponsored program, need considerable efforts to be implemented, and on top of everything else encounter resistance from a certain segment of the state authorities themselves.”

“We are accustomed to blaming the authorities for the slow pace of market reforms, excessive intervention in business, and even restriction on living their own lives: look, they’ve slapped an identification number on everybody, which falls just short of making everyone a serf! Suffice it to recall the rallies and demonstrations of entrepreneurs in reply to elementary demands to attach a price tag to each item, keep account of the trade turnover, and have a certificate of origin for at least the goods that can present hazards to human health, such as foodstuffs, medicines, and children’s articles. So from this standpoint, the state will have to wage a real struggle for the rights and interests of our citizens. At the same time, as far as some individuals are concerned, this is going to be a difficult and a long process, but not a hard struggle against their interests, for some of them will see that it aims not just to restrict their rights but to cut off the channels of illegal enrichment. We are fully aware of the magnitude of this resistance to be offered by those who feel their rights are being infringed upon and are prepared to overcome it.”

“Which specific clauses of the presidential decree could trigger such resistance?”

“Let us take, for example, the following clause of the Main Principles: ‘introduce proposals to tighten hard-currency control over the export and import operations of economic entities.’ In all probability, all to whom it may concern know that we abolished very recently Soviet Article 80 of the Criminal Code that prescribed punishment for personal possession of foreign currency. Indeed, the existence of an article like this runs counter to civil rights and does not befit a democratic state. While the article was still in force, billions of dollars were taken out of this country. Moreover, not a single dollar came to Ukraine voluntarily: each was paid for with a marketable Ukrainian commodity or with the work of our citizens. It is impossible to assess exactly the total sum of capital that has fled this country over ten years, with some saying it is 20 and others 50 billion dollars.

“However, the tax administration, which tracks current operations, announced a few days ago that Ukrainian companies had reduced last year the foreign currency repatriation debt by $29 million (about $250 million as of January 1, 2001). This is only what was officially accounted for, while the true figures of illegal capital drain from Ukraine are much higher. This is nothing but the result of unsatisfactory control over the cross-border movement of hard currency.”

“The State Tax Administration claims it has sent more than 3000 queries in the past two years to the tax-collecting and law-enforcement bodies of other states, including 1729 to Russia. The result was that more than a half of the Ukrainian companies’ contractors do not exist.”

“Money does but owners do not exist. How much are the latter ready to pay to keep a low profile? I suggest we watch the utterances of certain well-known personalities who are going soon to complain about and criticize the authorities for alleged political persecution and harassment of the opposition. For, in pursuance of this decree, we will undertake real and concrete actions.”

“The shadow turnover brings in a lot of spurious goods which jeopardize not only the economy but also human health and life.”

“According to Ukrvinprom, the Ukrainian viniculture and wine-making corporation, about 70% of retail outlets in Ukraine sell adulterated alcoholic drinks. It is possible that as many Ukrainian residents, if not more, buy them because they are cheaper. The state has incurred the loss of almost a billion hryvnias because of unpaid taxes, and even this is paltry compared to the damage done to the health of our people. But one should be aware that, as soon as this phenomenon has been done away with, the price of genuine goods will inevitably rise by force of market competition.”

“High prices should be offset by high wages: this is also a market law.”

“The decree on the basic principles of bringing money circulation out of the shadows envisions, among other things, introduction of a minimal wage as a civilized social standard, abolition of, so to speak, in-kind wages, government guarantees to index the wages lost due to inflation, etc. I must note in this connection that every country that strives for civilized relationships will only revitalize its economy by developing the domestic market, i.e., by increasing the purchasing power of its population in every way possible. The average Ukrainian must become an active buyer. This is the main thing. Yet, in terms of strategy, shadow business should be combated by creating such conditions that being honest is profitable and working in the shadows is obviously damaging. To take the economy out of the shadows, one should create conditions such that paying taxes is more advantageous than bribery. I am sure: no government decisions will be dutifully fulfilled as long as they run counter to common sense and cause economic losses.”

“It is common knowledge the Ukrainian shadow economy is financially based in offshore zones. Have any measures been developed to limit their negative impact on Ukraine’s economy?”

“Yes, the decree includes a clause which will affect the interests of a limited number of people but will also have essential quantitative consequences: ‘introduce restrictions on offshore loans drawn at an interest exceeding the domestic credit market interest and work out economic, including tax-related, measures to influence businesses that attract such loans.’ It is an open secret that a considerable part of the so-called foreign investment in Ukraine are our own funds, earned by the work of our people, which landed in tax havens in various shadow and semi-legal ways and only then returned to Ukraine as foreign investment. For it has been known since the times of Roman Emperor Vespasian that money has no smell, and many countries look at the origin of foreign investments far more condescendingly than at that of their own.”

