There are two main characteristic features of macroeconomic stability that matter for transition economies: maintaining public finances at an appropriate level and an adequate anti-inflationary monetary policy. The absence of either feature will sooner or later require significant policy correction. This is evidenced by the experience of Hungary after the 1994 crisis, the Czech Republic after the 1997 crisis, Slovakia after the 1998 crisis, and Poland during the economic downturn of 1999–2001, namely that delaying the correction of state policy leads to the introduction of excessive regulation and increased impact of any necessary fiscal restructuring, especially on the poorer members of society.
The second precondition for a successful poverty reduction policy is high rates of sustainable economic development. However, this topic goes beyond the scope of this analytical note. Thus, I would like to note one aspect of sustainable economic growth that is important for poverty reduction policy: diversification of the economy and smoothing of the economic cycle. Economies based on the production of a small range of agricultural crops or industrial goods and facing high cyclicality on world markets must go through a very harsh cycle of growth and decline in external demand. Slovakia was exactly such an economy in the mid-1990s, relying on exports of steel, chemical products and other intermediate productions. Such imbalances have an impact on the poor segments of the population similar to the impact of general macroeconomic instability.
Now let me draw attention to the actual goals of poverty reduction policy. Although defining poverty reduction goals may seem a simple and straightforward task, the experience of Central European countries shows that both the public and policymakers emphasize inappropriate and erroneous goals in the context of middle-income countries such as Ukraine.
First of all, how should poverty be defined? There are two schools with different approaches to economic and social policy problems. The first focuses on relative poverty. For example, in making some of its assessments, the European Commission looks at the percentage of the population with income below 60% of the median income level in the country. The second bases its analysis on absolute poverty: first it establishes the income level necessary for subsistence – the subsistence minimum (for example, two US dollars per day), and then determines what percentage of the population in individual countries receives income below this level. Meanwhile, both criteria are quite important. I would say that it is the second approach that matters for poor and fast-growing countries. Relative poverty criteria examine equality within any society, not the actual poverty level of an individual. Based on this criterion, the number of poor people in the United Kingdom is higher than in Bulgaria or Romania. Inequality also tends to increase in fast-growing countries, but this should not be a cause for serious concern as long as the results or products of growth are distributed, even if not absolutely equally, among the entire population.
Secondly, employment and unemployment should essentially be the main goal of any anti-poverty policy, because the risk of poverty is very closely linked to unemployment in transition economies (of course, with the exception of elderly people). Most societies focus on the unemployment rate. Although theoretically such an approach has an advantage since it measures the available labor force and focuses policymakers on those who want to work but cannot find a job – in practice this is not the case. What actually matters for the economy is how many people are working, which is measured by the employment rate (for example, the percentage of employed people in the 15–64 age category), because only these people actually produce goods, services and pay taxes. Even more important for social policy is focusing on the official unemployment rate, which creates incentives for maintaining economically and socially destructive policies, for example, early retirement, easy access to disability status, etc. This is a very important issue. Slovakia and Hungary have approximately the same employment rate – around 57%. However, Slovakia has a much higher unemployment rate – according to some estimates, more than 10%. Although this currently creates additional social tension in Slovakia, it will be able to increase the employment rate much more easily when its economy continues to grow. Hungary will find it much more difficult to get people back to work after they have received disability status or retired. At the same time, such a system costs Hungary much more, because pensions are usually much higher than unemployment benefits.
Last but not least: poverty is easier to bear and its social cost is minimized if poverty tends to be a short-term phenomenon, if it is not reproduced across generations and people feel that they can realistically get back on their feet and overcome it.
Finally, it must be said that Central European countries and, probably, Ukraine need to focus on three main tasks of anti-poverty policy: increasing employment, reducing absolute poverty and preventing long-term poverty, and improving social mobility.
Now, after we have examined the preconditions for reducing poverty levels and clearly defined our specific goals, let us focus on the ways to achieve these goals.
