Magic Reasons for Prosperity

Linked with our presentations of Valentyna Dovzhenko – Ukraine, of The Eurasia Foundation, also of the POLITICAL SITUATION IN UKRAINE.

The Three Magic Reasons for Prosperity of Nations: Does Ukraine Have Them? By Valentin Zelenyuk, July 31, 2006.

Back in the XVII century, Adam Smith clearly identified the key reasons behind the wealth and poverty of various nations. The three major reasons that this patriarch of modern economics mentioned were: (i) peace, (ii) easy taxes, and (iii) tolerable administration of justice. Ukraine was lucky to have the first one (unlike a number of other transitional countries), but has done very badly on the other two.

Indeed, as we argue in this article, the biggest and the main fundamental problem that prevented Ukraine from realizing its great economic potential until now has been a poor business environment. In particular, there were and unfortunately still are serious problems with the most important issues for any business: property registration, the tax system, protecting minority shareholders, dealing with licenses, opening and closing companies, and hiring and firing people.

People who have tried doing business in Ukraine or have just lived there for a while know these problems very well. But, how does Ukraine compare to the rest of the world? Such relative standing of a country is fundamentally important because it determines the flow and development of the two major factors of economic growth-physical and human capital-among countries.
Unfortunately, but not surprisingly, the numbers are astonishingly bad for Ukraine. For example, according to a very comprehensive recent World Bank survey Doing Business-2006, Ukraine was ranked only 124 out of 155 countries! (See Table 1.) This standing is substantially worse than that of most transitional and developing countries. In fact, among transitional countries only Uzbekistan was ranked worse than Ukraine, while such countries as Afghanistan, Belarus and Iraq ranked higher!

To be specific, in terms of property rights registration, which is crucial for any businessperson, Ukraine, a country with a relatively high level of education, was ranked only 127, which is below many countries in Africa!
Another serious concern is the poor legal protection of investors (minority shareholders from self-dealings by management, etc.), where Ukraine was ranked 141 (out of 155)-worse than any other transitional and most developing countries. This is an especially important issue since it constitutes the main reason for the poor development of the key market institution in Ukraine-the stock market.

Worst of all is the situation with the tax system, where Ukraine was ranked 151, only better than Belarus and three African countries! World Bank estimates also suggest that the current level of taxation in Ukraine is very similar to that in other European and Asian countries: firms have to pay about 51 percent of their gross profit in taxes. This is still unfavorable for the attraction of foreign investors and keeping locals from off-shoring their businesses. The major problem, however, is with the excessive tax bureaucracy: Ukrainian firms, on average, must make 84 payments, spending about 2,185 hours to comply with tax requirements.
Such bureaucracy substantially reduces the attractiveness of Ukraine for new foreign investors, slows down existing businesses and pushes many of them into the shadow economy, which by various estimates accounts for about 50 percent of Ukraine’s official GDP.
>From the first look, the problem seems to be one of confusing and contradictory laws. (For example, western experts generally regard the Civil Code of Ukraine, given some improvements, as a pro-market law, but the problem is that it contradicts the so-called Economic Code of Ukraine.) The solution then seems to be simple: change the law! Nevertheless, despite being criticized heavily by many experts and top officials for a long time, the law has not yet been improved significantly.
Why? The problem is rooted in the high level of corruption along the entire hierarchy of administrative and regulating agencies. This includes bribery and direct involvement in (owned or shared) businesses by many civil servants, from the bottom to the top. The problem can be described through a vicious cycle: excessive and contradictory laws give state bureaucrats the possibility to extract rent from businesses and this, in turn, encourages state bureaucrats to stop improvements in legislation that would reduce their rents. Yet, on the other hand, such situations encourage many business people to get involved directly or indirectly with politics on every level of the political hierarchy-to protect their businesses and, while there, to also get advantages and sometimes control and victory over their competitors.

Some positive signals can be also seen from the World Bank survey mentioned above. For example, Ukraine’s rating was very good for issues such as enforcing contracts (39), better than most transitional countries (including Russia and China) and even some developed countries (Italy and Portugal). Interestingly, it takes less time to resolve a dispute in Ukraine than in Bulgaria, Czech Republic, or Hungary and with much less court and attorney costs than in Russia, Slovenia or Kyrgyzstan.
Ukraine was also ranked relatively high on the issue of getting credit (75), better than Greece, Poland and Russia. This positive sign is a reflection of the relatively well-developed banking industry in Ukraine, as enormous foreign investments in this sector also might suggest, and it should serve as an example for other industries in Ukraine. Ukraine was also ranked high for ease of trading across borders (78), which is mainly related to some success recently achieved in the direction of entering the WTO.
Moreover, comparisons in the World Bank surveys for the last several years suggest that there has been an improvement in most areas, although it is still very, very small.

