Report No. 30741-RU Russia Fiscal Costs of Structural Reforms April 5, 2005 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank TABLE OF CONTENTS E X E C U T I V E SUMMARY ..................................................................................................... .xi Chapter 1. Principles o f Structural Reforms Financing....................................................... 1 A . Recent Fiscal Trends. 1998-2003 .................................................................................. 1 B. Fiscal Costs o f K e y Structural Reforms......................................................................... 5 C . Costs o f Structural Reforms: Examples o f Reforms in the C i v i l Service, Pension System, and Residential Housing .......................................................................................... 8 D. The Challenge o f Financing Structural Reforms: Can Fiscal Rules Help? .................13 E. Implications for Fiscal Policy ...................................................................................... 18 F. Conclusion ................................................................................................................... 22 Chapter 2 . Fiscal Costs o f C i v i l Service Reform in the Russian Federation..................... 25 A . Employment and Financing o f Core Govemment Administration and the Civilian Public Sector ........................................................................................................................ 25 B. C i v i l Service Reform Priorities and Progress to Date ................................................. 29 C . A Framework for the Assessment o f Reform Impact .................................................. 32 D. Data Sources and Key Assumptions ............................................................................ 35 E. C i v i l Service Reform Scenarios ................................................................................... 45 F. Outcomes o f C i v i l Service Reform in Light o f Cross-Country Comparisons ............. 50 G. Summary o f Simulations: Analysis o f Selected Reform Scenarios ............................. 51 H. Overview o f Risks Associated with Reform Implementation ..................................... 58 I. Conclusions and Recommendations ........................................................................... - 5 9 Chapter 3 . Fiscal Costs o f Reforms in the Housing and Utility Sector ............................. 65 A. Background .................................................................................................................. 65 B . Summary o f the Earlier Reform Efforts in the Housing and Utility Sector ................. 67 C. Govemment Involvement in Financing Residential Housing..................................... - 6 9 D. Recent trends in housing and utility tariffs .................................................................. 75 E. Aggregated costs structure in residential housing ....................................................... 77 F. Model for Simulating Budget Implications from Increases in Housing Costs ............ 80 G. Reform Scenarios Identified for Simulations ............................................................. -83 H. Assumptions o n Future Utility Costs ........................................................................... 86 I. M a i n Simulation Results.............................................................................................. 91 J. Simulations for Phasing out Housing Privileges (lgoty) .............................................. 98 K. Conclusions and Policy Recommendations ............................................................... 102 Chapter 4 . Implicit Fiscal Risks in the Russian Pension System .................................... 105 A. Introduction ................................................................................................................ 105 B. Background ................................................................................................................ 106 C. Reform Scenarios Identified for Simulations ............................................................ 112 D. M a i n Macroeconomic and Reform Assumptions ...................................................... 114 E. Demographic Assumptions ........................................................................................ 122 F. Simulation Results ..................................................................................................... 125 iii G. Summary and Conclusions ........................................................................................ 136 References .......................................................................................................................... 139 Annexes ............................................................................................................................. 145 Annex 2.1 Definitions on Civil Service Reform............................................................... 145 Annex 2.2 Categories o f Federal Civil Servants in the Russian Federation..................... 149 Annex 2.3 Classification o f Civil Servants Rewards ........................................................ 152 Annex 2.4 Intemational Public Sector Pay and Employment Data, 1996-2000" ............153 Annex 2.5 Assumption on Core Government Administration Attrition Rates ................. 155 Annex 2.6 Interpretation and Analysis o f Results: Impact o f Individual Factors ............157 Annex 3.1 Macroeconomic Framework Used for the Analysis o f Fiscal Costs o f Structural Reforms .............................................................................................................................. 171 Annex 3.2 M a i n Data Sources and Data Assumptions ..................................................... 173 Annex 4.1 Sensitivity Analysis For Pension Simulations ................................................ 177 Annex 4.2 Simulation Methodology ................................................................................. 180 Annex 4.3 M a i n simulation results for the pension reform analysis ................................ 183 Annex 4.4 Summary o f pension benefit r u l e s in the current system ................................ 199 LISTOF FIGURES Figure 1.1: Public Debt Projections .......................................................................................... 5 Figure 2.1 : Public Sector Employment in Selected OECD Countries and Transition Economies .......................................................................................................................... 28 Figure 2.2: Total Fiscal Costs o f Selected Scenarios .............................................................. 53 Figure 2.3: Fiscal Implications o f Scenario 20: Core Government Administration and Civilian Public Sector .............................................................................................................. 54 Figure 2.4: Fiscal Implications o f Civil Service Reform: Role o f Administrative Adjustments . .......................................................................................................................... 54 Figure 2.5: Total Fiscal Implications for Scenarios with the De-Linked Implementation o f Pay and Administrative Reform Components ......................................................................... 58 Figure 3.1 : Housing and Utility Costs to Consumers under Different Scenarios in 2006 ......-90 Figure 4.1: Trends in tax bases for unified social and personal incomes taxes, 2000-03, trillion rubles ........................................................................................................................ 110 Figure 4.2: GDP Growth by Scenario, Group 1.................................................................... 115 Figure 4.3 : Dynamics o f the Taxable Payroll Share in GDP, Group 1................................. 117 Figure 4.4: Real Growth in Taxable Wages, Group 1 Scenarios .......................................... 120 Figure 4.5: Economic Activity o f Population, Group 1 Scenarios ....................................... 121 Figure 4.6: Real Interest Rate, Group 1 Scenarios ................................................................ 121 Figure 4.7: System Dependence Ratio ................................................................................. 124 Figure 4.8: Pension Replacement Rate, Group 1 Scenarios ................................................. 125 Figure 4.9: UST Rate (Contribution Rate) Needed to Ensure the Replacement Rate o f 30 percent, Group 1 Scenarios .................................................................................................... 126 iv Figure 4.10: Ratio Between Average Pension and Pensioner’s Subsistence minimum. Group 1 Scenarios ........................................................................................................................ 126 Figure 4.1 1: Balance in the Base and N D C components o f the Pension System, Group 1 Scenarios ........................................................................................................................ 129 Figure 4.12: Pension Replacement Ration, Comparison in Scenarios Groups 1 and 2 ........131 Figure 4.13: Ratio Between Average Pension and Pensioner’s Subsistence minimum .......132 Figure 4.14: System Dependency Ratio, Comparison in Scenarios Groups 1 and 3 ............134 Figure 4.15: Pension Replacement Ratio, Comparison in Scenarios Groups 1 and .............135 Figure A2.1: Total Public Employment in the Russian Federation ...................................... 147 Figure A2.2: Civil Servants Rewards Classification ............................................................. 152 Figure A2.3: Sensitivity o f C i v i l Service Reform Costs to Real Wage Growth................... 157 Figure A2.4: Sensitivity o f C i v i l Service Reform Costs to Real Wage Growth (for Core Government Administration Only) ........................................................................................ 158 Figure A2.5: Total Fiscal Costs o f Civil Service Reform: Radical versus Moderate Pay Reform ........................................................................................................................ 159 Figure A2.6: Fiscal Costs o f C i v i l Service Reform: Radical versus Moderate Pay Reform 160 Figure A2.7: Fiscal Implications for Federal and Sub-Federal Budgets for Radical and Moderate Pay Reforms .......................................................................................................... 162 Figure A2.8: Internal Decompression in Federal Executive HQ-Based C i v i l Service: Radical versus Moderate Pay Adjustment .......................................................................................... 163 Figure A2.9: Internal Decompression in Federal Executive Civil Service: Radical versus Moderate Pay Adjustment...................................................................................................... 164 Figure A2.10: Distribution o f Total Fiscal Burden o f Civil Service Reform Scenarios, Depending upon Pay Reform Pace ........................................................................................ 165 Figure A2.11: Distribution o f Fiscal Burden o f Civil Service Reform Scenarios, Depending upon Pay Reform Pace........................................................................................................... 166 Figure A2.12: Total Fiscal Costs o f Civil Service Reform for Different Scenarios o f Administrative Reform Implementation., .............................................................................. 167 Figure A2.13: Fiscal Costs o f Civil Service Reform in Core Government Administration for Different Scenarios o f Administrative Reform Implementation ........................................... 168 Figure A2.14: Fiscal Costs o f Civil Service Reform in Core Government Administration: Dynamics o f Cash Compensation and Non-Wage Expenditure Increase for Different Administrative Reform Scenarios .......................................................................................... 168 Figure A2.15: Fiscal Costs o f C i v i l Service Reform in Core Government Administration for Different Scenarios o f Administrative Reform Implementation ........................................... 169 Figure A4.1: Indifference curves for the pension system: the ratio between the average pension and pensioner’s subsistence, 2030 ............................................................................ 178 Figure A4.2: Indifference curve for the pension system: compensatory relationship between an increase in the payroll share and cuts in the UST rate ...................................................... 178 V Figure A4.3: Indifference curve for the pension system: replacement ratio in the P A Y G system. 2030 ........................................................................................................................ 179 LISTOF TABLES Table 1.1: Expenditure Trends in Russia in 1997.2003. Enlarged Government Budget .......... 3 Table 1.2: Public debt sustainability estimates. Debt-to-GDP ratio. ........................................ -4 Table 1.3: Summary o f Incremental Annual Fiscal Costs for the Set o f Analyzed Fiscal Reforms .......................................................................................................................... 13 Table 1.4: Matrix o f the Proposed Fiscal Rules for Russia .................................................... 22 Table 2.1 : Structure o f Core Government Administration and Civilian Public Sector Employment in 2002 ................................................................................................................ 25 Table 2.2: Core Government Administration Employment in Russia in 1994-2002 ............. 26 Table 2.3: Structure o f Civil Service Employment in 200 1................................................... -27 Table 2.4: Cash Compensation and Non-Wage Expenditures on Core Government Administration and Civilian Public Employment in 2002 ....................................................... 29 Table 2.5: K e y Macroeconomic Assumptions ........................................................................ 37 Table 2.6: Estimated Public-Private Pay and Compensation Gaps, 2002 .............................. 39 Table 2.7: Civil Servants’ Perceptions: Expected Pay and Compensation Levels for Benchmark Positions in the Federal Civil Service .................................................................. 40 Table 2.8: Attrition Rates Expected in the Education Sector, 2001 ...................................... 43 Table 2.9: Assumption on Pay Reform Pace, Measured as a Share o f the Overall Planned Gap Covered .......................................................................................................................... 45 Table 2.10: Possible Scope o f Pay and Administrative Reforms ........................................... 47 Table 2.1 1: Description o f the Civil Service Reform Scenarios Included in Simulations .....48 Table 2.12: Fiscal Implications o f Civil Service Reform: Summary Results (Increase in Expenditures GDP, p.p. as compared to 2003) ........................................................................ 49 Table 2.13: Structure o f Expenditure Increase in Year 2010 for Selected Scenarios ............. 55 Table 2.14: Detailed Breakdown o f the Increase in Fiscal Costs o f C i v i l Service Reform ... 56 Table 2.15: Fiscal Implications o f More Radical Pay Adjustments for “Decision Makers” in Federal Executive C i v i l Service Headquarters as o f 2010 ....................................................... 57 Table 3.1: Structure o f Housing Financing .............................................................................. 69 Table 3.2: Financing ofthe Housing Sector ............................................................................ 70 Table 3.3: Cost Recovery and Collection Rates, 2000-02 ....................................................... 71 Table 3.4: Financial Indicators for the Housing and Utility Sector ......................................... 71 Table 3 -5: Average Household Expenditure on Housing and U t i l i t i e s .................................. 72 Table 3.6: Structure of Budget Spending on Housing and Utility Services to the Population (main programs of direct budget support) ............................................................................... 72 vi Table 3.7: Estimates for Total Fiscal and Quasi-fiscal Support to the Housing and Utility Sector in 2003 .......................................................................................................................... 75 Table 3.8: Total Volumes o f Available Financing in the Sector, 2003 ................................... 75 Table 3.9: Inflation and Price Growth in Housing and Utilities, 1998-2000 ........................... 76 Table 3.10: Estimates for the Effect o f “Deferred Inflation” in the H U S (non-energy part), 1997-2002 .......................................................................................................................... 77 Table 3.1 1: Cost Structure in the Housing and Utility Sector, per 1 Square Meter o f Residential Housing, as o f end 2002 ........................................................................................ 77 Table 3.12: Budget Expenditures on Utility Services Provided to Budget Organizations, by the Level o f Government ......................................................................................................... 79 Table 3.13: Macroeconomic Assumptions: Average GDP and Real Household Income Growth for 2004-06 ................................................................................................................. 83 Table 3.14: Scenarios for Housing and Utility Reforms, Selected for Simulations ................ 85 Table 3.15: Real Growth in Energy Tariffs for Households in 2006 Relative to 2002, Depending o n Scenario ............................................................................................................ 86 Table 3.16: Additional Growth in Residential Tariffs to Ensure the Elimination o f Cross- Subsidization .......................................................................................................................... 88 Table 3.17: Effect on Costs o f Efficiency Gains in Reform Scenarios .................................. 89 Table 3.18: Various Factors o f Growth in Unit Housing Costs, Accumulated Growth for the Period Relative to 2002 ............................................................................................................ 90 Table 3.19: Results o f Simulations for the Third Year o f Reforms: Status Quo Scenarios -- Slow Reforms in Housing and Utility Tariffs, N o Elimination o f lgoty ................................. 93 Table 3.20: Results o f Simulations for the Third Year o f Reforms: Scenarios with Advanced Reforms in Housing and Utility Tariffs, but without Elimination o f lgoty ............................. 97 Table 3.21: Results o f Simulations for the Third Year o f Reforms: Scenarios with the Advanced Reforms in Housing, Utility Tariffs, and the Elimination o f lgoty ...................... 101 Table 4.1 : Basic Parameters o f the Kussian Pension System, 1995 - 2002 .......................... 108 Table 4.2: Structure o f the total payroll ................................................................................ 109 Table 4.3 : M a i n preferential regimes for social insurance contributions, 9 months o f 2003 ..... ........................................................................................................................ 111 Table 4.4: Assumptions on Macroeconomic Parameters o f the Base Scenarios (Group I).. 115 Table 4.5: Additional Assumptions in Scenarios with Reduced UST Rates. (Group 11)...... 117 Table 4.6: Payroll Share in GDP o f Various Countries. Percent .......................................... 118 Table 4.7: Real Wage Growth in Various CEE Countries. 1995 2000. Percent ................ 120 - Table 4.8: Base Demographic Projections (scenarios from Group I-IV) ............................. 123 Table 4.9: System Dependency Ratio ................................................................................... 124 Table 4.10: Real pension as a percentage o f the average wage at the time o f retirement ..... 128 Table 4.1 1: Some results o f sensitivity analysis for 2030: equivalence table ....................... 132 Table 4.12: Potential impact o f an increase in immigration on the pension system ..............136 vii Table 4.13: Summary o f the simulation results for replacement rate and potential fiscal costs.. ........................................................................................................................ 137 Table A2.1: Federal Civil Servants in the Russian Federation . Categories in Accordance with the Current Legislation .................................................................................................. 149 Table A2.2: Tentative Classification o f Civil Service Positions in Accordance with the Draft New Legislation ..................................................................................................................... 151 Table A2.3: Significant Administrative Reform (Attrition Rates) ....................................... 155 Table A2.4: Fair Administrative Reform (Attrition Rates) .................................................. 155 Table A2.5: Assumption on Attrition Rates in Civilian Public Sector Employment Adjusted by Demographic Projections (2001- 2010) ........................................................................... 156 Table A2.6: Fiscal Costs o f C i v i l Service Reform for the Selected Scenarios ..................... 161 Table A2.7: Existing Pay Gap and Proposed Pay Increases in Federal Executive HQ-based Civil Service, times ................................................................................................................ 164 Table A3.1: Basic Data Used in Simulations and Related Assumptions............................... 173 Table A4.1: Total affordable replacement rate ...................................................................... 183 Table A4.2: Affordable average replacement rate in the pay-as-you-go pillar ..................... 184 Table A4.3 : Affordable average replacement rate in the fully funded pillar ......................... 185 Table A4.4: Overall affordable average replacement rate adjusted for the personal income tax ........................................................................................................................ 186 Table A4.5 : Real overall affordable replacement rate (replacement rate adjusted for the share o f informal wages in the total payroll) ................................................................................... 187 Table A4.6: Ratio o f the overall affordable average pension to the minimum subsistence level ........................................................................................................................ 188 Table A4.7: Additional funding needed to maintain the replacement rate at 30% ................189 Table A4.8: Average replacement rate in the pay-as-you-go system if the pension indexation rules remain to be based on the currently effective legislation.............................................. 190 Table A4.9: Balance o f the base pension component ............................................................ 191 Table A4.10: Balance o f the N D C pension component......................................................... 192 Table A4.11: Overall balance of the P A Y G pension (base+NDC) ....................................... 193 Table A4.12: GDP growth rate .............................................................................................. 194 Table A4.13 : Real annual growth in taxable wage (reflecting decline in shadow wages) ....195 Table A4.14: Share of Taxable Payroll in GDP .................................................................... 196 Table A4.15: System Dependency Ratio (ratio o f pensioners and employed) ..................... 197 Table A4.16: Tax rates for pension contributions to the N D C and fully funded components, depending on income and age, as percent of annual personal income .................................. 200 ... Vlll ACKNOWLEDGMENTS This report was prepared in response to a request from the Ministry o f Finance o f the Russian Federation. I t was produced by the joint team led by Lev Freinkman and included the staff o f the World Bank and several Russian think tanks. Chapter 1 was prepared by Alexander Morozov (ECSPE) and Lev Freinkman (ECSPE). Lorenzo Figliuoli and Antonio Spilmbergo (both IMF) provided useful comments on the earlier draft o f the Chapter. Chapter 2 was prepared by Yelena Dobrolyubova (ECSPE) and Lev Freinkman (ECSPE). Nikolay Klishch (Consultant) prepared a background paper on the policy implications and risks associated with the implementation o f public administration reform. The team i s grateful for the comments and suggestions received from Andrey Klimenko, John Litwack (ECSPE), and N e i l Parison (ECSPE). The Chapter also benefited from the discussions with Mr. Dmitriev, First Deputy Minister for Economic Development and Trade, Mr. Sharov, Head o f Department for State Regulation in Economy, Ministry for Economic Development and Trade, Mr. Petrov, Head o f Civil Service Department, Ministry o f Labor and Social Development, and Ms. Lamm, Head o f Financing o f the Government Apparatus, Ministry o f Finance, as well as other government officials. The earlier draft o f the Chapter was discussed at the seminar at the Higher School o f Economics and the Moscow State University. Comments presented by John Langenbrunner, Tatiana Loginova, and Mary Canning (all ECSHD) were very useful for preparation o f the report. The team i s also grateful to Ms. Daria Kononova, Department for Macroeconomic Forecasting, Ministry for Economic Development and Trade, for her suggestions on the draft report. Chapter 3 was prepared by Lev Freinkman (ECSPE), Sergei Sivaev (Institute o f Urban Economy (IUE), Moscow), Alexei Rodionov (IUE), and Irina Starodubrovskaya (Institute o f Economy in Transition). The team also benefited from advice and suggestions by Alexander Puzanov (IUE), Anastasia Alexandrova (WE) and Emin Askerov (WE). Comments and advice were provided by Arvo Kuddo (ECSHD), Peter Ellis (ECSIE), Ellen Hamilton (ECSIE), Peter Thomson (ECSIE), and Ruslan Yemtsov (ECSPE). Chapter 4 was prepared by Lev Freinkman (ECSPE) and Dmitri Pomazkin (Consultant) with contributions from Saeed Batkibekov and Pavel Trounin (Institute o f Economy in Transition (IET), Moscow). The background paper on eligibility rules under the existing special regimes o f pension contributions was prepared by Ekaterina Bolshakova (IET). Pavel Kadotchnikov (IET) helped with the development o f macroeconomic assumptions. The earlier draft of the Chapter was discussed at the seminar held at the IET, chaired by Dr Yegor Gaidar. The team also benefited from discussions with Mr. Karagodin, Department Director for Social Policy in the Ministry o f Economy and Trade, and his staff. Helpful comments and suggestions were provided by Olga Antimonova (ECSPE), Anton Dobronogov (SASFP), Anita Schwarz (ECSHD), Hermann V o n Gersdorff (ECSHD), and Ruslan Yemtsov (ECSPE). Olga Antimonova also assisted with assembling international data. Usha Rani Khanna and Emily Evershed assisted with editing the report and Anna Bazanova, Irina Partola, and Judy Wiltshire provided excellent support during the entire preparation process. The Ministry o f Finance and the State Committee for Statistics o f the Russian Federation provided considerable assistance with the data for the report. Deborah Wetzel and Asad Alam were the Sector Managers, and Cheryl Gray was the Department Director. Kristalina Georgieva was the Country Director for Russia. Thomas Blatt Laursen (ECSPE), Goohoon K w o n (IMF), and Pedro Alba (AFC13) were the Peer Reviewers. The team i s grateful to the participants o f the two seminars in Moscow, held in February o f 2005 respectively in the Center for Strategic Research and Moscow office o f Camegie Endowement, for comments and suggestions made o n the preliminary version o f this report. xii EXECUTIVE SUMMARY 1. This Report discusses the challenge o f budget financing o f core structural reforms within a broader framework o f fiscal management reforms in Russia. I t argues that explicit financing o f structural reforms i s fully justifiable because these are the investments in the institutional infrastructure with a high rate o f return. In addition, Russia currently appears to have a fiscal room for some incremental spending. However, the number o f simultaneous reform initiatives should be kept limited to ensure that the accumulation o f new liabilities do not undermine fiscal sustainability. In addition, the Government’s commitment to explicit reform financing should be accompanied by additional steps in strengthening the fiscal management system. The adoption o f formal fiscal rules could strengthen the government’s ability to manage external shocks, as well as provide budget support for the reform process in a predictable and affordable way. 2. The Report develops estimates for fiscal costs o f three key structural reforms (in civil service, housing and the pension system), reviews the feasibility o f different reform options, and provides recommendations related to their planning and sequencing. For each o f the structural reforms the Report discusses various scenarios, which altogether cover a broad range o f possible options for the Government with quite different fiscal implications. The models used for the preparation o f this Report represent an easily adaptable tool that government agencies can use to develop their own fiscal cost projections for alternative reform scenarios. 3. The Report treats the key structural reforms as medium-term projects/programs, thus suggesting that implementation o f these and other structural reforms can be put in the context o f medium-term expenditure framework (MTEF) that evolve in Russia. Thus, the proposed approach to fiscal costing o f the reforms i s in full concord with the recent Government’s initiatives o n introducing strategic planning, MTEF, and elements o f performance budgeting. Fiscal Costs of Civil Service Reforms 4. The report develops a general framework for costing-out the direct fiscal effects o f various reforms in the area o f public administration. I t suggests that broad reforms in the core government administration and in the civilian public sector at large may be implemented within five to seven years but should be differentiated by the scope o f pay adjustment in various sub-sectors o f civilian employment, closely monitored for non-wage expenditure growth, and complemented by significant staffing adjustments in the civilian public sector as well as by at least some staff reductions in the core government administration. 5. Implementation o f such reforms would require additional budget financing as compared to the 2003 expenditure levels, but fiscal costs could be sustained within a reasonable range. Under the most realistic set o f assumptions, incremental costs for a consolidated budget would amount to 1.2-2.3 percentage points o f GDP by the end o f the reforms as compared to 2003. Moreover, about two-thirds o f this increase has already been incorporated into the 2004 budget, reflecting the pay adjustments in the core government administration and the civilian public sector introduced in late 2003. Such additional financing would provide for a major reduction in the pay gap between the public and private sector, especially for senior government officials. 6. A more detailed analysis o f the incremental fiscal costs suggests that the costs to the federal budget would amount to about 40-45 percent o f the total cost increase, while the rest would become the responsibility o f subnational budgets. 7. While additional spending on public administration i s necessary to ensure better quality o f policymaking and public service delivery in the country, it i s not sufficient. Successful implementation o f the budget process reform, introduction o f performance budgeting, and creating incentives for better performance in the public sector would also be needed. 8. A significant adjustment in employment levels i s critical to make the civil service reform sustainable. Even moderate pay adjustments undertaken without a cut in staffing would make the reform fiscally unaffordable. I t i s expected that by 20 10 average employment in the civilian public sector would decline by about 25 percent. Making the Russian government leaner also seems to be consistent with the implications o f the existing demographic trends. Fiscal Costs of Reforms in Housing and Communal Sewices 9. The report analyzes the potential fiscal and social impact o f advancing cost-recovery increases in the housing and utility sector (HUS) under different scenarios. I t argues that in the current environment o f high growth in household incomes, by 2006 i t would be possible to attain 100 percent cost recovery in tariffs with the simultaneous elimination o f all quasi- fiscal cross-subsidization and the adjustment in domestic energy prices. Moreover, the reforms in residential housing could be made budget neutral in the medium term and they would bring considerable savings in the long term. However, the high sensitivity o f results to income dynamics suggests that the Government should establish an efficient monitoring system to track the affordability o f tariff increases for the population. The Report also emphasizes the restructuring o f financing mechanisms in the sector to ensure a higher degree o f accountability o f both municipal governments and service providers. 10. The baseline reform scenario suggests that as a result o f proposed reforms the real unit cost to households in the H U S would increase by about 90 percent relative to the prevailing 2002 level. However, given the tariff adjustments that already took place in 2003- 04, it i s expected that future cost increases would be limited o n average to about 40 percent relative to their levels at the end o f 2004. 11. An increase in energy and utility tariffs would make the delivery o f utility services to budget organizations more expensive by about 0.7-0.8 percent o f GDP per annum. Some o f these costs could be compensated through increased taxation o f energy and utility providers and, later on, through rationalization o f the public sector. However, in the medium term, a fiscal gap in public sector financing o f 0.4 percent o f GDP could emerge as a result o f tariff increases in H U S and energy. 12. The analysis suggests that elimination o f housing privileges could be affordable for most o f the current lgoty recipients, while the housing allowance program would be capable o f taking care o f those who face a high housing cost burden. However, given the political sensitivity o f entitlement reforms, there may be a case for reforming lgoty in a more gradual way. As a starting point, the Government should monetize the lgoty to transform them into explicit subsidies and link them directly with the system o f personal social accounts. Moreover, to reduce political costs, phasing out lgoty should be coordinated with other xii structural reforms, including wage increases in the public sector, and increases in pensions and child benefits. Costs of Pension Reforms 13. Estimates o f potential fiscal costs associated with various developments in Russia’s pension system are based on a comprehensive actuarial model. The report points out that such fiscal costs are likely to emerge as a result o f the declining relative value o f old age pensions and associated political pressures for budget support to the pension system. Without additional reforms, the existing pension system, even under the most optimistic assumptions, i s not capable of closing the growing gap between growth in wages and pensions. In the baseline “without the reforms” scenario, the average replacement rate declines from 33 percent in 2002 to 24.4-27.8 percent in 2030. Moreover, the proposed cuts in contribution rates would result in a hrther decline in the replacement rate relative to the baseline. To avoid a drastic widening in the gap between wages and pensions, a reduction in contribution rates has to be supplemented by additional reforms, including a decision o n a gradual increase in the retirement age. 14. In the baseline scenarios, the annual fiscal costs to the government, associated with the need to address the problems accumulated in the pension system, amount to 0.25-0.55 percent o f GDP in 2020 and to 0.55-0.90 percent o f GDP in 2030. These costs are measured against a target o f maintaining the replacement rate at 30 percent. However, the potential costs would increase rapidly in all scenarios with the reduced contribution rates. In the l o w case, the annual costs to the budget would exceed 2 percent o f GDP in 2030. 15. The analysis also suggests that trends in the share o f the taxable payroll in GDP play a critical role in determining the future results o f the pension reform. T h i s highlights the importance o f policies aimed at stabilizing payroll and income taxation, as well as at the removal o f various administrative barriers in the economy that currently hold back the reduction o f shadow incomes and wages. Conclusion 16. The current improved economic and fiscal situation in Russia provides a unique opportunity to policymakers to undertake key structural reforms, which have a high payoff in terms o f future growth and economic and social stability. Structural reforms in public administration, housing and utility services, and pension system are affordable if planned properly and sequenced in the context o f a rule-based fiscal management framework. ... Xlll Chapter 1. PRINCIPLES OF STRUCTURAL REFORMS FINANCING 1.1 This Chapter discusses recent fiscal trends and the challenge o f budget financing o f core structural reforms within a broader framework o f fiscal management reforms in Russia, I t argues that explicit financing o f structural reforms i s fully justifiable because these are the investments in the institutional infrastructure with a high rate o f return. In addition, at the moment Russia appears to have a fiscal room for some incremental spending. However, the number o f simultaneous reform initiatives should be kept rather limited to ensure that the accumulation o f new liabilities do not undermine fiscal sustainability. In addition, government’s commitment for explicit reform financing should be accompanied by additional steps in strengthening the fiscal management system. In this context, the Chapter suggests fiscal rules for Russia that could strengthen government ability to manage external shocks, as well as provide budget support for the reform process in a predictable way. In that respect, the fiscal rules may help in elaborating a mechanism for the medium-term financial planning stipulated, among other budget process reform measures, by the Government Resolution No.249 o f M a y 22, 2004. The Chapter also summarizes the estimates for fiscal costs o f reforms in civil service, housing and pension system, which are analyzed in a greater detail in the following chapters. 1.2 The World Bank has a long and extensive history o f public expenditure analysis in Russia. I t has been following the policy o f preparing focused analytical pieces on specific priority topics in the area o f expenditure management rather than trying t o cover all public expenditure issues in one report. Responding to changes in the macroeconomic and fiscal environment, the Bank naturally shifted i t s focus from the fiscal sustainability analysis (World Bank, 1996a and 1998c) and general diagnostics o f fiscal management system in Russia (World Bank, 1996b) to more narrow and more technical issues, such as quasi-fiscal subsidies and non-cash operations (World Bank, 2000) and analysis o f the public investment program (World Bank, 2001). Experience showed that for the Bank this i s the most productive and client-oriented way o f contributing to the reforms in expenditure management in Russia. The present report continues this practice by looking at fiscal aspects o f structural reform implementation in Russia. A. FISCAL RECENT TRENDS, 1998-2003 1.3 Since the 1998 crisis, Russia’s macroeconomic performance has improved considerably. The cumulative GDP growth during 1999-2003 reached 3 8 percent. Solid economic growth contributed to the growth in budget revenues and allowed Russia to substantially improve i t s fiscal performance. Starting in 2000, federal and enlarged budgets have been executed with a surplus. This brought the public debt down t o 28 percent o f GDP by the end o f 2003 from 85 percent at the end o f 1999. The problems o f non-cash budget execution, pension and wage arrears in the budget sector have been successfully solved. 1.4 Revenues o f general government recovered to the steady level o f 36.5-37.6 percent o f GDP in 2000-03 after a sharp decline to 33.6 percent in 1999 from 39.3 percent in 1997. Federal budget revenues grew markedly to 16.7-17.8 percent o f GDP in 2001-03 from the pre- crisis level o f 12.5 percent, helped by the centralization o f tax revenues and the progressive taxation o f the o i l windfall. At the same time, the non-oil federal budget revenues declined to an estimated 10.5 percent o f GDP in 2003 from 12.3 percent in 2001, while the o i l revenues were on the rise along with o i l prices (IMF, 2003 and 2004). As a result, the federal budget’s dependence on o i l prices increased significantly. The share o f i t s o i l revenues grew from 45 percent o f the total in 2001 to 59 percent in 2003. 1.5 Indeed, a more thorough analysis reveals that both the GDP and budget revenues were propelled largely by the high world prices o f crude o i l - Russia’s main export commodity. It i s estimated that almost 80 percent o f the incremental increase in general budget revenues was oil-factor driven, including spillover effects on the gas and other sectors (Kwon, 2004). Two developments played a major role here. First, with o i l prices standing high, o i l and gas companies increased their sales and profits and started making relatively more tax payments to the budget. Second, the tax legislation has changed in a way that has increased the o i l price elasticity o f tax payments in the sector. The most important changes have included the increased progressiveness o f o i l export duties and the introduction o f a linear relationship between o i l prices and the statutory rate o f the tax on the extraction o f mineral resources in the o i l sector. Both taxes are paid mainly to the federal budget, making it very sensitive to changes in o i l prices: In the present price range, every dollar-per-barrel change in o i l prices increases or decreases the enlarged budget revenues by 0.45 percent o f GDP, out o f which the share o f federal budget i s three-quarters. 1.6 Since 1998, there have also been considerable developments on the expenditure side o f the budget, which point to both the large fluctuations in and the pro-cyclicality o f budget expenditures (see Table 1.1). After the initial decline to 29.0 percent o f GDP in 2000 from 43.7 percent in 1997, the enlarged budget non-interest expenditures recovered by 5.6 percentage points o f GDP in just two years (2001-02) and reached 34.4 percent o f GDP. The increase in total budget expenditures was less pronounced since GDP growth and the policy o f budget surpluses helped to reduce both the stock o f public debt and the size o f annual interest payments. 1.7 The social expenditures o f the enlarged budget (Le., expenditures on education, health, and social protection) have had a clear pro-cyclical pattem in the past. They experienced the largest reduction (by more than 50 percent in real terms) during the post-1998 fiscal consolidation, which was followed by a strong increase thereafter. Within social expenditures the after-the-crisis recovery largely financed the growth o f recurrent expenditures, such as wages, pensions, etc. Inter alia, this also included the financing o f increased staffing levels in the civil service and budget sectors (such as health) at the subnational level (World Bank, 2003b). Apparently, recurrent expenditures on wages in the public sector atld household social benefits are those which would be the most difficult to compress politically should a fiscal adjustment be required if and when budget revenues fall together with o i l prices. 1.8 Non-social non-interest expenditures demonstrated less, but s t i l l some, pro-cyclicality. Responding to the 1998 crisis, they f e l l to 14.4 percent o f GDP in 1999 from 19.0 percent in 1997. Expenditure rationalization made by the government resulted in their further decline to 13.9 percent o f GDP in 2001 before growing to 14.7 percent in 2002, presumably on the wave o f the oil windfall spending and general fiscal policy relaxation. In 2003 the government managed to reduce these spending somewhat in relative terms to 14.4 percent o f GDP. 1.9 While most o f the non-interest non-social expenditures behaved pro-cyclically, some o f them did not. More specifically, expenditures on agriculture, liquidation o f emergencies and natural calamities, and state industrial funds have declined in percent o f GDP terms since 2000. In this way these expenditure cuts smoothed the pro-cyclicality o f overall non-social budget expenditures. 2 Table 1.1: Expenditure Trends in Russia in 1997-2003, Enlarged Government Budget, (Percent o f GDP) Expenditure Category 1997 1998 1999 2000 2001 2002 2003 Total Non-InterestExpenditures 43.7 36.3 29.9 29 30.7 34.4 32.1 I. Total Social Expenditures 24.7 10.8 15.6 14.5 16.9 19.7 17.6 1. Education 4.8 3.6 3 2.8 3.1 3.9 3.6 2. Health 3.6 3.4 2.9 2.8 2.9 3.2 3.0 3. Social Protection 11.5 10.1 7.5 6.9 8.7 10.3 9.1 4. Housing and Communal Services 4.8 3.7 2.2 2.1 2.2 2.4 1.9 11. Total "on-Social' Expenditures 19.0 15.5 14.4 14.5 13.9 14.7 14.4 1. General Public Services 7.5 6.4 6.5 6.0 6.5 7.1 6.9 2. Public Investment/Subsidies to 2.2 0.9 0.9 0.8 1.7 2.2 2.5 Industry and SMEs 3, TransportlRoads/Communications/ 1.o 0.7 0.5 0.5 0.7 0.5 0.3 Informatics 4. State Road and Industrial Funds 2.7 2.9 3.1 3.8 2.1 2.1 1.9 5. Agriculture/Fishing 1.3 0.9 0.7 0.7 0.8 0.6 0.5 6. Environment/Hydromet./Geodesy 0.2 0.1 0.1 0.1 0.1 0.2 0.1 7. Culture, Arts, and Mass-Media 0.7 0.5 0.5 0.6 0.6 0.7 0.6 8. Science 0.6 0.3 0.3 0.3 0.3 0.3 0.4 9. Emergencies and Liquidation o f 0.3 0.3 0.2 0.2 0.1 0.1 0.1 Natural Calamities 10. Other Expenditures 2.5 2.4 1.5 1.4 0.9 0.9 1.o Sources: MoF, Rosstat, Staff calculations. 1.10 As one would expect, among the items o f functional classification, budget spending o n both public investment and subsidies to industrial producers (net o f subsidies to SMEs) proved to be the most pro-cyclical expenditure category. These spendings f e l l more than threefold in 1997-99 -- from 2.1 percent o f GDP to 0.6 percent. They then increased to 2.5 percent o f GDP in 2003. This was the only broad expenditure category that exceeded i t s relative (as a percent o f GDP) pre-crisis level. Medium-term fiscal prospects and debt sustainability 1.11 The fiscal surpluses o f the general government recorded since 2000 have drastically improved Russia's debt profile and have practically eliminated the debt sustainability problem that was a major macroeconomic and fiscal problem for Russia in the 1990s (Figure 1.1). Recent analysis o f Russia's debt sustainability suggests that trends in the total public debt should be easily manageable under a broad set o f possible scenarios (IMF, 2003). Under the baseline scenario, it i s expected that the average primary surplus o f the general government would amount to 1 percent o f GDP in 2007-09, while the average primary balance o f the federal government would amount to 1.7 percent. This i s under the assumption o f average GDP growth o f 5 percent, external debt interest rate o f 5 percent, and a considerable slowdown in ruble real appreciation after 2006. 1.12 Even in the low-case scenario the debt would stabilize at a level below 30 percent o f GDP. In addition, stress tests showed that under the most gloomy macroeconomic assumptions (such as high external interest rates, a significant fall in GDP, considerable 3 depreciation of the ruble) the debt dynamics, measured by the public debt-to-GDP ratio, would deteriorate only temporary, and would s t i l l remain under control in the longer term (See Table 1.2). Moreover, since early 2004, when the most recent analysis was carried out, skyrocketing o i l prices have made the public debt profile in Russia even stronger, making public debt sustainability o f even lesser concern. 1.13 However, Russia remains highly vulnerable to external shocks associated with o i l prices. Should o i l prices drop significantly and remain at the l o w level, a sizable adjustment in exchange rate and fiscal policy would be required. In addition, short-term liquidity crunches caused by adverse o i l price shocks could lead to substantially lower G D P growth rates (IMF, 2004). Also the sustainability o f the country’s total external debt i s o f somewhat more concern, taking into account a rapid accumulation o f foreign debts by the private sector. Significant ruble depreciation could lift the total external debt to an unsustainable level. 1.14 Notably, the public debt sustainability does not mean that Russia does not have any problems in the area o f debt management. M a n y O E C D countries chose their longer term debt targets at the levels that are considerably below their debt sustainability thresholds. It i s assumed that even sustainable debt dynamics might be detrimental for the economic growth if the debt level i s relatively high.’ Various studies estimated that the optimal debt level for individual G 7 countries falls in the range o f below 20 to 50 percent o f GDP.’ Clearly, for less developed countries, such as Russia, the optimal debt level should be lower than in the G 7 countries, owing to higher country risk premiums, a higher share o f hard currency debts in the debt structure, and the lesser efficiency o f the public sector. Tahle 1.2: Puhlic deht sustainahilitv estimates. Deht-to-GDP ratio. oercent 1998 2000 2003 2004 2006 2009 Baseline 144.4 64.8 33.3 29.2 21.7 15.7 Stress tests: 1. High interest rate (In 04-05: 2 stand deviations above the hist average) 37.6 37.8 30.3 2. Lower GDP growth (In 04-05: 2 stand deviations below the hist average) 34.9 37.2 24.0 3. Larger primary deficit (In 04-05: 2 stand deviations above the hist average) 42.2 44.7 36.6 4. Simultaneous shocks (joint shocks 1-3, using 1 stand deviation) 43.6 42.9 22.9 5. Ruble depreciation (one time 30% real depreciation in 2004) 44.6 35.5 28.2 Source: IMF (2004). ’ Balls and O’Donnell (2001, pp.174-175) offer a discussion o f the concept o f debt optimality as an alternative to the conventional view o f debt sustainability. ’ Ibid. 4 Figure 1.1. Public Debt Projections , (In percent o f GDP) A I 100 Proiections 80 no 70 60 50 40 30 20 10 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: IMF (2004). B. FISCAL COSTS OF K E Y STRUCTURAL REFORMS 1.15 In spite o f the significant progress achieved in building market economy during the 1990s and early 2000s, Russia s t i l l needs to accomplish a number o f structural reforms, which would advance the development o f i t s market institutions and level up the public sector efficiency. The implementation o f structural reforms usually requires budget financing and can be rather costly. Depending o n the specifics o f a particular reform, these costs may be o f a temporary or permanent nature. From a fiscal viewpoint, launching a structural reform represents incremental, irregular spending with stronger or weaker feedback to regular expenditures. This issue i s o f paramount importance for Russia, which i s committed to carrying out multiple structural reforms simultaneously. 1.16 All structural reforms can be divided into three groups by the fiscal costs they incur. The first group consists o f those reforms that require only initial one-off financing for a limited time period or those that, with time, generate budget savings that offset their fiscal costs if the latter are o f a permanent nature. Examples include the elements o f both education reform and pension reform. In particular, a switch to the system o f unitary state exams (USE) for high school graduates requires investment in the institutional infrastructure for these exams, expenditures o n pilots, and the like. Once it becomes operational, the USE would replace the current system o f university entry exams that i s presently administered by individual universities. The annual costs o f undertakingthe USE would be offset by savings in the costs o f university admission. In pension reform, establishing a fully funded pillar gives rise to a fiscal gap in the pay-as-you-go part o f the pension system a few years down the road, which will disappear when the funded pillar starts to co-finance pension benefits. However, in the meantime, either the temporary medium-term fiscal gap in the pension system will have to be financed from the budget, or the real value o f benefits to the current pensioners will be lower in real terms than for both the preceding and the following generations o f pensioners. 1.17 There are two important specific sub-groups o f reform initiatives that could be identified within this f i r s t group o f reforms: e Structural reforms to be implemented at the subnational level, the early implementation o f which could be unattractive for regional leaders (e.g., because o f their perception o f additional political risks). Under the circumstances, the federal government could be interested in establishing a special support mechanism to provide fiscal and administrative incentives to regions that are ready to pilot specific regional reforms. The recent quite successful experience with the Federal 5 Fund for Regional Fiscal Reforms (FFRFR) provides a possible model for the organization o f such a federal support mechanism. It i s worth emphasizing that, even in cases where the reforms themselves may not lead to additional fiscal costs (as in the case o f reforms in residential housing), some modest costs for the federal government could arise from a need to establish a proper incentive framework for launching reform pilots in the regions. This relates primarily to the sectors that are primary responsibility o f subnational governments. Reforms to promote new private sector institutions, currently missing in Russia, which could generate considerable long-term externalities. One-time public investments in such institution building could reduce the future costs o f market entry for private operators. Examples o f such missing or severely under-developed institutions include entities that would provide student loans and venture fund industry. The govemment’s co-financing o f such institutional pilots could take the form o f either co-investments or guarantees for private investors against non- commercial risks. 1.18 The second group comprises reforms that demand a permanent increase in financing, while potential budget savings are not sufficient to cover their costs, even in the long term. C i v i l service reform i s one example o f such a reform. As estimated in Chapter 2, i t would cost the budget 0.9-1.3 percent o f GDP annually, o f which 0.5-0.7 percent would be the costs to the federal budget. These permanent additional spendings are needed to make salaries in the c i v i l service compatible with those in the private sector, as well as to increase non-wage costs in the c i v i l service (such as on training and retraining, office equipment and telecommunications, etc.). Without this, it would be difficult to ensure a drastic improvement in the efficiency o f the civil service in Russia. 1.19 Structural reforms belonging to the third group are those that generate expenditure savings without any substantial fiscal costs for the budget. Housing reform appears to be an example o f such a reform. Phasing out producer subsidies in the housing and communal services sectors and phasing in the targeted subsidies to poor families would generate substantial net budget savings, as experience has shown. In addition, potentially massive outflows from the budget to rehabilitate the communal infrastructure could be minimized. A system o f performance management contracts, leasing, and utility concessions can make i t profitable and attractive for private companies to invest in the communal infrastructure, which would remove this burden from the budget. 1.20 The financing o f structural reforms belonging to the first group could come from the two possible sources: (i)general budget revenues, and (ii) government borrowing. This would give rise to a temporary deficit for a budget recalculated at the long-term average o i l prices, which i s discussed below in this Chapter. Structural reforms belonging to the second group should be largely financed through compensatory policies such as: (i) savings o n other, less efficient, expenditures, (ii) savings achieved during the implementation o f the third group o f structural reforms, and ( iii)revenues from additional taxes. In this case, incremental expenditures and the compensatory increase in taxes could be justified by the expected reform gains - namely, the growing efficiency o f the public sector, including the provision o f better quality public services. However, i t i s likely that the financing o f these structural reforms through compensatory policies will become available with a delay, because some time w i l l be needed for the development and implementation o f such policies. Therefore, in this case an o i l price adjusted budget deficit may emerge as well, but it should gradually be phased out with the help o f compensatory policies. 6 1.21 From the institutional viewpoint, it seems appropriate to record and monitor budget resources channeled to finance the implementation o f structural reforms. For that purpose, corresponding program spendings could be analytically consolidated as structural reform funding in the federal budget. Following provisions o f the Concept o f the Budget Process Reform, approved by the Government in M a y o f 2004, such reform spendings would become a part of the ‘new expenditure commitments’ budget. This approach would enable the government to control the overall size o f such a virtual ‘fund’ dedicated to reform financing in line with i t s general principles o f fiscal policy (see more on this subject below in this Chapter). 1.22 I t follows that the existing Federal Fund for Regional Fiscal Reforms (FFRFR) or a similar facility should become one o f the components within such a broader category o f reform spending, along with the resources raised as loans from the IFIs that aim at the acceleration o f subnational reforms. As discussed earlier, a FFRFR-type facility would provide partial financing for subnational reforms within the f i r s t group o f reforms. 1.23 The issue o f costing structural reforms i s not absolutely new for Russia. The government i t s e l f estimated foregone revenues or costs o f some structural reforms (e.g. tax reform and pension reform). Yet, this work has never been done systematically and put in a proper fiscal framework, which would allow comparing different reform scenarios and different structural reforms and provide proper links between the costs o f reforms and the overall budget process. In addition, the earlier research in this area government (including the most advanced analytical exercise to date undertaken by the Expert Institute (Yasin, 2003)) relied mostly o n rough expert estimates. The present report suggests a much more rigorous multi-factor approach and models, which allow (i) tracking expenditure changes at the disaggregated level for every specific structural r e f o m , and ( ii)presenting and estimating multiple reform scenarios. 1.24 Yasin (2003) analyzed risks associated with the unfinished structural reform agenda in Russia for the country’s longer-term growth prospects. H e argues that l o w gas and energy prices, together with l o w salaries, are the fundamental barriers for raising competitiveness in Russian manufacturing. Depressed prices for production inputs are not conducive to the development o f domestic industries as they destroy incentives to save energy and raise productivity. H e develops a detailed argument to support two fundamental claims: 0 acceleration o f structural reforms in energy and housing sectors, as well as related measures in the areas o f wage policy and social security i s the core policy challenge for the Russian government; 0 there reforms are closely inter-related and should be advanced in parallel within the single financial framework, where higher domestic energy prices would bring additional taxes to pay higher pensions, social benefits and wages in the public sector. 1.25 Yasin’s paper also develops some aggregate estimates for the above mentioned financial framework within the 3-year time horizon, which are based on specific assumptions o n expected increases in domestic energy prices, housing costs, as well as wage and pension levels. In our report we intend to advance this work further, including through a generation o f more accurate set o f estimates o n potential costs o f particular structural reforms within this single framework under different sets o f assumptions. 1.26 The specific choice o f the key structural reforms analyzed in this report-public administration, housing and communal services, and pensions-was determined by the 7 Russian Ministry o f Finance in consultation with the World Bank team. This choice reflects both the importance o f these particular reforms for the medium term government program, as well as perceived scale o f potential fiscal implications in case if these critical reforms are mishandled. c. COSTS OF STRUCTURAL REFORMS: EXAMPLES OF REFORMS IN THE CIVIL SERVICE, PENSION SYSTEM, AND RESIDENTIAL HOUSING 1.27 This section summarizes the results o f the simulation o f the individual structural reforms that were developed in this report for three specific sectors, such as the c i v i l service, the pension system, and residential housing. The remaining Chapters o f the report present a full description o f the respective results, including the assumptions, data and models used in the analysis. Reforms in the civil service 1.28 The Russian government considers the implementation o f the comprehensive civil service reform as one o f the key priorities in the mid-term reform agenda. The objective o f Chapter 2 o f the report i s to help the government with the planning and sequencing o f i t s reform effort by (i)developing a general framework for costing-out the direct fiscal effects o f various reforms in the area o f public administration, ( ii) using this framework for generating consolidated estimates for the incremental fiscal costs o f specific reform scenarios, and ( iii ) developing recommendations o n the feasibility o f different reform options. 