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1 p.p. in UST tax rate cut Could be compensated by an additional budget transfer of 0.25 - 0.30% of GDP 4.85 An important conclusion from this part of the analysis is that without an increase in the retirement age even a rather substantial growth of the tax base does not allow halting the decline in the replacement rate. At the same time, as shown below, with the retirement age increase (as in Group III scenarios) and particularly when the retirement age increases along with cuts in UST benefits (as in Group IV scenarios), the effect of a declining replacement rate is fully compensated.

4.86 The basic distinctions between the scenarios within Group II (Figure 4.12) are associated with the differences in GDP growth rate, as well as with differences in the shares of payroll in GDP. The results also suggest that despite a considerable decline in the replacement rate, the ratio between the pension benefit and the subsistence minimum is less sensitive to cuts in the UST tax rate (Figure 4.13). The latter ratio did not change much relative to the results in similar scenarios of Group I.

Figure 4.13: Ratio Between Average Pension and Pensioners Subsistence Minimum,Comparisons of Scenarios in Group 1 and Group Ratio between average pension and pensioner's subsistence minimum, compariosons of scenarios in 6.0 Group 1 and Group Scenario 2 (Gr1) 5.Scenario 2 (Gr2) Scenario 4 (Gr1) 4.Scenario 4 (Gr2) 2009 2014 2019 2024 2029 2034 2039 2044 Latest government proposal: rate cut of 8 percentage points 4.87 Earlier in 2004, the Government announced a plan to introduce a more drastic cut in the UST rate compare to what has been discussed in this Chapter. Specifically, the latest Governments proposal calls for a rate cut of 8 percentage points, from 28 to 20 percent, which will be allocated among base (cut by 6 p.p.) and fully funded (cut by 2 p.p.) components of the pension benefit. The proposal includes the following compensatory measures:

a) substantial reduction in participation in the fully funded pillar, which, as we estimate, would reduce the average replacement ratio in this pillar by 0.8-1.0 p.p.

by 2030;

b) utilization of the currently expected surpluses in the base component to accommodate a decline in the contribution rate to this component from 14 to percent; and c) compensatory budget transfers to the Pension Fund funded either from regular budget revenues or from the Stabilization Fund.4.88 We estimate that the current plan, if implemented, would utilize about a half of the expected surplus in the base pension component, and it would reduce the affordable replacement rate in the PAYG system by 4-5 p.p. Thus, if there is no compensation for the pension system from the budget, the total reduction in the replacement ratio (including FFP) in 2030 could reach 5-6 p.p. relative to the baseline scenario in Group I without the rate cut.

This is equivalent to a 20-25 percent decline in real average pensions. This would raise potential (longer term) fiscal costs of supporting the replacement ratio of 30 percent to above 2 percent of GDP a year.

4.89 Moreover, the short term negative impact of the proposed could be also significant.

The PAYG component may lose more than 25 percent (6/22) of its regular incomes, while the affordable replacement rate would decline correspondingly. Based on the estimates obtained in this Chapter, we would recommend that the government should be prepared to compensate most of the lost revenues in the PAYG component to avoid either decline in real value of current pensions or accumulation of pension arrears. Such compensation may amount to an equivalent of not less than 4 p.p. of the UST rate and be funded from regular budget revenues.

It is estimated that the total annual budget costs associated with such compensation would amount to 1.0-1.1 percent of GDP. The compensation has to be provided until either considerable improvements in the revenue performance of the pension system materialize, driven either by strong recovery in real wages or by a decline in the share of informal wages or by both, or policy decisions are made, which reduce Pensions Funds financing needs.

Sensitivity to the high rates of economic growth 4.90 To reflect the fact that our base growth assumptions are quite conservative, we also undertook an alternative set of simulations based on the assumption of the much higher (percent average) growth for the period 2004-09. However, in this case we found rather an insignificant change to our base results. This is because higher GDP growth is expected to be accompanied by higher growth in real wages, which limits opportunities for additional improvements in the replacement rate.