“Civilized countries closely see to it that profits are legal and that proper taxes are paid for them.”

“In this country, many owners of capital, who have not yet become civilized entrepreneurs and amassed large money in a dubious way, try to pile up their profits in a similarly dubious way. One of these ways is very simple: the owner of a Ukrainian firm takes out a loan at an inflated interest rate from another firm of his situated in a offshore area, while payment of this interest is, legally, part of production costs and, hence, is not taxable. So offshore profits are being accumulated because of legislative lacunas. If you are interested in this matter, I can refer you to a well-known case when Ukrainian government bodies are being sued for allowing the Poltava Gas and Oil Company to inflict an artificial $60 million debt on JP Kenny Exploration & Production, one of its founders. The suit, now being considered in court, has raised a scandal in the media. It is too early to draw conclusions, but the accusations against Ukraine sound too demagogic: the rights a foreign investor are being trampled on, the investment climate is deteriorating, etc. To forestall this kind of demagoguery, we must urgently streamline the legislative and normative basis of such arrears.”

“The decree in question is only the beginning of a broad offensive on the shadow economy. Can we identify now the directions of further actions?”

“The harm done by the shadow economy and the danger it presents to the national interest has long been the subject of much comment. There have been a host of proposals. But, unfortunately, very little has been done. And our main trouble is not that we do not dare to work out effective measures but that we do not fulfill the decisions made long ago. Here are just a few: on production of an income declaration when making a costly purchase, on the establishment of the State Registry of Real Estate, and on levying taxes on real estate and other property utilized as an economic asset.”

“Why does the decree single out legalization of settlements, that is, bringing money circulation out of the shadows, among various other aspects of addressing the shadow economy?”

“Let me cite just one telling figure. Accounts receivable exceed those payable by over UAH 74 million, which is in fact the price of the public losses incurred by shadow settlements. I only emphasize the area of settlements, but there are also other ways to keep the shadow sector afloat. A thorough analysis of the problem made it possible to find the key link of shadow economic activity, out-of-bank money circulation. For this reason most measures set out in the decree are aimed at pulling such money out of the shadow and into the light. It should be understood that legalization of the money circulation now catering to shadow operations will make it impossible to carry them out outside the legal field.”

“As a rule, it is the sanctioned nonpayment to the budget that reinforces the shadow economy’s financial basis. Besides, large amounts flee Ukraine and are lost not only by the state sector but also by the economy as a whole.”

“To establish an effective mechanism of bringing the economy out of the shadows, one need not reinvent the wheel or borrow from the supposedly advanced experience of the developed countries. For instance, US budget expenditures, worth $500 billion, include $9 million (1.8%) appropriated by Congress as tax privileges. In contrast, Ukraine grants annual privileges of UAH 30 billion, which exceeds total revenues. Moreover, the privileged in fact draw considerable dividends because they usually work in those market sectors which have money even in times of depression. On the other hand, none of the supervising bodies can show a complete list of the privileged and assess their true incomes because, officially, nobody in Ukraine is authorized to grant privileges. All this looks like legalized corruption which, of course, should be rooted out.”

“Stricter oversight over the income and property of public officials must obviously become an important and effective way not only to expose but also to forestall any possible shadow activities.”

“By all means. We must tighten control over money flows and property acquisition of high public officials. Let me recall that the fundamental principle of a law governed system, the presumption of innocence, is resorted to rather selectively in the civilized states with respect to the sources of money and property acquisition, especially those of government officials. Under criminal law, an individual need not prove his absence of complicity in a crime committed, but under tax rules, on the contrary, he has to confirm the legitimate origin of his funds and property. This approach, used with respect to so-called free individuals, is all the more necessary with respect to public officials. You can’t combat corruption according the same principles as when combating crime in general.”

“But perhaps there is no prescription for doing away with the shadow economy once and for all?”

“It is the same as entertaining a hope to clean a room once and for all. As you know, we have to do this all our lives.”

“You mentioned that the presidential decree calls for setting up an interdepartmental financial security commission under NSDC aegis.”

“The financial sphere is today not only a potential engine of socioeconomic progress but also a true source of threat to national security. What becomes especially urgent under these conditions is the identification, monitoring, and forecasting of processes (including potential threats) on the banking, stock and insurance markets. The commission should exercise effective control over large-scale financial operations and powerful flows of hard currency in all segments of the financial market.”