1.29 The Chapter presents more than 40 different reform scenarios as well as the potential results o f their step-by-step implementation through the period 2004-1 0. The scenarios differ considerably in terms o f the pace and scope o f relative pay increases in the public sector, the scope and pace o f attrition, changes in the share o f non-wage costs, etc. In addition, the Chapter analyzes the sensitivity o f potential reform costs to changes in the basic macroeconomic parameters. I t identifies the future growth rate in private sector wages as the most important macroeconomic factor: the higher the wage growth in the private sector is, the more expensive it would be for the government to close the existing pay gap. 1.30 Overall, the results o f the simulations show that the reform may be implemented without a significant increase in overall fiscal costs. The Chapter argues that a fiscally affordable reform should be based o n moderate pay adjustment and should assume significant staff reductions in the core government administration, and especially in the civilian public sector. Under the most realistic set o f assumptions, the incremental costs for the consolidated budget would amount to 1.2-2.3 percentage points o f GDP by the end o f the reform (depending on the macroeconomic scenario) as compared to 2003. These costs do not look prohibitively high when considered in the international context. Moreover, about two-thirds o f this increase has already been incorporated into the 2004 budget, reflecting the pay adjustments in the core government administration and the civilian public sector introduced in late 2003. At the same time, the remaining one-third o f the total reform costs must be added to ensure full financing. 1.3 1 The Chapter also argues that the future reform package should not be applied to the core government administration only, but should cover the entire civilian public sector. Otherwise, politically it would be quite difficult for the government to sustain a drastic increase in the compensation gap between the civil servants and the rest o f the public sector 8 employees. Moreover, our modeling suggests that the expected fiscal gains from more aggressive staff attrition in the civilian public sector would help to finance a portion o f the costs related to the implementation o f c i v i l service reform in the core government administration. At the same time, it seems desirable to synchronize primary components o f the reform, such as pay and staffing adjustments. Such synchronization would allow the stabilizing o f the overall level o f employment-related expenditures on the civilian public sector. On the other hand, de-linking the reform measures might create unnecessary expenditure fluctuations, which could be an additional risk to reform sustainability. 1.32 To achieve i t s objectives, the reform strategy has to differentiate across the sub-sectors o f public employment. The pay increase should be the most significant for the headquarters- based c i v i l servants, lower for the deconcentrated units and regional and municipal parts o f the core government administration, and lowest for the rest o f the civilian public sector. The last could be justified in part by the growing share o f fee-based services provided by this sector, which would become an increasing source o f compensation for i t s employees. Inside the headquarters-based federal c i v i l service, the pay increase should emphasize a larger and faster increase in compensation for decision makers. Such a focus o f the pay reform would allow addressing the key constraints o f the l o w policymaking capacity inside the government and would help retain highly qualified public officials in key positions in the federal c i v i l service. 1.33 The results o f our simulations suggest that over the period up to 2010 it would be unlikely for the Russian budget to be able to afford a full closure o f the current public-private pay gap through a radical pay adjustment in the entire public sector. I t seems more realistic to expect that the average residual pay gap for core government administration would remain significant (in the 100 percent range o f the public sector wage). However, recent surveys o f public officials reveal that such a gap may be quite acceptable, because it seems to reflect the existing expectations o f the public officials. A stronger effort to close the gap (to the average level o f 50 percent) would raise the costs o f the proposed reforms to about 2.2-3.3 percentage points o f GDP as compared to 2003. 1.34 Still, the proposed moderate pace o f pay reform suggests that the average wage in the core government administration would grow at a rate that i s 25 percent higher than the growth o f the average wage in the economy, while the average pay in the civilian public sector would grow at a rate that i s 17 percent higher. Moreover, it i s recommended to complement this average increase by a more radical pay adjustment for a small number o f decision makers in the headquarters o f the federal executive authorities. The recommended scenarios would result in an increase in the decompression coefficient for headquarters-based c i v i l servants from 2.5 in 2002 to 6.8-9.0 in 2010. 1.35 A significant adjustment in employment levels i s critical to making the reform sustainable. Even a moderate pay adjustment undertaken without a cut in staffing would make the reform fiscally unaffordable. I t i s expected that by 2010 average employment in the civilian public sector would decline by about 25 percent. Making the Russian government leaner also seems to be consistent with the implications o f the existing demographic trends. The largest reductions are expected in the civilian public sector, where, in part, they could be implemented through the commercialization o f some o f the budget sector entities. 1.36 Implementation o f the broad reform agenda in the core government administration would entail significant additional non-wage expenditures. The full-scale modernization o f public service would require both significant investment costs and significant recurrent costs 9 for the operation and maintenance o f computer systems and physical infrastructure, as well as the implementation o f modern HR practices (including competitive recruitment, staff rotation, and training). However, the existing budget constraints suggest that the issue o f non-wage expenditure control would be quite important in the course o f reform implementation. It i s expected that the non-wage expenditure share would have to go down from the current 37 percent of total costs to at least 35 percent, which would still represent a significant increase in financing in real terms. 1.37 A more detailed analysis o f the incremental fiscal costs, undertaken for several median scenarios, suggests that the costs to the federal budget would amount to about 40-45 percent o f the total cost increase, while the. rest would become a responsibility o f subnational budgets. About two-thirds o f all incremental costs would be linked to the additional funding o f the core government administration, while the rest o f the civilian public sector would benefit from a smaller share o f the expenditure increase. 1.3 8 Chapter 2 also recommends that additional analysis would be desirable to overcome the important limitations o f this set o f results. In particular, regional comparative pay and compensation surveys would be critical to better measuring both the current actual value o f in-kind benefits and the overall current compensation gap in regions. Further costing o f particular investments associated with the modernization o f public service (such as the introduction o f administrative operational manuals, etc.) would also be helpful to policy deliberations. 1.39 Overall, the Chapter suggests that broad reforms in the core government administration and in the civilian public sector at large may be implemented within five to seven years but should be differentiated by the scope o f the pay adjustment in various sub- sectors o f civilian employment, closely monitored for non-wage expenditure growth, and complemented by significant staffing adjustments in the civilian public sector, as well as by at least some staff reductions in the core government administration. The implementation o f such reforms would require additional budget financing as compared to the 2003 expenditure levels, but fiscal costs could be sustained within a reasonable range. Sustainable public administration reform in Russia cannot be cheap, especially in the environment o f rapidly growing real wages. Additional spending on public administration i s the only way to ensure a better quality o f policymaking and public service delivery in the country. However, this i s a necessary but not a sufficient condition. The successful implementation o f the budget process reform, the introduction o f performance budgeting, and the creation o f incentives for better performance in the public sector would also be needed. Reforms in payment arrangements in the housing and utility sector 1.40 Chapter 3 o f the report analyses the potential fiscal and social impacts o f advancing cost recovery in tariffs in the housing and utility sector (HUS) in Russia under the different macroeconomic and reform scenarios. The simulations are based o n the disaggregated model o f the full costs o f operating the country’s residential housing and the allocation o f the costs among the major sectoral stakeholders - households, government, and service providers. For each scenario the model estimates the expected demand in overall budget support for the H U S that cover all types o f budget programs in the sector. The baseline scenario suggests that as a result o f the proposed reforms the real unit cost to households in the H U S would increase by about 90 percent relative to the prevailing 2002 level. However, given the tariff adjustments 10 that took place in 2003-04, it i s expected that future tariff increases would be limited to, on average, about 40 percent relative to their levels at the end o f 2004. 1.41 This Chapter argues that, in the current environment o f high growth in household incomes, it i s affordable (both politically and financially) to attain 100 percent cost recovery in tariffs with the simultaneous elimination o f all quasi-fiscal financing (cross-subsidization) and the adjustment in domestic energy prices. Moreover, the reforms in residential housing could be made budget neutral in the medium term, and they would bring considerable savings in the long term. However, the analysis revealed a high sensitivity o f the results to income dynamics. If household income growth slows down, this may generate incremental budget costs o f 0.4-0.5 percent o f GDP per annum in the medium term. The high sensitivity o f the results to income dynamics suggests that the government should establish an efficient monitoring system to track the affordability o f tariff increases for both the population in general and specific household groups. The Chapter also emphasizes the need to restructure the financing mechanisms in the sector to ensure a higher degree o f accountability for both municipal governments and service providers. 1.42 An increase in energy and utility tariffs would make the delivery o f utility services to budget organizations more expensive by about 0.7-0.8 percent o f GDP per annum. Some o f these costs could be compensated through the increased taxation o f energy and utility providers and, later on, through the rationalization o f the public sector. However, we estimate that in the medium t e r m a fiscal gap in public sector financing o f 0.4 percent o f GDP could emerge as a result o f tariff increases in the H U S and energy sectors. 1.43 The analysis suggests that the elimination o f housing privileges could be affordable for most o f the current lgoty recipients, while the housing allowance program would be capable o f taking care o f those who face too high a housing cost burden. However, given the political sensitivity o f entitlement reforms, there may be a case for reforming the lgoty in a more gradual way. As a starting point, the government should monetize the lgoty to transform them into explicit subsidies and link them directly with the system o f personal accounts. Moreover, to reduce political costs, phasing out the lgoty should be coordinated with other structural reforms, including wage increases in the public sector, and increases in pensions and child benefits. Pension reforms 1.44 The analysis in Chapter 4 aims at estimating the potential fiscal costs associated with various developments in Russia’s pension system based o n the comprehensive actuarial model. I t finds that such fiscal costs are likely to emerge as a result o f the declining relative value o f old age pensions and associated political pressures for budget to support the pension system. 1.45 The Chapter i s focused on the sensitivity o f current trends in the pension system to changes in macroeconomic performance and various combinations o f potential reform measures, such as proposed cuts in contribution rates, as well as possible increases in the retirement age. The core variables analyzed in the model are (i) the potential affordable replacement rate, and ( ii) the expected ratio o f the pension and subsistence minimum. Most o f the simulations cover a period up to 2050. However, the analysis i s focused mainly on the first half o f the period (up to 2025-30), which i s o f larger interest to policymakers. 11 1.46 The structural nature o f the pension reform in Russia relates primarily to the introduction o f the 2”d fully funded pillar, which fundamentally changed the structure o f pension financing in the country. According to the estimates in this report, by 2008 contributions to the second pillar may reach 1 percent o f GDP a year, while this amount increases t o 1.25 percent o f GDP by 2015. Respectively, the reform reduces the amount o f funds available for paying the benefits to current pensioners through the lStpay-as-you-go pillar, thus creating temporarily financing needs in the pension system. 1.47 The Chapter concludes that without additional reforms, the existing pension system, even under the most optimistic assumptions, i s not capable o f closing the growing gap between growth in wages and pensions, which i s reflected in the declining replacement rate. In the baseline “without the reforms” scenario the average replacement rate declines from 33 percent in 2002 to 24.4-27.8 percent in 2030. At the same time, it provides for a gradual increase in the value o f the average pension relative to the subsistence minimum. This indicates that with economic growth the real incomes o f pensioners will also grow steadily. However, there are two concerns regarding the patterns o f this future growth: (i) in the initial period up to 20 15, despite a l o w level o f current pensions, the growth will be rather slow, and ( ii) because the growth in pensions will be lagging the growth in real wages, it may become a politically sensitive issue. 1.48 In the baseline scenarios, the annual fiscal costs to the government, associated with a need to address the problems accumulated in the pension system, amount to 0.25-0.55 percent of GDP in 2020 and to 0.55-0.90 percent o f GDP in 2030. These costs are measured against a target o f maintaining the replacement rate at 30 percent. However, the potential costs would increase rapidly in all scenarios with the reduced contribution rates. In the l o w case, the annual costs to the budget would exceed 2 percent o f GDP in 2030. 1.49 Overall, without additional policy changes, any significant cuts in the contribution rates would result in a further decline in the replacement rate relative to the baseline. To avoid a drastic widening o f the gap between wages and pensions, a reduction in the contribution rates has to be supplemented by additional reforms, including a decision o n a gradual increase in the retirement age. The scenarios with the increased retirement age do not require any budget support to provide a replacement rate o f 30 percent. 1.50 I t i s quite likely that the cut in the contribution rates o f 8 percentage points under the latest government proposal would lead to an immediate and considerable decline in the Pension Fund’s collections relative to the baseline. T o avoid either a decline in the real value o f current pensions or an accumulation o f pension arrears, such a cut would require a substantial fiscal transfer (in the magnitude o f 1 percent o f GDP a year) to the Pension Fund. The compensation has to be provided until considerable improvements in the revenue performance o f the pension system materialize and/or policy decisions are made, which reduce the Pension Fund’s financing needs. 1.5 1 The analysis also suggests that trends in the share o f the taxable payroll in GDP play a critical role in determining the future results o f the pension reform. This highlights the importance of policies aimed at stabilizing payroll and income taxation, as well as at the removal of various administrative barriers in the economy that currently hold back the reduction o f shadow incomes and wages. 12 Cost summary for the analyzed set of structural reforms 1.52 Table 1.3 summarizes our estimates o f the total potential costs o f selected structural reforms analyzed in this report. We estimate that the full annual costs to the federal budget could be limited to 1.5 percent o f GDP. Given the current fiscal and macroeconomic performance o f Russia, this cost level appears to be affordable. Table 1.3: Summary of Incremental Annual Fiscal Costs for the Set of Analyzed Fiscal Reforms (relative to the 2004 budget baseline) (YOo f GDP) a. Pension reform (effect of the cut in contribution rate) a l . Cut in contribution rates - medium-term effect 1.o-1.1 a2. Cut in contribution rates plus long-term effect 2.2-2.5 a3. Increase in retirement age 0 b. Housing and utility reforms b l . Residential housing 0 b2. Maintenance of budget organizations 0.4-0.5 olw: federal budget 0.15 c. Civil service 0.4-0.75 olw: federal budget 0.18-0.25 Total (medium-term) for the selected sub-set o f reforms 1.8-2.35 olw: federal budget 1.33-1.50 Source: Stafestimates. See Chapters 2-4 of the report. D. THE CHALLENGE OF FINANCING RULES STRUCTURAL REFORMS: CAN FISCAL HELP? 1.53 As mentioned above, Russia, as a country in transition, faces the challenge o f catching up with the developed economies in many areas simultaneously. T h i s creates a demand for an active government structural policy aimed at the acceleration o f a broad range o f structural reforms. Such reforms in many cases require incremental financing, which may add too many extra claims on the budget envelope. Without financing, the implementation o f many structural reforms cannot be effective. But funding the reforms without proper fiscal discipline and prioritization could be fiscally distractive. T h i s presents a challenge for a fiscal policy in Russia. 1.54 In our analysis we consider government spending on implementation o f core structural reforms to be a sort o f public investments in Russia’s institutional infrastructure that ultimately have rather a high rate o f economic return. Delaying or under-financing such spending could be a sub-optimal longer term fiscal policy because it may affect longer term growth prospects o f the economy. In this sense, budget financing o f structural reforms could be treated as public investment in conventional infrastructure. As shown by Easterly and Semen (2003), under-investing in infrastructure too often creates an illusion o f the sustainable fiscal policies. While it may help to reduce the current budget deficits, it often brings too high costs in terms o f lower future growth, which undermines longer term fiscal sustainability. At the same time, there i s sufficient evidence that successful infrastructure investments have rates o f return that are higher than prevailing costs o f borrowing in the middle income economies, such as in Latin America. From this perspective, a certain level o f funding o f infrastructure 13 investments through public borrowing i s fully justifiable because it improves, not damages longer t e r m sustainability o f public finance. 1.55 Therefore, we believe that earmarked well-planned and accountable budget financing o f core structural reforms i s justifiable in principle because these are the investments with high rate o f retum. In addition, Russia’s strong fiscal position suggests that the government could afford some incremental spending without generating significant risks for macroeconomic stability. In other words, we do not consider an affordability argument as a reason to postpone key reforms. However, the number o f simultaneous reform initiatives should be kept rather limited to ensure that the accumulation o f new commitments do not undermine fiscal sustainability. Besides, the government capacity limitations also suggest a need for a strict prioritization o f the reform process. 1.56 In addition, as argued in this report, government’s commitment for explicit reform financing should be accompanied by additional steps in strengthening the fiscal management system. The challenges o f structural reforms are too numerous and most o f them create considerable longer-term and sometimes overlapping government commitments. This raises requirements to the quality o f the fiscal framework, within which various reform strategies could be analyzed, compared and eventually prioritized. 1.57 Moreover, fiscal challenges in Russia are not limited to the financing o f structural reforms. As past Russian experience has demonstrated, world o i l price volatility, not subdued by the proper macro policies, has translated into significant economic and fiscal volatility in Russia, which has brought high economic and social costs to the country. In fact, o i l price volatility i s the second and largest fiscal challenge that Russia (like any large o i l exporter) faces. 1.58 Additionally, the Russian economy i s subject to conventional cyclical ups and downs that are common to market economies. In Russia these changes in business conditions are closely correlated with the movements o f o i l prices. I t i s agreed in principle and i s actually followed by some countries (for example, in the EU) that it i s desirable to make fiscal policy countercyclical (that is, expansionary during recessions and contractive during growth phases). This makes it possible to maintain the real value o f expenditures during bad times and to smooth fluctuations in economy. Yet without proper fiscal discipline, the introduction o f countercyclical budget instrumentscould easily become a burden for the fiscal system. 1.59 While deciding o n the implementation and financing o f structural reforms, the Russian government should place these decisions in the broader context o f other macroeconomic and fiscal challenges that the country faces. Otherwise, macroeconomic stability and sustainable economic development could be jeopardized. 1.60 In order to deal with fiscal challenges and foster economic stability, it has become common in many countries to develop and apply fiscal rules (OECD, 2002; Kopits, 2004). These rules are usually fixed in legislation and represent a permanent constraint on fiscal policy. They applied t o budget deficit or expenditures, or both, and may be expressed in actual or cyclically adjusted terms. Kopits and Symansky (1998) argue that the strongest case for fiscal rules i s based o n political economy arguments -- the rules correct the bias o f short- sighted governments to accumulate public debt at the expense o f future generations and that avoiding time-inconsistency issues results in significant credibility gains. 14 1.61 The experience o f other countries shows that proper fiscal rules help in carrying out sound fiscal policy. They establish benchmarks for fiscal performance that help to discipline policymakers and subdue political pressures. F o r example, the United K i n g d o m uses two fiscal rules since 1997: (i)the “golden rule,” which stipulates that over the economic cycle, the government will borrow only to invest and n o t to fund current spendings, and (ii) the ‘sustainable investment rule’, which stipulates that the net public sector debt t o GDP ratio will be held over the economic cycle at a stable and prudent level. A fiscal rule introduced in Switzerland in 2003 sets a ceiling for government expenditures, which cannot exceed cyclically-adjusted revenues (OECD, 2002). 1.62 The Russian Budget Code (para. 3, Article 92) also contains a kind o f fiscal rule stipulating that the annual budget deficit o f the federal budget cannot exceed the sum o f budget investment and interest expenditures. I t means that government borrowing cannot b e used t o finance current outlays, except for interest expenditures. Although, at the first glance, this rule looks similar to the British ‘golden rule’, it does not provide for sufficient fiscal rigidity. In fact, the economy could be moving to a debt trap, while be in full compliance with this rule -- n e w borrowing would be made to finance interest expenditures, which would increase b o t h a stock o f debt and future interest spending, thus creating a need for even larger borrowing in the following budget cycle. 1.63 Nonetheless, this legislated fiscal rule has been an important positive development. If it had been adopted a few years earlier, the rule could have been helpful as a tool o f fiscal adjustment during the period o f high budget deficits in the 1990s. However, in i t s current f o r m the rule i s n o t sufficient to address the present fiscal challenges that Russia confronts. There i s a need for the further development o f fiscal rules for Russia, which would enable the government to successfully deal with the above-mentioned major fiscal challenges: o i l price volatility, the financing o f structural reforms, and economic cyclicality. Each o f the three fiscal challenges requires a special risk-mitigating strategy. The adoption o f fiscal rules could be considered a part o f such mitigation arrangements. 1.64 The rest o f this section suggests three possible specific fiscal rules for Russia, which could be introduced as a part o f the overall government efforts to strengthen i t s budget management system. Such rules could be ultimately incorporated into the Budget Code (Article 92) and become a part o f Russia’s regular budget p r o ~ e s s . ~ 1.65 Rule #I: Fiscal sustainabilitv rule. The debt stock of the federal government may not exceed 30percent o f GDP. L i k e the United Kingdom, Russia could benefit f r o m having a formal fiscal rule related to the debt stock o f the federal government. For the purpose o f simplicity, the debt-to-GDP ratio could be suggested as an indicator preferable to more sophisticated ones that allow measuring debt o n a net basis and in net-present value (NPV) terms. Given Russia’s country risk profile and a high share o f foreign currency debt in i t s debt structure, it appears that for sustainability Hereafter, proposals on fiscal rules are referred to Russia’s federal budget. Subnational governments in Russia have there own, more binding, fiscal rules written in the Budget Code, which limit the size o f both subnational debt and debt service spending. 15 reason Russia should maintain a fairly l o w limit for i t s government debt. In particular, we believe that the federal debt stock level in Russia should be limited to 30 percent o f GDP.4 1.66 At the same time, following the best OECD practice, w e believe that the rational longer term targeted debt level for Russia should be lower than i s allowed by sustainability constraints, and it may be advisable t o set such a target at 20 percent o f GDP or lower. The government debt-to-GDP ratio i s already below 30 percent o f GDP and i s heading towards a 20 percent level. Thus, the current government policy i s de facto w e l l in line with the proposed rule (i.e. in the short t o medium terms this rule will not be binding for fiscal policy in Russia). However, the problem o f high debt levels may re-emerge when o i l prices fall and the fiscal balance deteriorates markedly. The fiscal rule that limits future debt accumulation, adopted as a separate l a w or as an amendment t o the Budget Code, w o u l d help the government to prevent this problem. 1.67 Rule #2: Oil price rule. An oil price adjusted Federal budget is allowed to be in deficit only temporarily to finance earmarked expenditures that are related to the implementation o f specific structural reforms. The size of such a temporary deficit shall not exceed 2 percent of GDP. W o r l d o i l prices are highly volatile. This volatility i s driven by a number o f economic and political factors o n both the supply and demand sides. M o r e or less accurate long-term forecasting o f o i l prices i s virtually impossible and inaccuracies in forecasts are huge.5 However, the long-term moving average o i l price, around which actual o i l prices tend to fluctuate, demonstrates stability. 1.68 This makes it possible to design a fiscal rule based o n the long-term average price o f Such an o i l price adjusted budget could be recalculated using the counterfactual o i l price o f 20 US$/bbl for crude Russian oil. While the actual budget outcome may turn out to be in deficit or in surplus, the o i l price adjusted budget (or budget in the long-term) needs t o be balanced. 1.69 However, given the above-discussed needs for financing structural reforms in Russia, w e believe it i s important t o include a special covenant in the fiscal rule which would permit accommodation o f reform-related fiscal costs in the b ~ d g e t . ~ 1.70 The first group o f structural reforms, discussed above, requires just temporary budget financing for their implementation. Thus, the fiscal rule #2 would provide a binding fiscal framework for financing these reforms. In addition, the rule could help bridge the financing o f the second group o f structural reforms that result in permanent additional government spending. Specifically, budget financing for each selected reform belonging t o the second group could be provided o n a decreasing basis. This financing should be program-based and provided under and within the broader budget allocation designated for new expenditure Let u s note that, before the 1998 crisis, the debt-to-GDP ratio for the general government was below 50 percent, which i s substantially less than the debt ratio stipulated b y the Maastricht criteria. As Kopits (2004) emphasizes, markets have far lower tolerance for relatively high public debt-to-GDP ratios in emerging markets than in advanced economies. ’ Pinto (1987) estimated a standard forecast deviation for o f f price at US$10.7 per barrel. The latter i s estimated at $18-20 per barrel for the Russian Urals after accounting for the ongoing price boom. -- Beetsma and Debrun (2004) find in the context o f the Euro arca’s Stability and Growth Pact -- that fiscal rules sometimes may need to be relaxed for countries that are actively pursuing much-needed structural reforms. 16 commitments. For instance, it could cover 100 percent o f incremental costs during the first year o f implementation, 50 percent during the second year, and 0 percent during the third year. Such a n approach would give the government time to identify and implement measures necessary to create fiscal room in the regular budget for new liabilities that would emerge as a result o f the reforms. Controlling the overall size o f program spending o n structural reforms would allow the monitoring o f whether the second fiscal rule i s adhered toS8 Besides, this approach would be fully consistent with the ongoing transition to performance-based budgeting principles. 1.71 The proposed o i l price rule should be applicable for the federal budget, as it demonstrates the much higher o i l price sensitivity o f i t s revenues than subnational budgets. The reason behind it i s that almost all tax revenues, which are directly dependent o n o i l prices (oil export duties, mineral resource extraction tax on oil), accrue to the federal budget. 1.72 Rule #3: Structural fiscal balance rule. The structural budget should be kept in balance. It happens quite often that counties enjoying rapid economic growth boost their budget expenditures, which gives an additional (albeit temporary) impetus to their GDP growth. At the same time, such a pro-cyclical fiscal policy makes the public sector compete for resources with the private sector and pushes up interest rates. When the growth phase o f an economic cycle comes to an end, then it becomes very difficult to cut back the inflated government expenditures and restructure them in order to expand the counter-cyclical spending components. 1.73 This i s why, for example, the counties in the euro area have been discussing a . ~ budget adjusted for modification o f their budget rules to allow for a cyclical a d j ~ s t m e n tThe the impact of economic cycles i s called a structural budget. The same approach, in principle, could be applied in Russia in order to prevent pro-cyclical budgetary expansion during booms (e.g., when GDP growth rate i s above 5 percent) and to allow for countercyclical budgeting during recessions (e.g., when GDP growth rate i s less than one percent)." 1.74 This rule would require that during booms, which in Russia are highly correlated with the periods o f high o i l prices, the government should adhere to the budget surplus o f 1-2 percent o f GDP to avoid the pro-cyclicality in non-oil expenditure. Similarly, during recessions the government could allow the budget deficit o f 1-2 percent o f GDP. Meanwhile, the structural budget would be balanced in both cases. 1.75 However, it appears that the formal or informal adoption o f the o i l price fiscal rule precedes the adoption o f the third fiscal rule. The fiscal management o f o i l shocks and structural reforms should be given the highest priority in the Russian case. Moreover, Russia has not yet gone through a completed economic cycle. Therefore, at this stage it appears that the establishment o f r u l e #3 could not be done quickly because the reliable estimation o f the * As discussed, the third group of structural reforms i s fiscally neutral in terms of their costs. This approach was made explicit in the revised 2001 Code o f Conduct of the European Union. lo Perry (2004) argues that Latin American economies, which are subject to high macroeconomic volatility, ought to follow a rule that incorporates a countercyclical stance through a structural balance target or a stabilization fund. 17 structural budget would require additional time. Instead, a proper development o f this rule should be considered as part o f the longer term efforts to upgrade the fiscal management system in Russia. E. IMPLICATIONS FOR FISCAL POLICY 1.76 In this section we discuss some implications o f the proposed fiscal rules, especially the o i l price rule (rule #2), for fiscal policy. The o i l price r u l e i s largely a modification o f and a potential legal basis for a de facto fiscal policy carried out by the Russian government. Indeed in drafting the 2004 budget the government used the price o f 20 US$/bbl and the budget became l a w with the 0.5 percent o f GDP surplus at this counterfactual price. Still, the government's current fiscal strategy could be strengthened in a number o f aspects. 1.77 Stabilization Fund settings. The regime o f a financial reserve (before 2004) and a stabilization fund (since 2004) does not allow for saving all extra revenues associated with o i l prices exceeding 20 US$/bbl. Overall, the enlarged budget has been saving only about 50 percent o f the extra o i l revenues that it receives (World Bank, 2004a). Moreover, taxes on gas, which price i s strongly correlated with the o i l price with a six-month lag, as well as general taxes on goods and services that also tend to grow in response to o i l price increases, are not accmable to the stabilization fund in the course o f the fiscal year. Because the government saves too l i t t l e o f the available o i l windfall, this makes i t s budget policy too pro-cyclical. In particular, the government used a part o f the o i l windfall to expand the financing o f its public investment program by 1.4 percent o f GDP by 2002 (see Table 1.1, above). 1.78 Stabilization fund regulations need further strengthening to broaden the revenue base for within the year transfers to the fund beyond taxes paid by o i l companies, to include additional non-oil tax revenues actually received by the federal budget compared to the expected amount o f tax revenues budgeted at the counterfactual o i l price o f 20 US$/bbl. 1.79 This safeguard policy would sterilize the part o f the revenue windfall which i s an indirect result o f high o i l prices, and would limit spending expansion taking place in the course o f budget execution in cases when o i l prices and tax revenues tum out to be higher than assumed in the budget law. Presently, the Ministry o f Finance makes quarterly projections of expected tax revenues. Therefore, it appears to be quite possible to use these projections as benchmarks for assessing the amounts o f the general tax revenue windfall to be transferred to the stabilization fund on a quarterly basis. Such quarterly transfers should replace the current practice o f a single annual transfer to stabilization fund made in February o f the following year." 1.80 Notably, besides playing the role o f fiscal stabilizer, the stabilization fund should also perform an important function o f a macroeconomic stabilizer by sterilizing the o i l revenue windfall. Increasing the share o f the actual windfall accumulated in the stabilization fund would help the authorities to maintain the policy aimed at the relative stability o f the real exchange rate to prevent the development o f Dutch Disease. Technically, the amount of the quarterly transfer would be equal to the positive balance between the actual and counter-factual tax revenues for that quarter net o f transfers of oil export duty and tax on the extraction o f mineral resources that have already been transferred to the stabilization fund during that quarter. 18 1.8 1 Moreover, the current cap o n the size o f the stabilization fund in the amount o f Rb 500 billion (which i s 3.8 percent o f 2003 GDP), imposed by the Budget Code, i s too small. It may become a serious constraint to an efficient long t e r m fiscal policy. This cap has to be either revised or eliminated as early as 2005, when it i s expected that the accumulated reserves in the stabilization fund will exceed Rb 500 billion. 1.82 Expenditure control. At o i l prices standing above 20 US$ibbl, the second rule would help in maintaining overall fiscal discipline, especially with respect to control over expenditure levels. During the previous years, when actual o i l prices turned higher than stipulated in the budget laws, the government demonstrated l i t t l e resistance to pressures o n expenditure increases in the course o f the budget execution. In both 2002 and 2003, amendments to the budget laws considerably increased the expenditure amounts relative to the original budgets. I t means that a considerable portion o f the total o i l revenue windfalls was actually spent on the basis o f within-the-year decisions and without proper strategic prioritization. As a result, at a counterfactual o i l price o f 20 US$/bbl the general budget would have been executed with a deficit o f 1.25 percent o f GDP in 2003 (IMF, 2004). Our estimates show that in 2004, for the same reason, the budget outcome at this o i l price was in deficit o f 1.7 percent o f GDP and in 2005 it i s expected to w e l l exceed 2 percent o f GDP because o f unplanned spendings on benefit monetization in 2005. 1.83 Thus, as follows from the analysis o f recent developments, the adoption o f the fiscal r u l e s would require tightening o f the government’s fiscal policy, as well as speeding up the development o f budget programs that support structural reforms. This i s also because at the moment a very l i t t l e portion o f government expenditures represent program spendings o n structural reforms. 1.84 Tax policy. A recent government initiative to lower the social tax rates in 2005, compensating for foregone revenues o f the Pension Fund from the general revenues o f the federal budget, represents a suboptimal solution. In essence, this decision means that instead o f accumulating a higher proportion o f the o i l revenue windfall in the stabilization fund, the government returns a part o f the windfall to the private sector through lower taxes. To date, the private sector in Russia has demonstrated quite prudent financial behavior - i t has saved almost i t s entire share o f the windfall and invested a good chunk o f it in net foreign assets stretching i t s use in time (World Bank, 2004b). Therefore, for the time being this suboptimal solution could indeed generate serious potential macroeconomic benefits. 1.85 Yet for the government the flipside o f this policy i s that, when o i l prices eventually fall, the foregone revenues will sooner or later have to be raised. T h i s implies that the government should have an up front commitment to raise taxes in the future, and, (either increase tax rates or broaden tax bases) in the future. Respectively, the government should not make the commitment that all o f the tax cuts it suggests in times o f o i l windfalls will be permanent. Given the present high level o f the marginal social tax rate and the problems with administrating this tax, it would appear more appropriate to raise the rates on other taxes when time comes. 1.86 Public investment programs. Using the commodity price windfall to finance public investment has been quite a common practice for large commodity exporters around the 19 world. However, only a few countries have succeeded in doing this in a non-distorting way.” A few factors led to poor results. First, the investment usually went t o build structures rather than to purchase equipment, implying a lower rate o f return (both financial and economic) o n the investment. Second, the investment contributed to economic overheating by provoking higher inflation in the construction sector. This additionally reduced the efficiency o f public investment. Third, the typically weak institutional capacity o f the governments resulted in poor prioritization and in implementation inefficiencies that led to considerable waste and misuse o f public funds. 1.87 This i s another reason why Russia should pursue an opposite, countercyclical, policy in the area of public investment - being rather conservative during booms, while protecting the levels o f public investments (including reform-related spending) during “bad times” by investing a part o f the saved windfall. T h i s would allow for better selection o f public investment projects and improved predictability o f their financing and it would help to smooth the fluctuations o f activities in the construction sector. Moreover, such investment policies would be consistent with the lessons learned from earlier fiscal adjustments t o external shocks (Easterly and Serven, 2003). 1.88 Managing external shocks. In the o i l price range o f US$16-20 per barrel, the proposed second fiscal rule would imply that the actual budget w o u l d be executed with a deficit o f up to 4 percent o f GDP. This deficit would have to be financed by a reverse transfer from the stabilization fund, which would be sufficient to maintain the level o f budget expenditures stable in real terms. 1.89 Should o i l prices temporary fall below 16 US$/bbl, the government could employ the same mechanism o f financing budget expenditures f r o m the stabilization fund in order to maintain the constant level o f expenditures in real I f the government faces an extended period of depressed o i l prices, it should trigger additional adjustments in i t s fiscal policies by raising general taxation, cutting the least efficient expenditures, and borrowing. The cut-off time for switching to such a supplemental policy package would depend o n the amount o f resources accumulated in the stabilization fund -- the more reserves that are accumulated, the later the policy would have to be launched. 1-90 Specifically, a temporary increase in taxes should (i) b e accruable t o the federal budget, and (ii) target taxes that have a stable and broad base and those that have the least distorting effect o n the real sector, such as VAT and excises. 1.91 The cuts in expenditures should target (i) white elephant expenditures with the least transparency (and, most likely, the least efficiency), such as, the current federal targeted programs, and (ii) spending under the line “other expenditures.” The real expenditure cut could also be achieved by freezing specific expenditures in nominal terms. As opposed t o the method o f achieving fiscal consolidation after the 1998 crisis, social expenditures should be marginally affected at the time o f future fiscal adjustments in Russia. ” In the 1970s-80s Senegal and Botswana managed to avoid inflating relative prices on investment goods while increasing public investment during the periods o f positive trade shocks. The reason was that in both countries investment booms were heavily concentrated in purchases of machinery and equipment, Le., tradable capital (Collier and Gunning, 1999). l3Depending on the amount o f resources accumulated in the stabilization fund, this policy could be sustained for 6-12 months. 20 1.92 An efficient way of reactivating public borrowing could be through using the deferred drawdown option (DDO) offered by IFIs. The benefit o f this option i s that it can be agreed on well ahead o f time at l o w cost. At the same time, borrowing commercially on capital markets in the period o f l o w o i l prices would be much more expensive for Russia, which i s an unavoidable reflection o f the increased country risks during bad times. 1.93 When the r u l e #3 i s adopted, it would have an additional impact o n the management o f fiscal flows. During booms the structural fiscal surplus would have to be transferred to the stabilization fund as another funding source. Similar to that, during recessions the reversed transfers from the stabilization fund would prevent expenditures from falling in real terms. In addition, recessions usually bring about incremental expenditures (e.g., on benefits and retraining for the unemployed, capital investment projects and public works). This i s why running a countercyclical policy during recessions usually leads to an increase in government borrowing (if the stabilization fund quickly diminishes). At the same time, recessions are the best times from a political economy viewpoint for identifying and eliminating inefficient expenditures. When an economy prospers, this i s much more difficult to do. 1.94 Managing market expectations. As far as the policy o f maintaining a strong fiscal balance i s not fixed in the law, it remains unclear how strongly the government i s committed to continuing this policy in the future. Making the fiscal r u l e into law could be helpful in t e m s o f improving the perceptions o f various market players, including potential investors. 1.95 As far as the third fiscal rule i s concerned, if and when the govemment decides to follow it, it would be very important to adopt this rule while the economy i s in a growth phase. This step would send a strong signal demonstrating government’s commitment to smoothing the influence o f economic cycles on the economy. In this case, market participants would have stronger confidence in overall government fiscal discipline despite the govemment’s expansionary, countercyclical fiscal policy during a period o f recession. 1.96 The role for the IFIS.The fiscal framework for structural reforms, which i s analyzed in this Chapter, suggests considerable variation in budget expenditures (Le. their fluctuation in response to various challenges and shocks). However, to ensure that these expenditure interventions are timely and efficient, there should be appropriate institutional capacity within the public sector for strategic management o f financing o f both public investment programs and structural reforms. In this area the W o r l d Bank and other donors could offer their expertise and project management experience. For instance, joint investment projects with the World Bank in support o f various structural r e f o m s and infrastructure upgrades could be designed in such a way that the Bank would provide only the start-up and pilot financing and would help to set up project implementation mechanisms. Scaling-up the projects would become entirely the govemment’s responsibility. For this purpose, the govemment could use the same project preparation and implementation mechanisms that would be jointly established under the initial W o r l d Bank projects. Such a project framework may significantly increase the efficiency o f government spending o n investment and structural r e f o m s if relatively large volumes o f government co-financing would leverage the World Bank funds. In addition, the Bank and other IFIs, and the donor community in general, might provide direct technical assistance to public sector institutions to address the binding capacity constraints. 1.97 The govemment could keep the amount o f tied borrowing from IFIs stable, but at the same time could vary i t s contribution to joint investment projects by reducing co-financing o f structural reforms during recessions. Thus, the government’s share in IF1 projects could be lower during recessions and higher during high growth phases. This would help when 21 necessary to free the money for maintaining the stability o f vital current expenditures in real terms. Operationally, this could be done, for example, by varying the number o f regions in which original pilot projects are replicated. F. CONCLUSION 1.98 The outcomes o f the proposed second and third fiscal rules can be summarized in Table 1.4. Table 1.4: Matrix of the Proposed Fiscal Rules for Russia oil price, US$/bbl Budget balances under differentfiscal rules, % of GDP 20+ 16-20 12-16 1. Oil price adjusted budget balance balanced balanced Balanced 2. Oil price adjusted budget balance with the ceiling for structural reforms costs (2ndfiscal rule), not more than -1-2 -1-2 -1-2 3. Savings/expendituresfrom counter-cyclical policy (3rdfiscal rule), not more than +1+2 0 -1-2 4. Baseline budget balance estimated at actual oil price (excluding spending on both structural reforms and counter-cyclical policy), % of surplus -0-2 -2-4 GDP Overall actual budget outcome (= 2+3+4) surplus -1-4 -1-8 Source: World Bank staffestimates. 1.99 I t follows from the last column o f Table 1.4 that the combination o f all three fiscal rules may give rise to an actual budget deficit o f up to 8 percent o f GDP if the period o f very l o w o i l prices and output fall coincides with the implementation o f structural reforms. Specifically, fiscal sustainability rule would generate a budget deficit o f up to 4 percent o f GDP. Oil price r u l e would add to the deficit up to 2 percent o f GDP, and structural balance rule would add another 2 percent o f GDP. However, in the terms o f structural budget balance, the deficit would not exceed 4 percent o f GDP - 2 percentage points stemming from financing structural reforms under o i l price r u l e and another 2 percentage points stemming from countercyclical policy (structural balance rule). I t should be recognized though that during the periods o f l o w o i l prices the authorities could draw from the o i l stabilization fund and, in this sense, a portion o f respective deficits would be self-financed. Following the same fiscal rules during a period o f high o i l prices exceeding 24 US$/bbl requires that the federal budget i s executed with a s ~ r p l u s . ' ~ 1.100 In terms o f sequencing, the first two fiscal rules address the most crucial fiscal risks that the Russian fiscal policy faces, and therefore they have to be adopted first. The third fiscal rule i s somewhat supplementary and could be adopted thereafter. 1.101 Overall, following the proposed fiscal rules would allow the government to maintain the fiscal stability and yet adequately address the emerging structural and cyclical challenges l4At oil prices in the range of 20-24 US$/bbl the overall budget outcome i s ambiguous. It would depend on the extent to which the govemment would finance structural reforms and/or conduct countercyclical policy. 22 through the embedded flexibility. T h i s fiscal framework would make the budget policy more predictable and sustainable, thereby facilitating the development o f the private sector. 1,102 In addition, the adoption o f the proposed fiscal rules would contribute to the successful attainment o f objectives o f the government’s Concept o f Budget Reform in two program areas -- introduction o f medium-term budget planning and division o f budget spending into the existing commitments and new expenditure commitments. 1.103 The W o r l d Bank as well as other international financial institutions may help the government to overcome i t s institutional weaknesses in managing the implementation o f reform and public investment programs. This appears to be the way to increase the efficiency o f public spending, so that it fully complies with the proposed fiscal rules. 23 Chapter 2. FISCAL COSTS OF CIVIL SERVICE REFORM 2.1 This Chapter provides recommendations on the planning and sequencing o f c i v i l service reform in Russia based o n (i) estimates for direct fiscal effects o f various reforms in the area o f public administration, and (ii) analysis o f feasibility o f different reform options. The Chapter suggests that broad reforms in the core government administration and in the civilian public sector at large may be implemented within five to seven years but should be differentiated by the scope o f pay adjustment in various sub-sectors o f civilian employment, closely monitored for non-wage expenditure growth, and complemented by significant staffing adjustments in the civilian public sector as well as by at least some staff reductions in the core govemment administration. Implementation o f such reforms would require additional budget financing as compared to 2003 expenditure levels, but fiscal costs could be sustained within a reasonable range. A. EMPLOYMENT AND FINANCING OF CORE GOVERNMENT ADMINISTRATION AND THE CIL V IN IA PUBLIC SECTOR 2.2 Overall core government administration and civilian public sector employment accounts for a significant part o f the Russian population: in 2002, employment in these sectors was about 11 million people or about 7.7 percent o f the country’s total population. The structure o f c i v i l employment in Russia i s presented in Table 2.1. Table 2.1 : Structure o f Core Government Administration and Civilian Public Sector Employment in 2002 Sector Employment Employment (‘000 persons) (YOof total) Total: Core govemment administration and civilian 11,062.2 100.0 public sector (A+B) A . Core government administration employment 1,252.3 11.3 Civil service and local self-govemment 919.5 8.3 - Federal civil service 463.7 4.2 - Subnational civil service (incl. local self- 455.8 4.1 government) Other core govemment administration employment 332.8 3.0 B. Civilian public sector employment 9,809.9 88.7 Health, physical culture and sports, social services 3,356.1 30.3 Education 5,282.3 47.8 Culture and A r t s 915.4 8.3 Research and Development* 256.1 2.3 *Data are for 200 1. Source: Rosstat. 2.3 In 2002, core govemment administration employment accounted for 1.25 m i l l i o n people (or roughly 0.9 percent o f the total population) with about 47 percent employed by the federal authorities and 53 percent employed at the regional and municipal levels o f the govemment. Employment in executive authorities (including local self-government with executive functions) accounts for more than 86 percent o f core government administration employment. 2.4 Over the past eight years, the core government administration employment has increased by almost a quarter with the most drastic increases in legislative, judiciary and other government bodies. Employment growth in the executive branch o f core government administration was slower, but s t i l l since 1994 there have been significant increases in absolute staffing levels (Table 2.2). Table 2.2: Core Government Administration Employment in Russia in 1994-2002 (in thousands) 1994 1995 1996 1997 1998, 1999 2000 2001 2002 Total core government 1004.3 1061.8 1093.0 1108.9 1102.8 1133.7 1163.3 1140.6 1252.3 administration employment as % o f the 1994 employment 100 105.7 108.8 110.4 109.8 112.9 115.8 113.6 124.7 A. Legislative authorities 7.1 8.8 10.5 11.1 11.0 14.5 15.5 19.1 20.4 a s % i n 1994 100 123.9 147.9 156.3 154.9 204.2 218.3 269.0 287.3 B. Executive authorities 894.4 945.1 971.3 984.4 983.9 1006.5 1029.5 983.7 1072.6 as % in 1994 100 105.7 108.6 110.1 110.0 112.5 115.1 110.0 119.9 B l . Federal executive 379.9 416.2 433.0 442.5 409.9 412.8 404.7 377.1 446.8 as YO in 1994 100 109.6 114.0 116.5 107.9 108.7 106.5 99.3 117.6 - HQ-based 33.8 33.8 31.2 30.4 28.9 30.9 30.3 28.8 28.8 as % in 1994 100 100 92.3 89.9 85.5 91.4 89.6 85.2 85.2 - Deconcentrated 346.1 382.4 401.8 412.1 381.0 38 1.9 374.4 348.3 418.0 as % in 1994 100 110.5 116.1 119.1 110.1 110.3 108.2 100.6 120.8 B2. Subnational executive 514.5 529.0 538.3 542.0 574.0 593.4 624.8 606.6 625.8 (incl. Local self-government) as % in 1994 100 102.8 104.6 105.3 111.6 115.3 121.4 117.9 121.6 C. Judiciary authorities 102.7 107.3 110.1 111.5 105.6 110.1 115.2 134.3 153.9 as % in 1994 100 104.5 107.2 108.6 102.8 107.2 112.2 130.8 149.9 D. Other authorities 0.1 0.6 1.2 1.8 2.3 2.6 3.1 3.5 5.5 as %in 1994 100 600 1200 1800 2300 2600 3100 3500 5500 Source: Gimpelson (2002) and Rosstat (2002). 2.5 I t i s notable, that the only category o f core govemment administration employment that has been declining over this period was employment in HQ-based federal executive authorities, while the employment in deconcentrated federal executive bodies and particularly in the subnational executive branch has been steadily growing. This disproportional growth in part may be explained by the changes in government functions from central planning to regulation o f economic activities during the period o f transition. These functional changes led to growing numbers o f core government administration employees working for federal deconcentrated units (treasury, tax administration, customs, employment service, anti-trust agencies and property management units). Decentralization and transfer o f some o f the government functions from the federal to sub-federal levels may also explain part o f the employment growth at the subnational level (see Gimpelson, 2002), while some o f the increases may have resulted from a lack o f control o f staffing levels in the regional administrations and local self-government, Moreover, the recent W o r l d Bank report points to excessive employment generation in the public sector at the regional level due to insufficient j o b creation in the private sector. As a result, budget employment started to function as a quasi social safety net (see W o r l d Bank, 2004b). 26 2.6 Federal and subnational civil sewice in 2001 accounted for about 75 percent o f total core government administration employment. The structure o f the federal and subnational civil service i s presented in Table 2.3. Table 2.3: Structure o f Civil Service Employment in 2001 Federal civil servants Subnational civil servants Category Legislative Executive Judiciary Others Total Subjects Munici- Total Total ofRF pal Total core 4.5 377.1 122.0 1.3 504.9 N/A N/A 635.8 1140.6 government administration employment, (‘000 persons) O/w total civil 3.8 322.5 95.2 1.3 422.8 153.3 283.6 436.9 859.7 service employment, (‘000 persons) As % of total civil service employment Total civil 100 100 100 100 100 100 100 100 100 service Category A 11.7 0 20.4 2.2 4.7 3.6 4.3 4 4.3 Category B 26 0 1.7 3.2 0.6 3.7 4 3.9 2.3 Category C 62.3 99.9 46.6 94.6 87.5 92.7 91.7 92.1 89.8 Top 1.9 0.4 0.1 8.4 0.4 2.2 3.3 3 1.7 Chief 16.3 1.4 0.2 28.4 1.3 9.7 12.4 11.4 6.4 Lead 27.6 24.9 2.1 45.1 19.9 23.2 14.9 17.8 18.8 Senior 11.7 53.6 10.5 10.7 43.4 35.9 30.9 32.6 37.9 Junior 4.8 19.7 33.8 2 22.7 21.7 30.2 27.2 25.0 Prosecutors 31.3 7 3.4 Source: Rosstat (2002). 2.7 The remaining 25 percent o f the core government administration personnel do not have a status o f c i v i l servants and their employment contracts are regulated by the Labor Code. Most o f these employees perform supporting or logistical functions (secretaries, drivers, etc.). 2.8 Comparison o f cross-country data on public sector employment (see Figure 2.1. below and Annex 2.4 to this Chapter for more information) confirms: first, that the total employment in core government administration and the civilian public sector in Russia i s quite large as compared to other countries; but, second, the composition o f this employment i s rather distorted. It i s characterized by fairly tiny federal HQ-based government authorities, as opposed to much better staffed federal deconcentrated units, to even more numerous regional and municipal administrations, and to a clearly overstaffed civilian public sector. Some o f these imbalances were inherited from the central planning era, while others (especially an expansion in subnational administrative employment) have emerged over the years o f transition. 2.9 The core government administration in Russia i s rather small as compared to high- income OECD economies as well as many transition economies. In fact, only Poland and 27 Kazakhstan have smaller core government administrations, while all federative countries presented in the sample, especially those with comparable population numbers, have significantly higher core government administration employment, particularly at the sub- national level, as illustrated by the Figure 2.1 below. At the same time, the number o f education and health employees in Russia i s significantly higher than in all other countries in the sample, including transition economies that historically also had high employment in the health and education sectors. Figure 2.1: Public Sector Employment in Selected OECD Countries and Transition Economies (as a percentage o f population) PCivilian Central Government W Subnational Government 0 Education and HeaRh Employees Note: For some countries not all types o f employment data are available, hence there are some gaps in the figure above. Source: WB Database. 2.10 Overall, public sector employment i s rather high, and i t s financing i s not adequate vis- a-vis the employment level. T h i s coexistence o f high employment and l o w funding represents at the moment a major disproportion in the Russian public sector. 2.1 1 Based o n the 2002 baseline data, the current status o f financing core government administration and civilian public sector employment could be summarized as the following. As Table 2.4 shows, in 2002 the total budget expenditures on cash compensation in core government administration and the civilian public sector accounted for about 6.6 percent o f GDP. Cash compensation in core government administration was only 1.7 percent o f GDP out o f which only about 0.7 percent o f GDP was spent o n the federal government's wage bill (or 1.4 percent o f GDP including cash compensation o f the armed forces). This i s quite a l o w ratio by international standards. In the 1990s, the central government wage bill (including armed forces) in large developed economies with a federal structure varied from 1 percent to GDP in Germany to 2.1 percent in Australia. Some sources quote OECD averages for the early 1990s as being equal to 4.5 percent o f GDP, while Latin America and the Caribbean (LAC) as 4.9 percent (see Annex 2.4). In addition, there i s a view that while the expenditures on core government administration (specifically, o n federal executive civil service) in Russia are lower than in other countries, the functions o f the federal executive authorities in Russia are broader than in comparable countries with the federal structure o f the government (see Higher School o f Economics (HSE), 2004, for more information). 28 Cash Compensation, YOof 2002 GDP Non-Wage Expenditures, YOo f 2002 GDP* Federal Sub-federal Total Federal Sub-federal Total Budget Budgets Budget Budgets Core Government 1.7 0.7 1.o 1.o 0.4 0.6 Administration Civilian Public 4.9 1.1 3.8 3.2 0.2** 3.0** Employment Total 6.6 1.8 4.8 4.2 0.6 3.6 * Estimated. ** Non-wage expenditures in civilian public sector employment do not include budget transfers to extra-budgetary funds and government transfers to population. Source: Rosstat, Ministry of Finance, and staff calculations. 