The government indicated that in 2005 it may spend as much as 0.4 percent of GDP from the Stabilization Fund to cover the Pension Fund deficit that would derive from the introduced the UCT rate cut (Prime-TASS, August 24, 2004).

Group III. UST reforms supplemented by an increase in the retirement age by 5 years for men and 10 years for women 4.91 The growth in the retirement age by 5 years for men and by 10 years for women in the scenarios of Group III leads to a considerable decline in the system dependency rate. This decline amounts to approximately 40 percent by 2050 (Figure 4.14), and, therefore, to an increase in the average PAYG pension benefit by about 40 percent. Due to the increase of the contribution period, the affordable overall replacement rate in the optimistic case (with a higher tax base) increases to 33-35 percent in 2030 (Figure 4.15), i.e., by 20-30 percent as compared with the similar scenarios of Group I. Even in the base case, i.e. without the expansion of the tax base, the replacement rate still remains above 30 percent. This considerably reduces the risks of budget support for the pension system.

4.92 The ratio between the average pension and the subsistence minimum increases in the long term by approximately 50 percent as compared with the scenarios of both Groups I and II. In absolute terms, the latter ratio may reach 2.5-3.5 in 2025-30.

4.93 Our sensitivity analysis suggests that, without a mandatory increase in retirement age, a voluntary delay in retirement by 5 years under the current conditions and respective extension of the contribution period would have a noticeable impact on the individual pension. The replacement rate would be higher by 8-25 percent for both NDC and fully funded components, depending upon a particular combination of values for real wage growth and real interest rate. However, the size of this increase may be insufficient to create strong incentives for participants to retire later. The Government may consider amendments to the benefit formula to strengthen the link between the retirees length of service and his/her benefit size. The latter step would be of special importance if there is a delay in resolving the issue of mandatory increase in the retirement age.

Figure 4.14: System Dependency Ratio, Comparisons of Scenarios in Group 1 and Group System dependency ratio, compariosons of scenarios in Group 1 and Group 3, % 4 (Gr1) 0.Scenario 4 (Gr3) 0.0.2004 2009 2014 2019 2024 2029 2034 2039 2044 Figure 4.15: Pension Replacement Raio, Comparisons of Scenarios in Group 1 and Group Pension Replacement Ratio, compariosons of scenarios in Group 1 and Group 3, % 2 (Gr1) Scenario 2 (Gr3) 15.Scenario 4 (Gr1) 10.Scenario 4 (Gr3) 5.0.2004 2009 2014 2019 2024 2029 2034 2039 2044 Group IV. Additional reforms aimed at the reduction of current UST privileges 4.94 The results of the scenarios of Group IV show a modest additional growth of the affordable overall replacement rate by about 1 percentage point relative to the similar scenarios in Group III. This additional growth reflects primarily the following changes: (i) a one time twofold increase in the rates of pension contributions paid by the self-employed and indexation of these rates in accordance with the growth rate of average wages, and (ii) a reduction in the number of people who are eligible for reduced UST rates from 15 to percent of the employed. The latter decline may be achieved through a tighter definition of eligibility rules and their stricter enforcement.

4.95 Even under the most optimistic reform and macro assumptions as in Group IV, the replacement rate remains below 36 percent in 2030. Thus, if the policy target is reaching a percent replacement rate for the average pension, this objective can not be achieved without an expansion in additional private pensions, based on additional voluntary contributions.

Encouraging the development of private pensions is a large, separate task that would require the introduction of supportive regulatory, institutional and tax frameworks.

