This article summarizes the findings of work carried out by U-LEAD and the Polaris program since June of 2024 (Modelling the Impact of the Change in the PIT Allocation Mechanism on the Revenues of Municipal Budgets). This work was conducted to support the government’s “Action Plan for reforming local self-government and the territorial organization of power in Ukraine for the period 2024–2027.” The action plan calls for investigating the possibilities for changing the basis on which PIT is allocated to local governments. The plan is in line with both the 2023 and 2024 EU Commission reports on EU Enlargement which call on Ukraine to “make progress on ensuring a fair distribution of PIT to municipalities where taxpayers actually reside”.

1. The Problems with Ukraine’s current system of PIT Allocation

In Ukraine, companies are responsible for sending the local share of their employees’ personal income tax payments to the hromadas in which their business units are located. This method of allocating PIT to hromada is popularly understood as allocating PIT ‘by place of work’. But this is not really the case because companies are not legally required to define their business units by geographic location. Instead, they are free to define their business units in ways that best suit their accounting purposes and systems. Indeed, the Ukrainian courts have repeatedly ruled that firms cannot be compelled to change their accounting systems in order to send the PIT shares of their employees to the hromada in which they actually work.[1]

But even if Ukraine did allocate PIT to hromadas on the basis of where taxpayers actually work the system would be extremely problematic for two fundamental reasons, one political, the other financial: Politically, allocating PIT by place of work deprives all Ukrainians who live in one hromada, but commute to work in another, of the right to vote for the local officials who actually spend their taxes. Depriving commuters of this right breaks the link between tax payment and voting, a link which is crucial for encouraging citizens to engage with their hromadas and to hold their elected officials accountable for their performance.

The financial problem is better known: Allocating PIT to local governments on the basis of place of work, overfunds the larger, more urban, hromada to which people generally commute at the expense of the smaller hromada in which they generally live and receive most of their public services. This underfunding of smaller hromada then requires the unnecessary and inefficient expansion of the equalization system to compensate them for revenues that never should have been sent elsewhere in the first place.

In 2023, approximately 25% of the country's population resided in Kyiv and cities with a population of 500 thousand or more. But 38% of the total amount of PIT was credited to their budgets. Conversely, hromadas with a population of less than 50 thousand people accounted for only 36% of PIT, despite representing almost half of the country's population. As a result, 70% of hromada receive equalisation grants and most rural hromada are characterised by a significant imbalance between budget revenues and necessary expenditures.

It is for these reasons that virtually all European countries that fund a significant share of local government expenditures through PIT sharing, allocate the tax on the basis of where taxpayers live and vote, and not where they work.[2]

2. Work Carried out by the U-LEAD and Polaris Program’s since last spring

It is well understood in Ukraine that changing the allocation of PIT from place of work to place of residency would shift significant funds from larger, more urban hromada to smaller more rural ones. But estimating the magnitude of this shift is difficult because Ukraine does not have good data on either where people actually work, or where people actually live.

In May of 2024, the State Tax Administration provided U-LEAD with data that linked –for the first time – data on the hromada to which peoples’ PIT payments are sent with data on their current legal residency. This data is problematic for two reasons: First, the data on the hromada to which PIT payments were sent are – for the reasons discussed above – not fully reliable accurate with respect to whether the relevant employee actually worked in them. Second, the registry of where people live is painfully incomplete and out of date because there is no legal obligation for citizens to change their legal address when they move, and because of the large number of internally displaced people. As a result, a considerable proportion of the Ukrainian population resides outside the jurisdiction of their legally registered place of residence, particularly in urban and suburban hromadas.

The linkage of these registries marks a substantial achievement and a major step towards the government’s ability to actually implement a major reform of the PIT sharing system as a whole. At the same time, however, the weakness of the registries themselves with respect to where people actually live and work mean that the data can only be used to for indicative purposes, and that actually implementing a major reform of the PIT sharing system will require developing better registries, and in particular a more accurate and up to date registry of where people live.

That said, the data are important because they help define the magnitude of the problem. Indeed, what they suggest is that only 59 percent of all PIT is flowing to hromada in which taxpayers are currently legally registered to live, and that 41 percent of it is going to hromada to which taxpayers apparently commute. Moreover, This this gap has  widened since the full-scale invasion.

In small hromadas with a population of less than 50 thousand, the mean proportion of registered taxpayers who commute to work in another municipality is greater than 50%. This suggests that a considerable proportion of the taxpayers commutes to work in larger urban centres or resides outside the municipal boundaries of their place of registration. Consequently, in Ukraine, over 40 percent of the total amount of PIT credited to the budgets of hromadas is derived from taxpayers who are not registered in these municipalities but are employed there. In Kyiv, this figure exceeds 50 percent.

Fig. 1. Structure of PIT credited to the budgets of municipalities, %

* Calculated according to the State Tax Service data.

These data also allow us to estimate the nature of the shift in revenues across hromadas if PIT were allocated to hromada on the basis of taxpayers current legal residency. It is thus possible to comparison the actual system of PIT allocation with the allocation that would result if PIT were sent to the hromada in which people are currently registered as legal residents[3].

If PIT was allocated to hromadas on the basis of where taxpayers are legally registered to live the tax revenues of the majority of small and medium-sized hromadas would increase substantially. This is due to the fact that in these hromadas, a significant percentage of the population traditionally works outside their jurisdiction. Conversely, two-thirds of cities with more than 100 thousand inhabitants would experience varying degrees of PIT losses. In general, approximately 90% of hromadas, which collectively represent about 60% of the country's population, would experience a positive impact from changes to the PIT sharing system.

