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Figure 4.5: Economic Activity of Population, Group 1 Scenario Economic activity of population, Group 1scenarios, % 0.0.0.0.0.0.Scenario 0.Scenario Scenario 0.Scenario 0.2004 2009 2014 2019 2024 2029 2034 2039 2044 4.55 In Group IV (Reforms to Reduce Tax Privileges) we assume a considerable change in the structure of contributors. While in all the scenarios of Groups I-III the structure of 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 of regular employees is gradually increasing to 85 percent, while the share of those included in the privileged schemes is declining to 10 percent. It is 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 to reduce payroll costs. In addition, it is assumed that for those who keep their UST privileges, the fixed monthly pension contribution would be doubled in real terms.

4.56 No changes are envisioned in technical parameters of the pension system, such as collection and exemption rates, and coefficient of regressivity, which respectively remain at the base levels of 0.96, 0.94, and 0.94.

4.57 The real interest rate (pension savings yield) is higher for reform-oriented scenarios 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 is 3-3.5 percent in the latte. For the period after 2015, in the scenarios with reforms the yield is fixed at the level of one percentage point below the real growth rate in average wages of the respective year (Figure 4.6).

Figure 4.6: Real Interest Rate, Group 1, Scenarios % Real Interest rate, Group 1, scenarios % 7.6.5.4.3.2.Scenario Scenario 1.Scenario Scenario 0.2004 2009 2014 2019 2024 2029 2034 2039 2044 4.58 Another important assumption relates to the set of 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 on real values of pension benefits and respectively replacement rates. Moreover, in addition to full indexation for inflation, we used two alternative sets of indexation rules to assess trends in real values of the average pension benefit:

(i) The rule that corresponds to the existing legislation the base pension is indexed with the average inflation, while the NDC portion of the benefit is indexed based on the nominal growth rate of the Pension Fund collections per beneficiary.

(ii) The rule that corresponds to estimates for the maximum affordable pension indexation of the base pension remains the same (inflation-based), but the NDC portion is additionally indexed to distribute all available surpluses in the PAYG pillar.

4.59 In addition, a separate indexation rule is used for the subsistence minimum, which is indexed for inflation plus additional indexation equal to 30 percent of the real growth in average taxable wages.79 Justification for the latter indexation rule derives from the fact that the baseline scenario assumes relatively high growth in real wages for the entire period forecast. If the subsistence minimum is 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 of minimum social needs with the growth in average income (Chen and Ravallion, 2000).

For the cross-country data Chen and Ravallion (2000) estimate that elasticity of the poverty line by consumption level equals one third.

E. DEMOGRAPHIC ASSUMPTIONS 4.60 Basic demographic assumptions applied in the model are presented in Table 4.8. The key features of the baseline demographic projections for Russia provide for both a drastic reduction in the general population (particularly after 2025)80 and a monotonous growth of the system dependency ratio (ratio of 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 of 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), i.e., as compared with the base case projections, the maximum increase of 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 Birth rate* 1.31 1.33 1.35 1.37 1.40 1.40 1.40 1.40 1.40 1.Life expectancy 66.6 66.8 67.0 67.1 67.2 67.7 68.3 69.5 70.6 71. - Men 60.3 60.7 60.9 61.1 61.3 61.9 62.5 63.8 65.0 66. - Women 73 73 73 73 73 74 74 76 77 General population 143 143 142 141 139 136 132 121 110 - Men 67 67 66 66 65 63 61 55 50 - Women 76 76 76 76 75 73 71 66 60 Elderly load coefficient for general 0.33 0.32 0.32 0.32 0.35 0.40 0.46 0.49 0.58 0.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. - Women (above 55) 0.46 0.46 0.47 0.48 0.52 0.60 0.67 0.71 0.86 1.* 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 of Russia (2002).

4.62 In all the scenarios of Groups I-IV, net immigration was set at a conservative level of 60-100,000 persons per year. In Scenarios 1 and 3 of Group I, the net migration is close to the baseline demographic projections of 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. This is 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 is the reason why in the scenarios of Group V (Additional immigration), the net migration is additionally increased to 300,and 500,000 persons per year through the extended period81.

However, it is worth mentioning, that such sharp population reduction may lead to a much stronger expansion in net immigration, which is to some extent reflected in scenarios of Group V.

According to the data provided by the Institute of Economic Forecasting, over the last 15 years the maximum level of net migration of 800,000 persons per year was observed in 1994. Since then the flow of net migration declined significantly and in 2001 it made up only 50,000 persons.

