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Sensitivity to the depth of pay reform. It is clear that the scenarios assuming radical pay reform tend to be associated with larger fiscal costs than those assuming a more moderate approach to closing the public-private compensation gap. To illustrate the difference in costs, two pairs of reform scenarios were selected: (i) a radical pay reform to be implemented within 2004 2008 with moderate administrative changes (Scenario 13) and the same administrative reform effort but combined with a moderate pay reform (Scenario 20); and (ii) a radical pay reform to be implemented within 20042006 with significant administrative reforms (Scenario 16) and the same administrative reform effort but combined with a moderate pay reform option (Scenario 24). All these scenarios are cost out under the same wage growth assumptions.

Figure A2.5: Total Fiscal Costs of Civil Service Reform: Radical versus. Moderate Pay Reform3.2.Scenario 2.Scenario 1.Scenario 1.Scenario 0.0.2004 2005 2006 2008 Source: Staff estimates.

The results of the comparison are presented in Figure A2.5. that confirms that the radical pay reform aiming at a 50 percent residual public-private compensation gap is on average about 1.5 times as expensive as the moderate pay reform that allows for 100 percent public-private compensation gap at the end of the reform process. This difference becomes less extreme when we consider separately the costs of reform for core government administration (Figure A2.6). Although the proposed pay increase in the civilian public sector is lower than the one in core government administration, the much larger number of civilian public sector employees has a major influence on the total cost difference.

Scenario 13 assumes a radical pay reform to be implemented within 20042008 with moderate administrative changes. Scenario 20 assumes a moderate pay reform under the same administrative reform effort. Scenario 16:

a radical pay reform to be implemented within 20042006 combined with significant administrative reforms.

Scenario 24: a moderate pay reform but the same administrative reform effort.

of GDP Total Expenditure Increase, p.p.

Figure A2.6: Fiscal Costs of Civil Service Reform: Radical versus Moderate Pay Reform (Only Core Government Administration Covered)2.1.1.1.Scenario 1.Scenario 1.Scenario 0.Scenario 0.0.0.0.2004 2005 2006 2008 Source: Staff estimates.

The extent of the pay reform influences several components of the overall fiscal costs in our model, including both direct implications (such as increase in cash compensation, staff attrition costs, and increased PIT collection), and indirect implications (increased non-wage expenditures), which in our model are a function of the wage bill and the administrative reform pattern. Table A2.6 presents information on relative importance of different components of incremental costs.

See the previous footnote for a description of the scenarios.

Administration, p.p. of GDP Increase of Expenditures on Core Government Table A2.6: Fiscal Costs of Civil Service Reform for the Selected Scenarios (as p.p. of GDP) Scenario 2004 2005 2006 2008 Medium-Paced Radical Pay Reform with Fair Administrative Adjustment (Scenario 13) Core Government Administration 0.58 0.82 1.05 1.47 1.Cash Compensation 0.50 0.64 0.78 1.05 1.Non-Wage Expenditures 0.13 0.24 0.34 0.52 0.Staff Attrition Costs 0.01 0.01 0.01 0.01 0.Increased PIT Collection -0.05 -0.07 -0.08 -0.11 -0.Civilian Public Sector Employment 1.09 1.18 1.23 1.16 1.Cash Compensation 1.17 1.27 1.31 1.22 1.Staff Attrition Costs 0.03 0.04 0.04 0.05 0.Increased PIT Collection -0.11 -0.12 -0.13 -0.12 -0.Total Costs 1.67 2.00 2.27 2.63 2.Medium-Paced Moderate Pay Reform with Fair Administrative Adjustment (Scenario 20) Core Government Administration 0.49 0.63 0.78 1.03 1.Cash Compensation 0.43 0.51 0.58 0.73 0.Non-Wage Expenditures 0.09 0.17 0.25 0.37 0.Staff Attrition Costs 0.01 0.01 0.01 0.01 0.Increased PIT Collection -0.04 -0.05 -0.06 -0.08 -0.Civilian Public Sector Employment 0.96 0.94 0.88 0.64 0.Cash Compensation 1.03 1.00 0.93 0.65 0.Staff Attrition Costs 0.03 0.03 0.04 0.05 0.Increased PIT Collection -0.10 -0.10 -0.09 -0.06 -0.Total Costs 1.45 1.58 1.66 1.67 1.High-Paced Radical Pay Reform with Significant Administrative Adjustment (Scenario 16) Core Government Administration 0.90 1.25 1.53 1.65 1.Cash Compensation 0.58 0.79 0.96 1.01 1.Non-Wage Expenditures 0.37 0.53 0.67 0.75 0.Staff Attrition Costs 0.01 0.01 0.01 0.00 0.Increased PIT Collection -0.06 -0.08 -0.10 -0.11 -0.Civilian Public Sector Employment 1.16 1.24 1.19 1.11 1.Cash Compensation 1.22 1.29 1.24 1.22 1.Staff Attrition Costs 0.06 0.07 0.07 0.01 0.Increased PIT Collection -0.12 -0.12 -0.12 -0.12 -0.Total Costs 2.06 2.49 2.73 2.77 2.High-Paced Moderate Pay Reform with Significant Administrative Adjustment (Scenario 24) Core Government Administration 0.69 0.84 0.95 1.06 1.Cash Compensation 0.43 0.50 0.56 0.60 0.Non-Wage Expenditures 0.29 0.37 0.44 0.52 0.Staff Attrition Costs 0.01 0.02 0.01 0.00 0.Increased PIT Collection -0.04 -0.05 -0.06 -0.06 -0.Civilian Public Sector Employment 0.95 0.84 0.67 0.60 0.Cash Compensation 0.99 0.86 0.67 0.65 0.Staff Attrition Costs 0.05 0.06 0.06 0.01 0.Increased PIT Collection -0.09 -0.08 -0.06 -0.06 -0.Total Costs 1.64 1.68 1.62 1.65 1.Source: Staff estimates.