2.12 The 2002 ratio o f the ,average cash compensation in the federal core government administration to per capita GDP accounted for 1.21, which was lower than in other middle- income countries as well as in Europe and Central Asia (ECA) and OECD economies. For example, the E C A average i s 1.3, OECD average i s 1.6 while in L A C countries the indicator accounts for 2.5. 2.13 Hence, although core government administration pay and employment figures vary from country to country and are highly dependent o n the structure and functions o f the government as well as o n the methodology used for national public sector statistics, the cross- country comparison shows that in terms o f spending Russia’s core government administration i s quite small. B o t h wage bill in the core government administration (as a percentage o f GDP) and the average cash compensation (as a ratio to GDP per capita) are considerably lower than i s common internationally. B. CIVIL SERVICE REFORM PRIORITIES AND PROGRESS TO DATE 2.14 The need to increase productivity and transparency o f the public administration and improve quality o f public services has been widely recognized in Russia both inside and outside the Government as a necessary condition for ensuring implementation o f other reforms and sustainable development o f the country. Hence, implementation o f the c i v i l service reform (including administrative reform) i s one o f the Government’s key priorities in the mid-termreform agenda. 2.15 The priorities for c i v i l service reform were defined in the Presidential Decree No. 1336, dated November 19, 2002: On Federal Program, “Reform o f the Civil Service o f the Russian Federation (2003-2005) ”, containing a set o f measures aimed at improving legal, organizational, financial, and methodological framework o f the public service” in the Russian Federation. The main areas o f reform include the following: 0 creating a comprehensive normative and legal framework governing the public service o f the Russian Federation; 0 developing efficient mechanisms for implementing a personnel policy for the purpose o f optimizing the structure o f public service personnel; The term “public service” i s used in this section t o denote civil service, police service and armed forces. 29 developing measures aimed at improving compensation o f public servants and financial, economic, and logistic support o f the public service o f the Russian Federation, and at using advanced information technology in the public service system in a rational manner; implementing staff training programs for the public service o f the Russian Federation and professional development programs for public servants; and forming a system o f management o f the public service o f the Russian Federation. The specific objectives are described in the Federal Program as following: creating conditions for optimal organizational and legal support o f the public service; defining roles, powers, and responsibilities o f public servants o n the basis o f j o b (service) descriptions; implementing n e w techniques for planning, financing, stimulating, and assessing public servants’ activities, and using public service system resources in a rational manner; ensuring openness o f the public service for the benefit o f civic society development and strengthening o f the state; applying efficient methods for selecting qualified personnel for the public service and for assessing professional performance o f public servants, as well as creating conditions for their j o b (service) promotion; implementing staff training programs for the public service and professional development programs for public servants; implementing mechanisms for identifying and solving public service-related conflicts o f interest, as w e l l as introducing a legal regulation o f professional ethics of public servants; creating an optimal material and technical environment for efficient functioning o f the federal public service and for performance by public servants o f their official (service) duties; and ensuring the development o f a public service administration system. During 2002-2003, significant progress has been achieved in conceptualization o f the reform approaches and preparation o f the legislation that i s to provide a basis for reform measures implementation. A framework Federal L a w No. 58-FZ dated M a y 28, 2003 “On State Service System o f the Russian Federation ”, established a two-level system o f public service in Russia: federal public service (administered by the Federal Govemment); and civilian public service o f a subject o f federation. Federal public service i s subdivided into civilian, military and l a w enforcement service. Rule o f law, pre-eminence o f human and c i v i l rights and freedoms, equal access to public service for a l l citizens, integrity o f the public service, interconnection o f c i v i l and municipal service, openness and accountability, professionalism and protection f r o m undue interference in public service activity by private individuals or legal entities are declared as guiding principles for public service system in the country. The l a w introduces a notion o f a consolidated register o f public servants positions as w e l l as class, diplomatic, military, and special ranks that are to substitute the professional grades that existed under the previous legislation. 30 2.18 The framework law requires separate laws to be enacted for each type o f public service (civilian, military, and law enforcement). T o this end, a draft Federal L a w No. 79-FZ dated July 27, 2004, “On State Civil Sewice o f the Russian Federation, ” was enacted in February 2005. T h i s law defines rights and obligations o f c i v i l servants; limitations and prohibitions o f the state service requirement to the conduct o f the civil servants; regulation o f the conflict o f interests; and obligations to annually submit information on income, property, and related obligations. The law provides for a classification o f c i v i l service positions in accordance with categories and groups o f appointments (see Table A2.2 in Annex 2.2). The law contains a number o f important innovations, including competitive recruitment for c i v i l service positions; introduction o f j o b descriptions that should, inter alia, contain performance indicators for each position; and changes in remuneration related to introduction o f performance-oriented incentives.l6 2.19 In the framework o f the civil service reform based o n functional reviews several experiments related to introduction o f performance budgeting and performance management have been launched in five pilot regions participating in the Program. 2.20 Significant attention i s also given to the administrative reform agenda that, in the narrow sense, includes inventory o f functions o f the federal executive bodies and restructuring and right-sizing o f the government. Priority areas for implementation o f administrative reforms for 2003-2004, defined in the Presidential Decree No. 824 dated July 23, 2003, ”On Measures of Implementation o f Administrative Reform in 2003-2004, I‘ are the following: 0 restriction o f the state interference in economic activity o f entrepreneurs, including restriction o f state over-regulation o f the business; 0 elimination o f duplication o f functions and authorities o f organs o f the Federal Executive powers; 0 development o f the system o f self-regulating organizations in the economy; 0 organizational separation o f functions related to the regulation o f economic activity, control and supervision, management o f state property and provision o f service to the citizens and legal entities by the state structures; and 0 completion o f the process o f separation o f functions between structures o f executive power at federal and regional levels, optimization o f the activity o f the territorial structures o f the federal executive power. 2.21 In February 2004 a specially created Government Commission chaired by the Vice Prime Minister completed the review o f all 5,600 functions o f the federal executive bodies and it was expected that about h a l f o f the functions would be revised or abandoned. This would require significant changes in the legal and regulatory framework to be implemented by the end o f 2004. The results o f this inventory o f function^'^ became the basis for a major l6According to some analysis, however, the provisions for linkages between pay and performance in the law are still not sufficient since about 84 percent o f pay would not depend on performance (HSE, 2003). l7It should be noted that the review looked at the functions as they are set up in the existing legal and regulatory framework, without any analysis o f whether these functions have been actually implemented or whether the functions have been actually performed but are not reflected in the regulatory framework. More detailed agency-specific reviews would be needed later to increase the efficiency o f executive bodies. These future reviews should be also linked with the introduction o f administrative operations manuals and automation o f government business processes (see HSE, 2004). 31 reform in the federal executive government structure launched by the President in early March 2004. As opposed to the previous structure o f the federal government, the new one introduces a clear mechanism for division o f authority and responsibility between the three tiers o f the executive power: federal ministries responsible for policy development, federal services for exercising control and supervisory functions, and federal agencies in charge o f public service delivery. The number o f federal ministries was drastically cut from 23 to 14 (later the number o f ministries was increased to 16). 2.22 As o f M a r c h 2004 some work o n a number o f issues related t o administrative and c i v i l service reform, including development o f concepts and legal framework providing for introduction o f administrative operations manuals, quality, and accessibility standards for public services, e-government architecture, and deregulation issues as w e l l as access to information and development o f the pre-court appeals system, had been started. Some achievements have been made in introducing performance-oriented budgeting at the federal level" and initial steps have been taken to strengthen anticomption activities. This demonstrates the comprehensive nature o f public sector reform that i s being prepared in Russia with most o f the implementation s t i l l planned for the future. c. A FRAMEWORK FOR THE ASSESSMENT OF REFORM IMPACT 2.23 As described in Section B c i v i l service reform includes a variety o f measures that, for the purpose o f estimating the fiscal implications o f the reform, could be grouped into the following key components. B Pay reform intended to reduce the existing gap between the compensation in the public and private sectors (these efforts refer specifically t o salary adjustments in core government administration employment). Implementation o f this component o f reform would have direct fiscal implications caused by an increased wage bill. ' HR management reform involving the changes in recruitment, promotion, rotation % o f staff, training, performance appraisal, disciplinary procedures, career paths, retirement procedures, etc. Implementation o f this component would lead to increased expenditures o n human resource management and training.'' b Modernization o f public service that would entail development and introduction o f new business processes and procedures based o n m o d e m information technologies and e-government approaches. The direct fiscal implications o f this component include additional spending o n equipment, use o f infrastructure and support services (such as telecommunications), and other overhead costs o f core '* In accordance with the Concept for Reforming the Budget Process (2004-2006) approved by the Govemment of the Russian Federation in May 2004, as a part o f 2005 budget cycle all ministries and agencies reporting directly to the Government o f the Russian Federation were required to prepare Reports on Results and Main Areas o f Activity, which have to contain objectives, tasks, and performance targets for the relevant ministries (including their subordinate agencies) and present a budget breakdown by programs and tasks to be implementedby the ministries. l9 Another possible fiscal implication of the HR reform would be an increase in intensity o f inter-regional staff rotation. Currently the scope of rotation inside the civil service i s limited because of the fiscal constraints (Le. provision of housing, relocation benefits, etc.), and usually it i s HQ-directed. Since to the knowledge of the authors, there have been no estimates yet for the desirable intensity of rotation, this aspect of reforms i s not taken into account for the purpose of the Note. 32 government administration. The costs o f modernizing the public service would entail both significant investments and recurrent expenditures o n operation and maintenance o f the investments made. Estimating the requirements for investments needed for public service modernization i s a separate significant task that itself would suggest a number of reform scenarios. Hence, in this Chapter we will be focusing exclusively o n current expenditures.” For the purposes o f this analysis, it i s assumed that though automation o f some functions within the government may lead to reduction in staffing, this effect i s not analyzed separately for this reform component. All expected reductions in staff levels in the model are associated with administrative changes and are accounted for under the public administration reform component’. % Public administration reformz2includes decreasing the scope o f government interference in economic processes, eliminating duplication in functions and authorities o f different federal executive bodies, development o f self-regulating organizations, differentiation between regulatory, supervisory, property management, and service provision functions o f the government, as well as separation o f responsibilities between federal and regional executive bodies. I t i s expected that the reform process would involve restructuring and right-sizing o f the core government administration, better allocation o f functions between various government agencies, out-sourcing o f non-essential functions to the private sector, etc. This component o f reforms would mostly affect the executive branch o f the core government administrationz3. The reform would result in budget savings from the reduced number o f core government administration employees, as well as in significant efficiency gainsz4. 2.24 The ongoing debates o n civil service reform are mostly focused o n salary increases and other improvements in the c i v i l service (both federal and subnational), especially in the executive branch o f the federal c i v i l servicez5. However, the political economy o f the reform suggests that a significant pay adjustment in the c i v i l service i s likely to become a trigger for corresponding increases in compensation in the whole core government administrationz6,as ’O Fiscal costs of implementation of some HR management reform components (for example, introducing competitive recruitment for civil service positions) have been estimated by HSE (2004). 2 1 Some altemative estimates o f the costs of public service modernization related specifically to implementation of electronic administrative manuals are presented in the recent HSE (2004) report. ’’ Formally, the administrative reform in Russia i s not seen as a part of the civil service reform. I t i s considered to be a complementary reform with the priorities defined in Presidential Decree No. 824 of July 23, 2003 On Measures o f Implementation of Administrative Reform in 2003 - 2004. 23 Civil servants employed by other branches of the core govemment administration may be affected by other plannedon-going reform efforts (such as a judicial reform). However, for the purposes of this Chapter it i s assumed that these other branches remain unaffected by the administration reform. 24 In the framework of public administrative reform, it i s envisaged that some of the functions of the government entities would be abolished, while some of these functions would be transferred to “quasi-government” entities. For the purpose of this Note, by “a reduced number of core government employees” we mean absolute reduction in a number of civil servants/public employees as a result o f abolishing some of the existing functions. 25 The most recent discussions related to possible scenarios of the pay reform are presented in the HSE (2004) report. 26 Rationale for inclusion of non-civil servants into the analysis o f fiscal implications of the pay reform may be illustrated by the example of the State Customs Committee that currently has three types of personnel: (i) civil servants; (ii) uniformed personnel (that includes staff performing intelligence functions, as well as all staff at the positions o f Division Chief and above); and (iii) staff with employment regulated b y the Labor Code. In this 33 w e l l as in the public sector at large (in the general government), even i f the current legislation provides n o formal links between the wages levels o f civil servants’ and those o f other civilian public sector employees. Otherwise, it would be quite difficult politically for the Government to sustain a drastic increase in the salary gap between the civil servants and the rest o f the public sector employees. The importance o f this link was highlighted once again by the recent government decision regarding salary increases in the public sector, including a 30 percent pay increase in the entire public sector in October 2003 and the proposed similar all- inclusive 50 percent increase for 2004. Hence, the approach followed in this Chapter i s that the fiscal implications o f the proposed reforms in c i v i l service should be simultaneously assessed in two different frameworks: 0 ‘‘narrow approach” covering fiscal costs o f reforms in core government administration; and 0 “broad approach ” assessing fiscal implications o f a comprehensive reform package and salary adjustment in the entire civilian public sector employment. 2.25 I t i s recognized that in fact the proposed “broad approach” may be expanded even further to include the fiscal costs associated with the increased pay in police service and armed forces. These spheres were not included in this Chapter because o f the lack o f data readily available for simulations. Moreover, inclusion o f the armed forces into the analysis would call for additional analysis o f military reform options, which i s a large task in itsele7. Also, it i s recognized that implementation o f c i v i l service reform would create additional pressures o n the pension system, since keeping a decent proportion between the pensions and wages i s another important policy constraint. In particular, reducing positions that are to become vacant due to staff retirement presents a relatively soft option for adjusting staffing levels. In accordance with Rosstat data, in 2003 19.3 percent o f civil servants and 29.2 percent o f municipal servants were over 50 years old. However, the increase in pension age proposed as part o f pension reform in Chapter 3 reduces potential benefits o f such scenario. Proper consideration o f this area would require separate research and would have to be analyzed in the context o f the pension reform. Fiscal implications o f the pension reform are presented in a companion Chapter prepared jointly by the Bank and the Institute for Economy in Transition. 2.26 I t should be noted that the implementation o f c i v i l service reforms would bring about not only fiscal costs but also result in noticeable fiscal and economic benefits associated with a stronger productivity growth, better resource allocation (achieved through granting more autonomy to government agencies in reallocation o f budgeted funds, adoption o f more transparent procurement practices and wider application o f competitive procurement methods, etc.), automation of business processes, increased efficiency in the use o f public property, and better quality o f public services. However, it i s difficult to estimate most o f these benefits in quantitative terms and i t will take time for most o f these benefits to materialize. Hence, they have not been taken into account for the purposes o f this analysis. 2.27 The earlier attempts to estimate fiscal implications o f the on-going c i v i l service reform in Russia have been limited and were focused o n particular components o f the overall reform costs. In 2003-04, the Higher School o f Economics published some estimates related to fiscal case, should it be decided to adjust the pay scale for civil servants, it clearly has to be adjusted at least for the category (ii), but also probably for the category (iii). 27 Some analysis o f possible military reform options i s presented in the IET (2002) report. 34 effects o f .targeted pay increase for federal headquarter-based c i v i l servants, as well as investment costs associated with the introduction o f new technologies in the federal c i v i l service. The later were further refined in the framework o f drafting a Federal Program Administrative Reform (2005-1 0). The Presidential Program Reforming the Civil Service (2003-05) also presented some estimates for investment costs related to drafting new c i v i l service legislation and developing new methodologies and instructions needed to carry out both pay and HR management reforms. However, there have been neither attempts to estimate the full fiscal costs o f all the above components, nor any assessments o f a systemic fiscal effect o f the on-going reform on the entire costs o f financing the civilian public sector. SOURCES AND K E Y ASSUMPTIONS D. DATA 2.28 Datu Sources. The data used for calculating the fiscal implications o f civil service reform includes October 2002 public sector statistics published by Rosstat in 2002; data o n pay and employment in core government administration for 2001 and 2002 (Rosstat 2002 and 2003); results o f pay and public officials surveys conducted in 2002-2003 and sponsored by DFID (HSE, 2003, forthcoming); international statistics on the education and health sectors (including W H O and Bank data); international pay and employment database maintained by the Bank'(Wor1d Bank database); as well as data obtained from other sources (a complete l i s t o f sources i s presented at the end o f the Chapter). 2.29 Because o f the lack o f up-to-date comprehensive pay and employment data in Russia, the following assumptions were applied to calculations o f the pay and employment baseline: > F o r Core Government Administration 0 Because o f the lack o f data o n employment breakdown by groups/categories for 2002, we assumed that the 2001 employment structure remained unchanged and applied the 200 1 shares to the 2002 employment levels. Because o f the lack o f data o n compensation by groups/civil service categories for 2002, we applied the actual average compensation increases in relevant branches and levels o f the government to all 2001 categories/groups proportionally assuming that the compression ratio remained unchanged. > For Civilian Public Sector Employment 0 We assumed that the compensation level as o f October 2002 i s equal to the average compensation level in 2002. 0 Rosstat (2002) data contained average compensation levels with breakdown per four major civilian public sector branches (see Figure A2.1 in Annex 2.1) and per level o f government (Le,, federal, regional and municipal). These compensation levels were applied to all sub-sectors within each branch. 0 I t was assumed that organizations classified as being federal property are financed from the federal budget, while the entities in regional and municipal property are financed from sub-federal budgets. 0 Rosstat (2002) data cover all organizations in the civilian public sector that are partly or fully financed from the budget. For the purposes o f this Chapter it i s assumed that the reported wage bill and social charges o f civilian public sector employees were fully financed from the respective budgets. 35 2.30 Key Macroeconomic Assumptions. Macroeconomic assumptions for our simulations were developed jointly with the experts from the Institute o f Economy in Transition. The basic principles o f the macroeconomic framework used in our work for costing out various structural reforms are presented in Annex 3.1, In sum, we took the Government’s baseline macroeconomic projections for the period 2004-2006 and used them as a basis to build a set o f four macroeconomic scenarios, each o f which reflects a specific combination o f two primary determinants o f Russia’s future macroeconomic performance-average o i l price and expected speed o f structural reforms. Our initial plan was to use the four macroeconomic scenarios as a basis on which we would design and elaborate further more detailed sub- scenarios o f specific structural reforms2*. 2.31 However, in the case o f reforms in public administration we came to the conclusion that it would be appropriate to modify our original plan and follow a simplified set o f macroeconomic assumptions. The reason for such simplification derived from our early observation that the simulation results (presented in GDP p.p. 2 9 ) are not sensitive to GDP growth rate. The simulations are also not sensitive to inflation, since the model assumes full annual indexation o f wages in both core government employment and the civilian public sector. Therefore, we decided that it would be appropriate to develop cost estimates within the single macroeconomic scenario. 2.32 What significant for the outcomes o f our costing exercise i s the differences in growth rates, primarily the difference between the expected growth rate in private sector wages and GDP growth rates. The higher future wage growth in the private sector, the more expensive i s the government’s task o f closing the existing pay gap. Overall, we concluded that the key macroeconomic parameter in the model i s the ratio between real wage growth rate and real GDP growth rate. Currently, the share o f payroll (including hidden wages) in the Russian GDP i s quite low, but in the medium term we expect that in response to structural reforms i t will be growing quite rapidly to approach the levels prevailing in other economies in transition. This would occur owing to increased competition, reduced share o f the informal sector, and therefore improved wage/profit ratio in the economy. However, the costs o f the proposed reform in c i v i l service depend fundamentally upon the speed o f this future catch up. 2.33 Based o n the above considerations, we decided to base our simulations on the single macroeconomic scenario, but to consider three sub-scenarios that have different growth rates for the payroll share in GDP (Table 2.5). From our original four macroeconomic scenarios we selected the most optimistic one as our single macroeconomic framework. This scenario i s described as a scenario with the advanced reforms and high o i l prices in Annex 3.1. 28 This initial plan with multiple macroeconomic scenarios was fully implemented, however, for analysis o f fiscal implications for two other structural reforms - in the pension system and in housinghtilities. The results for these two reforms are reflected in Chapters 3 and 4 of this paper. 29 Costs reflected in absolute values, e.g., in constant 2002 rubles, would be different. 36 Table 2.5: Key Macroeconomic Assumptions (in constant 2002 rubles) 2003 2004 2005 2006 2007 2008 2009 2010 GDP growth, % 7.3 5.5 5.0 4.5 4.0 3.5 3.0 2.5 GDP, trln. RUR 10.0 10.5 11.1 11.6 12.0 12.4 12.8 13.1 GDP per capita, ‘000 RUR 69.9 74.1 78.2 82.0 85.7 89.1 92.2 94.9 Inflation, annual, % 10.0 10.0 10.0 10.0 10.0 10.0 10.0 Real investment growth, % 9 7.5 6.5 5.5 4.5 4 4 Real household incomes growth, % 7.5 7 6.5 6 5.5 5 4.5 Population (million people) 142.8 142.1 141.5 140.9 140.3 139.7 139.0 138.4 Scenario 1 (real wage growth rate exceeds GDP growth rate by 2 p.p.) Real Wage Growth, % 8.1 7.5 7.0 6.5 6.0 5.5 5.0 4.5 Scenario 2 (real wage growth rate exceeds GDP growth rate by 1 p.p.) Real Wage Growth, % 8.1 6.5 6.0 5.5 5 .O 4.5 4.0 3.5 Scenario 3 (real wage growth rate i s equal to GDP growth rate) Real Wage Growth, % 8.1 5.5 5.0 4.5 4.0 3.5 3.0 2.5 Source: Rosstat, MoEDT, and staff calculations. 2.34 W e selected the most optimistic scenario in order to highlight both the costs and risks o f implementing the proposed reform package. At the same time it i s quite clear that in the scenarios with l o w o i l prices and respectively with much higher fiscal pressures, the same reform task would become much more challenging politically. In the case o f a tight budget i t would be much more difficult for the government to justify the need for a radical pay increase in public administration and convince society that a considerable budget restructuring that favors govemment employees i s indeed urgently needed. In the discussion below we do not consider these additional and non-quantifiable policy risks could be derived from the overall deterioration in the macroeconomic situation, and which most likely would initiate additional pressures towards slower rates o f reforms. 2.35 The selected macroeconomic framework i s based o n the assumption o f an average growth rate o f 5 percent for 2004-0630 and 4 percent for 2004-2010. I t i s worth noting that these growth rates are lower than those assumed in the corresponding government projections. Overall, we expect that growth rates will decline after 2006. Better utilization o f existing reserves in the economy, which was a critical growth factor in 1999-2003, cannot support the future growth in the same way as before because the reserves are to a large extent exhausted. At the same time, we admit that this may be considered as a “conservatively-optimistic” scenario. 2.3 6 Private Sector Benchmarks for Net Cash Compensation Increase. The primary objective o f the pay reform i s to narrow the existing compensation gap between the core government administration and the private sector. However, so far the overall scope o f the c i v i l service pay reform remains undecided. Although some proposals o n increasing the compensation only to a limited number o f senior c i v i l servants (or those holding “strategically 30 The current consensus estimate for Russia’s growth in 2004-05 i s rather favorable and i s close to about 5.2 percent a year. 37 important positions”) have been formulated (HSE, 2003 and 2004) and have recently been implemented through a Presidential Decree, drastically increasing the cash compensation for some HQ-based federal civil servants3’, the sustainability o f such an approach remains unclear and n o further policy decisions related to deconcentrated units o f federal bodies, as well as to core government administration in general, l e t alone the civilian public sector, have been taken so far. 2.37 For the purpose o f this Chapter, the data from a comparative pay and benefits survey of the public and private sector (HSE, 2003) were utilized as a basis for the estimates for H Q - based federal authorities employees, and then was adjusted to account for the regional wage differential, which was estimated based o n the actual 2001 information about the pay differences between Moscow and other regions (Denisova, 2001). The specific figures applied are presented in Table 2.6. 2.38 These available data have important shortcomings related to a limited sample o f the participating Russian private sector companies in Moscow. Also, while the employees in the public sector especially in the top grades have access to a considerable amount o f in-kind benefits, the available information o n such benefits i s s t i l l limited and could be not statistically representative. Also, the survey did not allow for measuring the existing gap in remuneration for the top employment categories (Categories A and B) o f the civil service. For the purposes o f our analysis, it was assumed that the pay o f Category B employees should be at least 20 percent higher than that for Category C-top, and for Category A-20 percent higher than that for Category B, while estimated non-cash benefits are assumed to be the same for all top c i v i l servants (Category C-top and Categories A and B) and their private sector comparators. 2.39 To estimate the increase in net compensation o f the core government administration employees that do not have the status o f civil/municipal servants (ie., core government administration employees that are regulated by the Labor Code), an assumption was used that the compensation increase for these employees i s equal to a simple average increase for Category C Senior and Junior positions in the appropriate brancwlevel o f the government administration. This assumption was used because most o f these employees are technical and support staff. 2.40 The survey showed, inter alia, significant variance in both the pay and total compensation gap, especially for the top grades. Hence, to estimate the existing pay gap correctly, some in-kind benefits provided to civil servants are assumed significant and proposed to be retained (medical benefits, car, and driver), while others (sanatoria, apartments, dachas) are proposed to be discontinued (but their value i s to be reflected indirectly through a proposed pay increase). Due to a limited number o f recipients o f the latter type o f benefits, the direct fiscal savings from their discontinuation are negligible- estimated savings for the HQ-based federal executive service in 2002 accounted for about 550 million rubles or about 0.01 percent o f 2002 GDP. However, in case the government chooses to commercialize all related infrastructure, potential one-off revenues from disposal o f these assets at market prices would be much more significant. It should also be noted that the available data on benefits cover only federal H Q executive c i v i l service, hence, the adoption 31 Presidential Decree No. 5 19 On Improving the Compensation to Public Servants Holding Specific Positions o f the Russian Federation and Specific Positions in the Federal Civil Service of the Russian Federation dated April 10, 2004. 38 o f a similar policy for federal deconcentrated and subnational core government administration employees would probably yield additional fiscal savings. 2.41 Our results suggest that in 2002 the public-private gap in cash compensation varied between 2.4 and 8.6 times (Column 1, Table 2.6). However, the estimated gap in total (gross) compensation (Column 2) while s t i l l significant i s much smaller - between 1.7 and 4.3 times. This i s because of considerable amount o f in-kind benefits i s available to the top public servants, which in these employment groups exceeds their cash compensation by 3-5 times. T h e proposed reform strategy suggests elimination o f most o f these benefits, which would require a major increase in their cash salaries to compensate for lost benefits, make their overall compensation competitive and facilitate the establishment o f the environment supportive of the government anti-corruption efforts. This increase would be partly accommodated by decreased financing o f the in-kindbenefits for c i v i l servants. 2.42 Columns 3 and 4 in Table 2.6 present our estimates for the public-private net compensation gap, which i s the gap in current cash compensation adjusted for in-kindbenefits to be retained. The net compensation gap i s a critical parameter in our model - it defines the benchmark for necessary pay adjustment in the public sector to make salaries there fully comparable with the pay in the private sector. At the moment, the net compensation gap varies between 2.3 and 7.8 times for HQ-based staff and 1.2-3.9 times for federal deconcentrated and subnational service. However, based on the data available, we cannot estimate variances in the compensation gap among individual positions and specialties. Table 2.6: Estimated Public-Private Pay and Compensation Gaps, 2002 Measured as a Ratio o f Pay (Compensation) in the Private Sector to Pay (Compensation) in Federal and Subnational Civil Service Federal Civil Service Subnational Civil Service Public-Private Public-Private Category/ Public-Private Gross Net Public-Private Group Pay Gap, Compensation Compensation Net CompensationGap, time& Gap, timesb/ Gap, timesg times 1 2 3 4 Category A 8.6 2.2 7.8 3.9 Category B 7.1 1.9 6.3 3.2 Category C TOP 8.5 1.7 7.8 3.9 Chief 5.8 4.2 5.7 2.8 Lead 5.2 4.3 5.1 2.5 Senior 3.7 3.4 3.6 1.8 Junior 2.4 2.2 2.3 1.2 Notes: The estimated gaps are not adjusted for 30 percent compensation increase in core government administration and civilian public sector implemented in October 2003. - a/ reflects the estimated gap in cash compensation only. b’ reflects estimated differences in cash compensation combined with value o f all in-kind benefits currently received. /reflects estimated differences in cash compensation combined with value o f in-kindbenefits t o be retained. Source: HSE (2003) and staff calculations. 2.43 Based o n the understanding that some o f the in-kindbenefits will be discontinued, for the purpose o f this Chapter it i s assumed that the total amount o f expenditures o n in-kind 39 benefits in core government administration would not exceed the current level. Hence, the expenditures associated with in-kind benefits are not included in net increases o f fiscal expenditures o n core government administration. 2.44 Given the large current compensation gap with the private sector it i s highly unlikely that in the medium-term Russia could close most o f it and reach the level o f O E C D countries where the common remuneration gap with the private sector i s o n average o f about 10 percent32, while i t varies for particular positions/prQfessions. Thus, even in the medium-term, the proposed scenarios aim only at a partial closure o f the gap. In our simulations below even the “radical” scenario o f the pay reform assumes a relatively high residual compensation gap o f 50 percent. 2.45 The results o f the survey o f the public servants’ pay expectations (see Table 2.7) undertaken in 2002 (INDEM) also seem to confirm the feasibility o f a relatively high residual compensation gap for federal c i v i l service. The comparison o f pay expectations and the existing compensation gap shows that the surveyed officials either underestimate their existing pay differences with the private sector or they are prepared to accept lower pay levels (at least at Department/Division Chief levels). While the estimated pay gap accounts for a 5.0-7.5 increase, public officials would consider a 2 . 5 4 . 0 pay increase to be adequate. This difference between the actual pay gap and pay expectations could be explained by a number o f factors, including: (i) insufficient awareness o f public servants o f the comparative pay levels in the private sector; (ii) the extent to which the public servants surveyed have access t o and value various non-cash benefits provided; and ( iii) higher j o b security and lower intensity associated with a public sector employment as compared to the private sector positions. The results o f the public officials surveys may also reveal the fact that some o f the c i v i l servants in Russia m a y not perceive their official pay as the only (and the primary) source o f income. T h i s argument i s confirmed by the recent research o n ownership structure in Russia. In fact, there i s little, if any, separation between the authorities and business community in the country33. Table 2.7: Civil Servants’ Perceptions: Expected Pay and CompensationLevels for Benchmark Positions in the Federal Civil Service (based on Public Officials Survey) Expected Pay Pay Increase Expected Pay (in (with all in- (with case all in-kind Pay Increase Benchmark Category kind benefits retained in- benefits are (without in- Position C retained), kind discontinued), kind benefits), Group US% benefits), US$ times times Deputy Minister top 2,182 4.0 3,733 6.9 Department Head top 864 1.9 1,223 2.6 Division Head lead 672 2.2 887 2.9 Chief Specialist senior 448 2.6 634 3.7 , Sources: INDEM (2002), HSE (2003), and staffcalculations. 32Schiavo-Campo et al. (1997), p.10. 33For more information on this issue, see the recent Russia Country Economic Memorandum (World Bank, 2004). 40 2.46 The analysis o f both Tables 2.6 and 2.7 points out that both the existing net public- private compensation gap (Table 2.6) and the pay increases, which would meet the current expectations of the c i v i l servants (Table 2.7), vary greatly between the different grades and positions and tend to be lower for more junior servants and higher for more senior public officials. This suggests that the compression ratio in the core government administration i s significantly lower than the one in the private sector. Indeed, in 2002 the compression ratio for federal executive HQ-based civil service accounted for only 2.5. A compression ratio for federal executive c i v i l service was slightly higher (3.7), but s t i l l quite l o w by international standards. Internationally, the compression ratio varies widely from highs o f 30: 1 to lows o f 2 : l with the mode o f around 6 or 7 to What follows from this analysis i s that the decompression o f the existing pay scale in Russia by at least 2.0-2.5 times would be quite desirable in the medium term. 2.47 L o w compression ratios in Russia suggest that the pay increases in core government administration should be focused more on the managerial (higher level staff) than o n junior staff. I t should be noted, however, that the proposed reform strategy to close the same percentage o f the existing pay gap for all employee categories would automatically generate considerable pay decompression (because the net compensation gap i s so much higher today for the higher grades). 2.48 At the same time, it i s worth noting that selective increases that do not cover a l l o f the core government administration employees, at least to some extent, may create additional distortions in the staff grading process. Recent public officials surveys pointed out that there are quite a number o f federal and subnational civil servants that though formally employed at senior positions, in fact perform the responsibilities o f junior staff (see HSE, 2003, for more information). T o improve the incentives for proper grading in the core government administration and sustain the employment structure under the conditions o f significant pay adjustments for higher level staff, a “minimum wage increase for all grades r u l e should be ” made a part o f any pay adjustment strategy. In our simulations such minimum adjustment amounts to a 20-30 percent increase in real wage relative to i t s 2003 level depending o n the reform scenario. 2.49 Substantial cash compensation increases in core government administration, if not expanded to other categories o f general government employment, would significantly affect the balance between remuneration o f the core government administration and the rest o f the public sector. I t i s assumed that this imbalance would be politically unsustainable and the Government would ultimately have to adjust pay in the entire public sector regardless o f the fact whether there i s or not at the moment a legally explicit link between compensation o f these two categories. For the purpose o f this Chapter, an average cash compensation increase in core govemment administration i s used as a trigger for estimating a corresponding pay adjustment in the civilian government employment. Given the current number o f civilian employees, i t i s unlikely that it would be possible to sustain the current cash compensation ratio between the core government administration and the civilian public sector. It i s also expected that the ratio o f non-budgetary sources o f civilian public sector employees’ wage bill would be increasing owing to the growing share o f commercial services provided by the entities in this sector for additional pay. Hence, in our scenarios we assumed that the pay 34 Schiavo-Campo et a]. (1997), p. 44. 41 adjustment in civilian public service would be equal to 70 percent o f the average increase in cash compensation in the core government administration. 2.50 Payroll Taxes. All the estimates o f cash compensation include payroll taxes- personal income tax (PIT) and Unified Social Tax (UST)-Le., we estimated gross compensation aggregates. The existing regressive scale o f UST has been explicitly taken into account with tax brackets adjusted for real wages growth. N o possible future changes in the UST tax rates have been accounted for35.Increase in P I T collection because o f higher cash compensation in core government administration and civilian public sector employment was accounted for as a fiscal gain to the sub-federal budget. 2.5 1 Verification. Although there i s no “best international practice” related to the relative pay levels in the public sector, a ratio o f average federal government administration wage to GDP per capita could be used as a monitoring indicator to verify the viability o f the analyzed reform scenarios. In OECD countries, this indicator o n average i s 1.636,while in Russia in 2002 it was 1.2, which i s quite low, especially when compared to either the global average (3.0) or an average for L A C countries (2.5) that could be used as a proxy for middle-income countries 2.52 Relative Pay Adjustment: HQ-based Employees and Deconcentrated Staff. The estimated compensation gap i s higher for federal HQ-based core government administration employees than for deconcentrated federal civil servants and for subnational civil servants. This i s partially a reflection o f the existing imbalance in remuneration among the federal H Q - based c i v i l servants, c i v i l servants working in deconcentrated units o f federal bodies, and subnational c i v i l servants. Currently, in 60 percent o f regions, salaries o f regional servants are higher than those o f federal deconcentrated units; in 45 percent o f regions, salaries o f regional servants are higher than the salaries o f HQ-based federal c i v i l servants (see HSE, 2004, for more information). Hence, the ratio o f the compensation between these categories (current1 favoring subnational employees) should be reversed to reflect relative labor market prices . 3r T h i s policy may also be considered as part o f the proposed decompression agenda, since it suggests that as a result o f the reform the compression ratio in the federal executive branch (including deconcentrated units) would become significantly higher. 35The on-going debates on tax reform in Russia also include some proposals on decreasing the rate for Unified Social Tax up to 10 p.p. but no final decision had been taken on this issue by the time simulations were performed. 36 The relatively low levels of this ratio in the OECD countries are due to smaller skill differentials between the central government employees and the rest o f working population. Hence, for Russia a higher ratio than the one for OECD (probably the one approaching the level of middle-income LAC countries) could be expected. Cross country comparisons should, however, be used with caution since e.g. in many countries paramilitary personnel i s considered as a part o f the central government, while this report separates police service from the core government administration. 37 Source: Schiavo-Campo et al. (1997). An International Statistical Survey of Government Employment and Wages, p. 7; staff calculations for Russia (based on the Rosstat data). 38 This assumption suggests a completely different approach to compensation for the deconcentrated federal executive bodies that in effect creates a significant pay gap between HQ-based staff and those employed in the territorial branches of the same government entity. Implementation o f this approach would call for (i) continuous monitoring of regional labor market prices throughout the country, and (ii)imposing strict limitations on employment growth in the Headquarters o f federal executive bodies. 42 2.53 I t i s worth noting that the future nominal levels o f cash compensation in the civilian public sector should vary from region to region, depending on the local price level as well as o n some other factors, while our scenarios suggest only the national average estimates for a potential cash compensation for different employment categories. 2.54 Attrition Scenarios entailing implementation o f the administrative reform component assume some reduction in both core government administration employment, as well as in employment in the civilian public sector. 2.55 As far as the core government administration employment i s concerned, for the purpose o f this Chapter it i s assumed that attrition would take place only in the executive branch o f the core government administration. Since the detailed structure o f management bodies within the core government administration has not been determined yet, it i s especially difficult to make projections for a possible attrition rate. Moreover, the Wagner L a w claiming that public administration employment tends to grow with economic growth also may play a role in determining future trends in staffing levels in the core government administration in Russia. The attrition rates proposed in the Chapter are more conservative than the latest announcement made by the top government officials o n the expected 30 percent cuts in the number o f c i v i l servants because it i s not clear whether these expected reductions refer to HQ- based federal executive civil servants or to the whole federal executive c i v i l service. Moreover, given the l o w current staffing levels in the HQpart o f the executive service, we are concerned that a 30 percent cut for this component o f the public administration may be excessive, Our analysis o f the dynamics o f core government administration employment in 1994-2002 (see Section A) also suggests that subnational executive civil service and local self-government may accommodate higher attrition than federal executive authorities. These attrition rates are used here only as preliminary benchmarks for the analysis. More accurate forecasting o f future attrition rates would require much more detailed research o f the current employment rates, costing out the separate executive functions and analyzing broad statistical data o n regional variations in actual employment. 2.56 The specific attrition rates that have been used for simulations are presented in Annex 2.5 and briefly summarized below. Employment adjustments for the education sector were calculated based o n the difference between the studentdteacher ratio in Russia and in middle- income OECD countries. The target level was either estimated as an average between middle- income and OECD countries levels or as the one approaching the OECD countries level, depending o n the current indicators for Russia and the feasibility o f the quick changes in the staffing levels. Depending o n the sub-sector, possible attrition rates in the education sector were estimated in the range o f 10.5-26.9 percent o f the 2001 employment levels (see Table 2.8). For later years, demographic projections o n the number o f students were also taken into account. Table 2.8: Attrition Rates Expected in the Education Sector, 2001 Current ratio o f Benchmark ratio o f Expected Attrition Sub-Sector” studentdteacher studentdteachers Rate (YO) Higher Education 11.4 15.6 26.9 General Education 11.5 15 23.3 Vocational Education 10.2 11.4 10.5 * For other sub-sectors of the education sector a general 10 percent reduction rate used for all “other civilian public sector employment” was applied. Source: Poletaev et al., (2003), and staffcalculations. 43 2.57 Future employment adjustments for the health sector were estimated based o n the ratio o f doctors and paramedical staff per 100,000 o f population in Russia as compared to the same indicator in OECD countries. Given considerable cross-country variance o f this indicator as well as the comparatively high ratio in Russia, i t i s assumed that in the medium to long term the number o f health sector employees can be reduced by 20 percent. 2.58 There i s little if any information on a potential for staff reduction in the rest o f the civilian public service. For the purposes o f this Chapter i t was assumed that this reduction would account for 10 percent. 2.59 At the same time, for the scenarios that do not assume any administrative reform actions, it was assumed that the actual employment in core government administration may in fact grow, given that in 2001 about 5.6 percent o f positions in the government administration were vacant and some o f these are likely to be filled in after the salary increase. In 2001 the difference between the share o f vacant positions in subnational service (which i s considered relatively more attractive given local market opportunities) and federal c i v i l service accounts for about 2 percentage points. At the same time, in the process o f reforms the requirement o f public servants’ qualifications will increase significantly, and as a result some o f the positions may remain vacant. Hence, for the purpose o f simulations, it was assumed that the salary increases would lead to an increase in employment o f 2 percent, if not accompanied by a separate effort to cut staffing. The same assumption was applied to the civilian public sector employment. 2.60 Expenditures Related to Staff Attrition. For scenarios that assume employment cuts, additional expenditures related to one-time separation costs in core government administration have been calculated based o n the current legislation (i-e., Labor Code, legislation o n c i v i l service). These costs were estimated under the assumption that the redundant civil and municipal servants are paid an equivalent o f their four-month pay, while the other civilian sector employees are paid an equivalent o f their two-month pay. 2.6 1 Verification. Even a superficial cross-country comparison shows significant variation o f the employment numbers in different layers o f the core government administration and civilian public sector at large. Although there are significant methodological limitations to the actual application o f international comparative data, i t was helpful to use cross-country comparisons o f various employment ratios, such as shares o f core government administration employment, civilian public sector employment, and employment in health and education sectors in the total population, as monitoring indicators for reform progress. 2.62 Non-Wage Expenditures on Core Government Administration. Modemization of public service and implementation o f the full-scale HR management reform would call for increased financing o f non-wage expenditures o n core government administration, especially those o n equipment, communication and other services, and training. The UK data for running costs (used as a benchmark) shows that the average ratio o f non-wage expenditures accounts for 33-40 percent o f total expenditures o n government administration, while in Russia in 2001 this ratio (for federal budget only) accounted for about 38 percent (36 percent in 2003). This shows that the current share o f non-wage expenditures in Russia appears to be in line with international practice. I t i s anticipated that a full-scale implementation o f the comprehensive c i v i l service reform package would sustain this ratio at the level o f 25-36 percent (depending o n the reform scenario). In other words, we assume that the share o f non-wage costs in total budget expenditures o n core govemment administration would be either sustained or would somewhat decline primarily owing to an opportunity for considerable savings associated with 44 more efficient use o f existing office space (and associated decline in maintenance and utility costs). In addition, the possibility o f reallocating some o f the core government administration staff and subsequent renting o f government real estate could bring about additional fiscal gains. 2.63 I t should be noted that non-wage expenditures in civilian public sector employment are highly sector-specific. Identification o f appropriate benchmarks would require a separate research o f the current status o f civilian public sector financing and the need for further development. This research goes beyond the scope o f this analysis although we acknowledge the importance o f non-wage expenditures in the civilian public sector as a parameter o f c i v i l service reform in Russia. E. CIVIL SERVICE REFORM SCENARIOS 2.64 Fiscal implications o f the c i v i l service reform depend upon a large number o f factors. For the purpose of this Chapter, the following parameters were used to identify the possible reform scenarios and estimate their fiscal implications: k Macroeconomic scenarios (three sets o f indicators based o n the change in the share o f real wages in GDP); k Extent o f pay reform implementation, measured as the amount o f the residual public-private compensation gap: 0 Radical pay reform (by the end o f the reform period, Le., by 2010, the residual public-private compensation gap would not exceed 50 percent, Le., average compensation in core government administration would amount to two thirds (66 percent) o f the average compensation in the private sector. Minimum pay increase in core government administration i s 30 percent. 0 Moderate pay reform (by the end o f the reform, the residual public-private compensation gap would not exceed 100 percent, Le., average compensation in core government administration would amount to h a l f (50 percent) o f the average compensation in the private sector). Minimum pay increase in core government administration i s 20 percent. k Pay reform pace. Three variants were used for simulation: high, medium, and low. The differences in pace across pay reform scenarios are presented in Table 2.9 below. For consistency, i t was assumed that, the pace o f administrative reform (measured as the share o f number o f staff cuts in the total attrition planned within the specific scenario) i s identical to the pace o f pay reform (measured as the share o f the public-private compensation gap closed since the beginning o f the reform in the total gap to be closed within the specific scenario). Table 2.9: Assumption on Pay Reform Pace, Measured as a Share o f the Overall Planned Gap Covered, O Y 2004 2005 2006 2007 2008 2009 2010 . Low-pacedreforms (1) 15 30 45 60 75 90 100 Medium-paced reforms (2) 20 40 60 80 100 100 100 High-pacedreforms (3) 35 70 100 100 100 100 100 45 > Administrative reform implementation and the extent o f results in attrition as keys o f fiscally measurable impact. Specific attrition rates for core government administration are presented in Annex 2.5. Given the political sensitivity o f the issue, as well as the comparatively l o w share o f core government administration in the total population o f the country, the following scenarios have been proposed: 0 N o administrative reform, which would lead to increased employment in core government administration and the civilian public sector at large. This scenario assumes significant expenditure growth without any fiscal gains from staff attrition. As a result, i t i s likely to lead to fiscal pressures, which would prevent any substantial progress in implementation o f both HR management and public service modernization reform components. Thus, the share o f non-wage expenditures in total expenditures on core government administration i s assumed to be at the lower end (25 percent) o f a broader interval. 0 Fair administrative reform with moderate achievements in both HR management and public service modernization components. This would provide for cuts in staffing by 7-10 percent in federal authorities and 17-20 percent in regional administrations and local self-government and bring the share o f non- wage expenditures in total expenditures o n core government administration to about 32 percent. 0 Significant administrative reform with significant progress in HR management and public service modernization. This would provide for cuts in staffing by 15-20 percent in federal authorities and 25-30 percent at the regional and municipal levels and sustain the share o f non-wage expenditures in total expenditures o n core government administration at the level o f 36 percent. 2.65 Possible combinations o f scenarios with different pay and administrative r e f o m scope are summarized in Table 2.10. 2.66 Based o n the factors listed above, we developed a matrix containing 54 potential scenarios (all possible combinations o f selected variables). After a brief analysis o f the matrix, the scenarios that have inherent inconsistencies and are unlikely to be implemented (Le., radical pay reforms implemented at a l o w pace, moderate pay reforms implemented at high speed, slow-paced reforms combined with significant administrative changes) have been removed from the list. The matrix with the description o f 36 remaining scenarios that were selected for actual costing-out and analysis i s presented in Table 2.1 1. The basic results (cost estimates) o f the simulations for these 36 scenarios are summarized in Table 2.12. 46 Table 2.10: Possible Scope o f Pay and Administrative Reforms Significant Administrative N o Administrative Reform Fair Administrative Reform Reform + Employment in core + Employment in executive + Employment in executive government administration branch o f core government branch o f core government and civilian public sector i s administration and civilian administration and civilian increased by 2 percent public sector i s cut by 7-20 public sector i s cut by 15-35 percent percent + Share o f non-wage expenditures in total + Attrition rates for civilian + Attrition rates for civilian expenditures on core public sector are applied in public sector are applied in govemment administration i s accordance with sectoral accordance with sectoral 25 percent assumptions assumptions + Residual public-private + Share o f non-wage + Share o f non-wage compensation gap i s 50 expenditures in total expenditures in total percent expenditures on core expenditures on core + Minimum pay increase i s 30% government administration i 32 percent s government administration i s 36 percent Note: this group of scenarios was found unrealistic and was not + Residual public-private + Residual public-private compensation gap i s 50 compensation gap i s 50% included in simulations percent + Minimum pay increase i s 30 + Minimum pay increase i s 30 percent percent + Employment in core + Employment in executive + Employment in executive government administration branch of core government branch o f core govemment and civilian public sector i s administration and c ivi1ian administration and civilian increased by 2 percent public sector i s cut by 7-20 public sector i s cut by 15-35 percent; percent; + Share o f non-wage expenditures in total + Attrition rates for civilian + Attrition rates for civilian expenditures on core public sector are applied in public sector are applied in govemment administration i s accordance with sectoral accordance with sectoral 25 percent assumptions assumptions + Residual public-private + Share o f non-wage + Share o f non-wage compensation gap i s 100 expenditures in total expenditures in total percent expenditures on core expenditures on core government administration government administration i s + Minimum pay increase i s 20 i s 32 percent 36 percent percent + Residual public-private ,+ Residual public-private compensation gap i s 100 compensation gap i s 100 percent percent + Minimum pay increase i s 20 + Minimum pay increase i s 20 percent percent 47 No. Scenario Macro (share o f Pay Reform Pay Reform Admin Reform Code wages in GDP) Extent Pace 48 8 L 0 CI : I m 50 2.67 The main findings from the base set o f simulations could be summarized as follows: 0 Potential fiscal costs o f civil service reform are quite sensitive to relative growth rate o f private sector wages. A decrease in real wages growth by 1 p.p. leads to about 0.5-0.7 p.p. o f GDP in annual budget saving. 