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This 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 HUS tariffs may be modified if the economy faces a major slowdown in household income growth.

Some low income regions could be allowed to move with the reforms at a slower pace than the rest of 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 of housing allowance recipients. The average share of households that would become allowance recipients might reach 11 percent in the reform scenarios with the 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 of household income that is spent on HUS to 1518 percent.

3.145 From the financing perspective, the following steps constitute the core policy measures necessary to support the acceleration of HUS reforms.

At the subnational level:

An increase in tariffs to reach full cost recovery The phasing out of direct subsidization of service providers The expansion of the program of housing allowances At the federal level:

The phasing out of the federal programs of indirect financing of the HUS The establishment of a federal program of investment grants to support subnational rehabilitation projects in utilities, to be funded on the basis of co-financing The expansion of the scale of federal budget assistance to regions in the North 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 of utility services to budget organizations more expensive. Marginal annual costs are conservatively estimated to amount to 0.7-0.8 percent of 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 of the existing budget institutions in health and education. In addition, the tariff increases would increase the amount of taxes to be paid by energy and utility firms. However, we estimate that in the medium term a fiscal gap in public sector financing of 0.4 percent of GDP could emerge as a result of tariff increases in HUS and energy. In addition, to realize the expected tax gains, further strengthening of the tax administration may be required, in particular in the energy sector.

3.147 The analysis suggests that the elimination of housing privileges could also be affordable for most of the current lgoty recipients, while the housing allowance program would be capable of taking care of those who face too high a housing cost burden. This is primarily due to the fact that lgoty are concentrated in the middle income and high income groups of the population. However, given the political sensitivity of the entitlement reforms, there may be a case for postponing drastic reforms in lgoty until more basic HUS 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 old 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 of the remaining lgoty.

3.148 In addition, to support the above reforms in housing financing, additional structural reforms should be facilitated. This reform package is fairly well known and is described elsewhere. Its important components include, but are not limited to the following:

Additional reforms in inter-governmental fiscal relations An improved environment for private sector participation in the HUS The depolitization and increased transparency of the tariff setting process The strengthening of federal monitoring over reform progress at the subnational level The dissemination of the best regional and municipal practics for HUS reforms.

3.149 It also seems appropriate to provide additional fiscal incentives for subnational governments that are ready to accelerate the HUS reforms. The experience of the Regional Fund for Fiscal Reforms, which provided federal budget transfers to regions that were leaders in reforming their fiscal systems, could be replicatd to facilitate HUS reforms at the subnational level.


POTENTIAL IMPACT OF REDUCTION IN SOCIAL TAX RATES AND OTHER REFORMS 4.1 This Chapter estimates potential fiscal costs associated with various developments in Russias pension system based on the comprehensive actuarial model. It finds that such fiscal costs are likely to emerge as a result of the declining relative value of 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, is 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 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. 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 on a gradual increase in the retirement age.

A. INTRODUCTION 4.2 This Chapter is based on the findings of the earlier World Bank Report (2003c) Pension Reform in Russia: Structure and Implementation and it focuses on a financial trends in Russias pension system, including the pay-as-you-go (PAYG) and funded pillars, within the framework of the reform of unified social tax.

4.3 The Chapter develops a multifactoral analysis of potential fiscal costs associated with the future developments of Russias pension system. The analysis is based on a set of alternative formulations for the future pension reforms. It utilizes the comprehensive actuarial model as a tool of simulations of the pension system trends.59 The analysis makes an emphasis on the sensitivity of the current trends in the pension system to changes in macroeconomic performance, to the changes in demographic trends, as well as to various combinations of potential reform measures. It provides an analysis of the potential impact of 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 on the changes in the purchasing power of the average pension benefit.

4.4 The Chapter is using the level of the replacement rate (ratio of average pension to average salary) as a core policy variable for the pension reform analysis. This is because such a ratio reflects a basic proportion between the pension and pre-retirement income of 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, 2003c). However, sustaining the replacement rate above 40 percent has increasingly become a policy target in the developed countries. The World 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 is likely to be around 40 percent (Holtzmann, 2004, p. 33).