Table 4.9: System Dependency Ratio Scenario 2004 2005 2006 2007 2008 2009 2010 2020 2030 2040 Group I: Base scenarios 11 0.60 0.60 0.60 0.60 0.61 0.61 0.62 0.73 0.79 0.88 1.12 0.59 0.58 0.57 0.57 0.57 0.57 0.58 0.67 0.72 0.80 0.13 0.60 0.60 0.60 0.60 0.61 0.61 0.62 0.72 0.78 0.87 1.14 0.58 0.58 0.57 0.57 0.57 0.57 0.57 0.64 0.68 0.75 0.Group II. With the UST reform (cuts in the pension contribution rates) 22 0.59 0.58 0.57 0.57 0.57 0.57 0.58 0.67 0.72 0.80 0.24 0.58 0.58 0.57 0.57 0.57 0.57 0.57 0.64 0.68 0.75 0.Group III. UST reform supplemented by an increase in the retirement age 32 0.59 0.58 0.54 0.54 0.51 0.51 0.48 0.45 0.47 0.49 0.34 0.58 0.58 0.54 0.53 0.50 0.50 0.47 0.43 0.45 0.46 0.Group IV. UST reform, an increase in the retirement age and cuts in privileges 42 0.59 0.58 0.54 0.54 0.51 0.51 0.48 0.45 0.47 0.49 0.44 0.58 0.58 0.54 0.53 0.50 0.50 0.47 0.43 0.45 0.46 0.4.63 As mentioned above, without an increase in the retirement rate, the dependency ratio has been growing steadily and under the most optimistic assumptions reaches 0.68 in and 0.87 in 2050. However, the retirement age growth by 5 years for men and by 10 years for women (scenarios of Group III) in the longer run leads to a substantial decline in the ratio to 0.43 - 0.45 in 2030 and 0.53 - 0.57 in 2050. Table 4.9 presents an average system dependency ratio calculated for Groups I-IV of scenarios as a share of the number of labor pensioners in the total number of contributors. These changes in the dependency ratio trends are also illustrated in Figure 4.7.

Figure 4.7: System dependence ratio (ratio of pensioners and employed) System dependence ratio (ratio of pensioners and 1.employed) 1.0.0.Scenario 0.Scenario Scenario Scenario 0.0.2004 2009 2014 2019 2024 2029 2034 2039 2044 F. SIMULATION RESULTS Group I. No 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 pensioners living subsistence (Figure 4.10).

4.65 In the scenarios of 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 of economic growth, lower inflation, and reduced unemployment all have rather a modest effect on the future average size of the pension benefit (relative to the average wage). While 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 of 24.4-27.8 percent.Even under the most favorable macroeconomic assumptions, by 2025 the replacement rate drops considerably relative to its current level and then it stays basically unchanged. It is expected that the rate of decline would be the most pronounced between 2016-25, when it would lose on average about 3.5 p.p.

Figure 4.8: Pension Replacement Rate, Group 1 Scenarios Pension Replacement Rate, Group 1 scenarios, % Scenario Scenario Scenario Scenario 2004 2009 2014 2019 2024 2029 2034 2039 2044 The contribution of the fully funded pillar to the overall replacement rate amounts to about 10 percent in 2030, but it reaches a quarter in 2050.

Figure 4.9: SST Rate (Contribution Rate) Needed to Ensure the Replacement Rate of 30%, Group Scenarious SST rate (Contribution rate) needed to ensure the replacement rate of 30%, Group 1 scenarios, % Scenario Scenario Scenario Scenario 2004 2009 2014 2019 2024 2029 2034 2039 2044 Figure 4.10: Ratio Between Average Pension and Pensioners Subsistence Minimum, Group 1 Scenarios Ratio between average pension and pensioner's subsistence minimum, Group 1scenarios 6.Scenario 5.Scenario Scenario Scenario 4.3.2.1.0.2004 2009 2014 2019 2024 2029 2034 2039 2044 4.66 None of the scenarios in Group I could bring the replacement rate to the level of 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), it does not help to close the gap between growth in wages and pensions. It appears the existing pension system, even under the most optimistic assumptions, does not provide pensioners with a fair share of 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 of 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 of the pension system through additional budget transfers. We estimated potential fiscal costs of such budget support, based on the assumption that the government would be forced to keep the replacement rate at the level of 30 percent. In this case, annual fiscal costs of supporting non-reformed pension system would amount to 0.5-1.5 percent of GDP a year in 2030 and it increases to the level of 1.5-2.5 percent of GDP by 2050 (Table A4.7). The pension system would be able to generate the same amount of funding internally only through a considerable additional increase in the average contribution rate, from 28 percent to on average 32 percent in 2025 and to about 3536 percent in 2050 (Figure 4.9).

Box 4.2: Drivers of the decline in the replacement rate Separating the PAYG and fully funded pillars of 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 PAYG pillar will inevitably decline to approximately 17-20 percent (Table A4.2). This is because the current pension system, despite all its recent positive innovations, has largely preserved its re-distributional nature83, in which the replacement rate is 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 UST rate.

Taking into account also that the actual collections of the Pension Fund are lower than statutory collections due to such parameters as incidence of non-payments, exemptions, and the regressive nature of the tax rate84, in the long run the average replacement rate in the PAYG pillar could be maintained only at a level of about 19 percent (220.940.940.96=18.7 percent). However, taking into account that the self-employed and other special categories pay their PAYG contributions at a much lower rate (on average approximately only 3 percent), while their number comprises 15 percent of contributors, the longer-term ceiling for the replacement rate in the PAYG system will be even lower - 16.3 percent ((0.940.940.96)(0.8522+0.153) =16.3).

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