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4.102 At the same time, all scenarios show a gradual increase in the value of average pension relative to the subsistence minimum. This indicates that with economic growth the real incomes of pensioners will also grow steadily. However, there are two concerns with the patterns of this future growth: a) in the initial period till 2015, despite a low level of current pensions, the growth will be rather slow; and b) as reflected in the falling replacement rate, the growth in pensions will be lagging growth in real wages, which may become a politically sensitive issue.

4.103 A gradual increase in the retirement age by 5 years for men and 10 years for women in the long-term perspective would reduce the system dependency ratio by approximately percent. This makes it possible to provide practically full compensation for the negative impact of the both UST rate reduction of 4 pp. and demographic factors on average pensions.

The replacement rate (assuming the same reduction of the UST rate of 4 p.p.) in 2030 would grow to 33-35 percent, i.e., would be the same or higher than its 2002 level. Even in the case with no expansion in the tax base, the replacement rate would remain above 30 percent. This drastically reduces a risk for budget support to the pension system.

Table 4.13: Summary of the simulation results for replacement rate and potential fiscal costs Scenarios Replacement rate Fiscal costs per annum, % of GDP 2020 2030 2020 Scenarios of Group I 12: base case, no reforms, low growth 27.7 26.4 0.55 0.14: base case, no reforms, high growth 28.9 27.8 0.25 0.12 + 8 p.p. cut in UST rate 21.0 2.14 + 8 p.p. cut in UST rate 22.0 2.Scenarios of Group II 22: 4 p.p. cut in UST rate, expanded tax base, low growth 23.4 22.7 1.70 2.24: 4 p.p. cut in UST rate, expanded tax base, high growth 24.7 23.8 1.35 1.Scenarios of Group III 32: Scen. 22 + increase in the retirement age, low growth 35.5 33.0 - - 34: Scen. 24 + increase in the retirement age, high growth 37.1 34.8 - - Scenarios of Group IV 42: Scen. 32 + reduction of UST privileges, low growth 36.4 33.8 - - 44: Scen. 34 + reduction of UST privileges, high growth 38.0 35.7 - - Scenarios of Group V Scenario 12 + annual immigration of 300,000 28.0 0.Scenario 12 + annual immigration of 500,000 29.1 0.Note: Fiscal costs measured against a target of maintaining the replacement rate at 30 percent.

4.104 Additional policy reforms, related mainly to a twofold increase of the contribution rate for the self-employed and further elimination of tax exemptions, may lead to a modest additional growth in the affordable replacement rate by about 1 percentage point.

4.105 Based on these findings the following recommendations on pension policy could be suggested:

The simulations confirm the need to supplement the proposed reduction in the pension contribution rate with a set of decisions, such as a gradual increase in the retirement age, aimed at a longer-term sustainability of the pension system and an increase in the real value of future pension benefits. A decision on the retirement age is critical for longerterm prospects of the pension system. Further delaying this decision leads to high social and political costs in terms of reduction of the relative value of future pension benefits, and, as argued in this Chapter, is likely to trigger significant longer-term budget liabilities. Moreover, the political difficulties of rising the retirement age may increase in the future as the population continues to age.

The second best solution with respect to the retirement age increase, given the political sensitivity of the issue, would be the introduction of amendments to the Pension Law, which would modify the formula that defines the amount of retirement benefit in a way that create much stronger incentives to delay retirement voluntarily.

Trends in the share of the taxable payroll in GDP will play a critical role in determining future results of pension reform. This highlights the importance of policies aimed at stabilizing income and payroll taxation (to facilitate stability of taxpayers expectations), as well as at the removal of various administrative barriers in the economy that currently hold back reduction of shadow incomes/wages.

It seems unlikely that more radical cuts in the UST rate (in excess of 4 percent points) could be compensated for by the combined positive impact of the tax base expansion and an increase in the retirement age. Under the circumstances, the first best strategy for reducing the UST rates would be to avoid longer-term commitments regarding future additional cuts in the contribution rate that would exceed 4 p.p. It may be rational to do tax rate reductions in stages -- giving the system some time to stabilize after the initial round of UST rate cut of 4 p.p., and after accumulating certain experiences of operating with new parameters, planning for next steps of tax cuts and pension reforms.

At the same time, if the government is convinced that the UST rate cut larger than 4 p.p.

is urgently required to accelerate the formalization of the economy and sustain growth, it should be prepared to provide a substantial compensation to the Pension Fund from regular budget revenues (including the Stabilization Fund). In particular, if the current proposal is finalized to cut the average UST rate by 8 p.p., an annual budget transfer of 1.0-1.1 percent of GDP may be needed immediately to avoid either decline in real value of current pensions or accumulation of pension arrears. The compensation has to be provided until considerable improvements in the revenue performance of the pension system materialize and/or policy decisions are made, which reduce Pension Funds financing needs.

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