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Estimating the demand for housing allowances 3.61 Estimates for a potential demand for housing allowances were developed on a regionby-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 of the model is 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 of the Russian population by available housing space. A standard assumption on housing distribution was used: 10 percent of the population use 33 sq m per capita, 15 percent use 21 sq m, and 75 percent use 18 sq m. It is worth noting that housing space in excess of these amounts is 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 is eligible for budget support through housing allowances.

3.64 If I (r, j, t) * q > CC(r, t), then members of income group j are ineligible for housing allowances, where q is a maximum share of 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=percent. Thus we assume that subnational governments would largely follow federal guidelines on the eligibility threshold. In our simulations, we also considered alternative values of parameter q such as 10 percent and 15 percent.

3.66 The average allowance for a member of income group j in region r in year t, Allow (r, j, t) is estimated as:

Allow (r, j, t) = CC(r, t) - I (r, j, t)*q (2) 3.67 Aggregation by income groups and regions allows for estimating the total number of recipients of housing allowances and the total costs of this program for each scenario.

3.68 In the scenarios, which did not provide for the elimination of lgoty, the size of each income group was proportionally reduced to reflect the number of lgoty beneficiaries in this group. This would reduce an overall demand for housing allowances.

3.69 It is assumed that the future participation rate in the housing allowance program will be 75 percent (i.e., three-quarters of eligible households would apply for a benefit). The IUE field research suggests that at the moment the participation rate in the program is about percent. It is 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 of Economy in Transition. The basic principles and parameters of the macroeconomic framework used for costing out various structural reforms are presented in Annex 3.1. In sum, we took the governments baseline macroeconomic projections for the period 2004-06 and used them as a basis to build a set of four longer-term macroeconomic scenarios, each of which reflects a specific combination of two primary determinants of Russias future macroeconomic performance the average world market oil price and the expected speed of 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 (%) Slow reforms Advanced reforms Moderate oil prices ($18.5), low growth Scenario 1 Scenario GDP growth 2.0 GDP growth 1.Income growth 8.4 Income growth 6.High oil prices ($22.5 and higher), high growth Scenario 3 Scenario GDP growth 4.0 GDP growth 3.Income growth 8.4 Income growth 6.3.71 Overall, we based the analysis on a rather conservative macroeconomic framework. It is 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 of 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 oil prices and slow reforms. This scenario presents the most difficult macroeconomic environment, with low budget revenues, a relatively high expenditure burden, and a deteriorating balance of payments that triggers inflation and exchange rate pressures and damages investment expectations. This is the scenario with low growth in both investments and household incomes. Lack of reforms would mean that cross-subsidization of households would remain intact.

II. Moderate oil prices and advanced reforms. Under this scenario the macroeconomic environment for reforms remains rather difficult, with low government revenues and depressed earnings in the real sector. However, real devaluation of the Russian ruble implies some protection of domestic producers from international competition. This in combination with the reform momentum could be favorable for investments and growth in sectors with a high degree of processing. The reform of 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.

III. High oil prices and slow reforms. This is an inertial scenario, under which the existing structure of the economy remains basically intact with the energy and other primary sectors generating most of the investments, taxes, and exports. As with the first scenario, cross-subsidization of households is preserved.

IV. High oil prices and advanced reforms. This is the most optimistic scenario. It 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 of GDP, investments, and household incomes. However, given the required level of restructuring in the real sector, unemployment would remain relatively high, which would preserve a strong demand for government spending on social protection.

3.73 One of 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 of the Ministry of Economy, the real income growth for 2005-06 in all scenarios is assumed to be 8 percent per annum. This is equivalent to an average growth of 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 of estimates was obtained for the scenario, in which real incomes grow at a rate of 5 percent a year for the period 2003-06.

