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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 of the Russian pension system. Under the current rules, if they are fully enforced, the NDC portion of the system is expected to run considerable deficits, while the base component of pension benefit would be generating surpluses that in principle would be sufficient to finance the deficits of the NDC portion and keep the entire system fiscally sustainable. However, to base the pension systems fiscal sustainability on such permanent redistribution of funds between its two components could be a risky strategy in the longer term. Given the rather informal nature of the existing indexation rules, there is a considerable risk for pressure to mount that would push toward using the surpluses in the base pension component either for additional indexation of the base pension or for other social spending.

C. REFORM SCENARIOS IDENTIFIED FOR SIMULATIONS 4.25 Our simulations were primarily focused on the trends in the following performance characteristics of the pension system: (i) potential (fiscally affordable and actuarially justified) average replacement rate, (ii) ratio of the average pension and pensioners living subsistence minimum, (iii) pension system balance at the preset rules of pension indexation, and (iv) fiscal gap, estimated as a value of additional public funding needed to provide for a desirable replacement rate.

4.26 While some of the reform elements are still being defined by the government, five groups of scenarios were identified and simulated for the purposes of the current analysis.

These are based on the expanded actuarial model of the Russian pension system.

4.27 Group I. Base Case: No reforms in the unified social tax (UST) unchanged pension contribution rates.

Scenario 1 (11). Low growth and absence of structural reforms, including absence of UST reforms Scenario 2 (12). Low growth and advanced structural reforms, but without UST reforms Scenario 3 (13). High growth and absence of structural reforms, including absence of UST reforms Scenario 4 (14). High growth and structural reforms, but without UST reforms 4.28 This group of scenarios primarily reflects the status quo (i.e. continuation of policies as of early 2004) and its main objectives are to (i) provide estimates for the base line, i.e., what would happen to the pension system if no reforms are undertaken, and (ii) estimate the impact of main macroeconomic factors, such as variation in GDP growth rates. In these scenarios the main parameters of the system, including the retirement age, UST rates, number of contributors, etc., remained unchanged. However, it is worth noting that our base case scenario fully reflects the changes envisioned in the draft Law on Professional Pension Schemes that provides for a considerable reduction in implicit subsidies to early retirees. It is assumed that this Law would become effective in the near future in its present draft form.

4.29 Scenarios of Groups II-V consider various potential reforms in the pension system. For the purposes of consistency, we assume that the reforms in the pension system will be undertaken only if there is a broader across-the-sector acceleration of structural reforms in Russia, i.e., there is considerable progress in structural reforms as reflected in Scenarios 2 and 4 of Group I. Thus, in each of the Groups II-V we consider only two scenarios (both with advanced reforms) instead of four scenarios in Group I.

4.30 Group II. With the UST reform cuts in the pension contribution rates by 4 and percentage points Scenario 5 (22). Low growth and advanced structural reforms, including UST reforms Scenario 6 (24). High growth and advanced structural reforms, including UST reforms 4.31 Group III. UST reforms as in Group II supplemented by an increase in the retirement age by 5 years for men and 10 years for women Scenario 7 (32). Low 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 II supplemented by an increase in the retirement age and other changes and further reduction of 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 of such beneficiaries.

Scenario 9 (42). Low 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 of a considerable migration inflow to Russia. The question we have been asking in this part of the analysis was: to what extent immigration on its own could ease Russias pension system problem and as such be considered as a substitute to the comprehensive pension reform We consider two alternative options for such an extra migration inflow (relative to the baseline reflected in Group I).

Scenario 11 (52). Annual number of migrants increases by 300,000 a year Scenario 12 (54). Annual number of migrants increases by 500,000 a year 4.34 The UST reforms in Group II were modeled through cuts in the pension contribution rate for the base portion of the old-age pension. Within the Group II we consider two alternatives for a potential effect of such a cut in the contribution rate on 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 considerable expansion in the UST tax base (a share of taxable payroll in GDP)71. Moreover, in the latter case, it was assumed that the growth rate of taxable payroll exceeds the pace of decline in the contribution rate. These two cases represent quite extreme alternatives, which together help identify a range (low and high ends for collections), within which an actual future dynamic of the pension system is likely evolve.