Our discussion of these instruments will be substantively divided into two parts. The first concerns stimulating employment in the legal economy. The second focuses on other features of social adaptation policy that attempts to reduce the level of absolute poverty and its reproduction in addition to a strong full-employment policy.
Encouraging employment in the official economy is the foundation of any anti-poverty strategy in middle-income countries such as Ukraine. This strategy must focus both on moving jobs from the shadow economy to the official one and on creating new jobs in the legal economy. It is important to emphasize that any repressive element (for example, police, tax authorities, etc.) should play a secondary role in this strategy. The main task of the strategy is to make job creation in the official economy more attractive. Usually this goal can be achieved using combinations of the following elements:
- Changes in the tax system This step usually involves reducing tax rates, broadening the tax base, improving the tax administration system to achieve a better level of collection, shifting taxation from labor to consumption, and introducing tax systems that make tax evasion more difficult. In other words, successful strategies involve eliminating most, if not all, targeted tax exemptions and subsidies in favor of a relatively low tax rate for all; focusing on value-added tax and excise taxes as the main source of revenue; reforming the expenditure side of the budget to correspondingly reduce revenues; relatively low rates of personal income tax and social security contributions. Slovakia is a good example of applying such a strategy: it introduced a flat value-added tax rate of 19% from January 1, 2004, which made it possible to introduce a flat 19% personal income tax rate, prevent double taxation (for example, tax on dividends) and reduce the size of social security contributions by more than three percentage points.
- Incentives to work in the official economy As long as there is a limited connection between what a person pays to the state (taxes and social security contributions) and what they receive from it, there are no economic incentives to work in the legal economy, because a person receives nothing for it. Reforms in Central European countries included elements that tightly link state social payments to citizens' contributions. In Poland, Slovakia and Hungary, a so-called second pillar of the pension system was created, in which a large share of contributions is directed to personal pension accounts. Even in the still-existing state pay-as-you-go pension systems, there is a tendency to strengthen the link between contributions and pensions, sick pay and other payments. An example is Slovakia, as well as the Czech Republic, which is currently considering strengthening this link.
- Access to credits for entrepreneurial activity and the population One of the biggest obstacles in the development of entrepreneurial activity and economic growth in transition economies is insufficient access to financing both in the form of loans and in the form of capital injections. As Hernando de Soto determined, these problems to a large extent relate to problems with providing collateral, which in turn is a consequence of imperfect legal systems and unclear property rights. Most people, even in poor countries, own property, sometimes substantial, but their property rights are either not formally registered or there are problems with effectively providing it as collateral to secure loans. Another problem that manifests quite often is the generally low level of development of the banking sector, the comprehensive involvement of the state in banking operations as opposed to regulating banking activity and "protecting" borrowers from creditors, which is why private banks are in no hurry to provide loans. Sooner or later, radical restructuring and privatization of banks became the main principle of successful economic policy in Central European countries. Countries that resorted to such measures earlier – such as Hungary – carried out reforms more successfully and cheaply than those that did so later, for example Poland, Slovakia, the Czech Republic. Slovakia became a world leader in introducing an effective system for using movable property (trucks, passenger cars, inventory, etc.) as collateral. The use of mortgages as a source of lending for new enterprises has become increasingly common in recent years. The introduction of such systems enables a much larger number of people to start or develop their business than any specialized state loan system or grant program. Moreover, such a step is cheaper, and small business tends to become the main driving force of employment in the legal economy. Such systems also create considerable economic incentives for enterprises operating in the shadow economy to move to the official sector, because there are certain benefits for business owners there, for example, access to bank loans.