0 The radical pay reform aimed at a 50 percent residual public-private compensation gap i s on average about 1.5 times as expensive as the moderate pay reform that allows for 100 percent public-private compensation gap at the end o f the reform process. In addition, the more ambitious the pay reform, the more volatile are i t s fiscal costs, Le., they are more sensitive to the changes in other factors. 0 Sub-federal budgets would have to carry a much larger share o f the overall fiscal burden, associated with the reforms. About two thirds o f the total incremental costs would become responsibility o f subnational authorities. 0 The scenarios with both radical and moderate pay adjustments result in significant pay decompression in HQ-based civil service, from the current ratio between average wages in Top and Junior Groups o f 2.5 to 5.2-8.3 in 2006 and to 6.8-8.3 in 2010. 0 The sensitivity o f fiscal costs to the pace o f pay reform implementation i s relatively low. 0 Both radical and moderate pay reforms would not be affordable for the budget system if they are not complemented by administrative adjustments. F. OUTCOMES OF C I V I L SERVICE REFORM IN LIGHT OF CROSS-COUNTRY COMPARISONS 2.68 In this section we intend to validate various reform options using several monitoring indicators, which allow placing some expected reform outcomes in a broader comparative framework. 2.69 Section D o f this Chapter suggested several indicators based on international public sector statistics that may be used as tentative guidance in analyzing and evaluating the results o f our estimates. One o f these indicators was a ratio o f average federal government administration wage to GDP per capita. The results o f simulations suggest that this indicator falls within the interval between 1.8 (moderate pay reform in case o f unchanged share o f real wages in GDP-scenarios 29-36) and 2.4 (radical pay reform in case the real wages growth rate i s 2 p.p. higher than the GDP growth rate-scenarios 1-4). These are more or less in line with the indicators for L A C (2.5), lower than the world average (3.0), and higher than the average ratio for OECD (1.6), and E C A (1.3) (see table in Annex 2.4). The results suggest significant increase in this indicator as compared to the baseline o f 2002 (1.2). 2.70 Another relevant indicator i s the number o f core government administration employees as apercentage to population, which in our simulations varies from 0.8 percent to 0.9 percent, which i s quite close to the baseline value (0.87 percent o f population in 2002). T h i s indicator i s in line with the numbers for civilian employment in central and subnational government in Poland (0.7 percent), Bulgaria (0.8 percent), Ukraine (1.1 percent), and India (0.9 percent), but i t i s significantly lower than in Mexico (1.4 percent) and Brazil (1.6 percent), l e t alone the high-income OECD countries where government employment varies between 2.9 percent o f population in Australia to 6.9 percent in the United States. The only country in our sample where the ratio i s significantly lower than in Russia i s Kazakhstan (0.5 percent). 50 2.71 A similar ratio for the number o f health and education employees suggests that by the end o f the proposed reforms the number o f these employees may vary between 6.0 percent o f population (in case n o administrative reform i s implemented) or 4.2 percent (in case the administrative reform takes place), while the 2002 baseline i s 5.6 percent. The cross-country data vary greatly, but it i s clear that implementation o f administrative reform will bring Russia closer to OECD averages (3.4 percent) with the closest comparators in transition economies group being Hungary (4.5 percent), Kazakhstan (5.1 percent), and Ukraine (3.9 percent). By international standards, employment in health and education sectors will s t i l l remain quite high, but, o n the other hand, the specifics o f Russia &e,, vast territory most o f which has l o w density o f population) may justify a higher employment in public services. Indeed, in Canada the indicator appears to be 5.0 percent, in Australia and the US-3.8 percent. 2.72 Generally, the brief comparison o f the simulation results with international statistics suggests that the reform scenarios implying administrative reform would bring about considerable general improvements to the structural characteristics o f both Russian civilian public sector and core government administration employment as compared with the current status. G. SUMMARY OF SIMULATIONS: ANALYSISOF SELECTED REFORM SCENARIOS 2.73 The analysis presented in Section F and Annex 2.6 allows narrowing down the number o f reform scenarios that could be potentially implemented within the middle to long-term time frame. In this Section we would: first, discuss these potential policy constraints, and second, concentrate o n the analysis o f the relatively viable reform options. 2.74 Our simulations show that i t i s unlikely that by 2010 the budget would be able to afford a radical decrease in the public-private compensation gap for the entire core government administration employment and civilian public sector. In case when the residual public-private gap amounts to 50 percent, the additional budget expenditures caused by the reform would account for about 2.1 to 3.3 pop. o f GDP in annual extra costs, as compared to 2003 expenditure levels, depending upon a future wage growth rate in the private sector. These figures, although not very high in the international context, are s t i l l unlikely to be affordable for the Russian budget, especially for sub-federal budgets that would have to accommodate most o f the necessary increase in budget expenditures. In fact, these estimates do not capture other important costs, such as the need for a parallel and similar in magnitude increase in financing o f the police and armed forces, which will result in even higher fiscal pressures. Hence, in our view, the scenarios assuming radical pay adjustment for the entire civilian public sector employment (scenarios 1-4, 13-16, and 25-28) should be excluded from further consideration. 2.75 Secondly, implementation o f the administrative reform component and, more specifically, employment adjustment in the civilian public sector i s critical to the success o f the broad c i v i l service reform agenda. Pay adjustments not complemented by administrative reform efforts, even in case o f moderate pay adjustment, would result in unaffordable growth o f budget expenditures (by 2.8-4.2 p.p. GDP as compared to the 2002 baseline). This leads us to exclude scenarios with n o administrative reform actions (scenarios 5, 7, 10, 17, 19, 22, 29, 3 1, and 34). 2.76 The results presented in Annex 2.6 also highlight a need to control for non-wage expenditure growth while implementing the administrative reform and modernizing public service in the country. Although the administrative reforms and associated attrition calls for an increase in non-wage expenditures, Russia i s unlikely to sustain the current share o f non- 51 52 wage expenditures in total core govemment administration costs (37 percent). It seems that this share would have to go down to at least 35 percent, which would represent a significant increase in financing in real terms. 2.77 I t i s notable that the conclusions made above significantly limit the range o f civil service reform scenarios that appear affordable. In fact, only five groups o f reform scenarios that satisfy the constraints described above as the following: (i) moderate pay reform implemented at a l o w pace with a fair administrative reform effort (scenarios 6, 18, and 30); (ii) moderate pay reform implemented at a medium pace with a fair administrative reform effort (scenarios 8,20, and 32); (iii)moderate pay reform implemented at a medium pace with a significant administrative reform effort (adjusted scenarios 9,2 1, and 33); (iv) moderate pay reform implemented at a high pace with a fair administrative reform effort (scenarios 11,23, and 35); and (v) moderate pay reform implemented at a high pace with a significant administrative reform effort (scenarios 12, 24, and 36). 2.78 In summary, a realistic reform strategy should provide for a moderate pay reform targets and be supported either by significant or fair administrative reform effort. 2.79 As shown in Table 2.12, the total fiscal costs o f these reform scenarios in 2010 vary between 1.2 p.p. GDP and 2.3 p.p. GDP. Figure 2.2 illustrates the range o f fiscal implications simulated for the selected groups o f scenarios. To simplify further analysis and because the variation in pace o f pay reform does not have a major impact o n fiscal costs o f reforms (as discussed in Annex 2.6), hereinafter we concentrate o n analyzing the two groups o f above mentioned scenarios, namely, (ii) and (iii) that represent a median o f the reform options that we consider practical. To reflect the earlier finding with respect to a need for limiting the share o f non-wage costs in the total core govemment administration costs, we undertook further adjustment o f scenarios in the group ( iii) (scenarios 9, 21, and 33) to reduce a share o f non-wage expenditures to 35 percent. 52 Figure 2.2: T o t a l Fiscal Costs o f Selected Scenarios (p.p. o f GDP as compared to 2003)39 2.5 Scenario 8 2 .o -Scenario 9 (adj) 0Scenario 20 1.5 O S c e n a r i o 21 (adj) I.o -Scenario 32 Scenario 33 (adj) 0.5 -trendline Scenario 21 (adj): 0 .o 2004 2005 2006 2008 2010 Source: Staffestimates. 2.80 As shown in Figure 2.2, the fiscal implications o f the selected reform scenarios highly depend o n the share o f real wages in GDP. In fact, if the real wage growth i s 1 pap. higher than GDP growth (as in the scenarios 20 and 21), the fiscal costs o f the reform implementation are conveniently stable and account for about 1.6-1.7 pap. o f GDP in additional spending as compared to 2003. T h i s stability i s partly related to the substantial increase in cash compensation implemented in October 2003 for the entire civilian public sector4'. The fiscal implications o f this policy measure have already been incorporated into the 2004 budget, and hence in fact a significant portion (more than two thirds) o f the overall reform-related additional costs has already been accommodated by the government. Overall, the analysis suggests that the reform strategy that provides for a moderate pay increase in core government administration combined with signi9cant attrition (though differentiated by employment groups) and considerable increase in financing o f non-wage costs could be implemented within (or almost within) the currently established fiscal constraints, i.e. relatively little of additional financing may be needed compared to 2004 budget. However, some redistribution o f funding between the various expenditure categories within the consolidated budget would be required. 2.81 Such an outcome o f l o w reform costs i s possible, however, only if a broad approach to c i v i l service reform i s followed. Figure 2.3 presents a breakdown o f the total reform costs between two parts o f the public sector employment. I t shows that in fact even moderate pay increase in core government administration (complemented by some attrition) would bring about an increase in budget expenditures o n this part o f public employment. However, this increase may be compensated by a decline in overall costs o f financing the civilian public 39See the text o f this section for the description o f the selected scenarios. 40 I t i s noteworthy that significant attrition may also cause additional expenses, since some o f the benefits provided to civil servants do not cease after the termination o f their employment. The situation may already change with the adoption o f the new laws On State Civilian Service and On Municipal Service. Assessing the impact o f such additional costs would require substantial analysis related to age profile o f the civilimunicipal service and evaluating the opportunity costs for running parallel medical care structures, etc. Such analysis i s beyond the scope o f this Report. 53 54 sector, w h i c h becomes possible because o f lower salary increases and higher attrition rates proposed f o r this sector as compared to core government administration. Figure 2.3: Fiscal Implications o f Scenario 204': Core Government Administration and Civilian Public Sector (p.p. o f GDP as compared to 2003) 4 1 .20 4 1 .oo 0 0 0 N 0 L 0.80 E fI 0.60 0.40 i 0.20 - u 0.00 2004 2005 2006 2008 2010 f RCore Government AdministrationC&s Civilian Public Sector Costs Source: Staffestimates. 2.82 This pattern, however, changes drastically if the c i v i l service reforms are not complemented by any administrative effort to reduce overstaffing (especially in the civilian public sector). Should moderate pay reforms be implemented without any employment reductions, the fiscal costs o f reforms would be almost twice higher and reach about 3.5 p.p. o f GDP by 2010 (in case o f medium growth o f the real wages). Figure 2.4 illustrates this drastic expenditure growth. Figure 2.4: Fiscal Implications o f Civil Service Reform: Role o f Administrative Adjustments (pep.o f GDP as compared to 2003) ' 4.0 6 35 t 0 mderate pay %' 30 adjustmnt wlth - $ 25 admnistrabve reform (Scenario 20) 20 G 15 mderate pay i w 10 adjustmnt w lthout admnistrabve reform 3 05 (Scenario 19) - U 00 2004 2005 2006 2008 2010 Source: Staff estimates. 2.83 The detailed structure o f additional fiscal costs resulting f r o m the reform implementation (for the year 2010) i s illustrated in Table 2.13, for which w e selected two scenarios with a medium growth rate o f wages, namely 20 and adjusted 21. As demonstrated in Table 2.13, the broad structure o f expenditure increase under the selected scenarios i s very similar. 41 Scenario 20: Moderate pay reform implemented at a medium pace with a fair administrative reform effort and medium growth in private wages. 54 Table 2.13: Structure o f Expenditure Increase in Year 2010 for Selected Scenarios (in p.p. o f GDP) Medium-Paced Moderate Pay Medium-Paced Moderate Pay Reform with Fair Reform with Significant Administrative Adjustment Administrative Adjustment (Scenario 20) (Scenario 21, adjusted)* A. Core Government Administration 1.13 1.11 o/w: costs to Federal Budget 0.58 0.58 Costs to Sub-Federal Budgets 0.55 0.53 a. Cash Compensation 0.77 0.64 Federal Budget 0.38 0.33 Sub-Federal Budgets 0.39 0.31 b. Non- Wage Expenditures 0.44 0.53 Federal Budget 0.20 0.25 Sub-Federal Budgets 0.23 0.28 c. StaffAttrition 0.00 0.00 Federal Budget 0.00 0.00 Sub-Federal Budgets 0.00 0.00 Increased Collection o f P I T (sub- -0.08 -0.07 federal budgets) B. Civilian Public Sector 0.60 0.60 Employment o/w: costs to Federal Budget 0.23 0.23 Costs to Sub-Federal Budgets 0.37 0.37 a. Cash Compensation 0.63 0.63 Federal Budget 0.23 0.23 Sub-Federal Budgets 0.42 0.42 b. StaffA ttrition 0.01 0.01 Federal Budget 0.00 0.00 Sub-Federal Budgets 0.01 0.01 c. Increased Collection o f PIT -0.06 -0.06 (sub-federal budgets) Total Expenditure Increase (A+B) 1.71 1.69 o/w: costs to Federal Budget 0.82 0.81 Costs to Sub-Federal Budgets 0.91 0.89 * Assumption related to the share o f non-wage expenditures in total costs o f core government administration was adjusted to 35 percent as compared with the original share o f 36 percent. Source: Staff estimates. 2.84 As discussed above, significant portion o f these fiscal costs has already been incorporated into the consolidated budgets. Based on our simulations, fiscal implications o f c i v i l service reform in core government administration account for almost two thirds o f the total additional costs and require increased financing o f about 1.1 p.p. o f GDP, distributed almost equally between the federal budget and sub-federal budgets. Most o f these additional costs would be required for financing the executive branch o f the core government administration. 55 56 Table 2.14: Detailed Breakdown o f the Increase in Fiscal Costs o f Civil Service Reform in Core Government Administration as of 2010 (in constant 2002 billion rubles) Medium-Paced Moderate Medium-Paced Moderate Pay Pay Reform with Fair Reform with Significant Net Expenditure Increase Administrative Adjustment Administrative Adjustment (Scenario 20) (Scenario 21, adjusted)* A. Cash Compensation 156.59 139.06 A I . Federal Authorities 71.88 65.50 legislative authorities 3.09 3.09 executive authorities 43.64 37.27 o/w HQ-based 6.62 5.71 judiciary authorities 24.26 24.26 other authorities 0.88 0.88 A2. Regional and Municipal Authorities 84.71 73.56 legislative authorities 3.74 3.74 executive authorities 77.74 66.59 judiciary authorities 2.24 2.24 other authorities 0.99 0.99 B. Non-Wage Expenditures 57.92 70.63 B1. Federal Authorities 27.10 33.11 legislative authorities 1.37 1.64 executive authorities 15.82 18.39 judiciary authorities 9.52 12.61 other authorities 0.39 0.47 B2. Regional and Municipal Authorities 30.82 3 7.52 legislative authorities 1.47 1.95 executive authorities 28.09 33.89 judiciary authorities 0.87 1.16 other authorities 0.39 0.52 C. Increased PIT Collection (15.91) (14.17) Total Costs (A+B+C) 198.60 195.52 olw: costs to Federal Budget 98.98 98.61 costs to Sub-Federal Budgets 99.62 96.91 Total Costs (as a % of GDP) 1.13 1.11 Note: Figures may not sum up due to rounding. *Assumption related to the share of non-wage expenditures in total costs of core government administration was adjusted to 35percent as compared with the original share of 36percent. Source: Staffestimates. 2.85 Table 2.14 presents additional breakdown o f the expected expenditure increase under the scenarios 20 and 21 (adjusted) if the reforms are limited only to core government administration. I t shows that most o f the expected fiscal gains from more significant administrative actions in scenario 21 are likely to be spent o n additional non-wage expenditures. 2.86 The recent debates o n the pay reform in Russia suggest that the pay adjustments should have a stronger focus o n the middle and top management o f the c i v i l service (“decision-makers”) employed in headquarters o f the federal executive authorities. This would allow retaining the most qualified managers within the executive bodies and would result in better government performance, including improved policy making (for more deliberations o n this scenario see HSE, 2004, report). 2.87 To take into account this policy option, we introduced additional modifications to the selected moderate pay reform scenarios, namely: scenario 20, assuming fair administrative changes; and scenario 2 1, assuming significant administrative reform. These modifications 56 decreased the residual public-private pay gap for HQ-based federal executive c i v i l servants o f Categories A, B, and part of the Category C (Top and Chief Groups) from 100 percent (default value for all scenarios with moderate pay adjustment, such as e.g. scenarios 20 and 21) to 50 percent. As o f 2002, the share o f these civil servants in the total number o f c i v i l servants employed in H Q o f federal executive bodies accounted for about 14.1 percent. I t i s expected that administrative reform efforts would not significantly affect this share (in 20 10, the share o f officials in these Categories would account for 14.2 percent o f HQ-based executive c i v i l service in case o f fair administrative reform and for about 13.9 percent in case o f significant attrition, respectively). Table 2.15: Fiscal Implications o f M o r e Radical Pay Adjustments for “Decision Makers” in Federal Executive Civil Service Headquarters as o f 2010 Cash Compensation for Federal Executive HQ-Based Officials Medium-Paced Moderate Pay Medium-Paced Moderate Pay Reform with Significant Reform with Fair Administrative Administrative Adjustment Adjustment (Scenario 20) (Scenario 21 adjusted) Constant 2002 % o f 2010 Constant 2002 % o f 2010 billion rubles GDP billion rubles GDP Costs o f the base case, with 10.66 0.080 9.76 0.073 No additional measures Costs of additional pay 11.30 0.085 10.34 0.078 adjustment for “decision Source: Staff estimates. 2.88 Table 2.15 shows that the extra pay increase for the “decision making” group o f H Q - based federal executive authorities would not bring about significant additional fiscal pressures: the costs o f such an extra step would account for about 0.6 b i l l i o n rubles in 2002 prices (less than 0.005 percent o f 2010 GDP). Such a policy measure would result in both better external competitiveness o f the civil service in the labor market and in greater internal decompression: by the end o f the reform, the compression ratio for HQ-based federal executive civil service would increase to 9.0, which i s 0.8 higher than in the base case with moderate pay reform. 2.89 Another suggestion often made in the debates on implementation o f c i v i l service and administrative reforms relates to a possible separation o f administrative reform from the pay reform in core government employment and from the corresponding adjustment in the civilian public sector at large. To simulate potential effects o f this reform strategy, we made further modifications to the above scenarios 20 and 21 based o n the following additional assumptions: 0 Administrative reform measures in core government administration and civilian public sector would be implemented within 2004-2006, i.e., under the compressed schedule; 0 Pay adjustment in core government administration would be implemented in 2004- 2008; and 0 Pay adjustment in the civilian public sector would be implemented in 2004-2010, Le., at a slower pace. 57 58 Figure 2.5: Total Fiscal Implications for Scenarios4*with the De-Linked Implementation of Pay and Administrative Reform Components (p.p. o f GDP) L 1 2.50 li 4 2.00 n 150 - f g 100 a 3 6 & 050 2 Ly z 0.00 2004 2005 2006 2008 201 0 0 Scenario 20 Scenario 21 Source: Staffestimates. 2.90 Although de-linking the reform measures may be more attractive to the budget during the f i r s t three reform years (see Figure 2.5), a consequent rapid growth o f public expenditures in 2006-2010 may make it difficult to sustain the pace o f the reform agenda, which may in turn compromise the reform achievements. Overall, i t seems as a less desirable strategy than the one that assumes a more steady reform effort and should be used with caution since it yields a less predictable fiscal implications pattern. H. OVERVIEW OF R I S K S ASSOCIATED WITH REFORM IMPLEMENTATION 2.91 Implementation o f the broad civil service reform that would affect more than a m i l l i o n of employees in core government administration and about ten m i l l i o n o f those employed in the civilian public sector, l e t alone the implications o f the reform in non-civilian parts o f the general government, i s by definition a complex and risky task. Detailed analysis o f a l l possible risks associated with the reform implementation process calls for a self-standing piece o f research. Therefore, in this section we try to briefly overview only some key risks that should be taken into account during the reform implementation and that are directly linked to the fiscal implications o f the reform process. 2.92 Firstly, a balanced relationship between different components o f the public sector reform, especially between the reforms in core government administration and the rest o f the public sector has to be established. The absence o f such a relationship may lead to accumulation o f disproportions in the public sector. In particular, it could trigger a non- sustainable wage differential between the core government administration and the public sector at large, which could cause either a slowdown in wage adjustment in the public administration or may result in excessive in creases in budget costs because o f the need t o adjust the remuneration in the highly overstaffed civilian public sector. As confirmed by our simulations, attempt to increase the real wages for the current level o f employment in the civilian public sector would require additional Jinancing o f about two percent o f GDP by 42 Scenario 20: Moderate pay reform with a fair administrative reform effort and medium growth in private wages. Scenario 2l(adj): Moderate pay reform with a significant administrative reform effort and medium growth in private wages (share o f non-wage costs i s 35 percent). 58 2010. Analysis o f the current government plans for advancing the c i v i l service reform suggests that this risk i s not taken into account yet in the existing pay reform design. 2.93 Secondly, successful implementation o f public administration reforms calls for a close coordination between the c i v i l service and budget reforms. Slow delegation o f authority for budget spending to budget units would undermine the overall efficiency o f the reforms and would reduce incentives for implementing signiJicant staf cuts both in core government administration and in the civilian public sector. Introduction o f performance budgeting mechanisms that require a combination o f more flexible rules for budget spending and higher degree o f accountability for the results i s a necessary precondition for implementation o f many components o f c i v i l service reform, including HR management reforms, modernization o f public service, as well as administrative reform. The failure to ensure such coordination may result in top-down mechanical cuts in staffing levels that would not be sufficiently concerned that adjustment in staffing was driven the considerations about quality o f public service delivery. The recently approved Concept for Reforming the Budget Process (2004-06) provides a basis for integrating performance budgeting principles and the performance management agenda advocated in the framework o f c i v i l service reform. However, the risk o f possible disconnect between the two should be fully accounted for and controlled throughout the reform process. 2.94 Thirdly, the ultimate success o f c i v i l service reform depends largely o n the incentives o f subnational governments to pursue a similar agenda across the country. T h i s i s especially crucial because most o f the public service delivery i s taking place at the subnational level, hence the failure to demonstrate some tangible improvements in these parts o f the public sector would undermine overall credibility o f the reform process. Hence, the reform agenda should encompass both the activities related to building the capacity to implement public administration reforms at the regional and local levels (these issues are partly covered by the Presidential Program Civil Service Reform 2003-2005 that provides financing to undertake pilots and reform experiments in the regions) and, more importantly, building the incentives o f the regional and local administrations to engage in the reform process. These incentives are associated with both getting additional authority in resource allocation and increased transparency and accountability o f subnational administrations. One o f the relevant policy measures that could strengthen the subnational incentive framework i s currently proposed abolishment o f a Unified Salary Scale in the public sector, which would be accompanied by the delegating to the regions the authority to determine the pay levels in the civilian branches of the public sector, taken into account the regional fiscal situation and local labor market prices. 2.95 Finally, successful implementation o f the reforms in deconcentrated units o f the federal civil service would also require a proper accounting for cross-regional variation in staffing needs and remuneration levels i s also crucial for. Insufficiently differentiated pay adjustments for HQ-based staff and deconcentrated employees would create major disproportions in the regional labor markets and may also trigger significant additional budget expenditures (up to about 0.5 percent o f GDP in 2010). Hence, identification and establishment o f the pay levels for federal deconcentrated employees that are based o n local market realities i s one o f the key preconditions for successful and sustainable pay adjustment in core government administration in Russia. I. CONCLUSIONS AND RECOMMENDATIONS 2.96 Increasing efficiency o f the government machinery and improving the quality o f governance and service delivery in the country are prerequisites for successful implementation 59 60 o f the structural reforms in Russia. At the same time, implementation o f these reforms would create additional fiscal pressures on the budget system o f the country. Fiscal implications o f public administration reforms depend on a large number o f variables and are sensitive to changes in macroeconomic conditions. The model described in this Chapter does not capture all variables involved. However, the analysis o f the incremental costs o f c i v i l service reform estimated for more than 40 reform scenarios allows for some preliminary conclusions. 2.97 Clearly, the reform approaches to different sub-sectors o f the civilian part o f general government would need to vary both in terms o f pay adjustment and in terms o f attrition measures. T o achieve the reform objectives, the pay adjustment should be the most significant for the HQ-based portion o f the core government administration, lower for deconcentrated units and regional and municipal parts o f the core government administration, and the lowest for the civilian public sector. The latter could be justified in part by the growing share o f fee- based services provided by this sector, which would become a growing source o f compensation o f its employees. Inside the federal HQ-based executive service, the pay adjustment should be focused on managerial levels, which currently are affected by the highest pay gap with the private sector. Such a focus o f the pay reform would allow addressing the key issues o f l o w policymaking capacity inside the government and would help retain highly qualified public officials at key positions in the federal c i v i l service. 2.98 Our simulations suggest that over the period till 2010 the budget i s unlikely to accommodate a full closure o f the current pay gap through a radical pay adjustment in the entire core government administration and civilian public sector. As a result, the average residual net public-private pay gap for core government administration would s t i l l remain significant (in the 100 percent range). However, the recent surveys o f public officials reveal that such a gap may be quite acceptable and in general it reflects the existing expectations o f the public officials. 2.99 In fact, implementation o f moderate pay reform suggests that average wages in core government administration would grow 1.25 times faster than the average wages in the economy, while the average pay in civilian public sector would grow 1.17 times faster than the average wages in the economy respectively. Our simulations also show that by 2010 the average real wages in core government administration would be 1.7 times higher than current wages (average real wages in the civilian public sector would be respectively 1.6 times higher). 2.100 I f such pay adjustment i s complemented by more radical adjustments for a small number o f “decision makers” in the headquarters o f federal executive authorities, it i s likely that the pay reform would achieve i t s objectives through both increasing external competitiveness o f employment in the public sector (especially in core government administration) and significant internal decompression that would facilitate the introduction o f a performance oriented system in the Russian civil service. The selected scenarios assume a substantial decompression: the compression ratio for the federal HQ-based executive civil service would increase from 2.5 in 2002 to 6.8-9.0 in 2010, while the compression ratio for the federal executive branch as a whole would by 2010 grow up to 9.9-13.2 from 3.7 in 2002. The proposed pay reform would allow retaining a highly qualified cadre, which ultimately would result in better quality of policy making and public service delivery, as well as support the government anti-corruption effort. 2.101 The results o f our estimates confirm that implementation o f the administrative reform component and, more specifically, employment adjustment in core government administration and civilian public sector i s critical to the success o f the broad c i v i l service reform efforts. 60 Even moderate pay adjustments not complemented by significant employment changes would result in unjustified growth of annual consolidated budget expenditures (2.8 to 4.2 p.p. o f GDP in 2010). The expected employment dynamics in the core government administration and civilian public sector, as well as cross-country comparisons justify higher rates o f attrition in the civilian public sector and in sub-national core government administration, but smaller cuts for the federal portion o f core government employment. I t i s expected that by 2010 employment in the civilian public sector would decline by about 25 percent o n average as compared to the 2002 baseline, while the overall employment cuts in core government administration would account for about 9-1 3 percent and attrition in the executive branch reaching 15 percent o n average (with 13 percent attrition rate in the federal executive branch and 17 percent in subnational executive bodies). Similar adjustments would also be required in the non-civilian public sector that i s reportedly overstaffed and for which cash remuneration i s directly linked to the pay levels in the c i v i l service. 2.102 Implementation o f the broad reform agenda in the core government administration would entail significant additional non-wage expenditures. Full-scale modemization o f public service would require both significant investment and significant recurrent costs for operation and maintenance o f computer systems and physical infrastructure, as well as implementation o f modern HR practices (including competitive recruitment, staff rotation, and training). However, our simulations show that Russia i s unlikely to sustain the current share o f non-wage expenditures in total costs o f supporting the core government administration (37 percent). I t i s more likely that this share would have to go down to at least 35 percent, which would represent a significant increase in financing in real terms. Similar issues o f non-wage expenditure control are also likely to arise in the civilian public sector at large, but specific estimates related to fiscal implications o f growing non-wage expenditures in this sector go beyond the scope o f this Chapter because these are highly dependable o n specific situations in each particular sector (Le., education, health, etc.). 2.103 Overall, the results o f our simulations show that successful implementation o f c i v i l service reform calls for a broad approach to the reform, i,e. simultaneous reform measures in core government administration and civilian public sector at large44. Political economy o f reform also suggests that c i v i l service reform should not be applied to core government administration only. In fact, a significant pay adjustment in core government administration i s likely to become a trigger for corresponding increases in civilian public sector and general government at large. Otherwise, it would be quite difficult for the government to sustain a drastic increase in the compensation gap between those in core government administration and the rest o f the public sector employees. 2.104 Moreover, significant adjustments in the civilian public sector employment within five to seven year timeframe would yield the savings needed to keep overall fiscal costs o f public administration reform more or less within the current limits. Although the fiscal implications of a moderate pay reform complemented by administrative efforts would account for about 1.2-2.3 p.p. o f GDP as compared to 2003 levels, it i s assumed that a substantial part o f these costs (about two thirds) has been already included into the 2004 budget as a result .of the October 2003 salary increase. Implementation o f c i v i l service reform complemented by 43 OECD/SIGMA (1997), p.52. 44 In fact, these reforms should be closely linked with parallel adjustments in military and law enforcement parts o f public service. Such integral approach seems to be shared by the government: representatives o f both armed forces and law enforcement agencies have been involved in the preparation of civil service reform, and administrative restructuring o f all non-civilian parts of public service has been recently announced by the Russian President. 61 62 significant reform efforts in civilian public sector would call for some redistribution o f funds across expenditure categories within the consolidated budget: apportion o f savings from staff attrition in the civilian public sector may be used for providing additional funds to support core government administration. 2.105 Our simulations also suggest that it i s desirable for both components o f the reform - pay adjustment and administrative changes - to be synchronized. Although de-linking the reform components with employment adjustment implemented before the completion o f pay increase would cut the expenditures associated with the reform in the earlier years, completion o f the pay adjustment would call for an accelerated increase in consolidated budget expenditures that may be politically and fiscally difficult to afford. As a result, the sustainability o f the reform achievements would be at risk. 2.106 I t should be noted that, although the estimated budget costs o f the c i v i l service reform implementation are very significant if compared to the 2002-03 levels o f financing o f respective expenditures, the expected fiscal outcomes do not look prohibitively high when considered in the international context. This Chapter argues once again that public administration reform in Russia cannot be cheap, especially in the environment o f a rapidly growing economy and real wages. Otherwise the objectives o f reform could not be achieved and sustained. 2.107 The estimated fiscal costs depend significantly on the private sector real wage dynamics, and more specifically o n the change o f the share o f real wages in GDP. The higher i s the growth rate o f real wages as compared to GDP growth, the higher i s the additional fiscal pressure o n the budget system. This introduces a significant factor o f uncertainty in the costing out future reforms, because future growth in private sector wages i s largely outside o f the government control. Moreover, given the l o w share o f wages in GDP at the moment, there are reasons to believe that in the medium term growth in real wages would be higher than GDP, which would push the reforms costs towards the higher end o f the estimated range. 2.108 Because o f the magnitude o f core government administration and civilian public sector restructuring required, this Chapter argues that such reforms are not likely to be implemented within a mid-term time frame (Le., 2004-06) and would require a longer period o f time - five to seven years. This i s especially important given the fact that the success o f the c i v i l service reform would significantly depend o n i t s coordination with budget management reforms aimed at introduction o f performance budgeting principles, including delegation o f greater expenditure autonomy to spending units and significant increase in their accountability for the results. Thus, advancing budget management reforms would create additional incentives for reforms in the public administration. 2.109 Implementation o f c i v i l service reform i s a complex task entailing multiple risks which, if not controlled for, may result in significant fiscal implications. For instance, a failure to synchronize c i v i l service reform in core government administration with similar reforms in the civilian public sector may result in significant growth o f budget expenditures (about 2 percent o f GDP a year in 2010). A failure to account properly for regional labor market conditions when determining future pay increases for federal deconcentrated employees may also cause significant extra costs (up to 0.5 percent o f GDP in 2010). 2.110 The results o f our simulations should be interpreted and applied with caution. For instance, the estimates of net public-private compensation gap used for the simulations are quite rough and could be improved based o n the results o f regional comparative pay and compensation surveys. These surveys would also allow to better measure the actual value o f 62 in-kind benefits received by the core government employees of federal deconcentrated units, as well as regional and municipal servants. 2.111 I t should be also noted that some o f the financial resources needed for reform implementation could be derived from other reform actions that have not been cost .out in our simulations. Given the market prices for real estate in the largest Russian cities, more efficient use of federal, regional and municipal property may provide additional fundin (however, it i s unlikely that these gains would be sufficient to cover the total reform costs)4 8, There may also be important productivity gains from the introduction o f more efficient business processes and automation o f routine procedures, adoption o f more transparent procurement practices, etc. 2.112 Overall, the above arguments suggest that broad reforms in the core government administration and in the civilian public sector at large may be implemented within five to seven years but should be differentiated by the scope o f pay adjustment in various sub-sectors o f civilian employment, closely monitored for non-wage expenditure growth, and complemented by significant employment adjustments in the civilian public sector as well as by at least some staff reductions in the core government administration. However, even under the most optimistic assumptions, the residual pay gap between public and private sectors may remain considerable. 4sWe agree that, based on introduction of new budgeting mechanisms and improved incentives, a more efficient utilization o f publicly-owned real estate indeed could bring substantial fiscal benefits. However, it i s difficult to estimate the magnitude o f these savings in advance. Moreover, it seems that most o f these savings are likely to be concentrated in Moscow (with some of them representing one-time gains). As a result, these savings could be considerable if compared to the initial costs o f reforming the federal executive part o f the core government administration, but it i s unlikely that those could be a longer-term source of funding for reforms in the entire system o f the core govemment administration. Overall, we do not find it appropriate to reflect these savings in the model in addition to the above mentioned effect o f a possibly lower share of non-wage expenditures in the total expenditures on core government administration. 63 Chapter 3. FISCAL NTHE HOUSING COSTS OF REFORMS I AND UTILITY SECTOR 3.1 This Chapter analyses potential fiscal and social impact o f advancing housing and utility sector reforms in Russia under the different scenarios. It argues that in the current environment of high growth in household incomes, it i s affordable by 2006 to attain 100 percent cost recovery in tariff with simultaneous elimination o f all quasi-fiscal cross- subsidization and the adjustment in domestic energy prices. Moreover, the reforms in residential housing could be made budget neutral in the medium term, and they would bring considerable savings in the long term. However, high sensitivity o f results to income dynamics suggests that the government should establish an efficient monitoring system to track the affordability o f tariff increases for population. At the same time, it i s estimated that adjustment in domestic energy and utility prices could trigger a fiscal gap o f 0.4 percent o f GDP due to increased utility costs in the public sector. A. BACKGROUND 3.2 The Russian government has been pursuing reforms in the housing and utility sector (HUS) since the early 1990s. To date, these reforms have been only partially successful, and the sector remains one o f the major parts o f the economy that s t i l l operates o n predominantly non-market principles. The share o f the government’s involvement in both ownership and management o f the sectoral entities i s excessive, while the institutional framework to support market-based development i s rather weak. As a result, the housing stock i s deteriorating, the quality o f utility services i s low, and the sector i s the single largest recipient o f government subsidies. 3.3 In 2003 the government made a new commitment to accelerate reforms in the housing and utility sector aimed at i t s market transformation, the phasing out o f budget subsidies, and the mitigation o f social risks. This policy priority has been driven by the multiplicity o f problems that have accumulated in the sector as well as by the demands coming from parallel reform efforts in public administration and the energy sector that call for both the rationalization o f budget spending and an increase in domestic energy prices. 3.4 There are several channels through which reforms in the energy and utility sectors, which are expected to take place as a part o f the government’s medium term reform strategy, would have a major impact o n the costs o f operating the housing stock and thus would affect both household and government budgets. These channels include the following: 0 A direct increase in utility and housing maintenance tariffs, aimed at increasing cost recovery under the existing cost patterns 0 A substantial increase in domestic energy prices, which would affect the costs o f services both directly (direct electricity and gas consumption) and indirectly (use o f electricity and gas for heat generation and water supply) 0 An additional increase in utility tariffs to incorporate a capital repair component 0 The phasing-out o f the existing cross-subsidization in utility tariffs. 3.5 Overall, the reforms are expected to change considerably the current proportions in the financing o f the existing housing stock: the share o f the consolidated budget i s expected to decline, the share o f the population would increase, while the current financing by the enterprise sector through cross-subsidization i s intended to be fully phased out. In addition, 65 the budgets should be able to collect additional taxes from the energy sector, primarily the gas industry. However, while budget subsidies and total government spending o n housing would decline, budget expenditures o n social support to the poor are likely to increase, at least in the initial period that would follow the tariff increases. Objectives o f the Chapter 3.6 The overall objective o f the Chapter i s to estimate the potential fiscal impact o f the expected changes in energy prices and utility tariffs, based o n the series o f simulations o f different reform scenarios. The reform scenarios aim to reflect changes in the government’s fiscal and social policies intended to reduce budget subsidies to the sector, increase the overall efficiency o f government expenditures in housing and utilities, and, at the same time, help to mitigate the impact o f tariff increases on vulnerable groups o f households. The reform analysis follows the approach suggested by Yasin (2003), which emphasizes a reform strategy that closely links future tariff increases in the energy and housing sectors with structural reforms in these sectors, as well as with adjustments in both public sector wages and pensions. 3.7 Important factors to be reflected in simulations o f the various reform scenarios include: 0 Existing cross-regional variations in the main underlying factors, such as actual utility costs, access to utility services, and household incomes 0 Projections for future dynamics in domestic energy prices and their likely impact on utility prices 0 Expected trends in the real dynamics o f household incomes 0 Elimination (phasing out) o f cross-subsidization in the utility sector 0 Elimination (phasing out) o f privileges (lgoty) in housing and utilities 0 Actual participation rate o f households eligible for housing allowances. 3.8 More specific objectives o f the Chapter include: a. Costing out potential medium term reform scenarios in the housing and utility sector. b. Estimating an overall demand for budget financing related to the reforms in the sector that would cover (i) residual subsidies during the transitional stage (for the periods when the full cost recovery will remain below 100 percent), ( ii ) the costs o f social mitigation programs, and (iii) additional utility costs o f budget sector entities (in health, education, etc.), caused by the increased utility tariffs. c. Developing estimates o f budget revenue impact associated with an increase in housing and utility tariffs and improved tax yield. 3.9 The projections developed in this Chapter are based o n a flexible imitational model, which could be used for the simulation o f different reform scenarios in Russia’s housing and utility sector. An improved government capability to analyze and forecast the consequences o f the respective sectoral reforms i s critical to designing adequate mitigation policies, reducing the risks o f social tensions, and avoiding an excessive budget burden in the course o f reforms. To become a practical tool for policy analysis, the model explicitly takes into account several features o f the housing situation that are Russia-specific, such as the 66 considerable cross-regional variation in the main parameters and specific characteristics o f Russia’s housing allowance program. B. SUMMARY OF THE EARLIER IN THE HOUSING REFORM EFFORTS AND UTILITY 3.10 The reforms in the housing and utility services (HUS) were identified as a major structural reform challenge fairly early in Russia’s transition. Despite this, the H U S were not a part o f the original Government o f Russia’s economic liberalization program o f early 1992. Instead, the Government’s decisions o f 1992-93 provided for the gradual attainment o f full cost recovery in the sector (supported by considerable market transformation) by 1998. However, later these reform targets were adjusted and made considerably less ambitious. In particular, in 1999 the Duma adopted an amendment to the L a w o n the Foundations o f Federal Housing policy which set 2008 as a target for attaining full cost recovery in housing. 3.1 1 Overall, reforms in the H U S to date have produced three main achievements: 0 Divestiture o f enterprise housing (which in the early 1990s accounted for about 40 percent o f the housing stock) to municipalities i s practically completed. 0 Cost recovery in tariffs has been radically increased, with the current federal benchmark set at the level o f 90 percent, while collections remain high. 0 A new system o f targeted means-tested social assistance - housing allowances - has been established by almost all municipalities and has proved to be an efficient tool for protecting vulnerable households. 3.12 At the same time, the reforms to date have not succeeded in resolving the main problem - transforming the sector from an administratively managed one into a market driven one. The major remaining problems can be summarized as follows: 0 The sector’s operations remain heavily subsidized. 0 Consumers in the H U S have quite limited opportunities to influence the performance o f service providers. 0 Competition in housing maintenance i s highly restricted, and the sector i s s t i l l dominated by municipally owned monopolies and quasi-monopolies. 0 Most operators in the sector do not have real incentives to improve the efficiency o f their service delivery. 0 The sector does not have a market-based mechanism for investment financing. At the same time, it i s affected by years o f under-maintenance and under-investment, which undermines the quality and reliability o f service delivery. For the time being, government budgets are the only regular source o f investment financing in the HUS. 0 Regulatory policies and practices in the sector are affected by administrative interventions and are neither sufficiently transparent nor stable. T h i s makes the H U S quite unattractive/risky for the new private sector. 0 The incidence o f new private arrangements (such as condominiums) for managing multi-unit housing i s low. W h i l e more than h a l f o f the housing units are privately owned,, practically all urban housing i s s t i l l de facto managed by municipal 46 This section i s based primarily on Starodubrovskaya(2003) and IUE (2003b). 67 administrations. By late 2003, less than 6,000 condominiums were established in Russia. 3.13 The political economy analysis o f developments in the sector suggests that the existing incentives o f municipal governments are likely to be a key barrier to reform acceleration in the HUS. Municipal governments are seen as the main potential losers in future market transformation in the sector. The reforms would drastically reduce the sphere o f their administrative control, while their access to a considerable cash flow in the sector would be lost. Moreover, government control over utilities at the moment creates a major political advantage for administrations during the election campaigns, because it allows for easy access to and communication with local voters. 3.14 I t i s not surprising that under the circumstances most municipal governments have never been keen o n supporting market reforms in the HUS. Instead, considerable efforts were made to imitate market transformations but to keep the essence o f administrative regulation intact. This lack o f reform incentives at the municipal level was further aggravated by additional factors. First, there has been little external pressure for change -- neither from the private sector (tenants or business) nor from the federal authorities. The federal government was not consistent in i t s political signal to expedite H U S reform, which, owing to i t s political sensitivity, has never topped the l i s t o f federal policy priorities. Second, the system o f inter- budgetary relations has been unstable and generally has not provided sufficient incentives for budget savings, and thus for reforms that could lead to a reduction in municipal budget subsidies. Massive redistribution o f funds by regional administrations in general tends to benefit those municipalities that are not too proactive in reforming the H U S and thus could easily justify their needs for additional budget transfers. 3.15 The government adopted i t s new Housing and Communal Services Reform Program in November 200 1. The program called for significant reforms in the sector to be implemented in steps over 2002-10. The main priorities o f the government strategy include: increased cost recovery in tariffs, which should be achieved parallel with strengthening the safety net for the poor; improvements in the quality o f services and in reducing the costs o f services; and the expansion o f private sector participation. However, the implementation progress has been modest to date. The acceleration o f cost recovery increases after 2000 has been the most visible aspect o f the change. W h i l e progress remains highly uneven across the regions, the reported average cost recovery in tariffs exceeded 70 percent in 2003, which i s a major step forward when compared to about 30 percent in 1997-99. The Government resolution o f August 26,2004 set up an objective o f attaining 100 percent cost recovery in tariffs in 2005. 3.16 The Bank analyzed the reform implementation constraints in the HUS, faced by subnational governments and other stakeholders, in the recent Policy Note, “Housing and Communal Services in Russia: Completing the Transition to a Market Economy” (World Bank, 2003a). 3.17 Based on the lessons from the earlier analytical work (see W o r l d Bank 1998 and 2003; IUE, 2003a; Starodubrovskaya, 2003a), this Chapter argues that the reform acceleration in the H U S could be sustained only through simultaneous government actions in several important directions: 0 Advancing reforms in inter-budgetarv relations, in particular providing a more transparent regulatory framework for fiscal redistribution among municipalities within the regional budgets and expanding a local tax base for municipalities. Recent 68 amendments to the Tax and Budget Codes were an important step in this direction. A future priority relates to the introduction o f a local real estate tax. In addition, more active political pressure and monitoring o n the part o f the federal government would be required to change prevailing municipal government incentives. Reforming housing financing: changing disbursement mechanisms by transferring most of the budget support funds directly to customers o f the H U S instead o f service providers. Improving the regulatory framework, especially for tariff setting, as a tool to make the sector attractive to large private investors. While day-to-day regulation would remain decentralized, the federal government has to strengthen a unified national approach to H US regulation which would define clear r u l e s o f the game for subnational regulators. Creating conditions for established private investors to enter the H U S . Under the circumstances, large private firms, with their ability to withstand potential local political pressures, could become a real driving force for market transformation in the sector. This would require, inter alia providing a legal framework that supports longer-term contracts between private operators and municipalities (such as a good L a w o n Concessions in local utility networks) and strengthening the judiciary’s ability to enforce such contracts. c. INVOLVEMENT IN FINANCING GOVERNMENT RESIDENTIAL HOUSING Recent trends in housing and utility financing 3.18 At the moment, the population i s s t i l l paying about h a l f o f the total housing and utility costs, with the rest coming from budgets, enterprises, accumulation o f arrears and degradation of the housing stock and utilities (Table 3.1). 3.19 The total costs o f government programs that explicitly relate to the financing o f the H U S exceeded 1.75 percent o f GDP in 2003 (about US$8 billion, see Table 3.2), while the large cities historically have been spending about a third o f their budgets o n housing and communal services.47Direct subsidization o f heating and hot water services make up about 40 percent o f the total budget support in the system. Table 3.1: Structure o f Housing Financing (YO) 2001 2002 2003 Population 47.4 46.8 52.7 Budget (only direct budget support) 35.8 41.4 37.7 Enterprise sector and under-financing(residual) 16.8 11.8 9.5 Source: Staff estimates based on the data from Rosstat and Gosstroi. 47 This includes spending on operational subsidies, housing allowances, and investments in rehabilitation. 69 Table 3.2: Financing o f the Housing Sector (YOo f GDP) COSTS/EXPECTED ACTUAL FINANCING FINANCING 2001 2002 2003 2001 2002 2003 Total costs o f services, estimated on the basis o f the 4.03 4.73 4.67 3.35 4.17 4.22 reported tariffs olw: 1. Households 2.01 2.46 2.68 1.91 2.21 2.46 2. Budget: 2.01 2.26 1.99 1.44 1.96 1.76 - direct subsidies to cover tariff gaps 1.42 1.66 1.34 1.21 1.61 1.26 - compensation o f tariff benefits (lgoty) 0.54 0.46 0.42 0.19 0.24 0.30 - housingallowances 0.06 0.14 0.23 0.04 0.11 0.20 MEMO: 1. Enterprise sector, residual 0.68 0.56 0.44 2. GDP, bn 8,944 10,834, 13,285 Source: IUE. 3.20 The average cost recovery in tariffs in residential housing reached 69 percent in 2002, a major improvement relative to 53.5 percent in 2000 (Table 3.3) and 33 percent in 1993. The collection level remains relatively high, at about 90 percent. However, the actual billings are almost 20 percent lower than those that would correspond to the reported cost recovery levels because o f considerable benefits (lgoty) in the system. As a result, the actual household payments amount to just 50 percent o f the current housing costs. 3.21 By the end o f the third quarter o f 2003, the average cost recovery in tariffs increased further to 73 percent, and cost recovery in payments increased to 55 percent. However, i t should be emphasized that the cost recovery levels reported in Table 3.3 are considerably upwards biased because they are estimated relative to the prevailing average level o f domestic prices for energy resources, but not as a ratio to the long-term marginal costs (LRMC) o f energy production and delivery. This discrepancy i s especially important for gas and electricity supply. In the gas sector, for instance, assuming the average R L M C level i s between US$35 and US$40 per 1000 cub m, the 2002 average gas tariffs in Russia were at about 40 percent o f the R L M C . Because gas tariffs for households were below the average tariff, while the costs o f gas delivery to households were above the average, the properly estimated cost recovery in tariffs for population at the time was closer to 30 percent. 70 Table 3.3: Cost Recovery and Collection Rates, 2000-02 (YO) Total Housing maintenance 2000 2001 2002 2000 2001 2002 Cost recovery in tariffs 53.5% 58.2% 69.1% 50.9% 50.0% 67.5% Billing coeff. 11 86.8% 84.2% 80.6% 78.5% 79.1% 76.8% Collection ratio 86.9% 87.8% 89.8% 89.4% 89.4% 91.8% Cost recovery by payments 40.3% 43.0% 50.0% 35.7% 35.3% 47.6% Water Heating and hot water 2000 2001 2002 2000 2001 2002 Cost recovery in tariffs 53.6% 61.9% 68.8% 43.5% 52.5% 65.8% Billing coeff. 11 87.9% 84.1% 79.9% 84.6% 83.4% 84.1% Collection ratio 84.2% 86.1% 88.6% 87.0% 85.2% 87.4% Cost recovery by payments 39.6% 44.8% 48.7% 32.0% 37.3% 48.4% Power Network gas 2000 2001 2002 2000 2001 2002 Cost recovery in tariffs 76.8% 81.8% 81.5% 82.5% 88.6% 85.7% Billing coeff. 11 85.7% 83.2% 78.3% 100.0% 90.0% 80.0% Collection ratio 87.4% 89.6% 91.1% 82.6% 92.8% 90.9% Cost recovery by payments 57.5% 61.0% 58.2% 68.2% 74.1% 62.3% 11Actualbillings adjusted for discounts and Igoty. Source: Staffestimates based on the datafrom Rosstat and Gosstroi. 3.22 The financial performance o f the housing and utility sector remains weak, which i s a result o f both the existing government tariff policy and the poor operational efficiency o f the service providers, which primarily remain unreformed municipally owned entities. Total losses in the sector amounted t o 0.8 percent o f GDP in 2002 (Table 3.4), while the stock o f total payables (mostly for energy) was at the level o f 2.7 percent o f GDP in early 2003. Table 3.4: Financial Indicators for the Housing and Utility Sector (% o f GDP) TOTAL o/w Heating & Hot Water 2000 2001 2002 2000 2001 2002 Total losses in the sector -1.03 -0.99 -0.79 -0.51 -0.49 -0.36 o/w: from services to population -1.21 -1.26 -0.95 -0.66 -0.61 -0.41 Total receivables, stock 3.17 2.54 2.22 1.02 0.83 0.76 - olw: from budgets 0.95 0.66 0.59 0.41 0.30 0.25 - from population 0.44 0.44 0.52 0.13 0.14 0.18 Total payables, stock 3.25 2.58 2.69 1.20 1.02 0.95 olw: - to budgets 0.39 0.37 0.41 0.11 0.12 0.13 Source: Staffestimates based on the datafrom Rosstat and Gosstroi. 3.23 In 2000-01, average spending o n housing and utilities amounted to only about 6-7 percent o f household budget expenditures. In 2002, housing and utility prices rose by 50 percent in real terms, while real incomes increased by about 20 percent. As a result, the share o f housing s ending exceeded 8 percent, which historically i s a relatively high level in Russia (Table 3.5).!4 48 This share amounted to about 2 percent in 1993 (World Bank, 1998a). In comparison, households in Poland and Hungary typically spend over 20 percent o f their income on HUS (World Bank, 2003). Even in Belarus, 71 Table 3.5: Average Household Expenditure on Housing and Utilities (YOof total household expenditures) 1997 1998 1999 2000 2001 2002 Average 6.3 6.7 6.0 6.1 7.0 8.5 Median 4.6 4.6 4.3 4.5 5.2 6.5 Source: Staff estimates based on the HBS. 3.24 It i s worth mentioning, however, that even after accounting for the lgoty, the existing statistics on utility tariffs for households continue to overestimate considerably the actual level o f cost recovery. This i s due to two primary factors: 0 Services to the population are s t i l l cross-subsidized through higher tariffs from commercial consumers. The total annual amount o f cross-subsidization may be close to 1 percent o f GDP (see Table 3.7 below). 