4.35 The scenarios in Group III simulate the impact of increase in the retirement age. These scenarios assume a gradual increase in the retirement age for men and women up to 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 is also a global tendency for closing the gap in retirement age between men and women. As was shown in analysis of similar multipillar 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 of the retirement age increase, the GDP growth rate was recalculated based on the assumption of maintaining the labor productivity growth rate at levels similar to the respective scenarios of Group II (with UST reforms), but with a higher number of the employed.

4.37 Additional simulations in the scenarios of Group IV analyzed somewhat more comprehensive reform strategies that assumed simultaneous undertaking of 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 of those who benefit from preferential UST regimes would decline from 15 to 10 percent of the employed, and (ii) contribution rates for those who remain beneficiaries of the reduced UST rates would increase by 100 percent, from 150 to 300 ruble a month in 2002 rubles.

4.38 Most of the simulations in this Chapter cover a period up to 2050. However, the analysis is mainly focused on the first half of the period (up to 202530), which is of greater interest for policymakers. The main simulation results are presented in Annex Tables A4.1A4.15, and they are discussed in Sections F and G. Annex 4.2 presents the main features of the model that was used in our simulations.

D. MAIN MACROECONOMIC AND REFORM ASSUMPTIONS 4.39 Macroeconomic assumptions for our simulations were developed jointly with experts from the Institute of Economy in Transition. The basic principles 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 of 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 average world market oil price and expected speed of structural reforms in the country. As described in the previous section, then we used two out of four macroeconomic scenarios scenarios with advanced reforms, 12 and 14 -- as a basis Dmitriev at al. (1999) used a similar approach to the analysis of the potential impact of UST rate cuts on Russian pension system.

on 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 (18.5), low growth Scenario 11 Scenario High oil prices (22.5 and higher), high growth Scenario 13 Scenario 4.40 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 the ones assumed by the government.

4.41 The key macroeconomic parameters in the model include real GDP growth rate, payroll share in GDP, population growth, economic activity, unemployment level, inflation, and interest (yield of pension savings) rate. The payroll share in GDP is an important parameter that in the model determines the dynamics of the UST tax base.4.42 Macroeconomic parameters of 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 GDP growth by scenario, Group Scenario Scenario Scenario Scenario 2004 2009 2014 2019 2024 2029 2034 2039 2044 Roik (2003) also emphasizes a link between the growth in taxable wages in GDP and the financial position of Russias pension system.

Table 4.4: Assumptions on Macroeconomic Parameters of the Base Scenarios (Group I) 2004-2010 2011-2015 2016-2020 2021-2025 2026-Real GDP growth (annual rate, %) Scenario 1 (11) 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, %) Scenario 1 (11) 7% 6.5% 6% 5.5% 5% Scenario 2 (12) 10% 8% 6% 4% 3% Scenario 3 (13) 10% 9% 8% 7% 6% Scenario 4 (14) 20-9% 9-7% 7-5% 5-3% 3% Taxable payroll, share in GDP Scenario 1 (11) 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 (11) 3% 3% 3% 3% 3% Scenario 2 (12) 5% 5% wage r -1% wage r -1% wage r -1% Scenario 3 (13) 3.5% 3.5% 3.5% 3.5% 3.5% Scenario 4 (14) 6% 6% wage r -1% wage r -1% wage r -1% Unemployment level (%) Scenario 1 (11) 9% 9% 9-8% 8% 8% Scenario 2 (12) 8-7% 7-6% 6-5% 5% 5% 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 (%) Scenario 1 (11) 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 (%) 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 is higher than GDP growth rate due to expected decline in both population and employment.

4.43 Our simulations assume that wage growth is proportional to labor productivity growth.

At the same time, it is accepted that the taxable wage may grow faster than productivity through a decline in the share of informal wages and respective growth of the taxable payroll share in GDP (i.e., due to growth in formally registered wages and the expansion in the share of the formal sector facilitated by institutional reforms). Thus, one of the particular features of our projections is an introduction of an additional factor in the model that reflects faster growth of taxable wages (and respectively, the UST tax base) relative to labor productivity growth. Under such an approach, the share of the taxable payroll in GDP is an exogenous parameter, for which we consider a set of alternative trends depending on a scenario. The dynamics of the payroll share in GDP for the Group I (No reforms) scenarios is shown in Figure 4.3.

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