4.44 In the Scenarios of Group II (“Reduced UST rates”), it is assumed that the cut in the UST rate will become effective on January 1, 2005. Parameters of the PAYG pillar have a linear dependency on the effective contribution rate. Therefore, in the base case, the direct impact of changes in the contribution rate on the pension system could be estimated by simple recalculation of the base case results.
Figure 4.3: Dynamics of the Taxable payroll share in GDP, Group Dynamics of the taxable payroll share in GDP, Group Scenario Scenario Scenario Scenario 2004 2009 2014 2019 2024 2029 2034 2039 2044 Table 4.5: Additional Assumptions in Scenarios with Reduced UST Rates, (Group II) 2004 2005-10 2011-15 2016-20 2021-25 2026-Share of 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 of Group II, the payroll share in GDP is expected to expand (Table 4.5). Quantified estimates for such an increase were developed based on the assumption of unchanged contributors’ net incomes in cases when their tax rate is reduced73.
This assumption is similar to a hypothesis on a proportional link between the relative size of the UST rate cut and an associated additional increase in the share of taxable payroll in GDP.
Under such assumptions, as a result of UST rate cuts, absolute amounts of both pension contributions and pensions remain unchanged, while taxable wages would increase (due to a The idea behind this assumption is as follows: in response to the tax rate reduction, taxpayers will hide less of their incomes, and the share of their taxable wages will increase. It is also assumed that the size of such an increase could be conservatively estimated based on the assumption of constant net income: taxpayers, who benefit from an opportunity to reduce their hidden incomes (and, therefore reduce the size of potential penalties), will not seek additional financial benefits and will keep unchanged both the amount of paid tax and the size of their actual total incomes after taxes.
declined share of shadow wages), which means a decline in the nominal average replacement rate74.
4.46 The cross-country data suggest that indeed there is a room for Russia to increase the share of taxable payroll, but given high stability of this indicator in most countries, such changes could happen only gradually. In addition, considerable institutional reforms will be needed to support this trend toward higher formalization of the economy. In 2002, the share of taxable payroll (including payroll taxes) in Russia was estimated at about 32.5 percent of GDP, which is similar to the share in Mexico and somewhat higher than the one in Turkey.
Taxable payroll net of payroll taxes amounted to about 25 percent of GDP (Table 4.2 above).
Table 4.6 presents the comparative dynamics of this indicator across the OECD countries.
4.47 In our projections for the scenarios in Group I (“No UST reforms”), it was assumed that without UST rate cuts the share of taxable payroll (net of payroll taxes) would increase Note that the real replacement rate does not change in this case, because the total payroll (including the informal part) remains intact.
gradually from the current 25 percent of GDP to 31 percent of GDP by 202575. It is worth noting that after such an increase, in 2025 the payroll share in Russia will still 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 payroll/income taxation.
4.48 At the same time, in the optimistic case in scenarios of Group II (“Reduced UST rates”) it was assumed that the payroll share may grow considerably faster than in the scenarios of Group I, and the payroll growth rate would exceed the pace of decline in contribution rates by about 20 percent.76 Under such assumptions, the growth in the taxable payroll share would be more than 50 percent higher than the growth in similar scenarios of Group I, and the overall increase in the payroll share within the period would amount to 9.510 percentage points (p.p.) of GDP instead of the original 5.5-6 percent. Consequently, starting from 2020, the taxable payroll share in GDP (net of payroll taxes) in the optimistic case of Group II (Table 4.5) amounts to 35 percent (25+6·14/10·1.2)77. Such payroll shares are comparable to the actual current levels of this indicator in the most advanced reformers among transition economies in the CEE. In other words, under the conditions of aggressive structural reforms and with lower UST rates, within approximately 15 years additional expansion of the UST tax base could amount to 4-4.5 p.p. of GDP, from 30-31 to 35-35.5 percent. It is 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 of GDP threshold, even if more radical cuts in the UST rates (in excess of 4 percentage points) are introduced.
4.49 International experience, however, suggests that there is 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 of the labor market and improvements in expectations of market participants.4.50 In addition to a closer look at two quite different cases (“base” and “optimistic”) for a potential dynamics of 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 Or 39-40 percent of GDP, if payroll taxes are included.
Recent study of 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.
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 percent). This is a reflection of the current situation where the contributors are least interested in contributing to the basic portion of pensions, because this part does not have any effect on the size of 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 is believed to be related to other non-tax impediments to the formalization of 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).
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 is assumed that in the optimistic case of Group II, in 2004-10 the real average (taxable) wage will grow at an annual rate of 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). This is 0.5 to 1.5 percentage points higher than the growth in labor productivity in the same period. Given that a substantial portion of 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 of 5 percent and more in a number of CEE countries during the second half of the 90s (Table 4.7) despite the fact that the share of shadow wages in these countries at that time was significantly lower.
Figure 4.4: Real Growth in Taxable Wages, Group 1 Scenarios Real growth in taxable wages, Group 1 scenarios, % Scenario Scenario Scenario Scenario 2004 2009 2014 2019 2024 2029 2034 2039 2044 4.52 Overall, the assumptions in the optimistic case provide for the share of shadow wages to decline to 20 percent of 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 is 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.Estonia 23.Lithuania 38.Slovak Republic 62.Poland 24.Source: World Bank.
4.53 In addition, it is assumed in the reform-advanced Scenarios 2 and 4 in all groups that the economic activity of the population would be higher, which reflects an assumption on expansion in labor demand under the conditions of sustainable growth and a favorable investment environment created by structural reforms. In Scenario 2, it is assumed that the economic activity parameter would grow at an annual rate of 0.5-1 percentage point up to 2010, and it would remain unchanged after this. In Scenario 4, economic activity would grow at a rate of 1 percentage point a year up to 2010, and additionally 0.5 percentage points a year during 2011-15. Consequently, the average level of 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 of 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 of wages, but not a complete withdrawal from the system. This relates to two specific features of Russia’s pension system, which strengthen employees’ incentives to participate such as, (i) low eligibility requirements for the base pension, which requires just 5 years of service and no 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 of the system. At the same time, we estimated the elasticity of the average pension with respect to changes in the participation rate.
This 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.
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