Another country ranking, based on so-called ‘Economic Freedom Index’, constructed by The Heritage Foundation (USA), confirms the poor standing of Ukraine (ranked 99 out of 157!) relative to other, even poorly-developing countries in the world. This rating assigned Ukraine to the worst group, ‘repressed economies,’ in 1995-1996. Since 1997, Ukraine was assigned to the group of ‘mostly unfree’ economies, which is an improvement, but only a very, very small one, leaving our business environment at the same or at a lower level than Lesotho, Nicaragua, Senegal, and other poorly developing countries.
Yet another country ranking, a 2004 study by Transparency International, placed Ukraine at 122nd place (out of 144) in terms of the level of corruption (the higher the rank, the higher the corruption). This place was shared with such countries as Niger and Sudan but, ironically, Ukraine scored worse than Honduras, Zimbabwe, Belarus and many other poorly developing countries. In their latest study, in 2005, Ukraine made some improvements: we caught-up with Honduras, Zimbabwe and Belarus, now taking 107th place (out of 158). But is this as it should be in a country with as relatively high an educational level as Ukraine enjoys?
Summarizing our discussion above would actually help drafting the economic and political strategy for the new Ukrainian government-if it wants to achieve good and long-term economic growth for our nation. The very first thing the government should do is to reduce the tax burden by simplifying procedures for tax payments and reducing their level (mainly the profit tax, the value added tax, and the social security and pension tax, together with pension reform). The second most important objective is to simplify business regulation procedures (especially property registration and procedures for starting or closing businesses) and reducing government intervention in the markets.
Another specific step should be to abolish the Economic Code, while improving the Civil Code. The third most important objective that the new government should pursue is to ensure that human rights and property rights (including that of minority shareholders) are strengthened and respected, not violated as has so often been the case. A particular step here would be ensuring no massive re-privatization and also strong promotion of further privatization of state enterprises.
Finally, as any country, Ukraine needs peace for its prosperity. How should it be ensured? Ukraine is not a gigantic country by global standards and so needs to decide which military alliance to join. At this point in history, clearly, the choice is between Russia and NATO. Can Russia help Ukraine have peace? Most Russian and Ukrainian people have been friends and often relatives for centuries and this certainly should continue on individual level, but shall this determine the quest for the country’s security? Let us consider two important facts.
First, Russia indeed guaranteed Ukraine protection from invasions, according to the treaty back in the XVII century, but it largely failed to do so during the last two World wars. Moreover, in some sense, willingly or unwillingly, Russia used Ukraine as a buffer to protect itself-as the relative death count for both wars suggests.
Second, unfortunately, Russia is not a peaceful country itself-it has continued wars outside and even within itself for centuries and there is a big question if it is going to stop in the near future.

So, a pragmatic solution for ensuring peace for Ukraine is to follow the example of successful Slavic countries by joining NATO as soon as possible as well as integrating with the EU as deeply as feasible, while maintaining pragmatically friendly relationships with the Russian people, as any country with pragmatic leadership wants.
Reaching success in those three cornerstones of prosperity of a nation-ensuring peace, imposing easy taxes, and guaranteeing tolerable administration of justice-would help make Ukraine a prosperous, wealthy nation. This is not just a theory. The past century has given us excellent examples showing that this theory works well in practice.
The best example is Hong Kong that was among poor, developing nations in the 1960s but joined the club of rich in the 1980s, having per capita income higher than many European countries! The secret of success in Hong Kong was based on the same three reasons: peace, easy taxes, and tolerable administration of justice. Indeed, Hong Kong is ranked as the ‘most free economy’, ranked first by The Heritage Foundation and in the top 7 in the Doing Business survey by the World Bank.
All countries that showed miraculous economic growth and performance-Taiwan, South Korea, Singapore, Ireland, Luxembourg-understood the three magic reasons and used them to their advantage, to make their nations prosper. The hope is that Ukraine will do it too!
Valentin Zelenyuk is a Senior Economist at the Kyiv Economics Institute (KEI), visiting professor of EERC at Kyiv-Mohyla Academy, and Director of the Ukrainian Productivity and Efficiency Group (UPEG). Currently, he is a visiting Research Scholar at the Kennan Institute of Woodrow Wilson International Center for Scholars in Washington DC, USA. The author thanks Tom Coupe, Natalya Dushkevych, Kent Lewis and Pavlo Prokopovych for valuable comments. The views expressed in this article are those of the author and do not represent the views of abovementioned organizations or people. E-mail

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