0 The tariffs heavily underestimate the investment component. I t i s estimated that the amount o f annual under-investments in rehabilitation and repair o f local utilities may reach another 1 percent o f GDP. 3.25 Therefore, the actual financing needs o f the sector, at the current level o f i t s efficiency, are much higher than the cost estimates based on the reported information on tariffs and cost recovery, and exceed 6.5 percent o f GDP (see also Table 3.8 below). At the moment, annual household housing payments make up about 2.5 percent o f GDP (i.e. they cover less than 40 percent o f the total amount). Structure of budget support in the housing and utility sector 3.26 Table 3.6 presents the structure o f the main budget programs in the sector. There have been four main types o f budget channels that provide regular financing to the HUS. Most o f this financing i s provided by the subnational budgets. The role o f the federal government in H U S financing i s limited to: (i) providing special central budget transfers to regions related to the financing o f housing recently divested from local enterprises; and i i) providing indirect budget support to the sector by financing non-regular programs o f the emergency type (Table 3.7). Table 3.6: Structure of Budget Spending on Housing and Utility Services to the Population (main programs o f direct budget support) (YO) Expected Financing Actual Financing 2001 2002 2003 2001 2002 2003 Total budget spending: 100 100 100 100 100 100 - direct subsidies to cover tariff gaps 70.4 73.5 67.4 83.7 82.1 71.4 - compensation o f tariff benefits (lgoty) 26.7 20.4 21.2 13.2 12.3 17.1 - housingallowances 2.9 6.1 11.4 3.1 5.7 11.5 Memo: Federal transfers to regions to compensate for housing divestiture, as % 1.3 2.5 n.a. o f total budget spending Source: Staffestimates based on the data from Rosstat and Gosstroi. ~~ where structural reforms in general have been lagging, in 2003 households spent on average 11 percent o f their budget on HUS. 72 3.27 M a i n budget programs in the sector could be summarized as follows: Budget subsidies to service providers. This i s the main budget program in the sector, which accounts for more than 70 percent o f the total direct budget support. I t s preservation i s a direct reflection o f the slow pace o f reforms in the H U S . Prevailing tariffs are below actual costs and respective govemments have to compensate local utilities for these tariff deficiencies. This i s a traditional example o f “bad subsidies,” which are highly regressive: wealthier households tend to live in larger apartments, consume more services and receive more subsidies. This subsidization also undermines incentives to improve efficiency in the sector. Housing benefits &OW). Recently, more than one-third o f Russian households were eligible for various discounts from the established H U S tariffs, usually as high as 50 percent. The total annual cost o f this program amounted to 0.45 percent o f GDP in 2002-03. Most o f these programs are occupation-based, but not income-based, and many are relicts o f social program priorities o f the Soviet era. The analysis o f their beneficiaries clearly suggests that non-poor households received most o f the benefits. In addition, actual budget financing o f benefits never exceeded 70 percent. In the summer o f 2004, the Government o f Russia adopted a radical program o f reforming the lgoty starting from 2005. So far, it has announced a limited monetization o f lgoty through a replacement o f specific programs in health and public transportation. See a more detailed analysis o f lgoty in a separate section below. 0 Housing allowances. The introduction o f the housing allowance program represents one o f the major successes o f housing reform during the 1990s. I t i s the f i r s t Russian program o f targeted social assistance, and as such it has a major impact o n defining an overall approach to the reform o f social protection in the country. The program has been established practically in every municipality, and i t s evaluation suggests that it has been rather effective. As o f September 2003, 13.8 percent o f Russian households participated in the program. In several Russian regions more than 30 percent o f households became recipients o f housing allowances. It i s expected that in the course o f the reforms the share o f participants would increase further, but it i s believed that the existing infrastructure has the capacity to handle more applicants. A replacement o f other current programs o f housing financing with additional funding o f housing allowances would add a major efficiency gain to the system, because it would provide for the channeling o f most o f the budget expenditure in the H U S for the support o f low-income households and more broadly for a reallocation o f subsidies from producers to consumers. 3.28 Before 2004, the current legislation o n housing allowances provided for two parallel eligibility criteria as well as a formula to determine the benefit size: a) General. Household spending o n housing and utility services (within the established limits o f housing size) should not exceed the threshold share in overall household income; this threshold i s established by the decisions o f regional govemments and in most regions equals 22 percent o f family income. b) For l o w income households. Households with per capita incomes that are below the subsistence minimum are eligible for a housing allowance if their total housing and utility spending exceeds 50 percent o f the current minimum wage. 73 3.29 I t was believed that the second criterion was too generous, and that i t led to excessive subsidization o f l o w income households and distorted the entire process o f housing assistance. This i s especially problematic, given the quite low value o f the Russian minimum wage. In 2004, the Govemment adopted the decision to eliminate the 2"d criterion. 3.30 The elimination o f the second criterion, as estimated by the WE, other factors being intact, would reduce the number o f eligible participants in the program by about 75 percent, bringing the number to 7.5 percent o f households. In our simulations we also assumed that the second criterion would be eliminated. Respectively, the number 7.5 percent i s used as a benchmark for our analysis o f potential changes in the number o f allowance recipients as a result o f the proposed tariff adjustments in the H U S . 3.3 1 In the course o f recent reforms in the division o f powers between different government levels in Russia, it was decided that all functions related to social policy should be concentrated at the regional level. As a result, the responsibility for financing housing allowances was moved from the municipal to the regional budgets. W h i l e this change expands the funding base for housing allowances, i t also creates a potential incentive problem. Having no responsibility for financing this program themselves, municipalities may relax control over program administration, which could erode the efficiency o f its targeting. The government's instrument to mitigate this risk i s through an introduction o f the unified system o f regional housing standards that would encourage municipalities to follow a single region-specific set of eligibility criteria for housing allowances. 3.32 The earlier analysis identified two essential weaknesses in the administration o f housing allowances (Hamilton, 2004). First, their availability shows too high a variation by region, which by far exceeds the variation in housing affordability. Second, the program remains predominantly urban-based, with rural households being mostly left without access to it4'. 3.33 Indirect budget ,Drograms (investment support, expenditures for liquidation o f emergencies and deliverv o f f u e l to the North). This i s the least transparent and least efficient part o f public financing in the HUS, and i s provided mostly o n an ad hoc basis. The funds spent through this channel are not reported in the conventional budget reports as spent on housing sector support. Preservation o f these programs reflects primarily the failure o f sectoral reforms to date to create an institutional framework for sustainable investment finaricing that would include efficient mechanisms for tariff regulation, competitive mechanisms for service delivery, and providers that are creditworthy and have access to regular commercial credit. The overall amount o f budget funding through this channel i s estimated by the IUE to amount to about 0.6 percent o f GDP a year, or more than one-third o f funding under the conventional budget programs in the H U S (Table 3.7). 3.34 When indirect budget financing i s included, total annual government spending o n the H US i s estimated to amount to 2.4 percent o f GDP. If, in addition, the amount o f quasi-fiscal financing through cross-subsidization i s reflected, the total amount o f fiscal and quasi-fiscal funding in the sector reaches 3.3 percent o f GDP (Table 3.7). 49 It i s worth noting, however, that most rural households in Russia continue to benefit from much lower energy tariffs. 74 Table 3.7: Estimates for Total Fiscal and Quasi-fiscal Support to the Housing and Utility Sector in 2003 bnrbl %ofGDP Direct budget support provided 234 1.76 Indirect budget support 82 0.62 - Preparation for the winter 55 0.41 - Fuel delivery to the North 16 0.12 - Emergency rehabilitation 11 0.08 Quasi-fiscal financing: Cross-subsidies (*) 125 0.94 - heating 20 0.15 - electricity 50 0.38 - gas 55 0.41 Total fiscal and quasi-fiscalfinancing 44 1 3.32 Costs o f annual under-investments (missing rehab) 135 1.02 (*) Estimates relate to services provided to both population and budget organizations. Source: IUE 3.35 Table 3.8 presents an estimate o f the total volume o f actual financing in the Russian housing and utility sector through all available channels. I t amounts to 5.8 percent o f GDP, which i s quite high, given the predominantly l o w quality o f the existing housing. Moreover, given the available estimates o f annual under-financing in proper maintenance and rehabilitation, the total annual sector needs in financing under the existing institutional arrangements may amount to as much as 6.8 percent o f GDP. The latter number should be considered primarily as an indicator o f the sector’s inefficiencies, and not as a benchmark for future growth in tariffs and subsidies. Many sectoral experts believe that under the proper incentive regime the total costs o f operation in the sector could be reduced by at least 20%. At the same time, as shown below, the sector i s facing some additional cost increases associated with growth in domestic energy prices and with a need to incorporate capital costs into the tariffs. Table 3.8: Total Volumes of Available Financing in the Sector, 2003 (% o f GDP) I, Direct financing o f housing and utility services 4.2 o/w: Households 2.5 Budget 1.8 2. Indirect budget financing 0.6 3. Total cash financing, (1)+(2) 4.8 4. Quasi-fiscal financing 0.9 5. Total available financing, (3)+(4) 5.8 6. Under-financing 1.o 7. Total financing needs under the existing institutional arrangements, 6.8 (5)+(6) Source: Staffestimates, based on the data collected and estimated by the IUE. D. RECENT TRENDS I N HOUSING AND UTILITY TARIFFS 3.36 In the period that followed the 1998 Russia crisis, the government tariff policy in the housing and utility sector was inconsistent. In 1998-2001 the tariff growth in housing and utility services lagged behind general price growth (Table 3.9). The largest gap between the 75 two occurred in 1998: H U S prices grew by only 12 percent?’, while annual CPI inflation was 84 percent. This led to a considerable deterioration in the financial situation in the sector. In 2002, as a reaction to this extended period o f under-financing, the annual tariff increase in the H U S for the first time surpassed the rate o f CPI inflation. Table 3.9: Inflation and Price Growth in Housing and Utilities, 1998-2000 Implicit growth of Consumer Annual growth growth Annual growth tariffs for a non- of electricity Price Index of HUS tariffs of gas tariffs energy part of HUS tariffs services 1998 184.5 112.0 102.2 108.6 113.8 1999 136.5 125.0 119.7 113.6 128.7 2000 120.2 111.3 141.7 162.0 90.9 2001 118.6 110.9 137.0 129.0 99.1 2002 115.7 134.5 125.0 130.0 138.0 Source: W E , Rosstat. 3.37 I t i s worth noting that in 1998-99 the tariff growth in the electricity and gas sector was even slower than in the HUS. However, the period o f depressed tariffs was much shorter there. Starting from 2000, growth in electricity and gas tariffs surpassed the CPI rates and provided enterprises in these sectors with a more adequate level o f cost recovery. 3.38 Overall, the H US was used as a major “shock-absorber” during the period o f high inflation and economic instability o f 1998-99. By keeping housing and utility services costs low, the Government o f Russia was trying to maintain social and budgetary stability at the cost o f the deteriorating financial position o f the H U S . 3.39 The last column in Table 3 -9 provides estimates o f growth in tariffs that corresponds to a non-energy component o f H U S services. These indices were estimated by de-composing the total costs o f housing and utility service delivery in energy (electricity and gas) and non- energy component^.^' As can be seen from Table 3.9, in 2000-01, when energy tariffs started to grow relatively rapidly, but growth in H US tariffs remained depressed, the implicit tariffs for a non-energy part o f the HUS were declining even in nominal terms. 3.40 Since the growth in H U S tariffs in the post-1998 period was kept below general inflation, the accumulated under-financing has become quite significant. In this report it i s assumed that to provide the sector with conditions for financial rehabilitation at.least a portion o f this deferred inflation effect has to be compensated through future accelerated tariff growth. 3.41 In Table 3.10 we estimated the accumulated size o f this under-financing in the non- energy part o f the H U S for the period o f 1997-2002 as o f 126 percent relative to the C P I inflation rate. I t i s worth noting that this price gap declined considerably in 2002 after a major adjustment in H U S tariffs. Still, this gap indicates that the real level o f non-energy housing tariffs in 2002 was less than h a l f o f their 1997 level. In our simulations, we assumed that the future growth in housing tariffs would compensate for about 25 percent o f this effect o f 50 The index of HUS tariffs i s estimated based on the data for a federal standard o f HUS costs, annually adopted by a resolution of the Russian Government as a part of the budget preparation process. Both direct and indirect consumption of electricity and gas were taken into account. See the next section for more details. 76 deferred inflation. This means that in the model we assumed that for the f i r s t three years o f reforms the non-energy part o f the H U S costs would grow at a rate about 10 percentage points higher than the expected CPI rate, after accounting for all other factors that will influence the future H U S tariff dynamics. Table 3.10: Estimates for the Effect of “Deferred Inflation” in the HUS (non-energy part), 1997-2002 Implicit growth o f tariffs for a Deferred inflation effect (a gap CPI, non-energy part o f HUS between CPI and non-energy 1997=100 services, 1997=100 HUS tariff index) 1998 184.5 113.8 1.62 1999 251.8 146.4 1.72 2000 302.7 133.1 2.27 2001 359.0 131.8 2.72 2002 411.8 182.0 2.26 Source: IUE, Rosstat. E. AGGREGATED COSTS STRUCTURE I N RESIDENTIAL. HOUSING 3.42 In this section we review the role o f energy in overall housing and utility costs. This analysis i s important for further simulations o f the link between expected growth in domestic prices for gas and electricity and a future increase in housing costs. For the purposes o f such an analysis, it i s important to account for full gas and electricity consumption in the sector, that is, both their direct and their indirect (as input for production o f other utility services) consumption. 3.43 The first column in Table 3.1 1 presents the conventional cost structure in Russia’s housing sector. I t i s worth noting that the share o f housing maintenance in total costs i s quite low, less than one-fourth. In developed economies this share often amounts to 50 percent o f the total. Non-maintenance costs are much higher in Russia because o f several factors: (i) climate, (ii) major energy inefficiencies in the sector, and ( iii) the under-estimation o f actual maintenance costs in the existing maintenance feeskariffs, which cover operating costs (though not in the full amount) but exclude provisions for rehabilitation and major repair costs, land fees, and insurance payments. The implementation o f tariff reforms would require a major increase in housing maintenance fees. Table 3.11: Cost Structure in the Housing and Utility Sector, per 1 Square Meter o f Residential Housing, as o f end 2002 (YO) Cost structure that accounts for Conventional cost structure indirect consumption o f electricity and gas Electricity 9.4 15.8 Water and sewerage 13.6 9.5 Heating and hot water 48.6 34.9 Gas 5.8 19.2 Housing maintenance 22.6 20.3 Total 100 100 Source: IUE. 3.44 The second column in Table 3.1 1 presents the estimates for the full electricity and gas intensity o f the Russian housing sector. W h i l e the costs o f directly consumed electricity and gas make up only 15 percent o f total, the costs o f full consumption o f these energy inputs 77 amount to 35 percent. This i s because a l l main utility services are quite energy intensive. Electricity costs account for nearly 30 percent o f the total costs in water and sewerage. The share o f heat generated in gas-operating boilers reaches 60 percent. Gas accounts for 35 percent o f the total heat costs in such boilers. Respectively, 50 percent o f electricity i s generated by gas-operating power plants and gas accounts for 35 percent o f the generation costs o f these plants. 3.45 The estimates in Table 3.11 were used directly as weights in our simulations o f future housing costs, which were based o n the utilization o f three primary independent variables: growth in gas and in electricity prices, and growth in tariffs in the rest o f the sector. The last variable reflects a need for tariff adjustment to ensure proper maintenance and rehabilitation o f the housing stock and utility networks, but it i s unrelated to the costs o f energy inputs. Budget spending on utility services provided to budget organizations 3.46 The Russian budget statistics do not generate consolidated estimates for federal budget expenditures o n utility services consumed within the public sector. This i s because utility payments are budgeted as parts o f the budgets o f individual ministries and agencies, and the Ministry o f Finance does not provide for across-the-board consolidation o f such spending. However, the budget reporting at the subnational level provides sufficiently adequate data o n ' government utility spending. 3.47 The consolidated estimates o f the budget costs o f utility payments were developed by the IUE based o n the detailed analysis o f the budget execution for 2001. Respective expenditures made by b o t h regional and municipal govemments were extracted from individual regional consolidated reports o n the annual budget execution. Respectively, estimates for the 2001 federal budget spending o n utility services were developed using several assumptions o n the unit costs o f such services in the sectors, for which direct reports are unavailable. The latter includes expenditures under the Ministries o f Defense and Interior. Annex 3.2 presents a description o f the various assumptions made. 3.48 Consolidated budget expenditures o n utility services for 2002 and 2003 were generated based o n the simplified procedure, using the base estimates for 2001 and general trends in budget spending at a l l levels o f the government in 2002-03, as w e l l as the dynamics o f utility prices. 3.49 Total budget expenditures o n utility services have been slightly larger than 1 percent o f G D P in recent years (Table 3.12). H a l f o f these expenditures are made by municipal budgets. The analysis also suggests that at the subnational level (both regional and municipal) the largest component of the total utility spending relates t o the costs o f operating budget institutions in the education and health sectors, which account for about 70 percent o f the total utility expenditures. 78 Table 3.12: Budget Expenditures on Utility Services Provided to Budget Organizations, by the Level of Government (billion RUR and YO) I n bl Rbl In % o f GDP 2001 2002 2003 2001 2002 2003 Total expenditures 89.9 130.8 152.3 1.o 1.2 1.1 - Federal budget 29.1 43 46.9 0.3 0.4 0.4 - Consolidatedregional budget 60.8 87.8 105.4 0.7 0.8 0.8 including: - regional budgets 18 28.1 33.8 0.2 0.3 0.3 - municipal budgets 42.8 59.7 71.6 0.5 0.6 0.5 Memo: GDP 8.944 10,834 13.285 Sources: IUE, MOF, Rosstat. 3.50 At the federal level, utility spending on education and health i s considerably lower and accounts for less than 40 percent o f the respective total. T h i s i s because o f the completely different structure o f government functions at the federal level. The specific federal items that have significant utility costs relate to defense and law enforcement, including the operation o f the penal and penitentiary system. This group o f government functions accounts for nearly one-third o f all federal budget spending o n utility services. 3.51 I t i s worth noting that, owing to a considerable improvement in budget discipline in Russia since the late 1 9 9 0 ~ ~ actual government payments for utility services have improved considerably. The level o f current non-payments has become negligible. The stock o f government arrears for utility payments declined to below 0.6 percent o f GDP by the end o f 2002 (Table 3.7, above). Most o f the remaining quasi-fiscal financing takes places through cross-subsidization (Table 3.6 above): in many regions budget organizations have benefited from the same l o w utility tariffs as households. 3.52 As i s shown below, we expect that under the reform scenarios the unit costs o f H U S would increase by about 90 percent by 2006 relative to the 2002 Even adjusting for the expected modest efficiency gains in the sector, our estimates suggest that full adjustments in energy and utility prices would result in the total H U S costs to the government reaching 1.9-2.0 percent o f GDP, with h a l f to be incurred by municipalities. This amounts to 0.8-0.9 percent o f GDP in additional expenditures for Russia’s consolidated budget. We estimate that about half o f these incremental costs could be compensated through additional taxes paid by energy f i r m s and utility providers that are the primary beneficiaries o f the proposed tariff reform. T h i s leaves a residual fiscal gap o f about 0.4-0.5 percent o f GDP. In the longer term, we expect that most o f this gap would disappear as a result o f the expected rationalization and consolidation o f the budget sector, f i r s t o f a l l in health and education. But public sector rationalization could become a relatively lengthy process. Meanwhile, the government has to find ways to finance the gap. 52 This cost increase reflects some compensation for under-investments in the previous period. See below for more details on cost assumptions. 79 F. FOR SIMULATING BUDGET MODEL IMPLICATIONS FROM INCREASES IN HOUSING COSTS Lessons from the earlier simulations o f housing reforms in Russia 3.53 Given the long history o f the government’s attempts to accelerate housing reforms, which would include reforms in financing through higher cost recovery by tenants and reduced subsidies, it i s not surprising that there has been some experience o f quantitative analysis o f the potential impact o f the proposed tariff increases.53Most o f this work has been undertaken initially by the staff o f the Urban Institute, as part o f the housing reform program sponsored by USAID. 3.54 The primary focus o f the earlier work was related to the introduction o f the housing allowances programs in particular regions and municipalities, as well as to the analysis o f the actual efficiency o f such programs. This required developing the procedures for: (i)estimating the variation in future reform impacts across particular types o f housing and specific household groups, (ii) forecasting changes in the demand for housing allowances, and ( iii ) making projections for trends in the total requirements for budget financing, including costs o f both conventional budget subsidies and social assistance programs, such as housing allowances. These studies have been based on various types o f the survey data o n household incomes, expenditures, and housing conditions, which have helped provide an important understanding regarding the comparative advantages o f specific statistical sources. 3.55 The main lessons from the earlier simulations o f housing reforms, which were fully incorporated in this paper, could be summarized as follows: 0 Estimates o f the current level ,of housing costs to households have to be imuuted, and they should not be directly based on expenditure values self-reported in the household surveys. The conventional household surveys in Russia, including both the RLMS and the regular Household Budgetary Survey (HBS), bring an unacceptable level o f distortions when they deal with the issues related to housing and utility spending. Apparently the basic question, “How much did you spend o n housing and utilities last month?” was interpreted quite differently by respondents. This i s because o f the multiplicity o f available discounts and benefits (lgoty) to households, the high incidence o f arrears and late payments, and the s t i l l relatively l o w share o f housing- related payments in total spending for many households. 0 Accounting for cross-regional variations in costs and incomes i s important. There i s a striking cross-regional variation in all key parameters that determine a potential reform impact o n both the population and the fiscal system. In particular, regional differences are high with respect to average housing costs, average income levels, and income inequality. As a result, as was shown, for example, in W o r l d Bank (1998b), while o n the average the reform impact could be modest, some regions (particularly Siberia and the Far East), could be badly affected by the shift to full cost recovery in housing. 0 Regional income ,distribution i s a key determinant o f a demand for housing allowances. Relatively simple models that are based o n i)forecasting o f average regional housing costs, and i i)the aggregated income distribution by main income groups, proved to be sufficiently accurate in generating projections for both number 53 See specifically Housing Allowance Program (1996), Kolodeznikova and Stmyk (1997), World Bank (1998b), IUE (2003b). 80 o f future applicants and average size o f their allowance. Switching to more detailed (household-level) information o n incomes and housing conditions greatly complicates the analysis and does not bring significant improvements in the accuracy o f projections. Model: Estimatingfuture HUS costs" 3.56 The base model for estimating future average costs o f operating the residential housing stock had the following structure: HUS ( t ) = (H(t)*x l + E(t)* x2 + G(t)* x3) * Sav(t), (1) where HUS (t) - a housing cost index that reflects an increase in full average costs o f operating 1 square meter (sq. m) o f the housing stock in year t relative to the base year (2002), H(t)- an increase in unit non-energy costs o f operating housing in year t relative to the base year, E(t) and G(t) -- increases in unit costs o f electricity and gas, respectively, in year t relative to the base year, x l ,x2, and x3 - shares o f main components o f housing costs (non-energy, electricity and gas, respectively - see section 3 for additional information) in the total costs, Sav(t) - parameter o f cost savings in year t, which reflects the expected efficiency gains (primarily energy savings) as a result o f reforms, as a percent o f the base 2002 costs. 3.57 All costs are estimated in constant 2002 prices. Regional average costs HUS(r, t ) are determined based o n actual cross-regional variations in unit costs in the base year 2002: HUS(Y, t ) = HUS(t)*cost(r) Where cost (Y) - the coefficient o f regional costs that reflects the 2002 ratio between unit costs in region r and average costs for Russia. 3.58 Future growth in electricity and gas tariffs, E(t) and G(t),i s determined by two factors: - e l / g l - expected average real growth in domestic energy prices, - e2/g2 - expected effect o f elimination o f cross-subsidization that would provide for a higher growth in residential tariffs relative to their average growth. 3.59 Future growth in non-energy unit costs H(t)i s determined by: - h 1 - expected real growth in tariffs for non-energy services in the sector, mostly related to a partial compensation for earlier under-financing in the sector; hl was selected at the level o f 1.32 (i.e., for the period 2004-06 non-energy costs in the sector would be growing at a rate that i s 32 percentage points higher than general inflation), which would compensate for about a quarter o f earlier deferred inflation. - h2 -- expected effect o f the elimination o f cross-subsidization in non-energy services (primarily water) that would provide for a higher growth in residential tariffs relative to their average growth. Therefore: 54 A detailed description o f the model i s provided in IUE (2003a). 81 E(t) = el(t) * e2(t) G(t>= 81@) * g2(0 H(t)= hl(t) * h2(t) 3.60 Projections for costs o f housing and utility services for budget organizations are also based o n the above HUS(t) index (ie., it i s expected that future costs o f HUS for budget institutions would grow at a similar rate as those for households). Estimating the demand for housing allowances 3.61 Estimates for a potential demand for housing allowances were developed on a region- by-region basis, using region-specific information on (i) average unit housing costs, (ii) average household incomes, and (iii) income differentiation among eight main income groups. 3.62 The core variable for this bloc o f the model i s the future average housing costs per capita in region r, CC(r, t). It was estimated using the data on average regional housing costs HUS (r, t) and the aggregated distribution o f the Russian population by available housing space. A standard assumption o n housing distribution was used: 10 percent o f the population use 33 sq m per capita, 15 percent use 21 sq myand 75 percent use 18 sq m. I t i s worth noting that hausing space in excess o f these amounts i s not eligible for subsidizing through the housing allowance program. 3.63 For each region and income group, average household incomes I (r, j , t ) were compared with the regional per capita unit housing costs CC(r, t ) to determine if this income group i s eligible for budget support through housing allowances. 3.64 I f I ( r ,j , t ) * q > CC(r, t), then members o f income group j are ineligible for housing allowances, where q - i s a maximum share o f household income that could be spent on housing. 3.65 Only household housing costs that exceed q are eligible for full budget compensation through housing allowances. According to the current legislation, in most regions q=22 percent. Thus we assume that subnational governments would largely follow federal guidelines on the eligibility threshold. In our simulations, we also considered alternative values o f parameter q such as 10 percent and 15 percent. 3.66 The average allowance for a member o f income g r o u p j in region r in year t, A l l o w ( r , j , t ) i s estimated as: Allow ( r , j , t ) = CC(', t) - I (T, j , t ) *q (2) 3.67 Aggregation by income groups and regions allows for estimating the total number o f recipients o f housing allowances and the total costs o f this program for each scenario. 3.68 In the scenarios, which did not provide for the elimination o f lgoty, the size o f each income group was proportionally reduced to reflect the number o f lgoty beneficiaries in this group. This would reduce an overall demand for housing allowances. 3.69 I t i s assumed that the future participation rate in the housing allowance program will be 75 percent (Le., three-quarters o f eligible households would apply for a benefit). The IUE field research suggests that at the moment the participation rate in the program i s about 60 82 percent. I t i s expected to increase in the medium term in response to the growth in real housing costs. G. REFORM SCENARIOS IDENTIFIED FOR SIMULATIONS Macroeconomic scenarios 3.70 Macroeconomic assumptions for our simulations were developed jointly with the experts from the Institute o f Economy in Transition. The basic principles and parameters o f the macroeconomic framework used for costing out various structural reforms are presented in Annex 3.1. In sum, we took the government’s baseline macroeconomic projections for the period 2004-06 and used them as a basis to build a set o f four longer-term macroeconomic scenarios, each o f which reflects a specific combination o f two primary determinants o f Russia’s future macroeconomic performance - the average world market o i l price and the expected speed o f structural reforms in the country (Table 3.13). Then we used these four macroeconomic scenarios as a basis on which we have designed and elaborated further, more detailed, sub-scenarios that reflect specific reform packages in the housing and utility sector. Table 3.13: Macroeconomic Assumptions: Average GDP and Real Household Income Growth for 2004- 06 (Yo) Slow reforms Advanced reforms Moderate oil prices ($18.5), low growth Scenario 1 Scenario 2 GDP growth - 2.0 GDP growth - 1.5 Income growth - 8.4 Income growth - 6.4 High oil prices ($22.5 and higher), high growth Scenario 3 Scenario 4 GDP growth - 4.0 GDP growth - 3.5 Income growth - 8.4 Income growth - 6.4 3.71 Overall, we based the analysis on a rather conservative macroeconomic framework. It i s worth noting that GDP growth rates assumed in our scenarios for the period 2004-06 are lower than those assumed in the corresponding government projections. We believe that without advancing reforms growth rates will decline: better utilization o f existing reserves in the economy, which was a critical growth factor in 1999-2003, cannot support future growth in the same way as before because the reserves are to a large extent exhausted. At the same time, the “advance reforms” scenario implies that reforms are likely to temporarily slow down GDP growth compared to the “no reform” scenario, other things being equal. Therefore, in this case, growth rates are also likely to be lower for the next few years than those assumed by the government. 3.72 The four baseline scenarios could be summarized as follows. I. Moderate o i l prices and slow reforms. This scenario presents the most difficult macroeconomic environment, with l o w budget revenues, a relatively high expenditure burden, and a deteriorating balance o f payments that triggers inflation and exchange rate pressures and damages investment expectations. This i s the scenario with l o w growth in both investments and household incomes. Lack o f reforms would mean that cross-subsidization o f households would remain intact. 11. Moderate o i l prices and advanced reforms. Under this scenario the macroeconomic environment for reforms remains rather difficult, with l o w government revenues and depressed earnings in the real sector. However, real devaluation o f the Russian ruble implies some protection o f domestic producers from international competition. T h i s in combination with the reform momentum could be favorable for investments and 83 growth in sectors with a high degree o f processing. The reform o f natural monopolies and tariff reforms would lead to a gradual increase in electricity and gas tariffs for commercial consumers and a sharp increase in tariffs for households. 111. High o i l prices and slow reforms. This i s an inertial scenario, under which the existing structure o f the economy remains basically intact with the energy and other primary sectors generating most o f the investments, taxes, and exports. As with the first scenario, cross-subsidization o f households i s preserved. IV. High o i l prices and advanced reforms. This i s the most optimistic scenario. I t implies a deep economic restructuring and would be more sustainable in a longer term economic growth backed by vigorous structural and institutional reforms. This scenario provides for the highest annual growth rates o f GDP, investments, and household incomes. However, given the required level o f restructuring in the real sector, unemployment would remain relatively high, which would preserve a strong demand for govenunent spending on social protection. 3.73 One o f the core variables in the model relates to the real growth in household incomes. In our base case simulations, we assume that the current high growth in real incomes would continue, while the income differentiation would remain unchanged. In particular, in line with the latest projections o f the Ministry o f Economy, the real income growth for 2005-06 in all scenarios i s assumed to be 8 percent per annum. This i s equivalent to an average growth o f 10 percent a year for the entire period 2003-06. At the same time, we did a sensitivity analysis with respect to income growth: an alternative set o f estimates was obtained for the scenario, in which real incomes grow at a rate o f 5 percent a year for the period 2003-06. Scenarios for the housing and utility sector 3.74 Two baseline scenarios for reforming payment arrangements the housing and utility sector were developed for 2004-06 along the similar lines: 0 Slow reforms, mostly inertial development 0 Implementation o f the reform package that would include, inter alia, the elimination o f the cross-subsidization in tariffs, additional growth in housing tariffs to compensate for earlier under-financing, and encouragement o f investments in energy efficiency 3.75 The first scenario implies that housing and utility tariffs would grow only in line with the changes in the overall level o f inflation, and electricity and gas tariffs. In other words, there i s no autonomous growth in utility/housing tariffs to compensate for earlier under- financing (“depressed inflation”) and to create more favorable conditions for rehabilitation in the sector. 3.76 The second scenario provides for higher rates o f tariff growth in the sector, through which it would be compensated for a de facto tariff freeze during the period o f high inflation in 1998-99. We assume that about a quarter o f lost revenues during that tariff freeze would be compensated through an additional growth in housing and utility tariffs in 2004-06. Moreover, cross-subsidization would be eliminated through the introduction o f a single tariff for a l l categories o f consumers in all relevant sectors (power, gas, and local utilities). In addition, some efficiency gains are expected in the utility sector, first o f all through a reduction in heat and water losses. (See the next section for additional details o n potential efficiency effects). 84 Scenarios for the tariff policy 3.77 For each o f the four baseline scenarios, we have also developed a set o f possible policy options with respect to future changes in tariffs and cost recovery. These options for the tariff policy derive from different combinations o f the two key policy parameters: 1) Level o f cost recovery in tariffs for household - three altematives were considered: 0 Tariffs are set to cover 90 percent o f the total running housing and utility costs, while the remaining 10 percent i s s t i l l financed from the budget as a direct subsidy to providers o f housing and utility services 0 Tariffs cover 100 percent o f the total running housing and utility costs 0 Tariffs cover 100 percent o f the total running housing and utility costs, and, in addition, expenditures o n major repairshehabilitation o f the housing stock are also included in tariffs (these rehab-related costs are estimated to amount to 20 percent o f the current running costs). 2) Maximum share o f housing and utility expenditures in household incomes, above which households would be eligible for social assistance through the housing allowance - three altematives were considered: 10 percent, 15 percent, and 22 percent. 3.78 Ultimately, our simulations covered 36 scenarios (4 initial baseline scenarios * 3 options for the level o f cost recovery in tariffs * 3 options for the share o f housing expenditures in household income). Table 3.14 summarizes our sectoral reform scenarios. Table 3.14: Scenarios for Housing and Utility Reforms, Selected for Simulations Parameters of the tariff policy Moderate oil prices High oil prices The maximum Cost recovery in Slow reforms Accelerated Slow reforms Accelerated share of housing tariffs reforms reforms expenditures in household income 10% 90% Option 1-1-1 Option 1-2-1 Option 2-1-1 Option 2-2- 1 100% Option 1-1-2 Option 1-2-2 Option 2-1-2 Option 2-2-2 100% + costs of Option 1-1-3 Option 1-2-3 Option 2-1-3 Option 2-2-3 capital repairs 15% 90% Option 1-1-4 Option 1-2-4 Option 2-1-4 Option 2-2-4 100% Option 1-1-5 Option 1-2-5 Option 2-1-5 Option 2-2-5 100% + costs of Option 1-1-6 Option 1-2-6 Option 2-1-6 Option 2-2-6 capital repairs 22% 90% Option 1-1-7 Option 1-2-7 Option 2-1-7 Option 2-2-7 100% Option 1-1-8 Option 1-2-8 Option 2-1-8 Option 2-2-8 100% + costs of Option 1-1-9 Option 1-2-9 Option 2-1-9 Option 2-2-9 capital repairs 3.79 In the process o f the simulations o f each scenario, the following parameters were estimated for each administrative region o f Russia for the period 2004-06: 85 1. Total costs o f housing and utility services supplied to households 2. Number o f households eligible for housing allowances 3. Share o f allowance recipients in the population 4. Budget expenditures on financing housing allowances 5. Budget expenditures on financing housing privileges (lgoty) 6. Budget expenditures on financing housing subsidies to cover costs not covered by housing tariffs (under the options with 90 percent cost recovery in tariffs) 7. Budget expenditures on financing the repair and rehabilitation o f the housing stock 8. Total budget expenditures related to operations on residential housing 9. Share o f budget spending in financing the total costs o f housing and utility services supplied to households 10. Average share o f housing and utility expenditures in household incomes 11. Share o f housing allowances in household incomes in the lowest income groups. 3.80 In addition, for a limited set o f selected scenarios, we undertook complementary simulations to estimate the impact o f elimination o f housing privileges. H. ON FUTURE ASSUMPTIONS UTILITY COSTS Adjustment in domestic energy prices 3.81 The scenarios for reforms in Russian domestic energy pricing remain at the center o f heated political debates. Still, in the gas sector there i s a growing consensus that the longer- term marginal costs o f Russian gas are in the interval o f US$36-40, and the domestic gas price, which on average amounted to US$22.7 per 1,000 cubic meters in 2003, should ultimately reach this level. The latest draft o f the government reform program suggests a US$36 target (VAT excluded) in 2006 (through both annual price hikes and an expected ruble ’ appreciation), but similar plans in the past have failed to be fully implemented. 3.82 In the power sector, however, serious disagreements remain even about the direction for a future trend in the electricity price. A number o f analysts believe that, given the existing over-capacity, liberalization in the sector i s likely to lead to a decline in the average real electricity price. The current draft reform program envisions an increase o f 16-21 percent in real ruble terms in 2004-06, and no need for additional increases in later years when the effects o f sectoral reforms are fully utilized. 3.83 Table 3.15 summarizes the assumptions in this Chapter on the expected tariff growth for gas and electricity. In the most radical scenario, the real gas tariff would be 25 percent higher than in 2002, while the electricity tariff would be increased by one-third. I t i s worth noting that our macro assumptions provide for a considerable real ruble appreciation (in excess o f 40 percent) for the period 2003-04. T h i s means that dollar energy tariffs would almost double. In particular, the gas tariff would be higher than US$33 per 1,000 cub m, while in 2002 i t was less than US$19. Table 3.15: Real Growth in Energy Tariffs for Households in 2006 Relative to 2002, Depending on Scenario In rbl terms In US$ terms 86 Power gas power gas Scenario 1 - slow reforms, low oil prices 1.02 1.10 1.45 1.57 Scenario 2 - advanced reforms, low oil prices 1.19 1.16 1.70 1.65 Scenario 3 - slow reforms, high oil prices 1.05 1.16 1.49 1.65 Scenario 4 - advanced reforms, high oil prices 1.34 1.25 1.91 1.78 Assumptions on the elimination o f cross-subsidization 3.84 G i v e n the considerable volume o f cross-subsidization, merely increasing the average H U S tariffs t o achieve full cost recovery would be insufficient. In addition, a considerable tariff rebalancing i s needed to ensure that tariffs reflect the costs o f service delivery for particular consumer groups. Such tariff restructuring would result in a considerable additional growth in residential tariffs relative to their average expected growth for the economy (see Table 3.16). 87 Table 3.16: Additional Growth in ResidentialTariffs to Ensure the Elimination o f Cross-Subsidization Additional growth in residential tariffs Electricity 1.23 Gas 1.14 Water 1.45 Heating 1.13 Housing maintenance 1.oo Average for the sector 1.15 Sources: IUE, staff estimates. Assumptions on potential efficiency gains 3.85 The Russian housing stock i s quite inefficient and there i s considerable room for energy savings. For instance, the water consumption o f Russian urban households i s estimated to be more than 70 percent above the Western European level (World Bank, 2003a). However, the realization o f most o f these efficiency gains requires fundamental institutional changes in the sector, which could not be achieved in the short to medium term.55 In the period up to 2006, under the most optimistic assumptions about the pace o f sectoral reforms, only a small portion o f these gains could be realized. This i s due to the existing institutional and technological constraints that would hamper the introduction o f energy and resource saving technologies, especially at the household level. The situations regarding heating, water, and electricity are discussed immediately below. 3.86 Heating. Considerable savings in heating are technically possible but would require a major change in how Russian multi-apartment housing units are managed. In short, most savings could be achieved at the building level but not at the apartment-level, T o realize these savings, apartment owners must (i) transform the current means o f housing management into condominiums or similar, ( ii) be capable o f contracting and supervising efficient managing companies for their multi-unit buildings, and ( iii)invest in the proper metering o f delivered heat. The experience o f the past 10 years suggests that the introduction o f new management arrangements has been quite slow. 3.87 Water. The situation with water metering, which i s a pre-condition for incentives to save water, i s even less advanced than that for heating. And, because o f technical constraints, water metering at the apartment level i s not cost efficient. The efficient solution for metering has to be at the building level, which has the same limitation related to the need to introduce a collective form o f housing management such as condominiums. In addition, water utilities in most cases are not interested in the installation o f meters, because the current billing i s based on norms that usually exceed actual household consumption. The introduction o f meters would reduce the revenues o f water utilities. 3.88 Electricitv. In contrast to water and heating, households have better opportunities for savings in electricity. Most housing units have power meters and it i s much easier for households to save electricity than to save heat or water. Thus, the price elasticity o f .’’See also Eismont et al. (2003). 88 electricity demand i s higher than that for other utilities. Still, at the household level we do not expect substantial electricity savings for the period up to 2006. This i s due to the following: 0 Expected growth in the ownership o f household appliances, driven by the continuation o f a fairly strong growth in real household incomes 0 Growth in the installation o f electrical ovens, especially in new apartments 0 Improved quality o f the maintenance o f the housing stock (better lighting, etc.) 3.89 Overall, a combination o f two opposite factors - energy savings due to increased tariffs and growth in demand due to higher real incomes - would keep the absolute level o f electricity consumption in the residential sector basically constant. 3.90 Therefore, it i s assumed in the scenarios with advanced reforms that most efficiency gains in the HU S would be realized not within the household sector but by service providers in heating and water supply. In particular, it i s expected that by 2006 it would be realistic to achieve the following main improvements: 0 As a result o f investment in network modernization and improved management, the current level o f water losses could be reduced by 25 percent 0 Investments in energy savings could reduce unit electricity consumption in water supply by 12 percent 0 The reduction in heat losses in heating distribution could reach 10 percent 0 Improved energy efficiency in heat generation (mostly through replacement/modemization o f boilers) could amount to 10 percent 3.91 Overall, we assumed that owing to efficiency gains in the reform scenarios, by 2006 the total unit costs in the H U S could be reduced by 10-12 percent. In the non-reform scenarios, however, i t i s assumed that no reduction in unit costs would take place because o f the efficiency gains. Table 3.17: Effect on Costs of Efficiency Gains in Reform Scenarios Percent in decline in real unit costs due to energy savings Scenario 2 - advanced reforms, low oil prices 10 Scenario 4 - advanced reforms, high oil prices 12 Source: IUE. Assumptions on the effect o f delayed inflation (under-financing) 3.92 In our simulations we also assume that the non-energy part o f housing costs should be adjusted upwards additionally to compensate for the period o f the de facto tariff freeze in the late 1990s. I t i s assumed that this compensation would amount to a quarter o f the gap between CPI growth and H US tariff growth in 1998-2002. Summary of the assumptions for H U S costs 3.93 Based o n the above, we quantified four scenarios for the different cost dynamics o f service delivery in the Russian housing sector, reflected as changes in the real costs o f maintaining and servicing an average 1 sq. m o f residential housing. Figure 3.1 presents a 89 comparison o f housing and utility cost increases under the different scenarios. I t suggests that by 2006 in the most advanced scenario--scenario 4 n o s t s to residents would increase by almost 50 percent. I t i s worth noting that even in the inertial scenarios without reforms (scenarios 1 and 3), housing costs would also be growing in real terms, reflecting the continuation o f the (although slow) domestic energy price adjustment. Figure 3.1: Housing and Utility Costs to Consumers under Different Scenarios in 2006 (real growth r- relative to 2002) Growth in costs relative to 2002 4 1 3 I 2 1.40 1 0.0 0.5 1.0 1.5 2.0 1 - slow reforms, low oil prices Scenario 2 - advanced reforms, low oil prices Scenario 3 - slow reforms, high oil prices Scenario 4 - advanced reforms, high oil prices 3.94 This expected growth in €€US costs i s a combined effect o f the following four core an increase in domestic energy prices (gas and electricity), ( factors (Table 3.18): (i) ii)an increase in non-energy costs related to the need to compensate the sector for a period o f suppressed information, (iii) the elimination o f cross-subsidization, and (iv) the realization o f some efficiency gains. Table 3.18: Various Factors o f Growth in Unit Housing Costs, Accumulated Growth for the Period Relative to 2002 Cross- Scenarios Total costs Power Gas Non-energy Savings subsidization 1 1.02 1.oo 1.03 1.oo 1.oo 1.oo 2 1.40 1.17 1.08 1.32 1.15 0.90 3 1.04 1.03 1.08 1.00 1.00 1.00 4 1.47 1.32 1.17 1.32 1.15 0.88 Source: Staffestimates. 3.95 In addition to accounting for these four factors, the implementation o f housing and utility reforms implies that the existing tariff structure should be further adjusted to incorporate an adequate level o f investment costs in the sector. Based on the analysis undertaken by the IUE, this would require an additional increase in average tariffs by 30 90 percent. This would increase our estimate for the overall future growth in tariffs to cover all economic H U S costs in scenario 4 to 90 percent. 3.96 The latter estimate suggests that if the full reform package i s implemented the total costs to consumers o f the H U S (including budgets as a source o f residual subsidies) o f the H U S would increase from 4.8 percent o f GDP in 2002 to about 9 percent o f GDP in 2006. Such a change would produce not only a major tariff increase but also a considerable change in the cost structure in the sector, in which maintenance fees and capital charges would play a more prominent role than they n o w play. 3.97 The important caveat to the above estimates derives from the fact that they do not reflect actual changes in H U S tariffs that have taken place in Russia since 2002. Meanwhile, according to Rosstat, in the last two years actual tariff adjustment has been considerable -- real growth in H U S tariffs was 23 percent in 2003 and i s estimated to reach at least 13 percent in 2004. Overall, the tariff growth in 2003-04 amounted to almost 40 percent (i.e. it made up h a l f o f the tariff adjustment that i s claimed necessary to complete the reforms in the sector in 2006). 3.98 While the recent pace o f tariff adjustments appears to be consistent with the medium term objectives o f H U S reforms, there i s a risk that recent tariff growth was not accompanied by adequate institutional changes in the sector. Without complementary institutional reforms, tariff and cost increases in the sector could become excessive. In this respect, the current weaknesses o f municipal regulators are o f special concern. I f not addressed, these weaknesses may lead to a non-justified growth in the tariffs o f local utilities, especially water and district heating providers. In addition, without institutional reforms, it would be difficult to expect that sectoral players may become capable o f realizing any non-trivial efficiency gains. I. MAINSIMULATION RESULTS Scenarios for the continuation o f the current policies 3.99 Table 3.19 presents the results o f the simulations o f the group o f status quo scenarios that do not provide for any significant acceleration o f tariff reforms in the housing and energy sectors. In particular, they assume the preserving o f cross-subsidization in tariffs and a relatively l o w pace of adjusting domestic energy prices. 3.100 Among 12 different scenarios, the one in Column 10 i s the closest approximation o f the current government policies and ongoing macroeconomic trends: this i s the scenario with high rates o f economic growth and with an unchanged level o f cost recovery in tariffs o f 90 percent. 3.101 Under such assumptions, the total explicit costs (excluding cross-subsidization) o f H US will grow by about 30 percent, to 6.2 percent o f GDP from 4.8 percent in 2002. Households will have to absorb practically all o f these incremental costs. As a result, in 2006 households would pay 60 percent more in real terms for H U S (about 4 percent o f GDP), while in 2002 they paid about 2.5 percent o f GDP. Given the high growth o f household real incomes in 2002-06 (45 percent for the period), this would increase the average share o f housing costs in total population spending only slightly, from 8.5 percent t o 11 percent. Overall, the number o f recipients o f housing allowances would decline considerably, from the 7.5 percent benchmark to 3.7 percent. 91 3.102 Budget spending o n H U S would basically remain at the 2002 level and would amount to 2.3 percent o f GDP. However, the share o f the budget in total H U S financing would decline from almost half in 2002 to less than 40 percent. The largest portion o f these costs would be related to the continuation o f budget investment support (capital rehabilitation). 3,103 However, the above estimates hide considerable longer-term implicit budget costs and liabilities that the sector would continue to accumulate in such a no-reform scenario. First, the volumes o f quasi-fiscal financing (cross-subsidization) would remain significant (1 -25 percent o f GDP). Second, the incomplete tariff reform would delay changes in incentives in the sector, which would prevent the reduction o f current inefficiencies, while the government would continue to accumulate considerable contingent liabilities associated with the deterioration o f the municipal housing stock and the urban infrastructure. 3.104 In this group o f scenarios, a further increase in cost recovery in tariffs to 100 percent (column 11) would shift additional costs in the amount o f 0.5 percent o f GDP from the government to the population. The share o f budget spending in total sector financing would fall below 30 percent. The share o f households that receive allowances would grow by 30 percent but would s t i l l remain l o w (less than 5 percent). 3,105 Incorporating the capital repair charges into tariffs (column 12) would produce a major additional reduction in the budget financing o f the sector: total budget costs would decline to 1 percent o f GDP or to 16 percent o f the total financing. In this case, the population would be expected to pay more than 5 percent o f GDP in H U S charges (i.e. more than twice as much as in 2002). The number o f housing allowance recipients would increase to 7.4 percent o f the population. 3.106 The main conclusions drawn from simulating the continuation o f the current policies could be summarized as follows: The continuation o f the current policies provides for only a gradual shift o f responsibility for housing financing from the government to households, while keeping budget liabilities in the sector at the current level o f about 2.3 percent o f GDP. This fact, however, considerably underestimates the longer term costs o f the current policies related to the preservation o f non-transparency in financing and be distorted incentives o f sector players. Such inertial policies seem fully affordable to the population, and they do, for example, a reduction in the eligibility threshold for housing allowances). The sensitivity o f these results i s high relative to the modest changes in the level o f residential tariffs (e.g., all other factors being the same, the transition from 90 to 100 percent in cost recovery could increase the number o f recipients o f housing allowances by 30 percent. The sensitivity of the results i s l o w relative to the variation in rates o f economic growth: in our scenarios with lower economic growth (columns 1-6), we assumed a lower level of domestic energy prices and housing costs, but this effect i s largely compensated by lower household incomes in these scenarios. 92 3 0 0 W c 10 W 3 0 0 0 0 2 Y) W z Scenarios for the acceleration o f housing and utility reforms 3.107 Table 3.20 presents the results for simulations o f the group o f scenarios that provide for a significant acceleration o f tariff reforms in the housing and energy sectors, including the elimination o f cross-subsidization and a much more aggressive pace o f adjustment in domestic energy prices. However, these scenarios do not assume an elimination o f the housing lgoty (privileges). 3.108 W e again use as a base case the scenario reflected in Column 10, which assumes that the key current parameters o f housing policy remain unchanged: an eligibility threshold for allowances o f 22 percent and a 90 percent cost recovery in tariffs. This simulation suggests that the overall costs o f the housing sector’s operations would increase to 9 percent o f GDP (Le., a growth o f almost 90 percent relative to 2002). However, these are the full costs that assume the full elimination o f quasi-fiscal financing. 3.109 In this scenario, the budget would be responsible for 37 percent o f the total costs (3.3 percent o f GDP), while households would have to pay the remaining 5.7 percent o f GDP, which i s an increase o f 130 percent relative to 2002. T h i s would bring the share o f housing spending in household budgets to 16 percent. About 9 percent o f households would become recipients o f housing allowances. In only 1 out o f 88 regions the share o f allowance recipients would exceed 25 percent. 3.1 10 In this scenario the total costs o f housing lgoty, which grow in line with growth in unit housing costs, would reach 0.9 percent o f GDP. This would amount to 30 percent o f total budget spending in the sector. 3.1 11 A further shift o f the housing cost burden to the population (as reflected in Column 11) seems to be fully affordable as well. Under the 100 percent cost recovery, the share o f the government in total housing financing declines to 30 percent (2.7 percent o f GDP, namely, 0.3 percent more than in 2002). The share o f allowance recipients reaches 11 percent, which does not sound as prohibitively high. 3.1 12 In the most advanced scenario (column 12), which assumes the full incorporation o f capital repair charges in tariffs, the share o f the government would fall to 18 percent o f total financing (1.65 percent o f GDP, namely, 30 percent below the 2002 level). Households would face out-of-pocket housing expenditures o f 7.35 percent o f GDP (an increase o f almost 300 percent relative to 2002). More than 15 percent o f the population would become recipients o f allowances, while in 10 regions the share of recipients would exceed 25 percent. The average share o f total housing spending in household budgets would be close to 20 percent. This i s 2.5 times higher than the 2002 .level, but s t i l l somewhat below the levels currently common in CEE countries. 3.1 13 Thus, in the most advanced scenario, the households’ out-of-pocket expenditures o n H U S would be by almost five percent o f GDP above i t s 2002 level. T h i s i s a very large increase indeed. H o w affordable i s such a burden? In the view o f the authors o f this report, i t could be broadly affordable, assuming the latest trends o f high real income growth are sustained. As discussed in Chapter 4, it i s expected that in the medium term the real average wage growth in Russia will remain above the rate of GDP growth. T h i s in part will be driven, as shown in Chapter 2, by the reforms in c i v i l sector employment that should result in a considerable increase in public sector wages. Annual budget spending o n (non-military) wages may increase by 1 percent o f GDP under the advanced reform scenarios. Overall, preliminary estimates suggest that about 60 percent o f the future out-of-pocket housing 94 spending could be funded through a parallel growth in real household incomes. More accurate estimates could be obtained when the full information for 2003-04 i s available. Those were the years, during which real housing costs have been increasing at a relatively high for Russia pace, but this was mitigated by a high and broad-based income growth. 