Scenarios for the housing and utility sector 3.74 Two baseline scenarios for the housing and utility sector were developed for 2004-along the similar lines:

Slow reforms, mostly inertial development Implementation of the reform package that would include, inter alia, the elimination of the cross-subsidization in tariffs, additional growth in housing tariffs to compensate for earlier under-financing, and encouragement of 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 of inflation, and electricity and gas tariffs. In other words, there is no autonomous growth in utility/housing tariffs to compensate for earlier underfinancing (depressed inflation) and to create more favorable conditions for rehabilitation in the sector.

3.76 The second scenario provides for higher rates of tariff growth in the sector, through which it would be compensated for a de facto tariff freeze during the period of high inflation in 1998-99. We assume that about a quarter of 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 of a single tariff for all categories of consumers in all relevant sectors (power, gas, and local utilities). In addition, some efficiency gains are expected in the utility sector, first of all through a reduction in heat and water losses. (See the next section for additional details on potential efficiency effects).

Scenarios for the tariff policy 3.77 For each of the four baseline scenarios, we have also developed a set of possible policy options with respect to future changes in tariffs and cost recovery. These options for the tariff policy derive from different combinations of the two key policy parameters:

1) Level of cost recovery in tariffs for household three alternatives were considered:

Tariffs are set to cover 90 percent of the total running housing and utility costs, while the remaining 10 percent is still financed from the budget as a direct subsidy to providers of housing and utility services Tariffs cover 100 percent of the total running housing and utility costs Tariffs cover 100 percent of the total running housing and utility costs, and, in addition, expenditures on major repairs/rehabilitation of the housing stock are also included in tariffs (these rehab-related costs are estimated to amount to 20 percent of the current running costs).

2) Maximum share of housing and utility expenditures in household incomes, above which households would be eligible for social assistance through the housing allowance three alternatives were considered: 10 percent, 15 percent, and percent.

3.78 Ultimately, our simulations covered 36 scenarios (4 initial baseline scenarios * options for the level of cost recovery in tariffs * 3 options for the share of 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 2-2-100% Option 1-1-2 Option 1-2-2 Option 2-1-2 Option 2-2-100% + costs of Option 1-1-3 Option 1-2-3 Option 2-1-3 Option 2-2-capital repairs 15% 90% Option 1-1-4 Option 1-2-4 Option 2-1-4 Option 2-2-100% Option 1-1-5 Option 1-2-5 Option 2-1-5 Option 2-2-100% + costs of Option 1-1-6 Option 1-2-6 Option 2-1-6 Option 2-2-capital repairs 22% 90% Option 1-1-7 Option 1-2-7 Option 2-1-7 Option 2-2-100% Option 1-1-8 Option 1-2-8 Option 2-1-8 Option 2-2-100% + costs of Option 1-1-9 Option 1-2-9 Option 2-1-9 Option 2-2-capital repairs 3.79 In the process of the simulations of each scenario, the following parameters were estimated for each administrative region of Russia for the period 2004-06:

1. Total costs of housing and utility services supplied to households 2. Number of households eligible for housing allowances 3. Share of 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 of the housing stock 8. Total budget expenditures related to operations on residential housing 9. Share of budget spending in financing the total costs of housing and utility services supplied to households 10. Average share of housing and utility expenditures in household incomes 11. Share of housing allowances in household incomes in the lowest income groups.

3.80 In addition, for a limited set of selected scenarios, we undertook complementary simulations to estimate the impact of elimination of housing privileges.

H. ASSUMPTIONS ON FUTURE UTILITY COSTS Adjustment in domestic energy prices 3.81 The scenarios for reforms in Russian domestic energy pricing remain at the center of heated political debates. Still, in the gas sector there is a growing consensus that the longerterm marginal costs of Russian gas are in the interval of 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 of 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 of analysts believe that, given the existing over-capacity, liberalization in the sector is likely to lead to a decline in the average real electricity price. The current draft reform program envisions an increase of 16-21 percent in real ruble terms in 2004-06, and no need for additional increases in later years when the effects of sectoral reforms are fully utilized.

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