- Regulatory environment, in particular labor legislation Paradoxically, poorer countries where the state is weak tend to have more complex regulation, especially regarding the labor market. Studies reveal that some of the poorest countries in the world (for example, in Africa) have some of the strictest labor legislation. Of course, such legislation creates a double problem: it is not properly enforced and it forces employers to work in the shadow economy. Therefore, it is very important to have labor legislation that can be applied in this country under these circumstances and that will not prevent employers from hiring workers because it will be very expensive to dismiss them when necessary. At the same time, the experience of Central European countries has shown that it is impossible to stop or prevent the reduction of employment at large, formerly state-owned enterprises; it can only be slowed down. Delay is usually either very expensive for the government (if it pays subsidies to enterprises to maintain employment levels) or can destroy an entire enterprise (if the government forces employers to maintain employment levels). In the end, money will be spent much better on retraining workers, infrastructure development or social assistance. With this in mind, in 2003 Slovakia reformed its Labor Code to increase flexibility of working hours, hiring and dismissal procedures, and limit the powers of trade unions.
In addition to a strong employment policy, there are other areas of social adaptation policy that are necessary for reducing absolute poverty and preventing its reproduction. Such areas can take various forms that are most suited to local conditions. So let us discuss the principles on which they should be based, rather than the specific policy areas.
The main issue in view of Ukraine's experience is the issue of in-kind assistance, especially so-called privileges. First, Central European countries never had large systems of privileges. They also gradually tried to abolish any privileges and ensure state financing of remaining privileges. There are several reasons for such an approach. In-kind privileges turn out to be more expensive for both the state and the enterprises that provide them. They also insufficiently support the idea of targeting and are too generous. At the same time, they tend to create traps for citizens, since citizens very often cannot change housing, work, etc. without actually losing some privileges.
On the other hand, some Central European governments (for example, Poland or Slovakia) emphasized in-kind assistance and financial payments as an additional instrument for supporting the poor, in addition to basic assistance to the poor population. Provision of shelter or food by municipal authorities to unemployed citizens, subsidizing school breakfasts, textbooks and other necessary items for children from poor families, providing housing subsidies conditioned by rent and utility payments, or assistance to children conditioned by school attendance – all these elements are an integral part of social security systems in these countries. In-kind assistance and financial payments can be effective if there is a high probability that this money will be spent for purposes related to reducing poverty in the future (for example, spending on education and housing) and if they are additional to the main social security system based on cash payments.
One of the most important issues in the European Union as a whole and in Central European countries in particular is designing tax and social assistance systems in such a way as to create economic incentives to work. Slovakia and Germany launched ambitious reforms in this area in 2003 and 2004. Now the Czech Republic has joined them. These reforms, such as reducing social benefits, conditional provision of social assistance, lowering taxes for families with children and contributions to the social security system, attempt to force workers to pay for themselves, even if their work is relatively low-paid. In Ukraine, thanks to the low level of unemployment benefits, this issue may be less important than others discussed in this document.
Another important issue concerns the targeting of social programs. Middle-income countries, to which Ukraine belongs, cannot maintain the level of taxation that exists in European Union countries and at the same time the growth rates necessary for reducing poverty. Therefore, it is very important to avoid universal welfare systems of the type that exist in many Western European countries and to appropriately target social programs. Currently, there is a fairly widespread illusion that since in countries such as Ukraine almost all citizens are poor, the state should provide subsidies to everyone. This illusion ignores the fact that, ultimately, subsidies are financed by taxes paid by the same poor citizens, but reduced by all the costs and inefficient actions of the authorities. In this sense, successful non-European countries such as Chile and Korea can be a model to follow. Housing and education programs, as well as health care programs, should be carefully targeted to guarantee a minimum set of services and the ability to receive them. Moreover, the set of services must correspond to the country's capabilities. A very good method of targeting assistance is focusing on children from disadvantaged families. It has also been proven that integrated, effective and efficient programs that provide from a child's birth to adulthood and ensure sufficiently equal access for all children to health care, nutrition and education are among the best investments that the public sector can make.
Finally, let me draw attention to one issue in which no Central European country has achieved significant success and which may also be relevant to Ukraine. There are very many losers from the transformation of society – people over 45 years of age who have a fairly low level of education. The ability of such citizens to adapt to new conditions, especially if they have lost their jobs, is limited. Their reintegration into the labor market is not very successful, and they either remain unemployed (as, for example, in Poland and Slovakia), or become incapacitated, or retire early (as, for example, in the Czech Republic and Hungary).