3.114 Our further interpretation o f these results i s that a practical policy option for the government for the next two to three years would be some combination o f scenarios reflected in columns 11 and 12 o f Table 3.20. That is, regions with higher incomes should follow scenario 12 (with the incorporation o f capital repairs charges in tariffs), while those with lower incomes may follow scenario 11 (100 percent cost recovery, but n o household responsibility for capital repairs). Such a combination o f policies would keep the government spending in the sector at roughly i t s current level o f about 2.2 percent o f GDP. On average, households would be spending about 18-19 percent o f their budget o n HUS. 3.1 15 An important conclusion from our analysis i s that the acceleration o f energy and housing reforms in the current macroeconomic conditions should not bring any incremental costs to the consolidated government budget. In the worst case, the reforms should be budget neutral in the medium term, and they should bring considerable savings in the long term. 3.116 At the same time, it i s worth noting that in the analyzed scenarios while the total budget outlays o n the sector would decline, their structure o f budget spending would remain rather inefficient. This i s because, without the elimination o f lgoty, their costs would expand drastically in line with progress o n the tariff reforms. In scenario 12, the costs o f lgoty would amount to 1.2 percent o f GDP, and they amount to three-fourths o f the total budget spending in the sector. This means that phasing out lgoty i s critical for any significant improvement in the efficiency o f budgetary spending in the sector. 3.1 17 The l o w income regions, where the population cannot afford capital repair charges as yet, should be partially supported by the federal government. I t i s recommended that the federal government should develop a separate program for investment grants to support the rehabilitation o f the housing stock in such regions on a co-financing basis. Funding for such a program could be obtained by phasing out the existing nontransparent programs o f housing sector financing as described above. 3.1 18 The analysis identified two groups o f regions that are likely to be most affected by the proposed cost increases in the H U S , as follows: a Regions located in the south o f Eastern Siberia and in the Far East. These are the regions with high unit housing costs due to their remoteness and climate conditions. At the same time, these are relatively poor regions, which are significantly dependent upon federal budget transfers. a Autonomous (internal national) republics in various parts o f the country. These are predominantly the rural, least developed regions with a relatively l o w share o f urban housing that has full access to subsidized and expensive network utilities. Thus, these regions spend relatively little o n housing, but their policy in the sector has been traditionally the least reformed and they have had among the lowest levels o f cost recovery in tariffs. As a result, the future costs o f residual adjustment to reach full cost recovery in these regions could be quite high. Moreover, these regions are the most transfer-dependent entities in Russia, and this reduces their fiscal room for adjustment to additional policy and price shocks. 95 Additional sensitivity analysis 3.1 19 Additional analysis was undertaken to check the sensitivity o f the above results to changes in what are seen as the most important parameters in the model: i) the dynamic o f household incomes, and ii)the level o f housing costs. 3.120 Sensitivitv to changes in incomes. A set o f simulations was undertaken with significantly lower rates o f real income growth, which would result in 2006 household incomes being 20 percent below the level assumed in the base case scenario above. The simulation showed rather high sensitivity: in the scenario with 100 percent cost recovery (column 11) a 20 percent decline in incomes increases the number o f recipients on housing allowances by about 80 percent (to 20 percent o f the population). The total budget spending on housing allowances would increase by 140 percent (to 0.57 percent o f GDP). In such an environment an aggressive policy o f tariff adjustments may be much more difficult to implement. 3.121 The high sensitivity o f the results to income dynamics suggests that the government should establish an efficient monitoring system to track the affordability o f tariff increases for the population in general and for specific household groups. While within the current favorable macroeconomic environment the government should make a strong push toward the necessary adjustments in domestic energy prices, the elimination o f cross-subsidization, and the achievement o f full cost recovery in tariffs, this policy may be modified in cases where the economy faces a major slowdown in household income growth. Some l o w income regions could be allowed to move with the reforms at a slower pace than the rest o f the country. 3.122 If, in the environment with high growth in household incomes, the advancement o f housing reforms could be easily made budget neutral, this i s not case when income growth slows down. The latter may generate incremental budget costs o f 0.4-0.5 percent o f GDP per annum in the medium term, which would be mostly related to the additional financing o f housing allowances. 3.123 Sensitivity to changes in housing. costs. Additional simulations assumed are approximately 20 percent higher level o f housing costs. These simulations revealed a relatively high sensitivity (although lower than in the case o f household incomes) - the number of recipients of housing allowances increases by 27-3 1 percent depending on the level o f cost recovery. 96 2 0 5 o ms zz 3 3 0; J. SIMULATIONS FOR PHASING OUT HOUSING PRV IL IEGES (LGOTY) Incidence of lgoty 3,124 Various non-cash housing privileges (lgoty) represent one o f the major deficiencies o f Russia’s housing policy. Lgoty provide their beneficiaries with considerable discounts (usually 50 percent) against their housing and utility bills. Lgoty are category-based benefits, and as such they are an inefficient policy instrument o f social assistance that tends to channel most support to middle-income and high-income groups (World Bank, 2004~). 3.125 Moreover, lgoty i s a fairly non-transparent policy instrument. At the federal govemment level, there i s no single regulatory and legal framework to govern i t s allocation and financing. The existing system o f lgoty i s quite complicated because o f the dozens o f government resolutions .(some o f them more than 60 years old) that have introduced different eligibility criteria for potential b e n e f i ~ i a r i e sAs .~~a result, there are no reliable statistics on the actual budget and overall costs o f providing lgoty. The most commonly used source o f information on lgoty (deriving from Rosstat’s Form 26-ZhKH) i s believed to be somewhat unreliable because it i s filed not by lgoty recipients but by providers o f H U S (see Annex 3.2 on other issues related to the availability o f the data). 3.126 On the basis o f the 2000 Rosstat’s data for six regions Misikhina (2002) estimated that about 40 percent o f Russian households benefit from various housing payment privileges. Pensioners and budget sector employees have been the primary beneficiaries. Posarac and Rashid (2002), on the basis o f the 2000 RLMS data, also show that l o w income households receive a much smaller share than higher income households o f having privileges. 3.127 The conventional Rosstat report, based on Form 26-ZhKH, suggests that in 2003 about 43.4 million persons (29.9 percent o f the entire population) benefited from different housing payment privileges. This i s a 13 percent decline since 2002, which was a result o f the decision made in M a y 2002 to monetize housing lgoty for military servicemen. About half o f all current beneficiaries receive their lgoty on the basis o f the Law on Veterans, which grants considerable non-cash benefits to most Russian individuals with an extended employment history. An additional 30 percent o f beneficiaries claim their lgoty on the basis o f the Law on Social Protection o f People with Disabilities. 3.128 As reported by Rosstat, the total costs o f lgoty in 2003 amounted to about 0.4 percent o f GDP (see Table 3.2, above). The average per capita value o f the monthly benefit amounted to Rbl 93.8 or about US$3. However, as was shown in the earlier section, traditionally, lgoty have been under-financed. In 2002-03 the average level o f their actual financing was about 70 percent. Thus, the lgoty operate as an implicit tax on sector providers (World Bank, 2003a). 3.129 This Chapter uses newly available information on lgoty from the NOBUS survey, undertaken in the spring o f 2003. NOBUS i s believed to be a more reliable source o f both the incidence and the costs o f lgoty (see Annex 3.2 on different sources o f data). According to NOBUS the share of individuals benefiting from lgoty was 33.3 percent o f the population (Le., their overall number was 11 percent higher than in Rosstat reports). Moreover, the share o f households that benefit from lgoty i s even higher - 41 percent. This i s because the number o f beneficiaries i s higher among smaller families, such as pensioners. The analysis by the IUE identified the list o f govemment decisions that had established various housing privileges, which i s more than 30 pages long. 98 3.130 M o r e important, the region-by-region comparison o f the results from the two sources shows a systemic bias in the Rosstat data set: this set gives much higher shares o f lgoty recipients for poor regions (such as various Russian national republics) and underestimates the number o f recipients in wealthier regions (regions o f the European center). This i s an important bias from the perspective o f the impact analysis o f reforming the system to phase out the lgoty and provide cash compensation to vulnerable households: simulations that are based o n the Rosstat data would produce a much higher demand for cash compensation for the existing lgoty recipients. T h i s i s the reason why this report employs the NOBUS data for h t e simulation o f the fiscal and social effects related to the elimination o f lgoty. 3.13 1 The Russian Government has initiated reforms in the lgoty system in 2004. I t intends to define more precisely the sources o f financing o f the privileges, and it intends to shift the responsibility for financing a relatively large part o f them to the regional administrations, Moreover, the regional govemments would be allowed to terminate specific privileges if they could not afford their funding. However, to date the govemment has made only those decisions that provide for the phasing out and partial monetization o f privileges in public transportation and medical services. There i s no agreed timetable as yet for the reforms o f existing lgoty in the H U S . Reform scenarios that assume the elimination of non-cash housing privileges5’ 3.132 Table 3.21 presents the results o f simulations o f reform scenarios that combine policies reflected in the scenarios in Table 3.20 with the elimination o f housing lgoty (privileges). The results suggest that the elimination o f lgoty would have a very modest impact o n the vulnerable group o f households. This reflects the fact that lgoty are concentrated in middle-income and high-income groups, and that, therefore, phasing out lgoty would not make housing unaffordable for too many o f their current beneficiaries. 3.133 In the base case (column lo), the elimination o f lgoty increases the number o f allowance recipients by one-third, bringing their total number to 12 percent o f the population. In other words, only every tenth beneficiary out o f the current lgoty beneficiaries (the number o f which i s close to 30 percent) would become eligible for housing assistance through allowances. This would provide the budget with considerable savings through the elimination o f Igoty: the costs o f additional housing allowances (0.06 percent o f GDP) amount to only 8 percent o f the costs o f eliminated lgoty. 3,134 In the case o f 100 percent cost recovery (column 1l), the above-mentioned proportions hold: the elimination o f lgoty increases both the number o f allowance recipients and the total cost o f the allowance program by about one-third, while generating considerable budget savings. Overall, the scenario for the 100 percent cost recovery and fully removed housing lgoty in 2006 sounds quite affordable: the share o f the population that would receive ” The alternative set of simulations to assess the potential impact o f the elimination o f privileges was undertaken for the Russia Poverty Assessment (World Bank, 2004). Our modeling reflects two important differences relative to this earlier work. First, it uses 2002 (not 2000) as a base year for the analysis. As a result, our estimates reflect a major recovery in household incomes that took place in 2001-02. Second, we stimulate the phased-in reforms with tariff increases being expanded through three years, which provides household incomes with additional room to catch up with incremental costs. Overall, our estimates suggest that the elimination of the lgoty would generate an even smaller increase in the demand for housing allowances than was reported in the Poverty Assessment. 99 allowances i s only 15 percent, and the average household pays about 14.5 percent o f i t s income for HUS. 3.135 Our interpretation o f the latest set o f simulations i s as follows: if the current trend o f high growth in household incomes continues, then the elimination o f housing lgoty in about 2006 should not be a social/political problem. T h i s i s even more so if, as currently planned, the government would succeed in advancing other structural reforms, including those in public administration, pensions, and the social services, which would result in an additional growth in public sector wages, old age pensions and child benefi@. 3.136 With respect to sequencing the necessary reforms, this report argues that, given the sensitivity o f the lgoty issue, the entire set o f reforms could be divided into two main groups: 1. 2004-06: Accelerate tariff and financing reforms to increase tariffs, make the financial flows in the sector more transparent, and increase the accountability o f sectoral players, including municipalities and service providers. As a part o f this process, the Government should make a major effort to monetize the lgoty to transform them into explicit budget subsides and link them directly with the new system o f individual social accounts that would track all benefits and entitlements for which households are eligible. 2. 2006-07: Eliminate lgoty (probably with a partial cash compensation to particular categories o f recipients). The specific strategy for phasing out lgoty would depend upon the actual progress in housing and other reforms, the basic proportions between the prevailing levels o f household incomes and housing costs, and the capabilities o f the social assistance system. Additional modeling o f housing affordability would be justifiable at that stage. ’*Yasin (2003) provides a detailed discussion of linkages between changes in public sector wages and benefits and affordability o f tariff increases in the HUS. 100 b y o 0 W N 0 N q o o 0 f 220 mv, s 10 e. 0 0 m b c 0 y o 0 W v, 0 Nv, d " y o d 0 0 N y o 0 0 M o\ croo 3 3 0 O W r??O b 0 0 + 00 9 0 0 W e n I N 9 0 0 n I 0 x y b W W m K. CONCLUSIONS AND POLICY RECOMMENDATIONS 3.137 Despite more than 10 years o f reform efforts, the housing and utility sector remains among the least reformed segments o f the Russian economy. It i s increasingly becoming a bottleneck in the country’s overall development strategy. The H US i s too dependent o n government support, too costly to the budget, and too politicized and non-transparent, while the quality o f the provided services remains low. 3.138 At the same time, when compared with the previous decade, the current economic environment in Russia i s much favorable for advancing the H U S reforms. This i s the case for the following reasons: - Russia’s macroeconomic performance i s much stronger and it provides all major players with an additional income space for addressing the potential short-term costs o f reforms. - Recent improvements in cost recovery indicate that a significant portion o f the entire task o f phasing out inefficient housing subsidies has already been accomplished; what remains i s a much more manageable tariff increase relative to what was a major challenge in 2000. - Russia’s federal government has a much stronger influence over subnational developments and could be more proactive in setting up proper incentives for regions and municipalities to advance the H U S reforms. - Russia’s private sector has shown for the first time a real interest in entering the housing sector. 3.139 Our analysis suggests that the acceleration o f cost recovery increases and other H U S reforms in the current macroeconomic environment i s not supposed to bring any significant incremental fiscal costs. From the fiscal perspective, the main immediate challenge o f the reforms in housing i s not about changing the current level o f budget financing o f the sector but i s about the radical restmcturing o f the existing financing mechanisms in the direction o f the following: - A reduction in government involvement in the H U S operations and financing - Improved transparency in the residual government commitments in the sector - A strengthening o f the accountability o f the government for the full financing o f i t s commitments - Improved transparency o f the financial flows in the sector - A strengthening of the accountability o f both municipalities and service providers for the use o f budget funds and the quality o f services - Improved targeting of budget support to vulnerable households and depressed regions 3.140 Our estimates suggest that, as a result o f tariff adjustments and other reforms, the real unit cost in the H U S would increase by about 90 percent relative to the prevailing 2002 level. This would bring the annual costs o f operating residential housing to 9 percent o f GDP. At the same time, given considerable tariff adjustments that already took place in 2003-04, much a smaller additional growth in tariffs ( o f about 40 percent) i s needed to reach the levels that cover full economic costs in the sector. 3.141 This Chapter argues that in the current environment o f high growth in household incomes, it i s affordable (both politically and financially) to attain, by 2006, a policy target o f 102 100 percent cost recovery in tariffs with the simultaneous elimination o f all quasi-fiscal financing (cross-subsidization). In addition, in the wealthier regions it could be possible to incorporate capital repair charges in tariffs. In such a scenario, households are expected to pay 6.5 percent o f GDP, a major increase relative to 2.5 percent in 2002. Government budgets would pay the residual 2.5 percent o f GDP (which i s roughly the same level o f budget spending as in 2003). 3.142 The simulations also suggest that, in the current environment, with high growth in household incomes, advancing reforms in the residential housing could be easily made budget neutral in the medium term, and this would bring considerable savings in the long term. However, if household income growth slows down, this may generate incremental budget costs o f 0.4-0.5 percent o f GDP per annum in the medium term, which would be mostly related to the additional financing o f housing allowances. 3.143 Overall, the analysis revealed a high sensitivity o f the results to income dynamics. T h i s suggests that the government should establish an efficient monitoring system to track the affordability of tariff increases for both the population in general and specific household groups. A policy of aggressive push toward more justifiable domestic energy prices and H U S tariffs may be modified if the economy faces a major slowdown in household income growth. Some l o w income regions could be allowed to move with the reforms at a slower pace than the rest o f the country. 3.144 The analysis suggests that in most regions attaining the full cost recovery in tariffs and phasing out cross-subsidization in three years would be possible without a drastic expansion in the share o f housing allowance recipients. The average share o f households that would become allowance recipients might reach 11 percent in the reform scenarios with the 100 percent cost recovery in tariffs. In the regions with high income differentiation, an additional mitigation measure could include a reduction in eligibility requirements for housing allowances, e.g., from the current 22 percent o f household income that i s spent o n HUS to 15- 18 percent. 3.145 From the financing perspective, the following steps constitute the core policy measures necessary to support the acceleration o f HUS reforms. At the subnational level: 0 An increase in tariffs to reach full cost recovery 0 The phasing out o f direct subsidization o f service providers 0 The expansion o f the program o f housing allowances At the federal level: 0 The phasing out o f the federal programs o f indirect financing o f the H U S 0 The establishment o f a federal program o f investment grants to support subnational rehabilitation projects in utilities, to be funded o n the basis o f co-financing 0 The expansion o f the scale o f federal budget assistance to regions in the N o r t h and Far East (e.g., by establishing a respective federal investment program) 3,146 An increase in energy and utility tariffs would make the delivery o f utility services to budget organizations more expensive. Marginal annual costs are conservatively estimated to amount to 0.7-0.8 percent o f GDP. These costs would be mitigated by the ongoing reforms in the public sector, which, inter alia, would bring about some savings (e.g., through the consolidation o f the existing budget institutions in health and education. In addition, the tariff increases would increase the amount o f taxes to be paid by energy and utility f i r m s . However, we estimate that in the medium t e r m a fiscal gap in public sector financing o f 0.4 percent o f 103 GDP could emerge as a result o f tariff increases in H U S and energy. In addition, to realize the expected tax gains, further strengthening o f the tax administration may be required, in particular in the energy sector. 3.147 The analysis suggests that the elimination o f housing privileges could also be affordable for most o f the current lgoty recipients, while the housing allowance program would be capable o f taking care o f those who face too high a housing cost burden. This i s primarily due to the fact that lgoty are concentrated in the middle income and high income groups o f the population. However, given the political sensitivity o f the entitlement reforms, there may be a case for postponing drastic reforms in lgoty until more basic H U S reforms are more advanced. To reduce political costs, phasing out lgoty should be coordinated with other reforms, including wage increases in the public sector, and increases in real o l d age pensions and child benefits. To better understand the interlinkages between the reforms, additional modeling may be needed. In parallel, the government has to strengthen the accountability mechanism for the financing o f the remaining lgoty. 3.148 In addition, to support the above reforms in housing financing, additional structural reforms should be facilitated. This reform package i s fairly well known and i s described elsewhere. I t s important components include, but are not limited to the following: 0 Additional reforms in inter-governmental fiscal relations 0 An improved environment for private sector participation in the H U S 0 The depolitization and increased transparency o f the tariff setting process 0 The strengthening o f federal monitoring over reform progress at the subnational level 0 The dissemination o f the best regional and municipal practices for H U S reforms. 3.149 I t also seems appropriate to provide additional fiscal incentives for subnational governments that are ready to accelerate the H U S reforms. T h e experience o f the Fund for Regional Fiscal Reforms, which provided federal budget transfers to regions that were leaders in reforming their fiscal systems, could be replicated to facilitate €€US reforms at the subnational level. 104 Chapter 4. IMPLICIT FISCALR I S K S IN THE RUSSIANPENSION SYSTEM 4.1 This Chapter estimates potential fiscal costs associated with various developments in Russia’s pension system based o n the comprehensive actuarial model. I t finds that such fiscal costs are likely to emerge as a result o f the declining relative value o f old age pension and associated political pressures for budget support to the pension system. Without additional reforms, the existing pension system, even under the most optimistic assumptions, i s not capable o f closing the growing gap between growth in wages and pensions. In the baseline “without the reforms” scenario the average replacement rate declines from 33 percent in 2002 to 24.4-27.8 percent in 2030. Moreover, the proposed cuts in the contribution rates would result in a further decline in the replacement rate relative to the baseline. T o avoid a drastic widening in the gap between wages and pensions, a reduction in contribution rates has to be supplemented by additional reforms, including a decision o n a gradual increase in the retirement age. A. INTRODUCTION 4.2 This Chapter i s based o n the findings o f the earlier W o r l d Bank Report ( 2 0 0 3 ~ ) “Pension Reform in Russia: Structure and Implementation” and it focuses o n a financial trends in Russia’s pension system, including the pay-as-you-go (PAYG) and funded pillars, within the framework o f the reform o f unified social tax. 4.3 The Chapter develops a multifactoral analysis o f potential fiscal costs associated with the future developments o f Russia’s pension system. The analysis i s based o n a set o f alternative formulations for the future pension reforms. I t utilizes the comprehensive actuarial model as a tool o f simulations o f the pension system trends.59 The analysis makes an emphasis on the sensitivity o f the current trends in the pension system to changes in macroeconomic performance, to the changes in demographic trends, as well as to various combinations o f potential reform measures. I t provides an analysis o f the potential impact o f proposed cuts in the unified social tax (UST) rates and increases in the retirement age. The Chapter highlights both medium- and long-term trends in the pension replacement rate, as well as o n the changes in the purchasing power o f the average pension benefit. 4.4 The Chapter i s using the level o f the replacement rate (ratio o f average pension to average salary) as a core policy variable for the pension reform analysis. This i s because such a ratio reflects a basic proportion between the pension and pre-retirement income o f pensioners, i.e., it characterizes income losses associated with retirement. In the OECD countries, the pension system replacement rates vary, ranging from 36 percent in the USA to 49 percent in Finland (World Bank, 2 0 0 3 ~ ) . However, sustaining the replacement rate above 40 percent has increasingly become a policy target in the developed countries. The W o r l d Bank experience generally indicates that in the mandatory pension system, for a typical full career worker to maintain a subsistence income in retirement, an initial target for a replacement rate i s likely to be around 40 percent (Holtzmann, 2004, p. 33). 4.5 In addition to the replacement rate, the analysis in Chapter 4 pays a considerable attention to the dynamics o f the ratio between average pension and subsistence minimum. I t i s 59Andrews (2001) and Anusic and Petrina (2003) provide the examples of broadly similar analysis o f sustainability o f the pension systems under different reform options for other CIS countries. 105 justified by the fact that, when the average pension i s either below or close to the pensioner’s living subsistence level, as it i s in Russia, the value o f the replacement rate can not be an informative indicator o f changes in pensioners’ real incomes. 4.6 The fiscal cost analysis in this Chapter i s undertaken for an expanded set o f macroeconomic and reform scenarios. The basic group o f scenarios reviews the trends in the current pension system and analyzes their sensitivity to the core macroeconomic and demographic factors. Additional scenarios focused more specifically o n the potential impact o f such changes as cuts in the contribution rate, increase in the retirement age, and changes in certain pension rules, such as a reduction in the existing UST benefits for the self-employed. 4.7 This Chapter does not discuss either the issues related to the policies o n social pensions, which at the moment are received by 1.5 m i l l i o n pensioners (3.8 percent o f the total number o f pensioners) who are not eligible for a regular old-age pension. Social pension i s the parameter o f the government’s social protection policy and it has to be dealt with separately f r o m the issues related to social insurance and reform in the old-age pension system. Respectively, financing o f social pensions should be de-linked from payroll taxation and instead be included in the overall government budget expenditure o n social protection policies. Overall, we agree with the view that the govemment has to adopt a strategy for a gradual increase in the social pension f r o m i t s current l o w level o f 55 percent o f the minimum subsistence to the level o f pensioners’ subsistence minimum (Smirnov and Isaev, 2003). B. BACKGROUND 4.8 Currently the Russian pension system faces the challenge o f establishing a sustainable longer-term framework for a gradual increase in the level o f pension benefits. T o this end, as part o f the comprehensive pension reform, the govemment introduced a multi-pillar system in early 2002. The move to a multi-pillar system in Russia follows recent similar reforms in several other economies in transition, including Hungary, Kazakhstan, Latvia, and Poland.60 4.9 T w o out o f three main components o f the reformed pension benefit in Russia -- notional defined contribution (NDC) and mandatory funded -- directly depend o n the size o f actual pension contributions (a portion o f the unified social tax). In addition, the reforms that have been introduced made a major step toward simplification o f the benefit formula and more transparent eligibility criteria. This i s expected to improve incentives for compliance, cut down the unreported and untaxed share o f the payroll, and therefore improve the revenue performance of the pension system. However, so far the informal part o f the payroll has been shrinking only slowly. This i s believed t o be largely a result o f rather a high rate o f established contributions of 28 percent. In addition, the incentives for proper payroll reporting were further weakened because only h a l f o f the paid pension contributions (14 percent o f payroll) were taken into account t o assess the future size o f benefits, while another h a l f was reserved for financing the basic pension, w h i c h i s the same for a l l pensionersn6lAnnex 4.4 provides some details o n the m a i n benefit rules in the current pension system. 4.10 At the same time, the Russian Government set up a strategic objective o f easing the tax burden on the economy, w h i c h w o u l d include reduction in U S T rates. It i s expected that 6o Holtzman et al. (2004) presents a summary of the lessons from the early pension reforms in ECA. See also Rutkowski (2002, 2004). 6’ This was changed by the decision made earlier in 2004 (and which will become effective in 2005). These recent changes are discussed in detail below. 106 the tax rate reduction would help broaden the tax base for pension contributions, thus partially compensating for the direct loss from the UST rate cut. Under the circumstances, there i s significant interest in the analysis of potential fiscal implications o f both the current trends in the pension system, as well as the changes that would be generated by various reform proposals, such as the proposed cuts in UST rates. 4.1 1 The Russian Government has been considering improvements in pensioners’ welfare through a growth in real pension benefits as i t s core longer term policy objective. I t also considers a comprehensive pension reform, which provides for an introduction o f the fully funded pillar, as a primary instrument o f achieving this objective. At the same time, as a part o f i t s macroeconomic and growth policy, the Government intends to reduce the average UST rate, which i s likely to bring about a decline in pension contributions, at least in the short term. 4.12 Despite recent steps to reform the social insurance system, the current situation with the old-age pensions in Russia, similar to other pre-reform pension systems in countries o f the former Soviet Union, i s characterized by the l o w retirement age (60 for men and 55 for women), high contribution rates, high system dependency ratio, almost universal coverage for the current retirees, and the flat structure o f benefits that are not linked to the contributions.62 There i s some evidence, however, that participation rates have been declining among employees, but in Russia this trend has been weaker so far than in some other countries in ~ ~ . i s also a high number (almost 30 percent o f the regular old-age pensioners) t r a n ~ i t i o n There o f pensioners who benefit from various early retirement schemes, determined by special laws inherited from the Soviet era which have so far remained largely ~ n r e f o r m e d ~ ~ . 4.13 Basic parameters o f the current pension system in Russia are presented in Table 4.1. I t shows a rapid growth in the system dependency ratio owing to the ageing population. Moreover, in the 90s the ratio between the number o f pensioners and employees (60 percent in 2002) had been growing even faster than the share o f pensioners in the entire population (27 percent in 2002). This i s owing to an increased incidence o f both unemployment and non- participation in the labor force65. Annual contributions to the pension system amount to approximately 6 percent o f GDP. 4.14 At the same time, it i s worth noting that in the short term the broader demographic structure o f the Russian population has a less unfavorable impact o n pension financing. T h i s i s because the recent increase o f older people’s share in the population was accompanied by a drop in the birth rate, and therefore the overall share o f people o f non-labor age (children and retirees combined) in the total population did not increase. According to the Rosstat, in 2002 60.8 percent o f Russians were o f labor age, while this share was 57.0 percent in 1989 and 57.3 percent in 1997. T h i s means that in the short term sustaining a pension system in Russia may not necessarily require an immediate increase in the overall tax burden o n the working population. However, some restructuring o f the overall public taxation and spending may be needed to reflect the ongoing demographic changes. Still, in the longer run Russia’s pension 62 De Castello-Branco (1998) provides a general overview o f the main features of pension systems in the FSU economies as they were inherited from the planned economies. 63 In Romania, for instance, the number of contributors to the pension system declined from 8.2 million in 1990 to 4.4 million in 2003 (Plevko 2004). 64 The new draft Law on professional pension schemes i s currently under consideration in the Duma. 65 I t should be noted, however, that despite the growing pressures, the Russian pension system i s still in a more favorable position relative to one e.g., in Ukraine, where the ratio o f pensioners to employees reached 0.92 and overall pension spending have been approaching 10 percent of GDP (Anusic and Petrina, 2003). 107 system will have to deal with the same set o f fiscal problems associated with the ageing population as most developed and middle income countries. Table 4.1: Basic Parameters o f the Russian Pension System, 1995 2002 - 1995 2000 2001 2002 Number of pensioners (end year), million 37.08 38.41 38.63 38.43 olw: old-age pensioners 29.01 28.81 28.99 29.70 Share of pensioners in population, % 25.1 26.5 26.8 26.9 Pension system load (ratio of pensioners and employed) 0.56 0.60 0.60 0.60 Average monthly pension, including compensations (1995 - 188.1 694.3 1,024.1 1,378.5 ‘000 rubles; after 1998 -rubles) O/w: old-age pension 258.5 894.0 1,254.9 Minimum pension, rubles 89.6 427.8 474.1 522.4 (*) Replacement rate (ratio of average pension to average 40 31 32 32 monthly salary), % Ratio o f average pension to the pensioner’s living 101 76 90 100 subsistence minimum, % Ratio of average pension to the minimum pension, % 210 162 216 264 Employed in the economy, million 66.44 64.33 64.70 65.40 Economically active, million 70.86 71.46 70.97 71.90 Economic activity rate, YO 48.0 49.4 49.3 50.2 - Average (reported) monthly salary (1995 ‘000 rubles; after 472.4 2,223 3,240 4,360 - 1998 rubles) Taxable payroll amount, estimated (billion rubles) 377 1,716 2,516 3,422 - taxable payroll amount, as % of GDP 24.5 23.5 28.1 31.6 Total payroll amount, incl. informal wages but excluding n.a. 2,304 3,141 n.a. payroll taxes (billion rubles) - total payroll amount, as % of GDP n.a. 31.5 35.1 n.a. Total collections by the Pension Fund, as % of taxable 19.6 22.1 19.7 18.7 payroll - collections as % o f GDP 4.8 5.2 5.5 5.9 Pension expenditure by the Pension Fund, as % of GDP 4.4 5.2 5.9 Pension Fund balance, as % of GDP -0.03 1.24 0.19 -0.83 Memo: Total population (end year), million 147.60 144.80 144.00 143.10 GDP, billion rubles 1,541 7,306 8,944 10,834 (*) - Base component of the old age benefit. Source: Rosstat, Pension Fund. 4.15 The current pension system provides for a relatively high nominal replacement rate o f about 32 percent66. However, the purchasing power o f the average pension i s low, because it merely exceeds the pensioner’s living subsistence minimum. According to the Pension Fund, due to a real growth in pensions in 2002-03, by August o f 2003 the average pension reached 108 percent o f the subsistence minimum67 68. This contradiction between the high replacement 66 Here and everywhere in this Chapter the replacement rate i s estimated (according to the established tradition) on the basis of the average gross wage. A more accurate way to estimate the replacement rate would be based on the net wages (wages after personal income tax). This would result in the replacement rate estimates that are 13 percent higher. 67 K a b a n i and Sajaia (2004) argue, however, that the current official subsistence minimum in Russia i s inflated and in the case o f pensioners exceeds by about 25 percent the true cost o f the consumer basket that covers both minimum calorie requirements and basic non-food needs. 68 Monetarization of some non-cash benefits, introduced in early 2003, resulted in some additional increase o f the replacement rate, but did not change much the ratio between average pension and subsistence minimum. 108 rate and l o w pension purchasing power i s explained by a large proportion o f informal wages in the economy that are not taken into account in calculations o f the average reported salary size. Informal wages are not reflected in the conventional estimates o f the current replacement rate that are significantly upwards biased and somewhat misleading (especially for those in higher income brackets). 4.16 Under the circumstances, in addition to the values o f a nominal replacement rate, it i s worth looking at the estimates o f a real replacement rate (ratio o f the average pension to average real salary, i.e., salary that includes both formal and informal nontaxable wages). Based o n the Rosstat publications o f national accounts, we estimated that the share o f informal wages in 2001-02 amounted to about one-third6' o f the total labor earnings and to about a h a l f o f the taxable payroll amount (Table 4.2). Respectively, the real average replacement rate was one-third lower than the nominal one and amounted to only 22 percent. Table 4.2: Structure o f the total payroll, as YOo f GDP ~ 1997 1998 1999 2000 2001 2002 Total payroll, as % of GDP 50.0 47.2 40.6 40.2 43.2 - payroll taxes 11.0 10.6 8.3 8.7 8.1 8.0 - all wages 39.0 36.5 32.2 31.5 35.1 olw: taxable wages 27.3 26.4 21.2 20.4 23.9 24.5 hidden wages 11.7 10.1 11.0 11.1 11.2 Share of taxable wages in all wages, % 70.0 72.3 65.8 64.8 68.0 Other non-transfer incomes, as % of GDP 14.8 14.9 14.8 12.6 12.1 Source: Staff estimates based on Rosstat 's publications on National Accounts. 4.17 The prevailing statutory contribution rate i s 28 percent, which i s high relative to most OECD countries but much lower than in the transition economies o f Central Europe (IMF, 2002). The 2002 effective UST rate has been 18.7 percent o f the reported (Le., without informal wages) payroll amount, and it shows a steep decline relative to 22.1 percent in 2000. T h i s i s owing to two primary factors: (i) the introduction o f lower UST rates for higher wages in 200170; and (ii) the growing incidence o f UST benefits for those employed by SMEs. 4.18 The high UST rates are usually considered among the primary reasons for a high incidence o f informal wages in the economy. Indeed, World Bank experience indicates that mandated contributions in excess o f 20 percent are likely to be quite detrimental for compliance in middle and high-income countries (Holtzmann, 2004, p. 34). 4.19 Since the introduction o f the flat P I T rate o f 13 percent in Russia in 2001, there has been a striking difference in trends between UST and P I T tax bases. Nominal growth in the P I T tax base was twice as high in 2000-03 than the one for UST - 106 versus 59 percent (Figure 1). The response to a cut in average income tax rate was quite strong, and a noticeable share o f personal incomes was legalized, especially in 2002-03. While the marginal UST rates were also reduced in 2001, this cut was much smaller and apparently had a weaker incentive effect. As a result, the growth in the P I T tax base occurred primarily due to the legalization o f 69 I t i s worth noting, however, that the share o f informal wages declined somewhat since the middle of the 90s as a result of the post-1998 fiscal stabilization and phasing out non-cash settlements in the economy. 'O Since the beginning of 2001 the portions of the wages that exceed 100,000 Rbl a year (about $3,500) have been taxed at lower (steeply declining) rates. See also Annex 4.4. 109 non-wage incomes, especially among those in top income deciles for w h o m a substantial share o f total income comes from non-wage sources (Sinelnikov et al., 2003). This observation provides indirect support in favor o f further cutting the existing U S T rates, and may give additional backing for an assumption that future cuts in U S T rates could be accompanied by some expansion in the tax base. 4.20 One o f the problems with the existing U S T regime relates t o i t s fragmentation, with a considerable proportion o f the labor force being eligible for significantly reduced U S T rates. As can be observed f r o m Table 4.3, in 2003 the share o f such employees amounted to at least 16 percent o f the total number o f U S T taxpayers, and o n average they paid three times less in their pension contributions than the “regular” employees. The actual number o f beneficiaries o f the special U S T regimes i s even higher, in particular because the data in Table 4.3 do not cover those who are eligible for a single agricultural tax. The Pension Fund staff estimates that the overall share o f those who benefit from preferential U S T rates amounts to 19 percent. The m a i n beneficiaries o f these tax privileges are farmers and employees in small firms, who are eligible for a 50 percent reduced U S T rate (Box 4.1). These employment groups do n o t make any contribution to their base pension, and therefore they are implicitly cross-subsidized by regular U S T payers. Figure 4.1: Trends in tax bases for unified social and personal incomes taxes, 2000-03, trillion rubles SST and PIT tax bases, trln rbl 1 2000 2001 2002 2003 Box 4.1: Preferential UST regimes for employees o f small business According to the Russian Tax Code (Article 18), there are three specific tax regimes that de facto provide considerabletax benefits for specific employment categories: e Simplified taxation for SMEs e Single tax on imputed incomes for businesses engaged in specific types of economic activities e Single agricultural tax for agricultural producers In all these cases, the eligible businesses benefit from the overall lower taxation rate and simplified taxation structure, under which several major taxes are replaced by a single tax on revenues or imputed incomes. As a part o f this benefit package, SMEs are eligible for lower UST rates, which include: (i) a 50 percent discount on UST tax on employee earnings (full exemption for contributions to the base pension benefit); and (ii) a very low fixed payment of 150 ruble a month for employers and self-employed. In addition, agricultural producers benefit from further reduced UST rates (10.3 percent versus 14 percent for other SMEs and 28 percent for the rest of the enterprise sector). Source: Bolshakova (2004). 110 4.21 Another peculiar feature o f the pension system relates to the currently effective indexation r u l e s for both the base and N D C parts o f the pension benefit. Currently, the indexation r u l e s are broadly linked to the actual inflation rate, but the rules are insufficiently formal and provide the government with considerable discretion powers with respect to both timing and scale o f indexation. In addition, the pension legislation (Federal L a w No. 173, Article 17) envisions complementary indexation o f N D C components in cases when growth in wages exceeds the size o f basic pension indexation. However, the scale o f such additional indexation can not exceed the growth rate o f actual Pension Fund revenues per one current beneficiary”. This de facto makes the NDC component partially based on wage growth indexation, adjusted for real growth in collection rate and growth in a number o f beneficiaries. 4.22 As o f January 1,2002, when the Russia’s pension reform was launched, the size o f the monthly base pension was 450 rubles, the minimum pension - 600 rubles, and the overall average labor pension amounted to 1241 rubles. Subsequent indexation to compensate for the inflation so far has been broadly in line with the provisions o f the law. Moreover, indexation in both 2002 and 2003 o f the average pension exceeded the inflation rate. The latest indexation took place in April 2004. According to the Pension Fund, at that time the base pension reached 621 rubles, the minimum pension reached 944 rubles, and the average pension - 1892 rubles per month. Table 4.3: Main preferential regimes for social insurance contributions, 9 months of 2003 Number of contributors Number of Average monthly to the Pension Fund firms contribution, ruble 1. Reduced UST tax for particular employment groups -- agriculture 4,052,947 154.8 -- individual entrepreneurs 2,030,569 141.4 2. Simplified tax regime for small business (*) -- f i r m s 1,088,541 120,949 347.9 -- individual entrepreneurs 475,706 317,137 109.4 3. Presumptive tax on small business (*) -- f i r m s 1,485,162 165,018 174.7 -- individual entrepreneurs 2,373,903 1,582,602 89.9 Total for taxpayers under the preferential schemes (**) 11,506,828 158.0 -- share in the total number of UST taxpayers 16.3% -- average ratio between a preferential and regular contribution 32.3% Memo: regular UST taxation 59,270,991 489.8 (*) - Number of employees i s estimated based on the average size of respective businesses. (**) - Total does not include the number of taxpayers that pay single agricultural tax, for which no data are available. Source: Estimates by the I E T based on the datafrom the Taxation Ministry. ” The inflation-based indexation rules provide for the real values o f pensions for current pensioners to be maintained at their end-2001 levels. However, historically this was a period with rather low real pensions. The real value of average old age pensions in Russia declined dramatically as a result of the 1998 crisis, and at the end of 2001 it s t i l l was below the 1997 level (Smirnov and Isaev, 2003, p.19). 111 4.23 The earlier World Bank Report (2003) “Pension Reform in Russia: Structure and Implementation” undertook a comprehensive review o f the Russian pension reform strategy. The report identified major risks that the strategy has been facing and which relate to the following issues: (i) fiscal sustainability, (ii) deficiency in the system’s design that may weaken workers’ incentives to contribute to the system and work longer, (iii) weakness o f the financial sector that may constrain the development o f the funded pillar, and (iv) limited implementation capacity in the government. 4.24 The results from the earlier World Bank Report (2003) also demonstrate that the currently effective indexation rules are a critical determinant for the fiscal prospects o f the Russian pension system. Under the current rules, if they are fully enforced, the N D C portion o f the system i s expected to run considerable deficits, while the base component o f pension benefit would be generating surpluses that in principle would be sufficient to finance the deficits o f the N D C portion and keep the entire system fiscally sustainable. However, to base the pension system’s fiscal sustainability on such permanent redistribution o f funds between i t s two components could be a risky strategy in the longer term. Given the rather informal nature o f the existing indexation rules, there i s a considerable risk for pressure to mount that would push toward using the surpluses in the base pension component either for additional indexation o f the base pension or for other social spending. c. REFORM SCENARIOS IDENTIFIED FOR SIMULATIONS 4.25 Our simulations were primarily focused o n the trends in the following performance characteristics o f the pension system: (i) potential (fiscally affordable and actuarially justified) average replacement rate, (ii) ratio o f the average pension and pensioner’s living subsistence minimum, (iii) pension system balance at the preset rules o f pension indexation, and (iv) fiscal gap, estimated as a value o f additional public funding needed to provide for a desirable replacement rate. 4.26 While some o f the reform elements are s t i l l being defined by the government, five groups o f scenarios were identified and simulated for the purposes o f the current analysis. These are based o n the expanded actuarial model o f the Russian pension system. 4.27 Group I .Base Case: N o reforms in the unified social tax (UST) - unchanged pension contribution rates. Scenario 1 (1 1). L o w growth and absence o f structural reforms, including absence o f UST reforms Scenario 2 (12). L o w growth and advanced structural reforms, but without U S T reforms Scenario 3 (13). High growth and absence o f structural reforms, including absence o f UST reforms Scenario 4 (14). High growth and structural reforms, but without UST reforms 4.28 This group o f scenarios primarily reflects the status quo (i.e. continuation o f policies as o f early 2004) and i t s main objectives are to (i) provide estimates for the base line, Le., what would happen to the pension system if n o reforms are undertaken, and (ii) estimate the impact o f main macroeconomic factors, such as variation in GDP growth rates. In these scenarios the main parameters o f the system, including the retirement age, UST rates, number 112 o f contributors, etc., remained unchanged. However, it i s worth noting that our base case scenario fully reflects the changes envisioned in the draft L a w o n Professional Pension Schemes that provides for a considerable reduction in implicit subsidies to early retirees. I t i s assumed that this L a w would become effective in the near future in i t s present draft form. 4.29 Scenarios of Groups 11-V consider various potential reforms in the pension system. F o r the purposes of consistency, we assume that the reforms in the pension system will be undertaken only if there i s a broader across-the-sector acceleration o f structural reforms in Russia, i.e., there i s considerable progress in structural reforms as reflected in Scenarios 2 and 4 o f Group I Thus, in each o f the Groups 11-V we consider only two scenarios (both with . advanced reforms) instead o f four scenarios in Group I . 4.30 Group 1 1. With the UST reform - cuts in the pension contribution rates by 4 and 8 percentage points Scenario 5 (22). L o w growth and advanced structural reforms, including UST reforms Scenario 6 (24). H i g h growth and advanced structural reforms, including UST reforms 4.3 1 Group 1 11.UST reforms as in Group I1 supplemented by an increase in the retirement age by 5 years for men and 10 years for women Scenario 7 (32). L o w growth and advanced reforms, including UST reforms, and increase in the retirement age Scenario 8 (34). High growth and advanced reforms, including UST reforms, and increase in the retirement age 4.32 Group IV.UST reforms as in Group I1 supplemented by an increase in the retirement age and other changes and further reduction o f current UST privileges: (i) increase in contributions by self-employed and other beneficiaries from the existing tax regimes with lower UST rates; and (ii) reduction in the total number o f such beneficiaries. Scenario 9 (42). L o w growth and advanced reforms, including UST reforms, increase in the retirement age and additional cuts in UST privileges Scenario 10 (44). High growth and advanced reforms, including UST reforms, increase in the retirement age and additional cuts in UST privileges 4.33 Group V. These are the scenarios with the active migration policy, in which we looked at a potential impact o f a considerable migration inflow to Russia. The question we have been asking in this part o f the analysis was: to what extent immigration on i t s o w n could ease Russia’s pension system problem and as such be considered as a substitute to the comprehensive pension reform? We consider two altemative options for such an extra migration inflow (relative to the baseline reflected in Group I). Scenario 11 (52). Annual number o f migrants increases by 300,000 a year Scenario 12 (54). Annual number o f migrants increases by 500,000 a year 4.34 The UST reforms in Group I1 were modeled through cuts in the pension contribution rate for the base portion o f the old-age pension. Within the Group I1 we consider two alternatives for a potential effect o f such a cut in the contribution rate o n the tax base and collections: (i)base case - the rate cut does not lead to any expansion in the UST tax base and bring about a proportional decline in collections; and (ii) optimistic case, which assumes a 113 considerable expansion in the UST tax base (a share o f taxable payroll in GDP)72. Moreover, in the latter case, i t was assumed that the growth rate o f taxable payroll exceeds the pace o f decline in the contribution rate. These two cases represent quite extreme altematives, which together help identify a range (low and high ends for collections), within which an actual future dynamic o f the pension system i s likely evolve. 4.35 The scenarios in Group I11simulate the impact o f increase in the retirement age. These scenarios assume a gradual increase in the retirement age for men and women up to 65 starting in 2006. These changes are fully in line with the global and regional trends - increases in retirement age have been common for the recent pension reforms worldwide (Schwarz and Demirguc-Kunt, 1999). Most transition economies managed to start similar increases over the last ten years (Holtzmann et al., 2004, p. 85). There i s also a global tendency for closing the gap in retirement age between men and women. As was shown in analysis o f similar multi- pillar pension systems in other countries, such as Poland, preserving an earlier retirement for women would result in significantly lower pension benefits for them because the new systems deliberately reward longer carriers and later retirement (Balcerzhak-Paradovska et al., 2003). 4.36 It was assumed in simulations that transition to the new retirement age would be completed for men by 2016 and for women by 2026. In case o f the retirement age increase, the GDP growth rate was recalculated based on the assumption o f maintaining the labor productivity growth rate at levels similar to the respective scenarios o f Group I1 (with UST reforms), but with a higher number o f the employed. 4.37 Additional simulations in the scenarios o f Group I V analyzed somewhat more comprehensive reform strategies that assumed simultaneous undertaking o f cuts in UST rates, increase in the retirement age, and a considerable reduction in the existing privileges for those who are eligible for the reduced UST rates. In particular, it was assumed that (i) the share o f those who benefit from preferential UST regimes would decline from 15 to 10 percent o f the employed, and ( i i) contribution rates for those who remain beneficiaries o f the reduced UST rates would increase by 100 percent, from 150 to 300 ruble a month in 2002 rubles. 4.38 Most o f the simulations in this Chapter cover a period up to 2050. However, the analysis i s mainly focused o n the f i r s t half o f the period (up to 2025-30), which i s o f greater interest for policymakers. The main simulation results are presented in Annex Tables A4.1- A4.15, and they are discussed in Sections F and G. Annex 4.2 presents the main features o f the model that was used in our simulations. D. MAIN MACROECONOMIC AND REFORM ASSUMPTIONS 4.3 9 Macroeconomic assumptions for our simulations were developed jointly with experts from the Institute o f Economy in Transition. The basic principles o f the macroeconomic framework used for costing out various structural reforms are presented in Annex 3.1. In sum, we took the government’s baseline macroeconomic projections for the period o f 2004-06, and used them as a basis to build a set o f four longer-term macroeconomic scenarios, each o f which reflects a specific combination o f two primary determinants o f Russia’s future macroeconomic performance - average world market o i l price and expected speed o f structural reforms in the country. As described in the previous section, then we used two out o f four macroeconomic scenarios - scenarios with advanced reforms, 12 and 14 -- as a basis ’’Dmitriev at al. (1999) used a similar approach to the analysis o f the potential impact o f UST rate cuts on Russian pension system. 114 o n which we have designed and elaborated further more detailed sub-scenarios that reflect specific reform packages in the pension system. No reforms Advanced reforms Moderate oil prices (1 8.5), low growth Scenario 11 Scenario 12 High oil prices (22.5 and higher), high growth Scenario 13 Scenario 14 4.40 Overall, we based the analysis o n a rather conservative macroeconomic framework. I t i s worth noting that GDP growth rates assumed in our scenarios for the period 2004-06 are lower than those assumed in the corresponding government projections. W e believe that without advancing reforms growth rates will decline: better utilization o f existing reserves in the economy, which was a critical growth factor in 1999-2003, cannot support future growth in the same way as before because the reserves are to a large extent exhausted. At the same time, the “advance reforms” scenario implies that reforms are likely to temporarily slow down GDP growth compared to the “no reform scenario”, other things being equal. Therefore, in this case, growth rates are also likely to be lower for the next few years than the ones assumed by the government. 4.41 The key macroeconomic parameters in the model include real G D P growth rate, payroll share in GDP, population growth, economic activity, unemployment level, inflation, and interest (yield o f pension savings) rate. The payroll share in GDP i s an important parameter that in the model determines the dynamics o f the UST tax base.73 4.42 Macroeconomic parameters o f the base scenarios (Group I )are provided in Table 4.4. Projections for GDP growth used for all scenario groups are also presented in Figure 4.2. Figure 4.2: GDP Growth by Scenario, Group 1 7T GDP growth by scenario, Group 1 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049 ~ OL Table 4.4: Assumptions on Macroeconomic Parameters o f the Base Scenarios (Group I) 2004-2010 2011-2015 2016-2020 2021-2025 2026-2050 Real GDP growth (annual rate, YO) 73Roik (2003) also emphasizes a link between the growth in taxable wages in GDP and the financial position of Russia’s pension system. 115 2004-2010 2011-2015 2016-2020 2021-2025 2026-2050 Scenario 1 (1 1) 2% 2% 2.5% 2.5% 2.0% Scenario 2 (12) 1.5% 3% 4.5% 5.5% 5.0-3.5% Scenario 3 (13) 4% 4% 3.5% 3% 2.5% Scenario 4 (14) 3.5% 5% 6% 6.5% 6.0-4.5% Inflation (annual average, YO) Scenario 1 (1 1) 7% 6.5% 6% 5.5% 5% Scenario 2 (12) 10% 8% 6% 4% o 3y Scenario 3 (1 3) 10% 9% 8% 7% 6% Scenario 4 (14) 20-9% 9-7% 7-5% 5-3% 3% Taxable payroll, share in GDP Scenario 1 (1 1) 26-28% 28-29% 29-30% 30% 30-31% Scenario 2 (12) 27-30% 30-31% 31% 31% 31% Scenario 3 (13) 26-28% 28-29% 29-30% 30% 31% Scenario 4 (14) 27-30% 30-31% 31% 31% 31% Real interest rate/yield Scenario 1 (1 1) 3% 3% 3% 3yo 3% Scenario 2 (12) 5% 5% w a g e r -1% w a g e r -1% w a g e r -1% Scenario 3 (13) 3.5% 3.5% 3.5% 3.5% 3.5% Scenario 4 (14) 6% 6% wager -1% w a g e r -1% w a g e r -1% Unemployment level (YO) Scenario 1 (11) 9% 9% 9-8% 8Y o 8% Scenario 2 (12) 8-7% 7-6% 6-5% 5 ?‘o o 5y Scenario 3 (13) 9% 9-8% 8-7% 7% 7% Scenario 4 (14) 7% 7-5.5% 5.5-4% 4% 4% Memo items that correspond to the above presented assumptions: Taxable payroll, growth rate (YO) Scenario 1 (1 1) 3.4% 3.5% 3.8% 3.8% 3.4% Scenario 2 (12) 3.7% 3.3% 5.2% 6.0% 5.5% Scenario 3 (13) 6.2% 5.2% 4.8% 4.3% 3.8% Scenario 4 (14) 6.2% 5.9% 6.6% 7.3% 6.4% Labor productivity, growth rate (YO) Scenario 1 (11) 1.8% 2.6% 3.3% 3.4% 3.3% Scenario 2 (12) 0.5% 2.8% 5% 6% 5.5% Scenario 3 (13) 3.8% 4.3% 4.4% 3.7% 3.7% Scenario 4 (14) 2:4% 4.2% 6.3% 7.2% 6.4% Notes: a) wage r stands for annual real growth rate in average wage in the economy; b) projected productivity growth rate i s higher than GDP growth rate due t o expected decline in both population and employment. 4.43 Our simulations assume that wage growth i s proportional to labor productivity growth. At the same time, it i s accepted that the taxable wage may grow faster than productivity through a decline in the share o f informal wages and respective growth o f the taxable payroll share in GDP (i.e., due to growth in formally registered wages and the expansion in the share o f the formal sector facilitated by institutional reforms). Thus, one o f the particular features o f our projections i s an introduction of an additional factor in the model that reflects faster growth o f taxable wages (and respectively, the UST tax base) relative to labor productivity growth. Under such an approach, the share o f the taxable payroll in GDP i s an exogenous parameter, for which we consider a set o f altemative trends depending on a scenario. The dynamics of the payroll share in GDP for the Group I(“No reforms”) scenarios i s shown in Figure 4.3. 