A key factor in assessing the effectiveness of the PIT sharing system is its impact on the average per capita PIT revenues of hromada, and with this their eligibility for equalization grants. Figure 2 illustrates the calculations of the tax capacity indicator for 2021 (during this period, the introduction of the military PIT had not yet resulted in a notable distortion in the revenue-raising capacity of the various hromadas). If PIT were allocated to hromadas based on taxpayers’ current place of registration, the percentage of hromadas that would no longer require horizontal equalisation would double, and the proportion of the poorest hromadas with a tax capacity indicator of less than 50% of the national average would be significantly lower.

Fig. 2. Distribution of municipalities by tax capacity index value under different schemes for crediting PIT to local government budgets

* Calculated according to the State Tax Service and the Ministry of Finance data.

Similarly, if PIT was allocated to hromada on the basis of where taxpayers are currently registered as residing, the discrepancy in average per capita revenue between the 10% of the "richest" and 10% of the "poorest" hromadas would be approximately half that of what it is today. As can be seen from Table 1 below, in 2023 this ratio under the current system was 14.3 – 1, but would fall to 5.3 – 1 if PIT were allocated by current place of legal residence.

Table 1. The ratio between the average indicators of personal income tax per capita between 10% of the "richest" and 10% of the "poorest" hromadas, times

* Calculated according to the State Tax Service and the Ministry of Finance data.

But the problem with all this is – as we have stressed above – that the data on both where people actually live and actually work is extremely problematic: the former because the registry of where people actually live is incomplete and out of date, the latter because firms determine what they consider to be a business unit in ways that are not necessarily based on geographic location.

As a result, U-LEAD conducted a statistically representative sample of taxpayers in hromada of different sizes in order to better understand where people actually live and work, as well as why they might live in one hromada, but be registered in another[4]. The results indicate that over 15% of the Ukrainian population resides in a hromada other than the one in which they are legally registered. This figure is notably higher in Kyiv, reaching almost 32% (Fig. 3).

Fig. 3. Distribution of taxpayers who actually live in the municipalities in which they are legally registered, %

* According to the statistical survey of municipalities.

The distribution of PIT payers by place of actual residence, place of registration of residence and work was modelled based on the combination and calibration of the State Tax Service data and the statistical survey (Fig. 4).

Fig. 4. Distribution of taxpayers by place of actual residence, legal registration and work, %

* Calculated according to the State Tax Service and statistical survey of municipalities data.

Thus, if PIT were allocated to hromadas based on taxpayers place of residence as revealed by the survery:

• The PIT payments of 57.9% of taxpayers would continue to go to the same hromada as today because they currently reside where they are legally registered, and work in the same hromada,
• The PIT payments of another the 15.2% of taxpayers would continue to go the the same hromada that they go to today because these taxpayers actually live and work in the same hromada even if today they are legally registered as residing in a different hromada.
• The PIT payments of 26.9% of taxpayers that currently go to hromada on the basis of where they work would go to different hromada because these taxpayers actually live and work in different places.

In short, the survey suggests that if PIT were allocated by where people actually reside, approximately 25% of all PIT would go to different hromadas than it goes to today. This is substantially less than the 40% that would be reallocated if PIT was simply sent to the hromada in which people are currently legally registered as living.  Nonetheless, this shift would be quite substantial for both the larger hromada that will lose revenues, as well as the smaller hromada that will gain them. But what the survey makes clear is that to ensure the efficiency and equity of the PIT sharing system, the allocating  PIT by place of residency must be accompanied by a comprehensive reform of the residence registration system.

3. Recommendations for Next Steps

Changing the system of PIT allocation to hromadas where taxpayers actually reside is the key to improving the system for equalising the tax capacity of LSGs. This approach is consistent with European practices, because it ensures that people can vote for the officials who spend their taxes and because it reduces the financial inequalities between them. But allocating PIT by place of residence also requires reform of the system used to register peoples legal addresses, something that cannot reasonably be done during the war. As such, it seems reasonable to suggest that the full implementation of such a reform will be possible after the war ends. However, it is currently necessary to adopt the appropriate legislative changes and develop plans for their implementation.

While the change in the PIT sharing system offers numerous benefits, it may also pose certain challenges for hromadas that currently rely on substantial revenues due to the concentration of employers in their jurisdiction. To avoid negative consequences for these hromadas, the reform should be phased in over time and accompanied by other reforms that would allow larger jurisdictions to compensate for some of their losses by mobilizing their own revenues. Analytically, the U-LEAD and POLARIS programs can use the survey data to generate better estimates of which types and sizes of hromada will gain or lose the most by shifting to a residency-based system of PIT allocation. And these estimates should help in determining whether the reform of the current system should be phased in over a few years and/or whether the reform should be accompanied by other compensatory measures.

The implementation of the PIT sharing reform must be accompanied by a reform of the residence registration system. Currently, over 15% of taxpayers do not reside in the municipality where they are legally registered. Having reliable data on where Ukrainians are actually living will be crucial not only for the PIT system reforming, but for the rational planning and allocation of funding for recovery and reconstruction.

The new tax allocation mechanism will provide an additional incentive for local governments to become more active in legalising the stay of residents on their territory. This will contribute to greater transparency in the taxation system and attract resources to local budgets. It is recommended that the government implement measures to streamline these processes, including the establishment of rigorous criteria for accessing public goods contingent upon the verifiable registration of residence.

The study highlighted the critical importance of ensuring complete and reliable information to support analytics, process monitoring, and decision-making. A key initial step is to complete the verification and update of registry data, particularly information on the registered or declared place of residence between the State Register of Individual Taxpayers, the Unified State Demographic Register, and the departmental information system of the State Migration Service.