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Usha Rani Khanna and Emily Evershed assisted with editing the report and Anna Bazanova, Irina Partola, and Judy Wiltshire provided excellent support during the entire preparation process. The Ministry of Finance and the State Committee for Statistics of the Russian Federation provided considerable assistance with the data for the report.

Deborah Wetzel and Asad Alam were the Sector Managers, and Cheryl Gray was the Department Director. Kristalina Georgieva was the Country Director for Russia.

Thomas Blatt Laursen (ECSPE), Goohoon Kwon (IMF), and Pedro Alba (AFC13) were the Peer Reviewers.

EXECUTIVE SUMMARY 1. This Report discusses the challenge of budget financing of core structural reforms within a broader framework of fiscal management reforms in Russia. It argues that explicit financing of structural reforms is fully justifiable because these are the investments in the institutional infrastructure with a high rate of return. In addition, Russia currently appears to have a fiscal room for some incremental spending. However, the number of simultaneous reform initiatives should be kept limited to ensure that the accumulation of new liabilities do not undermine fiscal sustainability. In addition, the Governments commitment to explicit reform financing should be accompanied by additional steps in strengthening the fiscal management system. The adoption of formal fiscal rules could strengthen the governments ability to manage external shocks, as well as provide budget support for the reform process in a predictable and affordable way.

2. The Report develops estimates for fiscal costs of three key structural reforms (in civil service, housing and the pension system), reviews the feasibility of different reform options, and provides recommendations related to their planning and sequencing. For each of the structural reforms the Report discusses various scenarios, which altogether cover a broad range of possible options for the Government with quite different fiscal implications. The models used for the preparation of this Report represent an easily adaptable tool that government agencies can use to develop their own fiscal cost projections for alternative reform scenarios.

3. The Report treats the key structural reforms as medium-term projects/programs, thus suggesting that implementation of these and other structural reforms can be put in the context of medium-term expenditure framework (MTEF) that evolve in Russia. Thus, the proposed approach to fiscal costing of the reforms is in full concord with the recent Governments initiatives on introducing strategic planning, MTEF, and elements of performance budgeting.

Fiscal Costs of Civil Service Reforms 4. The report develops a general framework for costing-out the direct fiscal effects of various reforms in the area of public administration. It suggests that broad reforms in the core government administration and in the civilian public sector at large may be implemented within five to seven years but should be differentiated by the scope of pay adjustment in various sub-sectors of civilian employment, closely monitored for non-wage expenditure growth, and complemented by significant staffing adjustments in the civilian public sector as well as by at least some staff reductions in the core government administration.

5. Implementation of such reforms would require additional budget financing as compared to the 2003 expenditure levels, but fiscal costs could be sustained within a reasonable range. Under the most realistic set of assumptions, incremental costs for a consolidated budget would amount to 1.22.3 percentage points of GDP by the end of the reforms as compared to 2003. Moreover, about two-thirds of this increase has already been incorporated into the 2004 budget, reflecting the pay adjustments in the core government administration and the civilian public sector introduced in late 2003. Such additional financing would provide for a major reduction in the pay gap between the public and private sector, especially for senior government officials.

xii 6. A more detailed analysis of the incremental fiscal costs suggests that the costs to the federal budget would amount to about 4045 percent of the total cost increase, while the rest would become the responsibility of subnational budgets.

7. While additional spending on public administration is necessary to ensure better quality of policymaking and public service delivery in the country, it is not sufficient.

Successful implementation of the budget process reform, introduction of performance budgeting, and creating incentives for better performance in the public sector would also be needed.

8. A significant adjustment in employment levels is critical to make the civil service reform sustainable. Even moderate pay adjustments undertaken without a cut in staffing would make the reform fiscally unaffordable. It is expected that by 2010 average employment in the civilian public sector would decline by about 25 percent. Making the Russian government leaner also seems to be consistent with the implications of the existing demographic trends.

Fiscal Costs of Reforms in Housing and Communal Services 9. The report analyzes the potential fiscal and social impact of advancing housing and utility sector (HUS) reforms in Russia under different scenarios. It argues that in the current environment of high growth in household incomes, by 2006 it would be possible to attain percent cost recovery in tariffs with the simultaneous elimination of all quasi-fiscal crosssubsidization and the adjustment in domestic energy prices. Moreover, the reforms in residential housing could be made budget neutral in the medium term and they would bring considerable savings in the long term. However, the high sensitivity of results to income dynamics suggests that the Government should establish an efficient monitoring system to track the affordability of tariff increases for the population. The Report also emphasizes the restructuring of financing mechanisms in the sector to ensure a higher degree of accountability of both municipal governments and service providers.

10. The baseline reform scenario suggests that as a result of proposed reforms the real unit cost to households in the HUS would increase by about 90 percent relative to the prevailing 2002 level. However, given the tariff adjustments that already took place in 200304, it is expected that future cost increases would be limited on average to about 40 percent relative to their levels at the end of 2004.

11. An increase in energy and utility tariffs would make the delivery of utility services to budget organizations more expensive by about 0.7-0.8 percent of GDP per annum. Some of these costs could be compensated through increased taxation of energy and utility providers and, later on, through rationalization of the public sector. However, 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.