Andrews (2001) and Anusic and Petrina (2003) provide the examples of broadly similar analysis of sustainability of the pension systems under different reform options for other CIS countries.

4.5 In addition to the replacement rate, the analysis in Chapter 4 pays a considerable attention to the dynamics of the ratio between average pension and subsistence minimum. It is justified by the fact that, when the average pension is either below or close to the pensioners living subsistence level, as it is in Russia, the value of the replacement rate can not be an informative indicator of changes in pensioners real incomes.

4.6 The fiscal cost analysis in this Chapter is undertaken for an expanded set of macroeconomic and reform scenarios. The basic group of 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 on the potential impact of 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 on social pensions, which at the moment are received by 1.5 million pensioners (3.8 percent of the total number of pensioners) who are not eligible for a regular old-age pension. Social pension is the parameter of the governments social protection policy and it has to be dealt with separately from the issues related to social insurance and reform in the old-age pension system.

Respectively, financing of social pensions should be de-linked from payroll taxation and instead be included in the overall government budget expenditure on social protection policies. Overall, we agree with the view that the government has to adopt a strategy for a gradual increase in the social pension from its current low level of 55 percent of the minimum subsistence to the level of pensioners subsistence minimum (Smirnov and Isaev, 2003).

B. BACKGROUND 4.8 Currently the Russian pension system faces the challenge of establishing a sustainable longer-term framework for a gradual increase in the level of pension benefits. To this end, as part of the comprehensive pension reform, the government 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.4.9 Two out of three main components of the reformed pension benefit in Russia -- notional defined contribution (NDC) and mandatory funded -- directly depend on the size of actual pension contributions (a portion of the unified social tax). In addition, the reforms that have been introduced made a major step toward simplification of the benefit formula and more transparent eligibility criteria. This is expected to improve incentives for compliance, cut down the unreported and untaxed share of the payroll, and therefore improve the revenue performance of the pension system. However, so far the informal part of the payroll has been shrinking only slowly. This is believed to be largely a result of rather a high rate of established contributions of 28 percent. In addition, the incentives for proper payroll reporting were further weakened because only half of the paid pension contributions (14 percent of payroll) were taken into account to assess the future size of benefits, while another half was reserved for financing the basic pension, which is the same for all pensioners.61 Annex 4.provides some details on the main benefit rules in the current pension system.

Holtzman et al. (2004) presents a summary of the lessons from the early pension reforms in ECA. See also Rutkowski (2002, 2004).

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.

4.10 At the same time, the Russian Government set up a strategic objective of easing the tax burden on the economy, which would include reduction in UST rates. It is expected that 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 is significant interest in the analysis of potential fiscal implications of 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.

4.11 The Russian Government has been considering improvements in pensioners welfare through a growth in real pension benefits as its core longer term policy objective. It also considers a comprehensive pension reform, which provides for an introduction of the fully funded pillar, as a primary instrument of achieving this objective. At the same time, as a part of its macroeconomic and growth policy, the Government intends to reduce the average UST rate, which is 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 of the former Soviet Union, is characterized by the low 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 of benefits that are not linked to the contributions.There is 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 transition63. There is also a high number (almost 30 percent of the regular old-age pensioners) of pensioners who benefit from various early retirement schemes, determined by special laws inherited from the Soviet era which have so far remained largely unreformed64.

4.13 Basic parameters of the current pension system in Russia are presented in Table 4.1. It shows a rapid growth in the system dependency ratio owing to the ageing population.

Moreover, in the 90s the ratio between the number of pensioners and employees (60 percent in 2002) had been growing even faster than the share of pensioners in the entire population (27 percent in 2002). This is owing to an increased incidence of both unemployment and nonparticipation in the labor force65. Annual contributions to the pension system amount to approximately 6 percent of GDP.

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