4.44 In the Scenarios o f Group I1 (“Reduced UST rates”), it i s assumed that the cut in the UST rate will become effective o n January 1, 2005. Parameters o f the P A Y G pillar have a linear dependency o n the effective contribution rate. Therefore,’ in the base case, the direct impact o f changes in the contribution rate o n the pension system could be estimated by simple recalculation of the base case results. 116 Figure 4.3: Dynamics o f the Taxable payroll share in GDP, Group 1 Dynamics o f the taxable payroll share in GDP, Group 1 35 33 ___- Scenario 1 -Scenario -- 2 Scenario3 I I 2004 25+ 2009 2014 2019 2024 2029 2034 2039 2044 2049 Table 4.5: Additional Assumptions in Scenarios with Reduced UST Rates, (Group 11) 2004 2005-10 2011-15 2016-20 2021-25 2026-50 Share o f taxable payroll in GDP (optimistic case) Scenario 5 (22) 27% 29-33% 35% 35% 35% 35% Scenario 6 (24) 27% 29-43% 35% 35% 35% 35% Contribution rate to finance the base pension Scenario 5 (22) 14% 10% 10% 10% 10% 10% Scenario 6 (24) 14% 10% 10% 10% 10% 10% 4.45 In the optimistic case o f Group 1 1, the payroll share in GDP i s expected to expand (Table 4.5). Quantified estimates for such an increase were developed based o n the assumption o f unchanged contributors’ net incomes in cases when their tax rate i s reduced74. This assumption i s similar to a hypothesis o n a proportional link between the relative size o f the UST rate cut and an associated additional increase in the share o f taxable payroll in GDP. Under such assumptions, as a result o f UST rate cuts, absolute amounts o f both pension contributions and pensions remain unchanged, while taxable wages would increase (due to a declined share o f shadow wages), which means a decline in the nominal average replacement rate7’. 4.46 The cross-country data suggest that indeed there i s a room for Russia to increase the share o f taxable payroll, but given high stability o f this indicator in most counties, such changes could happen only gradually. In addition, considerable institutional reforms will be 74 The idea behind this assumption is as follows: in response t o the tax rate reduction, taxpayers w i l l hide less o f their incomes, and the share o f their taxable wages will increase. It i s also assumed that the size o f such an increase could be conservatively estimated based o n the assumption o f constant net income: taxpayers, w h o benefit f ro m an opportunity t o reduce their hidden incomes (and, therefore reduce the size o f potential penalties), w i l l not seek additional financial benefits and will keep unchanged both the amount o f paid tax and the size o f their actual total incomes after taxes. 75 Note that the real replacement rate does not change in this case, because the total payroll (including the informal part) remains intact. 117 needed to support this trend toward higher formalization o f the economy. In 2002, the share o f taxable payroll (including payroll taxes) in Russia was estimated at about 32.5 percent o f GDP, which i s similar to the share in Mexico and somewhat higher than the one in Turkey. Taxable payroll net o f payroll taxes amounted to about 25 percent o f GDP (Table 4.2 above). Table 4.6 presents the comparative dynamics o f this indicator across the OECD countries. Table 4.6: Payroll Share in GDP o f Various Countries, Percent 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Australia 48.44 48.09 47.69 47.38 47.62 47.95 48.68 47.91 48.42 48.10 48.07 47.48 Austria 53.25 53.86 54.15 54.72 54.11 54.29 53.14 52.91 52.50 52.60 51.87 51.80 51.56 Belgium 51.52 52.92 52.92 53.17 52.40 52.03 51.72 51.31 51.17 51.48 51.26 52.45 53.16 Canada 55.06 56.19 56.26 55.17 53.34 52.46 52.04 52.14 52.79 52.07 51.94 52.89 Czech Republic 44.82 45.32 46.48 47.10 48.28 47.84 46.10 46.18 46.43 45.60 46.36 Denmark 55.54 55.22 54.92 54.68 52.80 53.02 52.93 52.92 53.91 54.22 53.35 54.33 54.60 Finland 55.55 58.36 56.54 52.77 50.68 49.85 50.15 48.64 48.03 48.88 47.86 48.93 48.96 France 52.49 52.73 52.89 52.96 52.07 52.09 52.15 51.91 51.51 51.86 51.98 52.49 52.76 Germany 56.04 56.18 56.74 56.67 55.37 55.34 54.87 53.98 53.46 53.51 54.18 54.12 53.63 Greece 35.16 32.57 31.54 31.44 31.32 32.25 31.92 32.77 33.24 33.35 33.09 33.14 32.95 Hungary 46.94 45.66 44.95 44.79 43.15 45.30 Iceland 48.77 51.66 52.36 50.58 49.49 51.04 52.56 52.25 54.24 56.91 58.47 58.19 59.26 Ireland 46.28 47.40 47.90 47.76 47.25 45.30 44.39 42.52 41.67 40.63 40.63 41.28 Italy 46.14 46.29 46.19 45.85 44.27 42.56 42.52 42.66 40.58 40.74 40.64 40.91 41.24 Japan 52.16 52.93 53.26 53.96 54.36 54.58 54.04 54.25 54.40 54.31 54.23 54.61 Korea 45.87 47.01 46.90 46.70 46.61 47.65 48.85 47.20 45.23 43.59 43.99 45.50 44.99 Luxemburg 53.26 53.05 55.02 53.66 53.31 53.44 53.10 50.53 49.04 48.23 47.40 50.42 53.04 Mexico 29.53 30.88 32.88 34.75 35.34 31.08 28.86 29.63 30.60 31.23 31.25 Netherlands 51.61 52.00 52.90 52.96 51.61 50.86 50.59 50.35 50.82 51.42 51.05 51.37 52.26 N e w Zealand 45.06 44.71 44.26 42.75 42.58 42.57 43.26 43.45 43.62 42.47 41.84 41.98 Norway 49.15 48.58 49.16 47.96 47.92 47.36 46.37 46.48 50.15 49.16 43.57 44.67 47.16 Poland 41.90 47.05 44.17 42.66 42.92 44.33 45.15 45.22 44.93 43.75 Portugal 43.83 46.12 47.05 46.86 44.76 47.71 47.97 47.93 47.81 48.22 Slovak Republic 43.25 42.30 42.25 42.46 43.45 43.23 41.34 Spain 49.86 51.14 51.70 52.19 50.71 49.91 49.76 49.78 49.93 50.04 50.13 50.13 49.91 Sweden 57.51 56.99 56.70 55.20 54.29 52.66 54.66 54.28 54.20 53.22 55.23 57.38 57.94 Switzerland 61.98 63.31 63.68 62.80 62.00 62.59 62.59 62.88 62.61 62.35 62.45 Turkey 27.21 31.86 31.67 30.88 25.54 22.18 23.93 25.80 25.46 30.68 29.19 28.34 Great Britain 56.72 57.27 56.92 55.68 54.25 53.77 53.20 53.38 54.12 54.60 55.23 56.16 55.74 USA 58.31 58.30 58.26 58.00 57.49 57.33 ,56.77 56.39 ,57.28 57.69 , 58.69 58.69 57.63 Source: World Bank. 4.47 In our projections for the scenarios in Group I(“No UST reforms”), i t was assumed that without UST rate cuts the share of taxable payroll (net o f payroll taxes) would increase gradually from the current 25 percent o f GDP to 31 percent o f GDP by 202576.I t i s worth noting that after such an increase, in 2025 the payroll share in Russia will s t i l l be lower than the actual payroll share observed in such countries as Poland and the Slovak Republic in 2000. This indicates a possibility for a somewhat stronger expansion in payroll share under more favorable conditions associated with an additional reform effort and lower payroWincome taxation. 76 Or 39-40 percent of GDP, if payroll taxes are included. 118 4.48 At the same time, in the optimistic case in scenarios o f Group I1 (“Reduced UST rates”) i t was assumed that the payroll share may grow considerably faster than in the scenarios o f Group I , and the payroll growth rate would exceed the pace o f decline in contribution rates by about 20 percent.77 Under such assumptions, the growth in the taxable payroll share would be more than 50 percent higher than the growth in similar scenarios o f Group I , and the overall increase in the payroll share within the period would amount to 9.5- 10 percentage points (p.p.) o f GDP instead o f the original 5.5-6 percent. Consequently, starting from 2020, the taxable payroll share in GDP (net o f payroll taxes) in the optimistic case o f Group I1 (Table 4.5) amounts to 35 percent (25+6-14/10*1,q7’. Such payroll shares are comparable to the actual current levels o f this indicator in the most advanced reformers among transition economies in the CEE. In other words, under the conditions o f aggressive structural reforms and with lower UST rates, within approximately 15 years additional expansion o f the UST tax base could amount to 4-4.5 p.p. o f GDP, from 30-31 to 35-35.5 percent. I t i s worth emphasizing that we consider the above assumptions to be really optimistic and we do not see much room for a further growth in the payroll share. In other words, it seems unlikely that the payroll share in Russia may expand above this 35 percent o f GDP threshold, even if more radical cuts in the UST rates (in excess o f 4 percentage points) are introduced. 4.49 International experience, however, suggests that there i s no strong correlation between reductions in the payroll tax rates and expansion in the tax base. To attain a desired policy outcome, cuts in the UST rate in Russia have to be complemented by other policies aimed toward formalization o f the labor market and improvements in expectations o f market participant^.^^ 4.50 In addition to a closer look at two quite different cases (“base” and “optimistic”) for a potential dynamics o f the tax base, we develop a broader framework for a sensitivity analysis of our simulation results (Annex 4.1). It helps to address questions such as “What may happen to the pension system if the key parameters such as UST rate and payroll share in GDP would reach particular levels?” 4.51 Our payroll growth rate assumptions are equivalent to projecting relatively high growth rates for real taxable wages. In particular, it i s assumed that in the optimistic case o f Group 11, in 2004-10 the real average (taxable) wage will grow at an annual rate o f 4.4 percent in Scenario 2, and 6.3 percent -- in Scenario 4. And this growth will remain rather high for the period 2011-20 (Figure 4.4). T h i s i s 0.5 to 1.5 percentage points higher than the growth in 77 Recent study o f the Institute of Economy in Transition (Sinelnikov et al., 2003) has found that simultaneous reduction of income tax and UST rates in 2000 had rather a substantial effect on growth in tax bases of these taxes in the period of 2001-02. Given all existing uncertainty, these results cannot be directly applied for developing precise quantitative estimates for elasticity of the payroll tax base. However, they seem to confirm the plausibility of our assumptions. 78 Note that we link the potential incentive effect exclusively with the reduction of the base pension contribution rate (from 14 to 10 percent), but not with the change in the total pension contribution rate (from 28 to 24 percent). This i s a reflection of the current situation where the contributors are least interested in contributing to the basic portion o f pensions, because this part does not have any effect on the size o f their future pension benefits. Respectively, incentives for participants seem to be the most sensitive to adjustments in this component of the overall contribution rate. ’’ In Argentina, for instance, the payroll tax base did not expand despite the considerable cuts in tax rates in the course of pension reforms in the 90s (Rofman, 2002). This i s believed to be related to other non-tax impediments to the formalization o f the labor market (such as hiring and firing restrictions), as well as low credibility of reforms and respectively strong expectations of the employers that the tax cuts had been temporary. At the same time, several Eastern European countries, including Poland, the Slovak Republic and Czech Republic, have a relatively high payroll tax base despite preserving one of the highest payroll tax rates in the world, well above 40 percent (IMF, 2002). 119 labor productivity in the same period. Given that a substantial portion o f this wage growth will be associated with a reduction in shadow incomes, such growth rates seem quite feasible. In comparison, the real wage grew at an annual rate o f 5 percent and more in a number o f CEE countries during the second half o f the 90s (Table 4.7) despite the fact that the share o f shadow wages in these countries at that time was significantly lower. Figure 4.4: Real Growth in Taxable Wages, Group 1 Scenarios 10 9 1 -~cenano2 I 8 7 6 5 4 3 2 1 0 I 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049 4.52 Overall, the assumptions in the optimistic case provide for the share o f shadow wages to decline to 20 percent o f taxable wages (as compared with the current 45-50 percent). This indicates that total labor incomes (combined taxable and nontaxable wages) will be growing at a rate that i s about 20 percent lower than indicated in Table 4.4. Table 4.7: Real Wage Growth in Various CEE Countries, 1995 2000, Percent - Croatia 34.5 Estonia 23.2 Lithuania 38.6 Slovak Republic 62.0 Poland 24.7 Source: World Bank. 4.53 In addition, it i s assumed in the reform-advanced Scenarios 2 and 4 in all groups that the economic activity o f the population would be higher, which reflects an assumption o n expansion in labor demand under the conditions o f sustainable growth and a favorable investment environment created by structural reforms. In Scenario 2, it i s assumed that the economic activity parameter would grow at an annual rate o f 0.5-1 percentage point up t o 2010, and it would remain unchanged after this. In Scenario 4, economic activity would grow at a rate o f 1 percentage point a year up to 2010, and additionally 0.5 percentage points a year during 201 1-15. Consequently, the average level o f economic activity during the period increases by 5-8 percentage points (Figure 4.5). 4.54 The share of non-payers in the pension system (delinquent contributors) was assumed unchanged at a level o f 5 percent throughout the entire period. This corresponds to the assumption that most workers would continue to participate in the pension system, while the primary form of tax evasion would remain to be a underreporting o f wages, but not a complete 120 withdrawal from the system. This relates to two specific features o f Russia’s pension system, which strengthen employees’ incentives to participate such as, (i) l o w eligibility requirements for the base pension, which requires just 5 years o f service and n o minimum contribution, and (ii) availability of generous preferential tax rates for self-employed and other categories (such as farmers) that have a higher propensity to drop out o f the system. At the same time, we estimated the elasticity o f the average pension with respect to changes in the participation rate. T h i s elasticity has a simple linear character -- a decline in participation in the pension system by 5 percent would reduce the average replacement rate by about 5 percent. Figure 4.5: Economic Activity o f Population, Group 1 Scenario ~ o.8, Economic activity of population, Group lscenarios, YO 0.5 - - -Scenario 1 01 -- Scenario4 00 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049 4.55 In Group I V (“Reforms to Reduce Tax Privileges”) we assume a considerable change in the structure o f contributors. W h i l e in all the scenarios o f Groups 1-111the structure o f those employed in the economy was: 80 percent - regular employees, 15 percent - the self-employed and others eligible for lower UST rates, and 5 percent are UST delinquents, in the scenarios in Group IV, the share o f regular employees i s gradually increasing to 85 percent, while the share o f those included in the privileged schemes i s declining to 10 percent. I t i s argued that the current eligibility rules for reduced pension contributions are too soft and, moreover, they are often abused by employers who register their staff as self-employed t o reduce payroll costs. In addition, it i s assumed that for those who keep their UST privileges, the fixed monthly pension contribution would be doubled in real terms. 4.56 N o changes are envisioned in technical parameters o f the pension system, such as collection and exemption rates, and coefficient o f regressivity, which respectively remain at the base levels o f 0.96, 0.94, and 0.94. 4.57 The real interest rate (pension savings yield) i s higher for reform-oriented scenarios 2 and 4 than in the scenarios 1 and 3. For the period till 2015, the rate amounts to 5-6 percent per annum in the former case, while it i s 3-3.5 percent in the latte. For the period after 2015, in the scenarios with reforms the yield i s fixed at the level o f one percentage point below the real growth rate in average wages o f the respective year (Figure 4.6). 121 Figure 4.6: R e a l Interest Rate, Group 1, Scenarios YO Real Interest rate, Group 1, scenarios % ~ 7.0 1 60 50 40 I 4 2.0 I- - - - Scenario i14 -- -Scenario 2 10- Scenario3 ' Scenario4 4.58 Another important assumption relates to the set o f used indexation rules. In our simulations, all pension benefits are fully indexed for an actual inflation rate, and thus inflation does not have an impact o n real values o f pension benefits and respectively replacement rates. Moreover, in addition to full indexation for inflation, we used two alternative sets o f indexation rules to assess trends in real values o f the average pension benefit: (i) The r u l e that corresponds to the existing legislation - the base pension i s indexed with the average inflation, while the N D C portion o f the benefit i s indexed based o n the nominal growth rate o f the Pension Fund collections per beneficiary. (ii) The rule that corresponds to estimates for the maximum affordable pension - indexation o f the base pension remains the same (inflation-based), but the N D C portion i s additionally indexed to distribute all available surpluses in the P A Y G pillar. 4.59 In addition, a separate indexation rule i s used for the subsistence minimum, which i s indexed for inflation plus additional indexation equal to 30 percent o f the real growth in average taxable wages.*' Justification for the latter indexation r u l e derives from the fact that the baseline scenario assumes relatively high growth in real wages for the entire period forecast. If the subsistence minimum i s not adjusted for this growth in labor incomes, it quickly erodes and becomes a meaningless concept. Substantively, the real growth in subsistence minimum could be interpreted as expansion in the set o f minimum social needs with the growth in average income (Chen and Ravallion, 2000). E. ASSUMPTIONS DEMOGRAPHIC 4.60 Basic demographic assumptions applied in the model are presented in Table 4.8. The key features o f the baseline demographic projections for Russia provide for both a drastic 80 For the cross-country data Chen and Ravallion (2000) estimate that elasticity of the poverty line by consumption level equals one third. 122 reduction in the general population (particularly after 2025)81and a monotonous growth o f the system dependency ratio (ratio o f pensioners and contributors): from the current 0.6 to 0.65 - 0.75 in 2025 and 0.9 - 1.0 in 2050 (Table 4.9). 4.61 For the simulations, we have used the demographic parameters that are mostly identical to the existing base demographic projections for Russia (Population o f Russia, 2002). However, in the “advanced reform’’ Scenarios 2 and 4, we increased the birth rate from the conventionally projected 1.40 to 1.45 (Scenario 2) and to 1.50 (Scenario 4), Le., as compared with the base case projections, the maximum increase o f the birth rate in the model does not exceed 7 percent. Table 4.8: Base Demographic Projections (scenarios from Group I-IV) 2003 2004 2005 2006 2010 2015 2020 2030 2040 2050 Birth rate* 1.31 1.33 1.35 1.37 1.40 1.40 1.40 1.40 1.40 1.40 L i f e expectancy 66.6 66.8 67.0 67.1 67.2 67.7 68.3 69.5 70.6 71.8 - Men 60.3 60.7 60.9 61.1 61.3 61.9 62.5 63.8 65.0 66.3 -Women 73 73 73 73 73 74 74 76 77 78 General population 143 143 142 141 139 136 132 121 110 99 - Men 67 67 66 66 65 63 61 55 50 45 - Women 76 76 76 76 75 73 71 66 60 54 Elderly load coefficient for general o,33 0.32 0.32 0.32 0.35 0.40 0.46 0.49 0.58 0.71 population (60/55) - Men (above 60) 0.20 0.19 0.18 0.18 0.19 0.22 0.26 0.29 0.32 0.43 - Women (above 55) 0.46 0.46 0.47 0.48 0.52 0.60 0.67 0.71 0.86 1.03 * Birth rates presented are those for the most conservative options that correspond to the Scenarios 1 and 3 of Group I . Source: Demographic projections used in this Chapter were developed by Ye. M. Andreyev, the Centre for Human Demography and Ecology. See Population o f Russia (2002). 4.62 In all the scenarios o f Groups I-IV, net immigration was set at a conservative level o f 60-100,000 persons per year. In Scenarios 1 and 3 o f Group I ,the net migration i s close to the baseline demographic projections o f 60,000 persons a year, while in Scenarios 2 and 4 it was increased approximately by 50 percent. However, this growth in immigration has an insignificant impact on the results. T h i s i s primarily owing to the fact that, in our view, the net migration inflows are (unrealistically) low in the conventional demographic projections. In a long-term perspective with a continuing population decline, one should expect that the annual net immigration to Russia will expand substantially. This i s the reason why in the scenarios o f Group V (“Additional immigration”), the net migration i s additionally increased to 300,000 and 500,000 persons per year through the extended periodg2. *’ However, it i s worth mentioning, that such sharp population reduction may lead to a much stronger expansion in net immigration, which i s to some extent reflected i n scenarios of Group V. 82 According to the data provided by the Institute of Economic Forecasting, over the last 15 years the maximum level o f net migration o f 800,000 persons per year was observed in 1994. Since then the flow o f net migration declined significantly and in 2001 it made up only 50,000 persons. 123 F. SIMULATION RESULTS Group I.N o changes in the unified social tax, no changes in the retirement age Estimating baseline trends 4.64 As noted above, the main output indicators for the pension system in our scenarios include the overall affordable replacement rate (Figure 4.8), the contribution rate required to ensure the targeted replacement rate (Figure 4.9), and the ratio between the average pension benefit and the pensioner’s living subsistence (Figure 4.10). 4.65 In the scenarios o f Group I ,the variation in baseline macroeconomic parameters does not lead to any tangible variation in the overall replacement rate (Figure 4.8 and Annex Table A4.3). That is, our results suggest that acceleration o f economic growth, lower inflation, and reduced unemployment all have rather a modest effect o n the future average size o f the pension benefit (relative to the average wage). W h i l e differences in annual growth rates between Scenarios 11 and 14 are significant and amount to 3-4 p.p., they produce a modest variation in the replacement rates that in 2030 stays in the interval o f 24.4-27.8 percent.83 Even under the most favorable macroeconomic assumptions, by 2025 the replacement rate drops considerably relative to i t s current level and then it stays basically unchanged. I t i s expected that the rate o f decline would be the most pronounced between 2016-25, when it would lose o n average about 3.5 p.p. Figure 4.8: Pension Replacement Rate, Group 1 Scenarios / ” ] I ~ 40 Pension Replacement Rate, Group 1 scenarios, YO I I -- 30 25 I “1 , -Scenario 2 - - Scenario3 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049 _____ 83The contribution o f the fully funded pillar to the overall replacement rate amounts to about 10 percent in 2030, but i t reaches a quarter in 2050. 125 Figure 4.9: SST Rate (Contribution Rate) Needed to Ensure the Replacement Rate of so%, Group 1 Scenarios SST rate (Contribution rate) needed to ensure the 40 replacement rate ofl-roup ,- 1 scenarios, % 35 30 25 I -- -Scenario 2 Scenario3 10 I 0 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049 Figure 4.10: Ratio Between Average Pension and Pensioner's Subsistence Minimum, Group 1 Scenarios Ratio between average pension and pensioner's subsistence minimum, Group lscenarios - - - - Scenano 1 -Scenario 2 -- Scenanod 40 Scenano 4 4 4.66 None o f the scenarios in Group Icould bring the replacement rate to the level o f 30 percent. While higher economic growth results in much higher real pensions as well as in a higher ratio between average pension and subsistence minimum (Annex Table A4.6 and Figure 4-10), i t does not help to close the gap between growth in wages and pensions. I t appears the existing pension system, even under the most optimistic assumptions, does not provide pensioners with a fair share o f gains from economic growth (Box 4.2). 4.67 These results confirm that the current pension system does not have internal reserves to prevent a broadening o f the income gap between employees and pensioners, and as such they justify the need for additional reforms in the pension system. Without the reforms, the broadening of the gap may trigger a pressure for support o f the pension system through 126 additional budget transfers. W e estimated potential fiscal costs o f such budget support, based on the assumption that the government would b e forced t o keep the replacement rate a t the l e v e l o f 3 0 percent. In this case, annual fiscal costs o f supporting non-reformed pension system would amount to 0.5-1.5 percent o f GDP a year in 2030 a n d it increases to the l e v e l o f 1.5-2.5 percent o f GDP by 2 0 5 0 (Table A4.7). T h e pension system would b e able to generate the same amount o f funding internally only through a considerable additional increase in the average contribution rate, from 28 percent to on average 3 2 percent in 2025 a n d to about 35- 3 6 percent in 2050 (Figure 4.9). Box 4.2: Drivers o f the decline in the replacement rate Separating the PAYG and fully funded pillars o f the system helps to understand better the main factors behind the declining trends in the overall replacement rate. Without significant reforms in the current pension system, in the longer run the replacement rate in the P A Y G pillar will inevitably decline to approximately 17-20 percent (Table A4.2). This i s because the current pension system, despite a l l i t s recent positive innovations, has largely preserved i t s re-distributional natures4, in which the replacement rate i s inversely proportional to the system dependency ratio. With the system dependency ratio approaching 1 (under the current retirement age), the average replacement rate in the PAYG pillar will be to a growing extent determined by the average U S T rate. Taking into account also that the actual collections o f the Pension Fund are lower than statutory collections due to such parameters as incidence o f non-payments, exemptions, and the regressive nature o f the tax rates5, in the long run the average replacement rate in the P A Y G pillar could be maintained only at a level o f about 19 percent (22*0.94.0.94.0.96=18.7 percent). However, taking into account that the self-employed and other special categories pay their P A Y G contributions at a much lower rate (on average approximately only 3 percent), while their number comprises 15 percent o f contributors, the longer-term ceiling for the replacement rate in the P A Y G system will b e even lower - - 16.3 percent ((0.94~0.94~0.96)~(0.85.22+0.15~3) =16.3). For the fully funded pillar (FFP), a rough estimate for the potential longer-term replacement rate (Table A3) may be obtained in a similar manner. Assuming that the wage growth rate i s equal to the interest rate (yield) in the economys6, the FFP replacement rate as o f the date o f retirement i s proportional to the contribution rate and the number o f years o f service and inversely proportional to the average life expectancy after retirements7. Given the current maximum contribution rate for the funded pillar o f 6 percent, prevailing values o f both collection and regression factors, and working lives o f 30-35 years, the FFP replacement rate will be about 8.5-10 percent (6*0.94-0.96(30-35)/19)88. As a result, with the dependency ratio equal to 1, the combined (PAYG and FFP) longer-term potential replacement rate for the existing system would stay within the interval o f 24-25.5 percent. 4.68 Table 4.10 provides a compressed summary o f the expected trends in the replacement rate under the Group Iscenarios. I t suggests the f o l l o w i n g observations: 84 The current legislation provides that only 21 percent o f pension contributions (6 percent out of 28 percent o f payroll) will be directed to the funded pillar. 85 As mentioned above, the model uses the following estimates for these three parameters: 0.94, 0.94, and 0.96 respectively. 86 This i s a standard assumption for this kind o f model: if the interest rate i s below the wage growth, the incentives for participation in a pension system weaken notably. 87 Currently, annuity has not yet been fixed for the funded pillar, and the model i s using variable “life expectancy” with the same values as for the PAYG pillar (12-19 years depending on the year of projections). 88 This i s an upward biased estimate because it does not account for several factors, such as e.g., administrative costs in the FFP. 127 0 Each cohort o f the pensioners starts its retirement with quite a l o w real pension, and this relative value o f pension at retirement i s declining with time, i.e. each cohort i s better o f f at the moment o f retirement than those that follow. 0 The real value o f pension for each cohort i s growing with time, however this growth i s concentrated in the second part o f their retirement “career”. 0 Practically in all cases during the first part o f retirement the average pension i s less than one third o f the average wage at retirement. Table 4.10: Real pension as a percentage of the average wage at the time o f retirement. Year o f 2002 2010 2020 2030 2040 retirement Scenario 2 (12): Low growth 2002 31 34 41 - 2010 - 26 31’ 48 - 2020 - 20 31 49 Scenario 4 (14): High growth 2002 31 37 50 - 2010 - 25 34 57 - 2020 - 19 32 56 4.69 The dynamics o f real replacement rate (Table A4.5), i.e. the replacement rate estimated as a ratio o f the average pension to the full labor income (but not just to i t s taxable portion), shows much less variation than the conventional (nominal) replacement rate (Table A4.1). It suggests that, when one accounts for an expected decline in the share o f informal wages in the total payroll, the overall trend in the relative size o f the average pension i s quite different. I t shows modest growth for the period between 2005 and 2020 within the range o f 24-27 percent, and after this it declines much more gradually that the conventional (nominal) replacement rate. Still, in none o f the scenarios in Group I ,the real replacement rate exceeds 26 percent in 2030. 4.70 At the same time, all scenarios in Group Ishow a gradual increase in the value o f average pension relative to the subsistence minimum (Figure 4.10). The latter ratio i s a better measure o f absolute changes in pensioners’ standard o f living than the replacement rate. I t indicates that, even within the unrefomed pension system, with economic growth the real incomes o f pensioners will also grow steadily. However, there are two concerns with the patterns o f this future growth: a) in the initial period till 20 15, despite a l o w level o f current pensions, this growth will be rather slow, and b) as reflected in the falling replacement rate, the growth in pensions will be lagging growth in real wages, which may become a politically sensitive issue. 4.71 In contrast to the replacement rate, the ratio between average pension and subsistence minimum shows a considerable variability depending o n the growth rate in the economy, as well as growth in real average wages. By 2030, the difference in increases o f this ratio across the scenarios i s about 3 times, from 50 percent in Scenario 11 to 165 percent in Scenario 14 (which i s the scenario with the highest GDP growth rate). 4.72 The analysis also suggests that the existing pension indexation rules could be somewhat relaxed without compromising the stability o f the pension system. In the expected environment o f the high wage growth the existing indexation rules, which are primarily inflation based, are too restrictive and do not allow for utilization o f the entire pension 128 contributions. Ifthe PAYG pensions are adjusted only for price inflation, and do not reflect real wage growth, the future average pensions would be much lower (Table A4.8) than those that the system could afford, and the pension system would generate considerable surpluses that would reach 1.8-2.7 percent o f GDP by 2030 (Table A4.11). Comparison between the average pension, estimated for the “inflation-only” indexation rules, with the average pension that could be afforded by the pension system (ie., with the zero balance o f the PAYG pillar, (Table A4.1) shows that by 2020 the difference,(measured by the replacement rate) amounts to 50 percent and it reaches 100 percent by 2050. 4.73 While under the existing indexation rules overall the P A Y G system would generate considerable surpluses, they would be generated entirely by the base pension component (Table A4.9). The NDC component would have considerable deficits (Table A4.10 and Figure 4.1 1). Figure 4.11: Balance in the Base and NDC Components o f the Pension System, Group 1 Scenarios, % o f GDP Balance in the base and NDC components of the pension scenarios, YO system, Group-1.__..._-..I... of GDP .- 3.5 ” 3.0 --- -Scenario 1 -Scenano 2 2.5 2.0 1.5 1 .o 0.5 I 4.74 The inflation-only indexation rules would have a major effect on the real value o f the base pension and could lead to a quick erosion o f i t s value. If the real wages grow at 6 percent, the replacement rate for the base pension will decline by factor o f approximately 3 by 2025, and by factor o f 18 by 2050. The share o f the base pension in the total average pension benefit will decline from 30 percent in 2003, to 20 percent in 2025 and to only 5 percent in 2050. 4.75 Under the circumstances, i t would make sense (probably after 2030) to convert the base pension into an instrument o f social assistance, link i t s size to the minimum subsistence benefit, and respectively move the responsibility for i t s funding from the Pension Fund to the federal budget. T h i s would be consistent with the nature o f the basic pension, which aims to provide basic income security for the elderly (Hotzmann et al., 2004, pp. 10-1l).*’ This would cause an annual increase in government budget expenditures o f about 1 percent o f GDP in A similar suggestion was made by the Russian Union o f Industrialists and Entrepreneurs (Concept o f the Pension Reform. Employers’ Position, 2001). Hungary and Poland abolished their minimum pension and provide a minimum income support for the elderly from outside o f the pension system (IMF, 2002, p. 30). 129 2030, but this amount would be declining quickly to less than 0.4 percent o f GDP in 2050. Accordingly, the same amount o f pension fund resources could be freed and may be used for an increase in the P A Y G pensions. Impact of other specific factors on the replacement rate 4.76 The sensitivity o f the results for future average pensions to changes in the interest rate proved to be quite high. An increase in yield by 1 p.p. leads to a 15-20 percent increase in the replacement rate for the fully funded component o f the pension benefit. For 2050 this could bring about an additional 1.5 pap. to the overall replacement rate in the system. However, for the period till 2030 the share o f the fully funded component in the overall benefit remains low, and therefore changes in the interest rate have only a marginal impact o n the real value o f the overall pension benefit. Our baseline estimates assumed a rather conservative assumption regarding the interest rate, which i s kept at 1 p.p. below the real wage growth, while usually these parameters are assumed to be equal in the longer term. Our choice o f a lower interest rate relates to the fact that the baseline scenarios assume quite high real wage growth, and equalizing interest and wage growth under the circumstances may produce unrealistically high yields. 4.77 While the pension system may have potential financial reserves associated with an increase in the economic activity (labor market participation) o f the population, as well as with declining unemplovment, the possible impact o f these two parameters seems to be low. I t appears in our assumptions used for Scenario 14 (high growth with advanced reforms) that we have already accounted for most o f the realistic reserves in these two areas. 4.78 An increase in the birth rate along with the effects o f declining unemployment, growing economic activity, and higher net migration inflows in the base scenarios o f Group I help to reduce the system dependency ratio by about 10 percent and, respectively, to increase the average pension benefit by 10 percent. 4.79 The above estimates for baseline trends in the replacement rate assume a considerable compression o f the early retirement schemes as proposed by the Draft L a w o n Professional Pension Systems. Thus, there are n o significant unaccounted reserves associated with this factor. We estimate that if the current draft L a w becomes effective, this would reduce the number o f early ensioners from about 3 m i l l i o n in 2002 to 2.25 m i l l i o n in 2030, and to 1 3 8 m i l l i o n in 2050. Given that the total incremental annual payments to early retirees, as estimated, amount to about 4 percent o f total Pension Fund spending o n pension benefits, total savings due to the proposed reduction in this benefit would be modest - from 1 percent o f the total pension payments in 2030 to 2.7 percent in 2050. 4.80 The existing proposals for UST reforms also suggest considerable changes to existing tax brackets, and also introduce a regular indexation o f the tax brackets for the future. If implemented, this would change both the average effective tax rate and the coefficient o f regressivity (currently equal to 0.94) for the pension system. However, it i s difficult to predict the magnitude o f possible changes in the latter because we do not have data o n actual distribution of wages within each group of contributors. More importantly, it i s quite difficult to make longer-term projections for future changes in wage differentiation. We have therefore kept the coefficient of regressivity intact in our simulations and focused primarily on the impact o f changes in the average contribution rates. 90 However, the number of early pensioners would increase till 2012 due to the grandfathering clauses. 130 Group 11. UST reform: cuts in the pension contribution rates Modest rate cut of 4percentagepoints 4.81 The pension system understandably i s very sensitive to even modest cuts in the contribution rates. Scenarios o f Group I1 were used to undertake a series o f simulations that help evaluate the possible effects o f cuts in the average UST rate o n the overage benefit under the assumption that such a cut i s not complimented by other reform efforts. In the base case, when there i s n o increase in the UST tax base relative to the baseline o f 31 percent o f GDP, the proposed rate cut i s expected to cause by 2030 an additional decline in the average replacement rate by 6.5-7.5 pap. This would bring the replacement rate to the level about 20 percent, i.e. one quarter below the replacement rate that i s likely to be generated in the system without the reforms (and 40 percent below the current replacement rate). T h i s would represent a major compression o f the real value o f the pension benefit. 4.82 The ratio o f the average pension and subsistence minimum in the latter scenario i s about 20 percent below those in the Group Iscenarios. I t i s worth noting, however, that i t remains considerably higher than 1 (by 60-120 percent in 2030), which i s a major improvement relative to the current situation. 4.83 In the optimistic case, despite an assumed considerable expansion in the tax base (See Section D), the average replacement rate would decline relative to the baseline in the Group I scenarios. By 2030 the decline would amount to 3.5-4 percentage points, which bring the replacement rate to the range o f 22.7-23.8 percent (Figure 4.12). Along with this, potential fiscal costs o f closing the gap in the pension system (measured against the replacement rate target o f 30 percent) would increase from approximately 0.6-0.9 to 1.7-2.1 percent o f GDP. Figure 4.12: Pension Replacement Ratio, Comparisons o f Scenarios in Group 1 and Group 2 Pension Replacement Ratio, compariosons o f scenarios 400,- - _ Group _ in - - __ 2, % 1 and Group __ I_ - --- -Scenario 2 (Grl) - -Scenario 2 (GR) 100 - -- Scenano 4 (Grl) - Scenano 4 (GR) 50 - 00 r 4.84 Due to a linear dependency among the parameters in the P A Y G system, the above results may be used for generating rough estimates for potential alternative plans for cuts in the contribution rates in the P A Y G pillar. O n average 1 percentage point in reduction o f the UST rate could be compensated for by an increase in the share o f taxable payroll in GDP by 1.0-1.3 p.p. At the same time, a 1 p.p. cut in the UST tax rate could be compensated by 0.25- 0.3 percent o f GDP in additional external (budget) transfers to the pension system (Table 131 4.1 1). Annex 4.1 presents additional results o f sensitivity analysis: i t helps to get the idea o f the variation in real value o f average pension for different pairs o f U S T contribution rate and payroll share in GDP. Table 4.11: Some results of sensitivity analysis for 2030: equivalence table 1 p.p, in UST tax rate cut Could be compensated by an expansion in the UST tax base of 1.O -1.3 P.P. 1 p.p. in UST tax rate cut - Could be compensated by an additional budget transfer o f 0.25 0.30% o f GDP 4.85 An important conclusion from this part o f the analysis i s that without an increase in the retirement age even a rather substantial growth o f the tax base does not allow halting the decline in the replacement rate. At the same time, as shown below, with the retirement age increase (as in Group I11 scenarios) and particularly when the retirement age increases along with cuts in U S T benefits (as in Group I V scenarios), the effect o f a declining replacement rate i s fully compensated. 4.86 The basic distinctions between the scenarios within Group I1 (Figure 4.12) are associated with the differences in GDP growth rate, as well as with differences in the shares o f payroll in GDP. The results also suggest that despite a considerable decline in the replacement rate, the ratio between the pension benefit and the subsistence minimum i s less sensitive t o cuts in the U S T tax rate (Figure 4.13). The latter ratio did not change much relative to the results in similar scenarios o f Group I. Figure 4.13: Ratio Between Average Pension and Pensioner's Subsistence Minimum, Comparisons of Scenarios i,nGroup 1 and Group 2 Ratio between average pension and pensioner's subsistence minimum, compariosons of scenarios in I 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049 " ' I Latest government proposal: rate cut of 8 percentage points 4.87 Earlier in 2004, the Government announced a plan to introduce a more drastic cut in the U S T rate compare to what has been discussed in this Chapter. Specifically, the latest Government's proposal calls for a rate cut o f 8 percentage points, from 28 to 20 percent, 132 which will be allocated among base (cut by 6 pep.)and fully funded (cut by 2 p.p.) components of the pension benefit. The proposal includes the following compensatory measures: a) substantial reduction in participation in the filly funded pillar, which, as we estimate, would reduce the average replacement ratio in this pillar by 0.8-1.0 p.p. by 2030; b) utilization o f the currently expected surpluses in the base component to accommodate a decline in the contribution rate to this component from 14 to 8 percent; and c) compensatory budget transfers to the Pension Fund funded either from regular budget revenues or from the Stabilization Fund.” 4.88 We estimate that the current plan, if implemented, would utilize about a h a l f o f the expected surplus in the base pension component, and it would reduce the affordable replacement rate in the P A Y G system by 4-5 p.p. Thus, if there i s n o compensation for the pension system from the budget, the total reduction in the replacement ratio (including FFP) in 2030 could reach 5-6 p.p. relative to the baseline scenario in Group I without the rate cut. T h i s i s equivalent to a 20-25 percent decline in real average pensions. This would raise potential (longer term) fiscal costs o f supporting the replacement ratio o f 30 percent to above 2 percent o f GDP a year. 4.89 Moreover, the short term negative impact o f the proposed could be also significant. The P A Y G component may lose more than 25 percent (6/22) o f i t s regular incomes, while the affordable replacement rate would decline correspondingly. Based o n the estimates obtained in this Chapter, we would recommend that the government should be prepared to compensate most o f the lost revenues in the P A Y G component to avoid either decline in real value o f current pensions or accumulation o f pension arrears. Such compensation may amount to an equivalent o f not less than 4 pap. o f the UST rate and be funded from regular budget revenues. I t i s estimated that the total annual budget costs associated with such compensation would amount to 1.0-1.1 percent o f GDP. The compensation has to be provided until either considerable improvements in the revenue performance o f the pension system materialize, driven either by strong recovery in real wages or by a decline in the share o f informal wages or by both, or policy decisions are made, which reduce Pension’s Fund’s financing needs. Sensitivity to the high rates of economic growth 4.90 T o reflect the fact that our base growth assumptions are quite conservative, we also undertook an alternative set o f simulations based o n the assumption o f the much higher (6 percent average) growth for the period 2004-09. However, in this case we found rather an insignificant change to our base results. This i s because higher GDP growth i s expected to be accompanied by higher growth in real wages, which limits opportunities for additional improvements in the replacement rate. 91The government indicated that in 2005 it may spend as much as 0.4 percent o f GDP from the Stabilization Fund to cover the Pension Fund deficit that would derive from the introduced the UCT rate cut (Prime-TASS, August 24, 2004). 133 Group 111. UST reforms supplemented by an increase in the retirement age by 5 years for men and 10 years for women 4.91 The growth in the retirement age by 5 years for men and by 10 years for women in the scenarios o f Group I11 leads to a considerable decline in the system dependency rate. This decline amounts to approximately 40 percent by 2050 (Figure 4.14), and, therefore, to an increase in the average P A Y G pension benefit by about 40 percent. Due t o the increase o f the contribution period, the affordable overall replacement rate in the optimistic case (with a higher tax base) increases t o 33-35 percent in 2030 (Figure 4.15), Le., by 20-30 percent as compared with the similar scenarios o f Group I . Even in the base case, i.e. without the expansion o f the tax base, the replacement rate s t i l l remains above 3 0 percent. This considerably reduces the risks o f budget support for the pension system. 4.92 The ratio between the average pension and the subsistence minimum increases in the long term by approximately 50 percent as compared with the scenarios o f both Groups Iand 11. In absolute terms, the latter ratio may reach 2.5-3.5 in 2025-30. 4.93 Our sensitivity analysis suggests that, without a mandatory increase in retirement age, a voluntary delay in retirement by 5 years under the current conditions and respective extension o f the contribution period would have a noticeable impact o n the individual pension. The replacement rate would be higher by 8-25 percent for b o t h NDC and fully funded components, depending upon a particular combination o f values f o r real wage growth and real interest rate. However, the size o f this increase may be insufficient to create strong incentives for participants to retire later. The Government m a y consider amendments to the benefit formula t o strengthen the link between the retiree’s length o f service and hidher benefit size. The latter step would be o f special importance if there i s a delay in resolving the issue o f mandatory increase in the retirement age. Figure 4.14: System Dependency Ratio, Comparisons o f Scenarios in Group 1 and Group 3 1 ~ 1.0 I 0.9 4 , System dependency ratio, compariosons o f scenarios in Group 1 and Group 3, YO 07 08 05 04 03 02 01 00 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049 134 Figure 4.15: Pension Replacement Ratio, Comparisons o f Scenarios in Group 1 and Group 3 Pension Replacement Ratio, compariosons o f scenarios 45.0 ___l__ll_ in Group 1 and Group 3, ___ - YO -__- 40.0 35 0 30 0 25 0 1 1 20.0 1 - - - -Scenario 2 ( G r l ) l d I -Scenario -- 2 (Gr3) Scenario 4 (Grl) 100 - 50 - 00 7 Group IV. Additional reforms aimed at the reduction of current UST privileges 4.94 The results o f the scenarios o f Group I V show a modest additional growth o f the affordable overall replacement rate by about 1 percentage point relative to the similar scenarios in Group 1 11. This additional growth reflects primarily the following changes: (i) a one time twofold increase in the rates o f pension contributions paid by the self-employed and indexation o f these rates in accordance with the growth rate o f average wages, and (ii) a reduction in the number o f people who are eligible for reduced UST rates from 15 to 10 percent o f the employed. The latter decline may be achieved through a tighter definition o f eligibility rules and their stricter enforcement. 4.95 Even under the most optimistic reform and macro assumptions as in Group IV, the replacement rate remains below 36 percent in 2030. Thus, i f the policy target i s reaching a 40 percent replacement rate for the average pension, this objective can not be achieved without an expansion in additional private pensions, based on additional voluntary contributions. Encouraging the development o f private pensions i s a large, separate task that would require the introduction o f supportive regulatory, institutional and tax frameworks. Group V. Effects of expanded immigration 4.96 In this group o f scenarios we simulated a potential impact o f a considerable migration inflow to Russia o n the trends in the pension system. As a base case, we used a scenario 12 from the Group 1, and compared it with the two additional scenarios that differ by both the level and structure o f migration inflow. In these additional scenarios, the annual net number o f migrants increases from about 100,000 to respectively 400,000 and 600,000 a year. In addition, i t i s assumed that the immigration i n f l o w would have a higher share o f people o f working age (and thus, a higher share o f contributors to the pension system) than the average share o f working age people in the Russian population. The latter assumption i s reflected in a higher share o f labor force participants, which i s increased by 4-7 p.p. 135 4.97 While an increase in migration would have a drastic impact o n the overall demographic trends in Russia, it has rather a modest influence on parameters o f the pension system. Table 4.12 presents the main results o f these simulations, which do not change much our previous conclusions - the system dependency ratio continue to growth rapidly, while the replacement rate s t i l l declines below 30 percent. Even under the boldest assumption on immigration level (which by 2050 bring a considerable increase o f 30 percent in the total population), the replacement rate increases by less than 15 percent. In n o way, the active migration policy in Russia could become a substitute for a comprehensive pension reform. Table 4.12: Potential impact o f an increase in immigrationon the pension system Russia’s population, System dependency Replacementrate: total, million ratio percent 2030 2050 2030 2050 2030 2050 Base scenario 12, 122 102 0.72 0.93 26.4 24.6 Group I,low growth The same scenario with additional immigration: a) of 300,000 a year 132 119 0.68 0.84 28.0 26.9 b) o f 500,000 a year 138 130 0.66 0.8 29.1 28.2 G. SUMMARY AND CONCLUSIONS 4.98 Based on simulations o f various policy scenarios, this Chapter estimates potential fiscal costs associated with various developments in Russia’s pension system. I t finds that these costs are likely to emerge as a result o f the declining relative value o f o l d age pension and associated political pressures for budget support to the pension system. These results are based o n the projections that, within the framework o f the basic macroeconomic projections and with the current demographic trends, the long-term financial self-sustainability o f the existing Russian pension system may be ensured only at the cost o f a substantial reduction in the average replacement rate, from 33 percent in 2002 to 24.4-27.8 percent in 2030 and to 23.5-25.5 percent in 2050. 4.99 This replacement rate reduction i s driven primarily by demographic factors, while i t s dynamics i s less sensitive to variations in macroeconomic parameters, such as growth and unemployment rates. Even under the most favorable macroeconomic scenario without an increase in the retirement age, the overall replacement rate declines below 30 percent by 2020 and by 2050 it goes further down to 25 percent. The rate o f decline would be the most pronounced in the period 2016-2025, when it i s the most likely to expect that political pressures to support the pension system through budget transfers would emerge. W h i l e higher economic growth results in a much higher real value o f pensions, it does not help to close the gap between growth in wages and pensions. Additional immigration and any realistic improvements in demographic and employment trends do not change much these basic results. 4.100 Table 4.13 summarizes our results for expected replacement rates and associated potential fiscal costs. Fiscal costs are measured against a target o f maintaining the replacement rate at 30 percent. In the baseline scenarios, annual fiscal costs amount to 0.25- 0.55 percent of GDP in 2020 and to 0.55-0.90 percent o f GDP in 2030. However, potential costs increase rapidly in all scenarios with the reduced contribution rates. In the most 136 pessimistic case, with 8 p.p. cut in the USR rates and no expansion in the tax base, annual costs to the budget exceed 2 percent o f GDP in 2030. In contrast, the scenarios with the increased retirement age do not require any budget support to provide a replacement rate o f 30 percent. 4.101 However, the above fiscal costs would expand quite rapidly if the Government implements significant cuts in the pension contribution rates. The simulation results suggest that even under the most optimistic assumptions about potential expansion in the tax base (reaching 35 percent o f GDP), this factor cannot compensate for a cut in the UST rate o f four percentage points if it i s not supported by additional pension reforms. Political demands for maintaining simultaneously higher benefits and l o w UST rates can result in quick widening o f the deficit o f the pension system, which would become a contingent liability o f the government. Even with a modest rate cut o f four p.p., annual fiscal costs would increase to 1.35-1.70 percent o f GDP. If the current Government proposal to cut the UST rate by eight pap. (6+2) i s fully implemented, this would raise the fiscal costs above 2 percent o f GDP per annum. 4.102 At the same time, all scenarios show a gradual increase in the value o f average pension relative to the subsistence minimum. T h i s indicates that with economic growth the real incomes o f pensioners will also grow steadily. However, there are two concerns with the patterns o f this future growth: a) in the initial period till 2015, despite a l o w level o f current pensions, the growth will be rather slow; and b) as reflected in the falling replacement rate, the growth in pensions will be lagging growth in real wages, which may become a politically sensitive issue. 4.103 A gradual increase in the retirement age by 5 years for men and 10 years for women in the long-term perspective would reduce the system dependency ratio by approximately 40 percent. This makes it possible to provide practically full compensation for the negative impact o f the both U S T rate reduction o f 4 pp. and demographic factors o n average pensions. T h e replacement rate (assuming the same reduction o f the UST rate o f 4 pap.) in 2030 would grow to 33-35 percent, Le., would be the same or higher than i t s 2002 level. Even in the case with no expansion in the tax base, the replacement rate would remain above 30 percent. This drastically reduces a risk for budget support to the pension system. Table 4.13: Summary of the simulation results for replacement rate and potential fiscal costs Scenarios Replacement rate Fiscal costs per annum, 2020 2030 2020 2030 Scenarios of Group I 12: base case, n o reforms, l o w growth 27.7 26.4 0.55 0.90 14: base case, n o reforms, high growth 28.9 27.8 0.25 0.55 12 + 8 p.p. cut in UST rate 21 .o 2.45 14 + 8 p.p. cut in UST rate 22.0 2.15 Scenarios of Group I1 22: 4 p.p. cut in UST rate, expanded tax base, l o w growth 23.4 22.7 1.70 2.05 24: 4 p.p. cut in UST rate, expanded tax base, high growth 24.7 23.8 1.35 1.70 Scenarios of Group I11 32: Scen. 22 + increase in the retirement age, l o w growth 35.5 33.0 34: Scen. 24 + increase in the retirement age, high growth 37.1 34.8 Scenarios of Group IV 42: Scen. 32 + reduction o f UST privileges, low growth 36.4 33.8 44: Scen. 34 + reduction o f UST privileges, high growth 38.0 35.7 Scenarios o f Group V Scenario 12 + annual immigration o f 300,000 28.0 0.50 Scenario 12 + annual immigration o f 500,000 29.1 0.20 Note: Fiscal costs measured against a target o f maintaining the replacement rate at 30 percent. 137 4.104 Additional policy reforms, related mainly to a twofold increase o f the contribution rate for the self-employed and further elimination o f tax exemptions, may lead to a modest additional growth in the affordable replacement rate by about 1 percentage point. 4.105 Based on these findings the following recommendations on pension policy could be suggested: The simulations confirm the need to supplement the proposed reduction in the pension contribution rate with a set o f decisions, such as a gradual increase in the retirement age, aimed at a longer-term sustainability o f the pension system and an increase in the real value o f future pension benefits. A decision o n the retirement age i s critical for longer- term prospects o f the pension system. Further delaying this decision leads to high social and political costs in terms o f reduction o f the relative value o f future pension benefits, and, as argued in this Chapter, i s likely to trigger significant longer-term budget liabilities. Moreover, the political difficulties o f rising the retirement age may increase in the future as the population continues to age. The second best solution with respect to the retirement age increase, given the political sensitivity o f the issue, would be the introduction o f amendments to the Pension Law, which would modify the formula that defines the amount o f retirement benefit in a way that create much stronger incentives to delay retirement voluntarily. Trends in the share o f the taxable payroll in GDP will play a critical role in determining future results o f pension reform. This highlights the importance o f policies aimed at stabilizing income and payroll taxation (to facilitate stability o f taxpayers’ expectations), as well as at the removal o f various administrative barriers in the economy that currently hold back reduction o f shadow incomeslwages. I t seems unlikely that more radical cuts in the UST rate (in excess o f 4 percent points) could be compensated for by the combined positive impact o f the tax base expansion and an increase in the retirement age. Under the circumstances, the first best strategy for reducing the UST rates would be to avoid longer-term commitments regarding future additional cuts in the contribution rate that would exceed 4 p.p. I t may be rational to do tax rate reductions in stages -- giving the system some time to stabilize after the initial round o f UST rate cut o f 4 p.p., and after accumulating certain experiences o f operating with new parameters, planning for next steps o f tax cuts and pension reforms. 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World Bank Administrative and Civil Service Reform Web-Site. http://www 1.worldbank.org/publicsector/civilservice/index.html World Bank Public Sector Employment and Wage Database. http://www 1.worldbank.org/publicsector/civilservice/development.htm World Health Organization (WHO) http://www.who.org. Yasin, Yevgeny. 2003. Nerynochnyi Sektor. Structurnuye Reformy i Ekonomicheskii Rost. Moscow: Liberal’naya Missiya Foundation (in Russian). Zolotareva, Anna. 2002. “Nefinansiruemuye Federal’nuye Mandaty.” Institute o f Economic Transition. Moscow. Mimeo. 144 ANNEXES ANNEX2.1. DEFINITIONS ON CIVIL SERVICE REFORM The following definitions o n Civil Service are used in Chapter 2. Federal Civil Service includes a l l employees o f the federal executive, legislative, judiciary and other federal bodies (these bodies include the Accounting Chamber, Central Election Commission, and the Apparatus o f the Plenipotentiary o n Human Rights) that enjoy the status o f federal c i v i l servants and are financed from the federal budget. Employment o f federal c i v i l servants i s regulated by the framework L a w o n State Service System enacted in M a y 2003. Subnational Civil Service includes all employees o f the regional and municipal executive, legislative, judiciary and other regional and municipal bodies that have the status o f c i v i l servants o f subjects o f Federation or municipal servants and are financed from the regional and municipal budgetsg2. Employment in subnational c i v i l service i s regulated by c i v i l service and municipal service legislation (including federal legislation o n municipal service and regional legislation o n c i v i l service at the regional level). Categories of Civil Servants refer to the groups o f c i v i l service positions used, inter alia, for determination o f cash compensation, in-kind benefits, and the like. A detailed table o n the existing categories o f federal c i v i l servants i s presented in Annex 2.2. Core Government Administration Employment includes federal and subnational c i v i l service, as w e l l as other employees o f the executive, legislative, judiciary and other authorities that do not have the status o f federal/subnational c i v i l servants (employment o f such employees i s usually regulated by Labor Code)93 that are performing functions not related to maintaining public order and internal security. Core government administration employment includes employees o f the federal authorities that are either headquarter- based or deconcentrated (but in any case financed directly f r o m the federal budget) and employees o f regional and municipal authorities (financed f r o m subnational budgets). Civilian Public Sector Employment includes employees o f health, education, research and development, and other social sector branches financed f r o m the federal, regional, and municipal budgets. Staff o f the Ministry o f Education, Ministry o f Health, etc., i s not 92The term includes both “civil service o f a subject o f the Federation” - a category used in accordance with the new Law “On the System of State Service in the Russian Federation” No.58FZ dated May 27, 2003 - and municipal service. Civil service o f a subject of the Federation i s to be financed from the regional budgets. Civil servants of the subjects o f the Federation may also be financed from the federal budget, if there i s an appropriate provision to this effect included in a federal law. Municipal servants are financed from sub-national budgets. 