Group V. Effects of expanded immigration 4.96 In this group of scenarios we simulated a potential impact of a considerable migration inflow to Russia on the trends in the pension system. As a base case, we used a scenario from the Group 1, and compared it with the two additional scenarios that differ by both the level and structure of migration inflow. In these additional scenarios, the annual net number of migrants increases from about 100,000 to respectively 400,000 and 600,000 a year. In addition, it is assumed that the immigration inflow would have a higher share of people of working age (and thus, a higher share of contributors to the pension system) than the average share of working age people in the Russian population. The latter assumption is reflected in a higher share of labor force participants, which is increased by 4-7 p.p.

4.97 While an increase in migration would have a drastic impact on the overall demographic trends in Russia, it has rather a modest influence on parameters of the pension system. Table 4.11 presents the main results of these simulations, which do not change much our previous conclusions the system dependency ratio continue to growth rapidly, while the replacement rate still declines below 30 percent. Even under the boldest assumption on immigration level (which by 2050 bring a considerable increase of 30 percent in the total population), the replacement rate increases by less than 15 percent. In no way, the active migration policy in Russia could become a substitute for a comprehensive pension reform.

Table 4.12: Potential impact of an increase in immigration on the pension system Russias population, System dependency Replacement rate, total, million ratio percent 2030 2050 2030 2050 2030 Base scenario 12, 122 102 0.72 0.93 26.4 24.Group I, low growth The same scenario with additional immigration:

a) of 300,000 a year 132 119 0.68 0.84 28.0 26.b) of 500,000 a year 138 130 0.66 0.8 29.1 28.G. SUMMARY AND CONCLUSIONS 4.98 Based on simulations of various policy scenarios, this Chapter estimates potential fiscal costs associated with various developments in Russias pension system. It finds that these 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. These results are based on the projections that, within the framework of the basic macroeconomic projections and with the current demographic trends, the long-term financial self-sustainability of the existing Russian pension system may be ensured only at the cost of a substantial reduction in the average replacement rate, from 33 percent in 2002 to 24.4-27.8 percent in 2030 and to 23.5-25.5 percent in 2050.

4.99 This replacement rate reduction is driven primarily by demographic factors, while its dynamics is less sensitive to variations in macroeconomic parameters, such as growth and unemployment rates. Even under the most favorable macroeconomic scenario without an increase in the retirement age, the overall replacement rate declines below 30 percent by and by 2050 it goes further down to 25 percent. The rate of decline would be the most pronounced in the period 2016-2025, when it is the most likely to expect that political pressures to support the pension system through budget transfers would emerge. While higher economic growth results in a much higher real value of pensions, it does not help to close the gap between growth in wages and pensions. Additional immigration and any realistic improvements in demographic and employment trends do not change much these basic results.

4.100 Table 4.12 summarizes our results for expected replacement rates and associated potential fiscal costs. Fiscal costs are measured against a target of maintaining the replacement rate at 30 percent. In the baseline scenarios, annual fiscal costs amount to 0.250.55 percent of GDP in 2020 and to 0.55-0.90 percent of GDP in 2030. However, potential costs increase rapidly in all scenarios with the reduced contribution rates. In the most pessimistic case, with 8 p.p. cut in the USR rates and no expansion in the tax base, annual costs to the budget exceed 2 percent of GDP in 2030. In contrast, the scenarios with the increased retirement age do not require any budget support to provide a replacement rate of percent.

4.101 However, the above fiscal costs would expand quite rapidly if the Government implements significant cuts in the pension contribution rates. The simulation results suggest that even under the most optimistic assumptions about potential expansion in the tax base (reaching 35 percent of GDP), this factor cannot compensate for a cut in the UST rate of four percentage points if it is not supported by additional pension reforms. Political demands for maintaining simultaneously higher benefits and low UST rates can result in quick widening of the deficit of the pension system, which would become a contingent liability of the government. Even with a modest rate cut of four p.p., annual fiscal costs would increase to 1.35-1.70 percent of GDP. If the current Government proposal to cut the UST rate by eight p.p. (6+2) is fully implemented, this would raise the fiscal costs above 2 percent of GDP per annum.

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