12. The analysis suggests that elimination of housing privileges could be affordable for most of the current lgoty recipients, while the housing allowance program would be capable of taking care of those who face a high housing cost burden. However, given the political sensitivity of entitlement reforms, there may be a case for reforming lgoty in a more gradual way. As a starting point, the Government should monetize the lgoty to transform them into explicit subsidies and link them directly with the system of personal social accounts.

Moreover, to reduce political costs, phasing out lgoty should be coordinated with other xiii structural reforms, including wage increases in the public sector, and increases in pensions and child benefits.

Costs of Pension Reforms 13. Estimates of potential fiscal costs associated with various developments in Russias pension system are based on a comprehensive actuarial model. It finds that such fiscal costs are likely to emerge as a result of the declining relative value of old age pensions 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 2002 to 24.4-27.8 percent in 2030. Moreover, the proposed cuts in 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.

14. In the baseline scenarios, the annual fiscal costs to the government, associated with the need to address the problems accumulated in the pension system, amount to 0.25-0.percent of GDP in 2020 and to 0.55-0.90 percent of GDP in 2030. These costs are measured against a target of maintaining the replacement rate at 30 percent. However, the potential costs would increase rapidly in all scenarios with the reduced contribution rates. In the low case, the annual costs to the budget would exceed 2 percent of GDP in 2030.

15. The analysis also suggests that trends in the share of the taxable payroll in GDP play a critical role in determining the future results of the pension reform. This highlights the importance of policies aimed at stabilizing payroll and income taxation, as well as at the removal of various administrative barriers in the economy that currently hold back the reduction of shadow incomes and wages.

Conclusion 16. The current improved economic and fiscal situation in Russia provides a unique opportunity to policymakers to undertake key structural reforms, which have a high payoff in terms of future growth and economic and social stability. Structural reforms in public administration, housing and utility services, and pension system are affordable if planned properly and sequenced in the context of a rule-based fiscal management framework.

xiv Chapter 1. PRINCIPLES OF STRUCTURAL REFORMS FINANCING 1.1 This Chapter discusses recent fiscal trends and the challenge of budget financing of core structural reforms within a broader framework of fiscal management reforms in Russia. It argues that explicit financing of structural reforms is fully justifiable because these are the investments in the institutional infrastructure with a high rate of return. In addition, at the moment Russia appears to have a fiscal room for some incremental spending. However, the number of simultaneous reform initiatives should be kept rather limited to ensure that the accumulation of new liabilities do not undermine fiscal sustainability. In addition, governments commitment for explicit reform financing should be accompanied by additional steps in strengthening the fiscal management system. In this context, the Chapter suggests fiscal rules for Russia that could strengthen government ability to manage external shocks, as well as provide budget support for the reform process in a predictable way. The Chapter also summarizes the estimates for fiscal costs of reforms in civil service, housing and pension system, which are analyzed in a greater detail in the following chapters.

1.2 The World Bank has a long and extensive history of public expenditure analysis in Russia. It has been following the policy of preparing focused analytical pieces on specific priority topics in the area of expenditure management rather than trying to cover all public expenditure issues in one report. Responding to changes in the macroeconomic and fiscal environment, the Bank naturally shifted its focus from the fiscal sustainability analysis (World Bank, 1996a and 1998c) and general diagnostics of fiscal management system in Russia (World Bank, 1996b) to more narrow and more technical issues, such as quasi-fiscal subsidies and non-cash operations (World Bank, 2000) and analysis of the public investment program (World Bank, 2001). Experience showed that for the Bank this is the most productive and client-oriented way of contributing to the reforms in expenditure management in Russia. The present report continues this practice by looking at fiscal aspects of structural reform implementation in Russia.

A. RECENT FISCAL TRENDS, 1998-1.3 Since the 1998 crisis, Russias macroeconomic performance has improved considerably. The cumulative GDP growth during 1999-2003 reached 38 percent. Solid economic growth contributed to the growth in budget revenues and allowed Russia to substantially improve its fiscal performance. Starting in 2000, federal and enlarged budgets have been executed with a surplus. This brought the public debt down to 28 percent of GDP by the end of 2003 from 85 percent at the end of 1999. The problems of non-cash budget execution, pension and wage arrears in the budget sector have been successfully solved.

1.4 Revenues of general government recovered to the steady level of 36.5-37.6 percent of GDP in 2000-2003 after a sharp decline to 33.6 percent in 1999 from 39.3 percent in 1997.

Federal budget revenues grew markedly to 16.7-17.8 percent of GDP in 2001-2003 from the pre-crisis level of 12.5 percent, helped by the centralization of tax revenues and the progressive taxation of the oil windfall. At the same time, the non-oil federal budget revenues declined to an estimated 10.5 percent of GDP in 2003 from 12.3 percent in 2001, while the oil revenues were on the rise along with oil prices (IMF, 2003 and 2004). As a result, the federal budgets dependence on oil prices increased significantly. The share of its oil revenues grew from 45 percent of the total in 2001 to 59 percent in 2003.

1.5 Indeed, a more thorough analysis reveals that both the GDP and budget revenues were propelled largely by the high world prices of crude oil Russias main export commodity. It is estimated that almost 80 percent of the incremental increase in general budget revenues was oil-factor driven, including spillover effects on the gas sector and other sectors (Kwon, 2004).

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