93In some cases, government employment may be regulated by specific legislation, such as a Law on Customs Service. For example, all uniformed and managerial staff (division heads and above) in the State Customs Committee are not counted as civil servants, but as customs servants. At the same time, some technical and support staff, a s well as temporary employees working in the government agencies are not considered civil servants, and their employment i s regulated by the Labor Code. I t i s expected that during the implementation of civil service reform, the legal framework would become simpler and more systematic. 145 included in this category as they are part o f the above mentioned category o f core government administration employment. Police Service includes all employees o f the authorities responsible for maintaining public order and internal security. Police service includes, inter alia, Federal Security Service, Ministry o f Interior, etc. Armed Forces include all personnel employed by military authorities (i.e., Ministry o f Defense, military officers and solders). General Government Employment includes core government administration employment, civilian public sector employment, police service and armed forces94. Total Public Employment includes general government employment and SOE employees (employees o f enterprises that are majority-owned by the government). SOE employment and wages are beyond the scope o f this Chapter. The definition i s listed here primarily for the purposes o f cross-country comparisons. 94 This definition corresponds to the one adopted in the International Standard o f Industrial Classification o f All Economic Activities (ISIC). According to the ISIC, General Government refers to employment in “all government departments, offices, organizations and other bodies which are agencies or instruments o f the central or local authorities whether accounted for or financed in ordinary or extraordinary budgets or extra- budgetary funds. They are not solely engaged in public administration, but also in defense and public order, in the promotion o f economic growth and in the provision o f education, health, cultural and social services.” (International Standard o f Industrial Classification o f All Economic Activities (ISIC), Series M No.4, Rev 3 - 1990). 146 The main components o f the government employment are illustrated in Figure A2.1, : Figure A2.1: Total Public Employment in the Russian Federation I I. a I T O T A L PUBLIC EMPLOYMENT General Government S O E Employees Employment / t Civilian Public Core Government 1 I Sector Administration Police Service I I Empolyment Employment I I I Health, Physical Federal I Culture and Sports, Authorities Armed Forces I Social Services I I I I I - HI2 - based I I I I I I I I I I - federal civil servantdII I I I I - other employees I I Research and Development Municipal i subnational civil service I \ ; '-_______-_-_-______ other employees General Government Sectors Analysed in this Note Notes: Sectors in Civilian Public Sectors are divided in accordance with Rosstat (2002b). Sectors of the general government analyzed Chapter 2 are depicted inside the dot line area. Cash Compensation refers to an average monthly amount o f the base salary and a l l other payments in cash received by an employee for services rendered, including payroll taxes. Wage Bill refers to the total annual amount o f cash payments t o a l l public employees in return for services rendered before deduction o f payroll taxes. I t i s calculated by multiplying cash compensation by the number o f employees and by twelve (the number o f months). Non-Monetary Benefits refer to all in-kind benefits, such as transportation, housing, meals, travel, but do not include intangible rewards, including j o b security, prestige, social privileges, training, trips abroad (see Annex 2.3 for classification o f public servants' both contractually provided and intangible rewards). Non-Wage Expenditures refer to overhead costs o f providing public services and include costs o f office maintenance, equipment, s t a f f training, etc. For purposes o f this Chapter, 147 these expenditures are calculated for core government administration only and represent a difference between total expenditures on core government administration and the sum o f the wage bill, payroll taxes, and identifiable non-monetary benefits. Compression Ratio for Federal Executive HQ-Based Civil Service i s estimated as a ratio between the average pay to federal executive HQ-based servants holding positions classified as Category C Top Group and average pay to federal executive HQ-based servants holding positions classified as Category C Junior Group. In this case, pay includes all monetary payments to civil servants. Compression Ratio for Federal Executive Civil Service i s estimated as a ratio between the average pay to federal executive HQ-based servants holding positions classified as Category C Top Group and average pay to federal executive servants employed in deconcentrated units and holding positions classified as Category C Junior Group. In this case, pay includes all monetary payments to c i v i l servants. Internationally, there i s no methodological consensus for estimation o f compression ratios, The W o r l d Bank website and database estimate the compression ratio as a ratio o f the highest salary to the lowest o n the central government’s main salary scale. The OECD measures wage compression in OECD countries as the mean o f ninth decile salaries divided by the mean o f first decile salaries. The OECD’s approach ensures that a handful of salaries will not dramatically skew the compression ratio. Given that the base salary paid to the c i v i l servants in Russia represents only a part o f total monetary payments made to c i v i l servants and the provisions o f the draft Federal L a w “On State Civil Sewice of the Russian Federation ” suggest that this situation would continue to be the case in the future (see HSE (2003) for more specific analysis), for the purpose o f t h i s Chapter the compression ratios were estimated based o n the average monetary payments to the officials holding positions in Category C Top Group (a proxy for high level officials) as compared to the average payment in Category C Junior Group (a proxy for the lowest grades in the service). Because o f this methodological difference, the cross-country comparisons in this Chapter may be used primarily for reference rather than for policy deliberations Civil Service R e f o r m includes a l l reform efforts affecting the functions, structure, and employment o f core government administration employees. In Russia, unlike in most other countries, the government makes a clear distinction between c i v i l service and public administration reforms, which derives from the division o f responsibilities for preparation o f these two reform packages among different commissions within the Govemment. However, the two are interrelated (in fact, the pay reform, which forms an integral part o f civil service reform, i s an important condition o f implementation o f the administrative reform, as it would supposedly reduce the internal opposition within the c i v i l service to restructuring efforts). For the purpose o f this Note, administration reform i s considered as a component o f the overall c i v i l service reform agenda. Attrition denotes the amount o f actual staff reduction and i s estimated as a difference between the staffing levels at the beginning o f the reform and staffing levels at the end o f the reform. 148 I I : 4 t! 4 Y I I 3 t ANNEX2.3. CLASSIFICATION OF C I V I L SERVANTS REWARDS The basic classification o f civil servants rewards used for cross-country comparisons i s presented in the figure below. Figure A2.2: Civil Servants Rewards Classification Source: World Bank Public Administration Website. Most o f the rewards listed in the figure are also applicable to federal and subnational civil servants in Russia. However, the structure o f monetary rewards included in the wage bill i s more complicated than shown in this figure. In addition to base wageisalary it usually includes allowances for grade, years in employment, as w e l l as performance bonuses and other cash payments. I t should be noted that there i s a tendency to substituting in-kind allowances for transportation, housing, meals and travel (especially in the police service and armed forces) with cash allowances. 152 ANNEX2.4. INTERNATIONAL PUBLIC SECTOR PAY AND EMPLOYMENT 1996-2000” DATA, Countries Public Sector Employment (%of Total Central Govt. Average population) Wage bill (Civilian central and Armed Forces) govt. wage to per Civilian Subnational Education % of % of capita GDP Central Govemment and Health GDP govt. ratio Govemment Employees expend. High-Income OECD Countries Australia 0.8 2.1 3.8 2.1 2.6 1.3 Canada 1.1 2.1 5.0 1.6 10.4 1.5 France 3.6 2.4 3.2 4.5 15.9 1.o Germany* * 1.o 5.1 1.o 7.9 0.9 United Kingdom 3.1 3.4 3.0 1.5** 5.9 1.4 United States 1.o 5.9 3.8 1.4 8.4 1.4 Transition Economies Bulgaria 0.4 0.4 2.2 5.2 7.9 1.o Czech Republic 4.8 2.3 1.o 2.7 8.1 0.8 Hungary 1.5 1.6 4.5 7.3 8.6 0.7 Kazakhstan 0.0 0.5 5.1 4.9 9.7 0.9 Poland 0.4 0.3 2.1 7.6 1.4 Russia*** 0.4 0.5 6.0 1.2 4.5 1.0 Ukraine 1.1 3.9 8.7 1.2 Developing Countries with Federal System Brazil 0.3** 1.3** 1.8** 12.2 16.5 India 0.3 0.6 0.4 1.8 11.0 4.8 Mexico 0.7 0.7 0.3 2.6** 24.9 1.1 Regional Averages**** Africa 0.9 0.3 0.8 6.7 5.7 Asia 0.9 0.7 1.o 4.7 3.0 Eastem Europe and 1.o 0.8 5.1 3.7 1.3 Former USSR Latin America and 1.2 0.7 1.1 4.9 2.5 Caribbean Middle East & 1.4 0.9 1.6 9.8 3.4 North Africa OECD 1.8 2.5 3.4 4.5 1.6 Overall 1.2 1.1 2.4 5.4 3.0 *Data are for the latest year available. ** Latest data available i s for 1991-95. ***For Russia data i s for 2002, Central Govemment includes employees o f the federal authorities (both HQ- based and deconcentrated, but does not include Ministry o f Interior. ****Regional data i s for early 1990s based on sample cross-country survey. Source: World Bank Public Sector Employment and Wage Database, Rosstat, Schiavo-Campo, et al., “Government Employment and Pay in Global Perspective: A Selective Synthesis of International Facts, Policies and Experience, ” World Bank (1997). 153 ANNEX2.5. ASSUMPTION ADMINISTRATION A ON CORE GOVERNMENT TTRI T O I N RATES Table A2.3: Significant Administrative Reform (Attrition Rates) Employment Reduction Assumptions, Executive, Category C Group Federal HQ Federal Deconcentrated Subnational TOP 25% 25% 35% Chief 20% 20% 30% Lead 20% 20% 30% Senior 15% 15% 25% Junior 15% 15% 25 % Other 20% 20% 30% Table A2.4: Fair Administrative Reform (Attrition Rates) Employment Reduction Assumptions, Executive, Category C Group Federal HQ Federal Deconcentrated Subnational TOP 10% 10% 20% Chief 10% 10% 20% Lead 10% 10% 20% Senior 7% 7% 17% Junior 7% 7% 17% Other 7% 7% 17% 155 E N OI e z a c c N I- e c N = e z w z c 0 c p1 Cr c c p1 p1 c 5 E c p1 ANNEX2.6. INTERPRETATION AND ANALYSISOF RESULTS: IMPACT OF INDIVIDUAL FACTORS As shown in Table 2.12 o f the main text, the estimated annual fiscal costs o f the reform scenarios vary significantly both in the mid-term perspective (between 1.3 and 3.3 GDP p.p. for 2006 as compared to 2003) and in the long term (between 1.2 and 4.2 GDP p.p. for 2010 as compared to 2003). In this annex we analyze the sensitivity o f these results to the key parameters used in the simulations (macroeconomic parameters, extent o f pay reform, pace o f reform and extent of administrative reform). Our cost estimates are generated as additional government expenditures (in pep. o f GDP) needed to finance operations o f both government administration and civilian public sector as a result o f the proposed reforms. Sensitivitv to macroeconomic parameters. The results o f the simulations proved that potential fiscal costs o f c i v i l service reform are quite sensitive to relative growth rate o f private sector wages, and respectively to the changes in the share o f the total payroll in GDP. To illustrate this sensitivity, three groups o f reform scenarios were selected: (i) radical pay reform combined with significant administrative reform implemented at a high pace, Le., within 2004-2006 (scenarios 4, 16, and 28); (ii) moderate pay reform combined with fair administrative reforms and implemented at a medium pace, Le., in the period from 2004 to 2008 (scenarios 8,20, and 32); and (iii) moderate pay reform implemented during 2004 - 2010 with no administrative reform (scenarios 5, 17 and 29). Within each group, there i s a considerable variation o f the growth - (relative to GDP growth) - in private wages, ashescribed in Table 2.5 in Section D. Figure A2.3: Sensitivity of Civil Service Reform Costs to Real Wage Growth” 45 b c? 40 c 35 f Scenario 16 30 0 Scenario 28 - 0 Scenario 6 1 2 5 f w Scenario 20 2 20 Scenario 32 15 w Scenario 5 5 0 Scenario 17 5 -1 Y 05 0 c 00 I 2004 2005 2006 2008 201 0 Source: Staff estimates. 95 Scenarios 4, 16, and 28 all assume a radical pay reform undertaken at high pace and accompanied by significant administrative reforms, but they differ by the growth rate in private sector wages. Respectively, scenarios 8, 20, and 32 all assume moderate pay adjustment at medium pace, and fair administrative reform effort, but the same difference in private wage growth. Scenarios 5, 17, and 19 assume moderate pay reform at a l o w pace and no administrative reform at all, while the same variation by wage growth remains intact. 157 As may be seen from Figure A2.3, the same reform scenario implemented in a situation when the real wages growth rate exceeds the GDP growth rate by 2 p.p. (Scenarios 4, 8 and 5) will be significantly more expensive for the budget that the one implemented in a situation when the share o f real wages in GDP doesn’t change over time (Scenarios 28, 32, and 29). As a result, variation in total budget costs within each group o f scenarios amounts to 1.1 to 1.4 pap,o f GDP. A decrease in relative real wages growth by 1 p.p. leads to about 0.4 - 0.7 percent o f GDP in annual budget saving for the end o f the reform period. I t i s notable that the degree o f sensitivity to changes in relative wage growth varies among different groups o f scenarios: it i s higher for scenarios without any administrative adjustments (Scenarios 5, 17, and 29), and lower for scenarios with administrative reform (Scenarios 4, 16 and 28 that assume radical pay adjustment and Scenarios 8, 20, and 32 that assume moderate pay changes). Such cost variation i s explained by the fact that Scenarios 5, 17 and 29, while leaving a significant residual pay gap, assume n o any attrition. Thus, a much larger number o f core government administration and particularly civilian public sector employees benefit from the pay increase, and the stronger effort to close the compensation gap leads to more serious fiscal implications relative to the scenarios assuming significant attrition in civilian public sector and at least some attrition in core government administration. Overall, the more ambitious the pay reform, the more volatile are its fiscal costs. The above findings with respect to sensitivity o f total reform costs to changes in the real wage growth remain valid when we look separately at the variation o f costs associated with a narrower task - reform o f the core govemment administration only (Figure A2.4). Figure A2.4: Sensitivity of Civil Service Reform Costs to Real Wage Growth (for Core Government Administration Only)96 2.0 Scenario 4 0 4 ( 3 - 1.5 Scenario 16 0 Scenario 28 0 Scenario 8 W Scenario 2C D l Scenario 3; Scenario 5 0 Scenario 17 2004 2005 2006 2008 201 0 Source: StafJ’ estimates. 96 See the previous footnote for a description of the scenarios. 158 Sensitivitv to the depth ofpav reform. It i s clear that the scenarios assuming radical pay reform tend to be associated with larger fiscal costs than those assuming a more moderate approach to closing the public-private compensation gap. To illustrate the difference in costs, two pairs o f reform scenarios were selected: (i) a radical pay reform to be implemented within 2004 - 2008 with moderate administrative changes (Scenario 13) and the same administrative reform effort but combined with a moderate pay reform (Scenario 20); and ( ii ) a radical pay reform to be implemented within 2004-2006 with significant administrative reforms (Scenario 16) and the same administrative reform effort but combined with a moderate pay reform option (Scenario 24). All these scenarios are cost out under the same wage growth assumptions. Figure A2.5: Total Fiscal Costs of Civil Service Reform: Radical versus. Moderate Pay Reform9' 2 2 3.00 $ 2.50 t - c n 2.00 Scenario 13 5 1.50 6 Scenario 20 H Scenario 16 g = I + O 1.00 E Scenario 24 r" 0.50 0.00 + 2004 2005 2006 2008 2010 I c) Source: Stafestimates. The results o f the comparison are presented in Figure A2.5. that confirms that the radical pay reform aiming at a 50 percent residual public-private compensation gap i s o n average about 1.5 times as expensive as the moderate pay reform that allows for 100 percent public-private compensation gap at the end o f the reform process. T h i s difference becomes less extreme when we consider separately the costs o f reform for core government administration (Figure A2.6). Although the proposed pay increase in the civilian public sector i s lower than the one in core government administration, the much larger number o f civilian public sector employees has a major influence o n the total cost difference. 97Scenario 13 assumes a radical pay reform t o be implemented within 2004-2008 with moderate administrative changes. Scenario 20 assumes a moderate pay reform under the same administrative reform effort. Scenario 16: a radical pay reform to be implemented within 2004-2006 combined with significant administrative reforms. Scenario 24: a moderate pay reform but the same administrative reform effort. 159 Figure A2.6: Fiscal Costs of Civil Service Reform: Radical versus Moderate Pay Reform (Only Core Government Administration Covered)'' E 2.00 , Scenario 13 Scenario 20 Scenario 16 0 Scenario 24 - 2004 2005 2006 2008 2010 Source: Staffestimates. The extent o f the pay reform influences several components o f the overall fiscal costs in our model, including both direct implications (such as increase in cash compensation, staff attrition costs, and increased P I T collection), and indirect implications (increased non-wage expenditures), which in our model are a function o f the wage bill and the administrative reform pattern. Table A2.6 presents information o n relative importance o f different components o f incremental costs. See the previous footnote for a description o f the scenarios. 160 Table A2.6: Fiscal Costs o f Civil Service R e f o r m for the Selected Scenarios (as p.p. of GDP) Scenario 2004 2005 2006 2008 2010 Medium-Paced Radical Pay Reform with Fair Administrative Adjustment (Scenario 13) Core Government Administration 0.58 0.82 1.05 1.47 1.58 Cash Compensation 0.50 0.64 0.78 1.05 1.10 Non- Wage Expenditures 0.13 0.24 0.34 0.52 0.59 StaffAttrition Costs 0.01 0.01 0.01 0.01 0.00 Increased PIT Collection -0.05 -0.07 -0.08 -0.11 -0.12 Civilian Public Sector Employment 1.09 1.18 1.23 1.16 1.09 Cash Compensation 1.17 1.27 1.31 1.22 1.20 StaffAttrition Costs 0.03 0.04 0.04 0.05 0.01 Increased PIT Collection -0.11 -0.12 -0.13 -0.12 -0.11 Total Costs 1.67 2.00 2.27 2.63 2.67 Medium-Paced Moderate Pay Reform with Fair Administrative Adjustment (Scenario 20) Core Government Administration 0.49 0.63 0.78 1.03 1.13 Cash Compensation 0.43 0.51 0.58 0.73 0.77 Non- Wage Expenditures 0.09 0.17 0.25 0.37 0.44 Staff Attrition Costs 0.01 0.01 0.01 0.01 0.00 Increased PIT Collection -0.04 -0.05 -0.06 -0.08 -0.08 Civilian Public Sector Employment 0.96 0.94 0.88 0.64 0.58 Cash Compensation 1.03 1.oo 0.93 0.65 0.63 StaffAttrition Costs 0.03 0.03 0.04 0.05 0.01 Increased PIT Collection -0.10 -0.10 -0.09 -0.06 -0.06 Total Costs 1.45 1.58 1.66 1.67 1.71 High-Paced Radical Pay Reform with Significant Administrative Adjustment (Scenario 16) Core Government Administration 0.90 1.25 1.53 1.65 1.77 Cash Compensation 0.58 0.79 0.96 1.01 1.06 Non- Wage Expenditures 0.37 0.53 0.67 0.75 0.82 StaffAttrition Costs 0.01 0.01 0.01 0.00 0.00 Increased PIT Collection -0.06 -0.08 -0.10 -0.1 1 -0.11 Civilian Public Sector Employment 1.16 1.24 1.19 1.11 1.09 Cash Compensation 1.22 1.29 1.24 1.22 1.20 Staff Attrition Costs 0.06 0.07 0.07 0.01 0.01 Increased PIT Collection -0.12 -0.12 -0.12 -0.12 -0.11 Total Costs 2.06 2.49 2.73 2.11 2.86 High-Paced Moderate Pay Reform with Significant Administrative Adjustment (Scenario 24) Core Government Administration 0.69 0.84 0.95 1.06 1.16 Cash Compensation 0.43 0.50 0.56 0.60 0.64 Non- Wage Expenditures 0.29 0.37 0.44 0.52 0.59 Staff Attrition Costs 0.01 0.02 0.01 0.00 0.00 Increased PIT Collection -0.04 -0.05 -0.06 -0.06 -0.07 Civilian Public Sector Employment 0.95 0.84 0.67 0.60 0.58 Cash Compensation 0.99 0.86 0.67 0.65 0.63 StaffAttrition Costs 0.05 0.06 0.06 0.01 0.01 Increased PIT Collection -0.09 -0.08 -0.06 -0.06 -0.06 Total Costs 1.64 1.68 1.62 1.65 1.74 Source: Staffestimates. 161 The affordability issue o f radical pay reforms becomes even more critical when one considers the distribution of the additionalfiscal burden between the federal and sub-federal f the budget system presented in Figure A2.7. T o illustrate the difference in the fiscal levels o implications we considered radical and moderate pay reform scenarios implemented at a medium pace, Le., within 2004-2008, and accompanied by fair administrative reform efforts (scenarios 13 and 20). Figure A2.7: Fiscal Implications for Federal and Sub-Federal Budgets for Radical and Moderate Pay Reforms” 1.8 7 1 z’ 1.6 1.4 d E 1.2 p 1.0 - P c) 0.8 0.6 5 04 ; - 0.2 d 0.0 + 0 2004 2005 2006 2008 2010 Scenario 13 (Federal Budget) 0 Scenario 13 (Sub-Federal Budgets) Scenario 20 (Federal Budget) Scenario 20 (Sub-Federal Budgets) Source: Staff estimates. Figure A2.7 shows that the sub-federal budgets would be much more affected by higher fiscal pressures than the federal budget: costs for subnational budgets are almost 1.5 times higher than for the federal budget. Even increased collection o f P I T by subnational governments doesn’t compensate for the fact that most o f public employees in Russia are paid from subnational budgets, which as a result become more affected by the proposed pay adjustment. Sustainability o f the sub-federal finances would call for a substantial increase in transfers from the federal budget complemented by a significant increase in the revenue base for sub-federal budgets. As discussed in Section D, the pay reform has two major tasks: improving external competitiveness o f the core government administration and the civilian public sector and instilling internal performance incentives through internal decompression o f pay in the core government administration. The results o f our simulations confirm that the magnitude o f pay adjustment affects the compression ratios in the executive branch (Figures A2.8 and A2.9). To illustrate this effect, we selected 6 reform scenarios: (i) Scenarios with radical pay adjustments implemented in various macroeconomic conditions (scenarios 4, 16, and 28); and (ii) Scenarios with moderate pay adjustments implemented in various macroeconomic conditions (scenarios 8,20, and 32). Figure A7.6 shows that both radical and moderate pay adjustments result in significant decompression in HQ-based c i v i l service, from the ratio between average wages in Top and Junior Groups of 2.5 in 2002 to 5.2-8.3 in 2006 and to 6.8-8.3 in 2010. At the 99 Both scenarios 13 and 20 assume implementation o f reforms at a medium pace and accompanied by fair administrative reform efforts and by medium growth rates o f private wages. However, scenario 13 provides for a radical pay reform, while scenario 20 for a moderate one. 162 same time, the decompression effect i s stronger for the scenarios with radical pay adjustment. This can be explained by a combined effect o f the t w o parameters used for simulating p a y adjustment: residual public-private sector gap and minimum p a y increase. In the scenarios that assume a radical pay reform (Scenarios 4, 16, and 28), the residual public- private pay gap i s smaller, and hence, most o f the wages in core government administration are increased by a factor exceeding the minimum pay increase o f 30 percent. As a result, the salary structure i s brought closer t o the private sector comparators, and the decompression ratios are higher. Reversely, in the scenarios that assume moderate pay adjustment (Scenarios 8, 20 and 32), the rule o f minimum pay increase (20 %) plays a greater role in determining expected wage growth for a lower level staff. Hence, the residual pay gap i s smaller than the average for lower grade staff, which moderates adjustment in the pay structure and results in smaller decompression. Figure A2.8: Internal Decompression in Federal Executive HQ-Based Civil Service: Radical versus Moderate Pay Adjustment"O Ia 9.0 1 i [3 Scenario 4 H Scenario 16 0 Scenario 28 0 Scenario 8 H Scenario 20 u E 2004 2005 2006 2008 201 0 Source: Staff estimates, This differentiation in decompression effort could also be seen f r o m the comparison o f the proposed pay increases for moderate and radical pay reform scenarios"' (Table A2.7). As one may notice, the ratio between the pay adjustment proposed for T o p and Junior Groups i s lower in the case o f moderate pay reform than in the case o f radical pay adjustments. Considering that for non-HQ-based staff (Le., for a great majority o f affected employees) w e propose pay increases that are only 50 percent o f those presented in Table A2.7, application o f the minimum p a y increase rule i s more frequent when w e simulate the dynamics o f wages for employees in both deconcentrated units and regional and municipal core government administration. looScenarios 4, 16, and 28 all assume a radical pay reform, but different growth rates o f private wages. Scenarios 8, 20, and 32 assume a moderate pay reform, but the same variation in private wage growth. lo' Note that in actual simulations these increases are further adjusted to reflect annual real wage growth in the private sector. 163 Table A2.7: gxisting Pay Gap and Proposed Pay Increases in Federal Executive HQ-based Civil Service, times Category C Actual Net Estimated Net Proposed Pay Increase Group Public-Private Public-Private Pay Pay Gap, 2002 Gap, 2003 (adjusted for actualpay Radical Moderate increases in 2003) Scenario Scenario TOP 7.8 6.5 4.3 3.3 Chief 5.7 4.7 3.1 2.4 Lead 5.1 4.2 2.8 2.1 Senior 3.6 3.0 2.0 1.5 Junior 2.3 1.9 1.3 1.2* * Minimum pay increase is applied. Source: Staffestimates; see also Table 4.2. This trend towards decompression i s even stronger in case the compression index captures both H Q and deconcentrated units o f federal executive civil service (Figure A2.9), because, as was mentioned above, the proposed pay adjustment for deconcentrated service i s smaller and based on local labor market prices. Adopting separate pay scales for HQ-based and deconcentrated civil servants leads to a drastic increase in internal compression ratios from 3.7 in 2002 to about 10-12 in 2010. Figure A2.9: Internal Decompression in Federal Executive Civil Service: Radical versus Moderate Pay 102 Adjustment 3 130 'E v) 120 ?= 11.0 Scenario 4 80 Scenario 16 70 0 Scenario 28 a8 60 0 Scenario 8 ;$ 50 Scenario 20 Scenario 32 T m 30 20 55 10 'f 0.0 2004 2005 2006 2008 2010 V ~~~~ ~ Source: Staffestimates. Pay reform ,Dace and overall affordability of reforms. A brief review o f summary results for all 36 scenarios presented in Table 5.4 points to several reform combinations that do not seem at the moment affordable to the Russian government budget. If we assume that the increase in total fiscal costs should be lower than 1.7 GDP p.p.lo3 in 2004 as compared to '02See the previous footnote for a description o f the scenarios. lo' Significant pay increase in core government administration and civilian public sector implemented in October 2003 already suggests substantial increase o f financing in 2004 as compared t o 2003. Therefore, the assumption for fiscal costs growth for 2004 i s set at quite a high level. 164 2003, and/or in 2006 - 2.3 p.p. o f GDP respectively, andor in 2010 - 2.7 p.p. o f GDP, then the following two groups of scenarios become hardly affordable for the budget: (9 scenarios assumin implementation o f radical pay reforms (Scenarios 1-4, 13-1 6 and 26-28 1%4) especially those assuming implementation o f radical pay adjustments at a high speed, Le., within 2004-2006 (Scenarios 3,4, 15, 16, 27, and 28); (ii) implementation o f pay reforms without any administrative reform actions (Scenarios 5,7, 10, 17, 19,22,29, 3 1,34) regardless o f options for private wage growth dynamics. This preliminary review leads us to two major conclusions. Firstly, signzjkant attrition in civilian public sector and at least some attrition in core government administration is a precondition for successful implementation o f civil service reform. Secondly, radical pay increase for public sewants is not affordable to the budget, especially f considered in the 3-year implementationframework. i Taking the above into account, we focus on a moderate pay reform with fair administrative reform efforts to illustrate the impact o f the pay reform pace o n fiscal costs in 2004-2010 (Figures A2.10 and A2.11). Figure A2.10: Distribution o f Total Fiscal Burden o f Civil Service Reform Scenarios, Depending upon 105 Pay Reform Pace I 8 CL 2.0 1.8 4 1.6 1.4 Scenario 20 - e 0.8 $ 0.6 0 Scenario 23 0.4 0.2 w 0.0 t I- 2004 2005 2006 2008 201 o Source: Staff estimates. Figures A2.10 and A2.11 illustrate that although there i s some variation in annual fiscal costs depending on the pace o f reform implementation, and it should be taken into account in the context o f other forthcoming fiscal challenges (such as peaks in public debt reduction), yet the variation i s not very large. T h i s can be explained by the fact that the fiscal implications o f the civil service reform consist mostly o f the increased current expenditures: indeed, the only type o f one-time expenditures captured by our simulations are the costs associated with attrition, and those are not very high (see Table 2.12)'06. Moreover, to sustain the reform achievements, the consolidated budget would have to accommodate annual indexation o f pay in the core government administration and civilian public sector in line I O 4 However, the simulations show that implementation o f radical pay adjustments at moderate pace i s a viable option in case the share o f the real wages in GDP remains constant (see Scenario 25). 'Os Scenarios 18, 20, and 23 assume different pace o f pay reforms, but all provide for a moderate pay adjustment, fair administrative reform effort, and medium growth in private sector wages. I O 6 As discussed above, we do not try to evaluate investment costs associated with public service modemization in the scope o f this Note. 165 with real wage growth in the private sector. Because in our example the scenarios 18,20, and 23 are implemented under the conditions o f accelerated real wage growth as compared to GDP growth, the fiscal costs o f reforms in scenario 18 and 20 (which assume the completion o f reforms in 2006 and 2008, respectively) continue growing even after the reforms have been completed. Figure A2.11: Distribution of Fiscal Burden o f Civil Service Reform Scenarios, Depending upon Pay Reform Pace (Only Core Government Administration Covered)”’ B 1.2, 0 2004 2005 2006 2008 2010 Source: Staff estimates. Administrative reform magnitude. Three additional scenarios illustrate potential cost differences associated with different scopes o f administrative reform: (9 scenarios with “no administrative reforms” assumed some increase in the employment levels in core government administration and civilian public sector with a reduction o f the share o f non-wage expenditures in total expenditures o n core government administration to 25 percent; (ii) “fair effort” in administrative reform assumed that executive core government employment will be slightly reduced, and employment in the civilian public sector will be reduced (based o n the defined ratios between staffing levels in the sectors that provide these services and numbers o f their clients) with the share o f non- wage expenditures in total costs o n core government administration moderately reduced to 32 percent from 37 percent in 2002; (iii) “significant administrative changes” that assume, in addition to the adjustment for civilian public sector employment described above, higher attrition rates for core government administration and sustainability o f the share o f non-wage expenditures in total costs o f core government administration at the level o f 36 percent. To illustrate the cost variation under different scenarios o f administrative reform implementation, we compared three options Figure A2.12) for a moderate pay reform scenario implemented at a medium pace (i.e., between 2004 and 2008) and accompanied with: (i)no administrative reform (scenario 19); (ii) fair administrative reform (scenario 20); and (iii) significant administrative reform (scenario 2 1). See lo’ the previous footnote for a description of the scenarios. 166 Figure A2.12: Total Fiscal Costs o f Civil Service Reform for Different Scenarios of Administrative Reform Implementation (p.p. o f GDP a s compared to 2003)10s p 3.6 0 3.4 3.2 0 3.0 2 #- 2.8 2.6 2.4 g, 2.2 g 2.0 1.8 5 1.6 0.8 1 0.6 2 0.4 0.2 0.0 2004 2005 2006 2008 2010 Source: Staff estimates, Figure A2.12 shows that pay reform implemented without attrition clearly drives the total fiscal costs o f the reform too high (with additional costs reaching about 2 percent o f GDP by 2010). The results o f the estimates for fair and significant reform scenarios (20 and 21) do not vary significantly because the key administrative reform component (attrition rates for the civilian public sector employment) i s the same for both scenarios. C i v i l service reform with significant administrative changes requires more financing for non-wage expenditures, which makes scenario 2 1 slightly more expensive than scenario 20. 'Os Scenarios 19, 20 and 21 assume different scope of administrative reform, but all provide for a moderate pay adjustment, medium pace o f pay reforms, and medium growth in private sector wages. 167 Figure A2.13: Fiscal Costs of Civil Service Reform in Core Government Administrationfor Different Scenarios of Administrative Reform Implementation, pap.o f GDP'" r I 6 c 1.4 1.2 1 I .- 1.o $En e : 0.8 3 5 '0 0.2 0.0 2004 2005 2006 2008 2010 Source: Staff estimates. Similar estimates for the same reform scenarios but applied only to core government administration surprisingly yield a different cost pattern: in this case scenario 19 i s less expensive than scenario 20 (see Figure A2.13). To explain the reason for such a difference between the results in Figures A2.12 and A2.13, w e looked at the structure o f this expenditure increase. Figure A2.14 illustrates the dynamics o f the two key components o f total fiscal expenditures o n core government administration: increased spending for cash compensation o f employees (depicted by columns) and increased financing o f non-wage expenditures (depicted by lines). Figure A2.14: Fiscal Costs of Civil Service Reform in Core Government Administration: Dynamics of Cash Compensationand Non-Wage Expenditure Increase for Different Administrative Reform Scenarios - (p.p. of GDP a s compared to 2003)"0 1.2 , 1 0 P 2 1.0 0 Sc. 19, conpensation d Q 0.8 0Sc. 20, corrpensation d Sc. 21, conpensation 0.6 +FSc. 19, non-w age costs .- u -n-Sc. 20, non-w age costs f 0.4 +Sc. 21, non-wage costs z CI 5 0.2 Ir" 0.0 2004 2005 2006 2008 2010 Source: Staffestimates. Figure A2.14 illustrates two trends. Firstly, the more signiJicant the administrative changes and respectively employment cuts are, the lower is the Jiscal burden caused by pay increase. Secondly, the more signijkant the administrative changes are, the higher is the See the log previous footnote for a description o f the scenarios. It0 See footnote 10 for a description o f the scenarios. 168 pressure to increase non-wage expenditures on core government administration and finance public service modernization, H R reforms, etc. Therefore, the total fiscal implications o f the c i v i l service reform in core government administration will highly depend o n the dynamics o f the share o f non-wage expenditures in total structure o f core government administration financing - this dependence i s in fact so high that it reversed the costs pattern and brings a different trend for the total increase in fiscal expenditures o n core government administration as illustrated by the difference between Figures A2.12 and A2.13. Given that the scenario o f pay reform without any administrative changes i s unlikely to be selected because o f the higher overall fiscal costs (i.e., when increased financing o f the civilian public sector i s taken into consideration), we did additional analysis o f the fair and significant administrative reform scenarios in order to find a “breaking point” - the share o f non-wage expenditures in total expenditures o n core government administration that would s t i l l make the “significant administrative reforms” scenario more affordable than the scenario with the “fair administrative reforms”. To do this, we modified the assumptions used for estimating the costs o f scenario 21, The estimates showed that when the share o f non-wage expenditures i s equal or lower than 35 percent in the total structure o f core government administration expenditures, the scenario with significant administrative reforms becomes less costly than the one implying lower attrition rates (Figure A2.15). Figure A2.15: Fiscal Costs of Civil Service Reform in Core Government Administration for Different Scenarios of Administrative Reform Implementation (measured in pap.of GDP a s compared to 2003)”’ Scenario 20 2004 2005 2006 2008 2010 Source: Staff estimates. This observation underlines the fact that, while non-wage expenditures are often neglected in policy debates, they do play a key role in determining overall trends in costs o f core government administration, and thus they should be fully taken into account at the design stage of c i v i l service reforms. This finding also suggests that the total fiscal costs o f reforms (that account for the entire civilian public sector costs) may be underestimated in our ‘I1See footnote 10 for a description o f the scenarios. Scenario 21 (adjusted) i s similar t o Scenario 21, but has a share o f non-wage spending reduced t o 35%. 169 model because the simulations do not take into account the dynamics o f non-wage expenditures for the civilian public sector. 170 ANNEX3.1 MACROECONOMIC FRAMEWORK USED FOR THE ANALYSISOF FISCALCOSTS OF STRUCTURAL REFORMS T h i s work i s based o n the following approach to the development o f macroeconomic scenarios for the analysis o f the fiscal costs o f structural reforms. We took the government’s baseline macroeconomic projections for the period 2004-06, and used them as a basis for building a set o f macroeconomic scenarios, each o f which reflects a specific combination o f factors that are primary determinants o f Russia’s macroeconomic performance. We identified two such determinants o f Russia’s performance in the medium to longer term: external, which i s outside the government control, and internal, which depends o n government policies. Given the high dependency o f both the Russian economy and the government budget o n w o r l d o i l prices, their level was used as the external determinant o f macroeconomic trends. Following the government’s macroeconomic projections, we selected the same two benchmark values for the Urals o i l price: US$l8.5 per barrel and US$22.5 per barrel. With ongoing global economic recovery, it seems unlikely that o i l prices might decline below US$18.5 per barrel in the next two to three years. Beyond that, temporary price drops are possible, but it i s s t i l l unlikely that they would reduce the 10-year moving average o f the Urals o i l price to below the benchmark US$18.5 per barrel, which was the long-term average price before 1999. Thereby, our assumptions about future o i l prices appear to be fairly conservative and to allow a rather accurate reflection o f the possible “low case,” (Le., a macroeconomic slowdown caused by l o w o i l prices). The speed o f implementing reforms was the internal determinant o f macroeconomic dynamics. For this determinant we distinguish two cases: ‘no reforms’ and “advanced reforms” scenarios. The scenario without reforms reflects an inertial strategy o f dealing with major structural challenges, which i s similar to the reform strategy pursued by the government in 2001-03, when progress in most key structural reform areas was slow and incomplete. The advanced reforms scenario was built on the assumption that the implementation o f reforms would be accelerated, primarily in sectors such as energy, housing and utilities, public administration, pensions, and the investment climate. The characteristic features o f the advanced reforms scenario include, inter alia higher growth in domestic energy prices in the initial period (owing to aggressive reforms in energy and utilities) and high investment rates (owing to improvements in the investment climate and, more generally, to improved investment confidence in the environment o f stronger government reform commitment). At the same time, in the advanced reforms scenario we assume that the acceleration o f reforms may cause some shocks for the real sector, which would result in lower growth rates for the initial period. However, growth i s expected to p i c k up considerably in the medium term, when structural reforms would bring a significant pay-off. I t i s assumed that by 2010 the annual rates o f GDP growth under the advanced reforms scenario would exceed the rates under the n o reforms scenario, and by 2015 cumulative GDP growth under the advanced reforms scenario, would exceed that under the n o reforms scenario. The detailed presentation o f specific quantitative macroeconomic parameters used in simulations could be found in Tables 2.5, 3.13, 3.15, and 4.4 o f the main text, 171 I t i s worth noting that GDP growth rates assumed in our scenarios for the period 2004-06 are lower than those assumed in the corresponding government projections. Overall, we believe that without advancing the reforms growth rates * ill be declining: better utilization o f existing reserves in the economy, which was a critical growth factor in 1999- 2003, cannot support future growth in the same way as before because the reserves are to a large extent exhausted. At the same time, the advance reforms scenario implies that reforms are likely t o temporarily slow down GDP growth compared to the n o reform scenario, other things being equal. Therefore, in this case growth rates will also be lower than those assumed by the government. The consensus medium-term estimates for Russia’s economy made by investment companies, IFIs and NGOs for 2004-05 are rather favorable; everyone expects that in the most likely scenario the economy would grow at about 5.2 percent a year under the assumption o f a modest reform effort (no breakthrough) and favorable o i l prices (23-25 $/bbl). At the same time, almost all o f them predict the slowdown o f economic growth along with declining o i l prices. In this respect, our growth scenarios would not differ much from the alternative projections if the latter are recalibrated at our lower o i l prices. At the same time, it i s worth noting that the two out o f three models, used for costing structural reforms in this report, designed in a way that the main results (i.e. incremental fiscal costs) are not sensitive to the assumptions on economic growth. The growth parameter i s critical only for modeling the pension reform in Chapter 4. To reflect this, in the latter case we undertook an alternative set o f simulations based on the assumption o f 6 percent average growth for the period 2004-09. But even in this case we found quite a modest sensitivity o f the results t o the variation in the growth rate. A combination o f the o i l price scenarios with the reforms speed scenarios provides for the following set o f four possible macroeconomic scenarios. While each o f these four scenarios i s internally consistent, their combination allows the consideration o f rather a broad variation in possible macroeconomic trends. For instance, across-scenario variation in the projected average growth rate for 2004-06 would be between 2.3 and 5.0 percent, annual average inflation would vary between 9.0 and 12.3 percent, and real investment growth would be between - 5.7 and 7.7 percent. N o reforms Advanced reforms Moderate oil prices (1 8.5), low growth Scenario 11 Scenario 12 High oil prices (22.5 and higher), high growth Scenario 13 Scenario 14 We used the above framework for the analysis o f the fiscal implications o f specific structural reforms - pension reform, public administration reform, and housinghtility reform. In each o f these cases, we used the four macroeconomic scenarios as a basis o n which we design and elaborate further more detailed sub-scenarios o f specific structural reforms. 172 ANNEX3.2 MAIN DATA ASSUMPTIONS SOURCES AND DATA The simulation o f future costs o f the delivery o f housing and utility services, as well as estimates o f the associated demands for budgetary support were undertaken based o n the following data sources and assumptions (Table A3.1). Table A3.1: Basic Data Used in Simulations and Related Assumptions Indicator Comments 1. Average per capita household We used 2002 household income data as reported by the Rosstat (2003) income by region. Household Regiony Rossii. Social 'no-economicheskiye Pokazateli. income distribution, by region Related assumptions: (a) For the period of forecast, the average real per capita income assumed to grow at an identical rate across regions. (b) The income distribution by octile in each region would remain unchanged during the forecast period, Le., the shares of households in each octile remain the same (but region specific). Average income for each octile changes i s based on the assumptions about real income growth. The forecast was based on the actual household income distribution b y octile in 2002. 2. Share o f population groups that Two special population groups were identified: have much lower liabilities with (a) Families eligible for benefits on payments (Igoty) for housing and respect to housing and utility utility services, established by the federal legislation. These data were payments, by region based on the 2003 NOBUS survey. (b) Families that occupy housing units with permanent access to running water. These data were based on Rosstat reports for 9 months of 2003 (statistical report 22-ZhKH). The importance of separating this group relates to the fact that families without access to running water are, as a rule, occupants of sub-standard housing who do not have access to other most expensive utilities, such as district heat, sewage, and hot water. As a result, the overall costs of housing and utility services for the residents of this type of housing are considerably lower than the average. In practical terms, it means that those households in the units without running water never apply for housing allowances. 3. Monthly costs of delivering The model provides estimates for unit costs of delivering housing and housing and utility services per utility services using information on the federal standards for maximum 1 sq. m. of the occupied housing housing and utility costs per 1 sq, m. of housing in 2002, approved by the stock, by region federal government for each region (Government Decree No. 804 of November 19, 2001). The model (a) estimates the future national average costs o f housing under chosen assumptions, and then (b) differentiates these costs by region, based on the historical cross-regional cos1 differentiation in 2002. Related assumption: The regional proportions between housing costs will remain unchanged during the forecast period for all simulated scenarios. 4. Cross-subsidizationin tariffs Estimates are based on the data on actual energy and utility tariffs by types of consumers in early 2003 as reported by the Rosstat in Tseny i Tarijjfi I Zhilishno-kommunal 'nom Khozyaistve 2003. Issue 1 (15). January-March. Related assumDtion: Cross-subsidization in tariffs i s phased out in t w c years (2005-06) in two equal steps. 5 . Information on housing Rosstat Bulletin. Tseny i Tarffi v Zhilishno-kommunal 'nom Khozyaistve. allowances programs (total costs and number of recipients), by region 173 6. Estimates for budget Expenditures on utility services were estimated as the share of the reported expenditures on utility services budget expenditures on particular government functions and were based provided to budget organizations upon: data (in economic classification) on the execution of the consolidatedregional budgets in 2001 (source: www.budietrf.ru) data on the federal budget expenditures in 2001-03 and reports on the consolidated regional budget execution in 2002 (in functional classification) (source: www.minfin.ru) the findings o f the IUE survey for the Vologodskaya and Rostovskaya oblasts in 1999-2001 data on housing and utility prices and the norms of per capita consumption of these services in 2002 (source: Rosstat Bulletin. Tseny i Tarijjj v Zhilishno-kommunal 'nom Khozyaistve: 1(1 5), 2003) data of the Center for Facilitation of Penal Reform on the number of inmates and personnel in the penitentiary institutions as of 1 July 2003 data on the number of military and civil personnel in the Armed Forces, the Federal Border Guard, the Interior Troops of the Ministry o f Interior and on the number of staff in law enforcement agencies, the Federal Security Service and tax police (source: www.budietrfm). Information on the incidence of housing privileges (lgoty) The information o n a number o f beneficiaries o f lgoty by region i s in principle available from three different sources: 0 Rosstat: the federal government's statistical survey o f housing and utilities (Form 26- ZKH). T h e latest available information i s for the nine months o f 2003. 0 Ministry o f Finance: A specially prepared data set used by the Ministry for the estimation of regional fiscal needs. The latest available information i s for the first six months o f 2002. 0 NOBUS: National survey o f household budgets and participation in social programs (Russian acronym NOBUS), undertaken for the first time in spring 2003. Information about the number o f people enjoying discounts o n payments for housing and utility services has been traditionally reported by the Rosstat in Form 26-ZhKH. A major deficiency o f this source i s that housing and utility providers that file Form 26-ZhKH have incentives to report larger numbers of lgoty recipients. Moreover, lack o f effective control over these reports results in quite distorted statistics. In the past, despite i t s reliability problem, most research o n the topic was based o n this source just because n o nationwide alternative was available. Data from the Finance Ministry do not represent an independent source of information. They are based o n Rosstat data, but a considerable effort was made to clean up the original information and eliminate most inconsistencies. However, this data set i s the most outdated. In particular, i t does not reflect some reduction in a number o f lgoty recipients that took place in 2002-03 owing to the monetization o f their benefits. 174 The NOBUS survey provides the best available data to date o n lgoty recipients. The survey was undertaken for the first time in April-May 2003. Forty-five thousand households in a l l Russian regions participated in the survey. I t i s believed to be much more reliable than the 26-ZhKH data, in part because the parties responsible for collecting and processing the survey returns were not interested in misreporting the results. This i s the reason why this report uses the NOBUS data for the simulation o f fiscal effects related to lgoty. 175 A”EX4.1. SENSI T I V T I Y ANALYSISFOR PENSION SIMULATIONS Given the fact that two parameters - UST tax rate and share o f payroll in GDP (i.e. the UST tax base) - have the greatest impact on the performance o f the pension system, additional sensitivity analysis o f the results was undertaken to explore details o f their influence o n the average pension, as well as to assess potential links between such individual influences. Figure A4.1 presents the indifference curves for the average pension in 2030, measured as i t s ratio to the pensioner’s subsistence minimum. These estimates correspond to the scenario 44 (advanced institutional reforms under the high o i l prices). Each curve corresponds to the same ratio o f average pension to subsistence minimum, Le. it reflects the same purchasing power o f the average pension. These results reflect the outcomes o f about 100 simulations that correspond to specific values o f these two parameters (UST rate and payroll share). In the base scenario without UST rate cut, the share o f payroll i s expected to increase from the current 25% to 29% o f GDP, which bring the pensiodsubsistence ratio from 2.3 to about 2.5. The diagram also shows how much the payroll share should increase to keep the ratio roughly at the same level o f 2.5 under different assumptions regarding the magnitude o f the tax cut. If the rate i s cut by 4 p.p., the share has to reach 36% to keep the pensiodsubsistence ratio intact. In general, 1 p.p. decline in the UST rate could be compensated by an increase in the payroll share by about 1.5 pup. At every specific tax rate the decline in the payroll share by 2 p.p. brings the pensiodsubsistence ratio down by about 12 points, from 2.5 to 2.38. T h e latter result suggests that our estimates are rather robust: substantial fluctuations in the payroll share cause modest changes in the purchasing power o f the average pension. Figure A4.2 presents a more accurate non-linear approximation for the relationship between these two parameters that corresponds to the indifference curve o f 2.3 at Figure A4.1. Figure A4.3 presents a similar set o f indifference curves for the replacement rate. The presented approach helps expand understanding o f potential dynamics o f the analyzed variables. Instead o f generating specific point estimates o f particular parameters, it focuses on larger intervals o f policy variables, within which the performance characteristics o f the pension system remain sensible. I t also helps to concentrate the analysis o n the issue o f internal consistency o f the assumptions: h o w realistic i s that the future j o i n t dynamic o f main parameters would go in a way that would ensure a stable performance o f the system? 177 Figure A4.1: Indifference curves for the pension system: the ratio between the average pension and pensioner's subsistence, 2030 Share o f payroll in GDP, Y o Additional growth in payroll, triggered by the cuts in UST rates Growth in the payroll wio cuts in UST rates Figure A4.2: Indifference curve for the pension system: compensatory relationship between an increase in the payroll share and cuts in the UST rate. Payroll share in GDP, YO 33 32 31 30 29 28 27 25 26 3 -4 -3 -2 -1 0 Change in the UST rate (base pension) 178 Figure A4.3: Indifferencecurve for the pension system: replacement ratio in the PAYG system, 2030 Replacement Rate r t 30 29 28 27 2Bc 5 10 11 UST Rate 179 ANNEX4.2 SIMULATION METHODOLOGY Simulation methodology used in this report i s close to the approach employed in the PROST program by the World Bank. Accordingly, the type o f model used in this study had been employed frequently by the World Bank for undertaking similar analyses in other countries. I t i s also worth noting that the model followed some implementation principles that are similar to those used in the ILO Social Budget Program. The latter related e.g., to the model implementation in Excel with partial use o f the Visual Basic. On the one hand, such an approach allows for more transparency in calculations because intermediate results for each program block are stored in separate spreadsheets o f Excel books making it easier to trace l i n k s between the spreadsheets and check the formulas. O n the other hand, rather complicated links between the spreadsheets present certain difficulties for the analysis o f calculation sequences, and the formulas inserted directly in E X C E L cells make the model more vulnerable because it i s easier to make a mistake in copying formulas, while it i s rather time consuming to change separate formulas. A brief description o f the model i s provided in the Annex to the W o r l d Bank ( 2 0 0 3 ~ ) report, as well as in Simulation and Actuarial Estimates (2003). The earlier version o f the model was reviewed by the TACIS consultants, and their main comments (Stott, 2002), such as more accurate reflection o f pension contributions by working pensioners, were reflected in the current version o f the model. T h e simulation program used for analysis in Chapter 4 was fully implemented in Visual Basic. The same simulation technique was previously used for the preparation o f the World Bank Report (2003). A specific structural feature o f this version o f the computer program as compared to the earlier version described in Baskakov et al. (2003) i s i t s analytical focus, absence o f interface forms and reliance on bar chart reports, which substantially facilitate the analysis and quality control o f results obtained. As compared with the W o r l d Bank ( 2 0 0 3 ~ )report, the simulations in Chapter 4 are based o n a radically revised set o f assumptions regarding Russia’s macroeconomic projections that reflect the actual changes in the country’s economic performance that occurred in 2001-03. Besides, we consider a broader range o f potential development scenarios. In addition, it i s worth mentioning a certain difference in the logic between this model and the model in the World Bank ( 2 0 0 3 ~ ) report. The latter modeled the accelerated growth o f the payroll based o n the explicit assumption about difference in growth rates between average wage and productivity. In this paper, the trend in the payroll share in GDP i s instead considered as a key exogenous variable. This trend i s described in the model by a conventional exponential transition process. Such an approach adds flexibility to the model. In particular, it allows undertaking additional analysis o f the pension system’s sensitivity to changes in the basic trends in taxable wages. The following set o f basic input variables in the model determines most o f the variability within and across the scenario groups: 0 GDP growth rate Share of payroll in GDP 180 Level o f economic activity o f population Birth rate N e t migration Inflation rate Unemployment rate Interest rate Contribution rate (tax rate for UST) Pension system parameters (such as e.g., collection ratio) Retirement age The model employs a module principle based on the following sequence o f calculations applied to each group o f contributors and pensioners.' l2 0 Estimating the number o f contributors and pensioners; 0 Estimating the average size o f salaries and pensions; 0 Estimating the flows o f pension contributions and benefits; 0 Balancing revenues and expenditures o f the pension system; 0 Determining the key performance characteristics o f the pension system, such as a replacement rate, etc. T o estimate the number o f contributors, all employees in the economy are divided into three groups: (i) regular employees; ( ii)those who benefit from the reduced UST rates, including self-employed; and ( iii)delinquent taxpayers. ,The number o f pensioners in the model i s determined using the Stock method, where share matrixes are defined for each type o f pensioner, as w e l l as for each age and sex group. Then, to determine the number o f pensioners in a particular group one has to multiply the population number in each age and sex group (defined by the existing demographic projections) by a respective value in the share matrix. The size o f pension benefit for each group o f pensioners i s determined based upon the overall amount o f UST collection, the number o f pensioners in each pension group, types o f pension benefits established for these groups, as well as upon the adopted pension indexation rules. The level o f administrative costs in the system i s considered to be constant at 2 percent o f the total annual P A Y G benefits. The N D C benefit i s determined as accumulated notional individual fund divided by the annuitization factor that reflects the remaining l i f e expectancy o f the cohort and the notional interest rate. The annuitization factor i s gradually increasing between 2002 and 2013 from 12 to 19. The initial notional individual fund for those who are enrolled in the system in 2002 i s equivalent o f the average monthly pension o f 830 Rbl. The overall inflow o f revenues to the pension system i s determined by the number and structure o f contributors, average UST rates, as well as by the following factors: 0 Collection rate (currently amounts to 0.96); 'I2 The model considers two groups o f contributors (regular employees and those who are eligible for reduced UST rates) and four groups of pensioners: old-age pensioners, disability pensioners, survival pensioners and early retirement pensioners. 181 0 Nature o f the wage distribution relative to the regression scale o f the existing UST rates; this factor i s reflected in the model by the introduction o f a separate coefficient o f regressivity (currently amounts to 0.94); 0 Exemption rate for UST that reflects the average reduction in effective UST rate for contributors due to the existing legal benefits for particular groups o f taxpayers, such as those who pay a single agricultural tax (currently amounts to 0.94) Average working l i f e period i s estimated as 30-35 years. The indexation o f benefits in the model i s based o n current legislation: the base pension i s indexed with average inflation, while the N D C portion o f the benefit i s indexed based o n the growth rate o f the pension fund collections per beneficiary (which o n average exceeds the inflation rate due to the growth in real wages). The model calculations were undertaken without feedback, Le., even if the pension system balance starts to accumulate considerable surpluses, the model does not provide for an automatic change in the rules o f pension indexation. The logic behind such an approach i s in focusing the analysis o n what outcomes various indexation r u l e s may generate (in terms o f both the pension system balance and average replacement rate) if kept intact for a considerable period o f time. In addition to this, however, the model generates an alternative estimate for the replacement rate, which i s the rate that could be attained at a zero balance o f the pension system. T o get this estimate in the model a l l current surpluses in the system are distributed among the groups o f beneficiaries proportionally to their N D C pensions. T h i s alternative estimate reflects a potential maximum pension benefit that could be funded by utilizing a l l collected funds (Le., without running surpluses), but at the same time without creating debts in the pension system. In Chapter 4 we call this indicator o f the maximum potential pension benefit as an “affordable replacement rate”, and this i s an indicator that represents the core to our analysis. In other words, we are especially interested in understanding for each particular scenario how much the pension system could afford to pay. It i s assumed that if in the longer t e r m the selected indexation rules proved to be too restrictive (as they seem to be now), they could be adjusted to allow for a full pay-out o f available pension funds. While statistical data required for building a full quantitative model o f the link between the pension contribution rate and the taxable base for UST were unavailable, a numeric experiment was undertaken, which allowed estimating sensitivity o f the basic pension system parameters to the cuts in contribution rate. 182 c 1")9 70 7 (1 r) hs