The affordability issue of radical pay reforms becomes even more critical when one considers the distribution of the additional fiscal burden between the federal and sub-federal levels of the budget system presented in Figure A2.7. To illustrate the difference in the fiscal implications we considered radical and moderate pay reform scenarios implemented at a medium pace, i.e., within 2004-2008, and accompanied by fair administrative reform efforts (scenarios 13 and 20).

Figure A2.7: Fiscal Implications for Federal and Sub-Federal Budgets for Radical and Moderate Pay Reforms1.1.1.1.1.0.0.0.0.0.2004 2005 2006 2008 Scenario 13 (Federal Budget) Scenario 13 (Sub-Federal Budgets) Scenario 20 (Federal Budget) Scenario 20 (Sub-Federal Budgets) Source: Staff estimates.

Figure A2.7 shows that the sub-federal budgets would be much more affected by higher fiscal pressures than the federal budget: costs for subnational budgets are almost 1.times higher than for the federal budget. Even increased collection of PIT by subnational governments doesnt compensate for the fact that most of public employees in Russia are paid from subnational budgets, which as a result become more affected by the proposed pay adjustment. Sustainability of the sub-federal finances would call for a substantial increase in transfers from the federal budget complemented by a significant increase in the revenue base for sub-federal budgets.

As discussed in Section D, the pay reform has two major tasks: improving external competitiveness of the core government administration and the civilian public sector and instilling internal performance incentives through internal decompression of pay in the core government administration. The results of our simulations confirm that the magnitude of pay adjustment affects the compression ratios in the executive branch (Figures A2.8 and A2.9).

To illustrate this effect, we selected 6 reform scenarios:

(i) Scenarios with radical pay adjustments implemented in various macroeconomic conditions (scenarios 4, 16, and 28); and (ii) Scenarios with moderate pay adjustments implemented in various macroeconomic conditions (scenarios 8, 20, and 32).

Figure A7.6 shows that both radical and moderate pay adjustments result in significant decompression in HQ-based civil service, from the ratio between average wages in Top and Junior Groups of 2.5 in 2002 to 5.28.3 in 2006 and to 6.8-8.3 in 2010. At the Both scenarios 13 and 20 assume implementation of reforms at a medium pace and accompanied by fair administrative reform efforts and by medium growth rates of private wages. However, scenario 13 provides for a radical pay reform, while scenario 20 for a moderate one.

GDP Total Expenditure Increase, p.p. of same time, the decompression effect is stronger for the scenarios with radical pay adjustment. This can be explained by a combined effect of the two parameters used for simulating pay adjustment: residual public-private sector gap and minimum pay increase. In the scenarios that assume a radical pay reform (Scenarios 4, 16, and 28), the residual publicprivate pay gap is smaller, and hence, most of the wages in core government administration are increased by a factor exceeding the minimum pay increase of 30 percent. As a result, the salary structure is brought closer to the private sector comparators, and the decompression ratios are higher. Reversely, in the scenarios that assume moderate pay adjustment (Scenarios 8, 20 and 32), the rule of minimum pay increase (20 %) plays a greater role in determining expected wage growth for a lower level staff. Hence, the residual pay gap is smaller than the average for lower grade staff, which moderates adjustment in the pay structure and results in smaller decompression.

Figure A2.8: Internal Decompression in Federal Executive HQ-Based Civil Service: Radical versus Moderate Pay AdjustmentSource: Staff estimates.

This differentiation in decompression effort could also be seen from the comparison of the proposed pay increases for moderate and radical pay reform scenarios100 (Table A2.7).

As one may notice, the ratio between the pay adjustment proposed for Top and Junior Groups is lower in the case of moderate pay reform than in the case of radical pay adjustments.

Considering that for non-HQ-based staff (i.e., for a great majority of affected employees) we propose pay increases that are only 50 percent of those presented in Table A2.7, application of the minimum pay increase rule is more frequent when we simulate the dynamics of wages for employees in both deconcentrated units and regional and municipal core government administration.

Scenarios 4, 16, and 28 all assume a radical pay reform, but different growth rates of private wages. Scenarios 8, 20, and 32 assume a moderate pay reform, but the same variation in private wage growth.

Note that in actual simulations these increases are further adjusted to reflect annual real wage growth in the private sector.

Table A2.7: Existing Pay Gap and Proposed Pay Increases in Federal Executive HQ-based Civil Service, times Category C Actual Net Estimated Net Proposed Pay Increase Group Public-Private Public-Private Pay Pay Gap, 2002 Gap, 2003 (adjusted Radical Moderate for actual pay Scenario Scenario increases in 2003) Top 7.8 6.5 4.3 3. Chief 5.7 4.7 3.1 2. Lead 5.1 4.2 2.8 2. Senior 3.6 3.0 2.0 1. Junior 2.3 1.9 1.3 1.2* * Minimum pay increase is applied.

Source: Staff estimates; see also Table 4.2.

This trend towards decompression is even stronger in case the compression index captures both HQ and deconcentrated units of federal executive civil service (Figure A2.9), because, as was mentioned above, the proposed pay adjustment for deconcentrated service is smaller and based on local labor market prices. Adopting separate pay scales for HQ-based and deconcentrated civil servants leads to a drastic increase in internal compression ratios from 3.7 in 2002 to about 1012 in 2010.

Figure A2.9: Internal Decompression in Federal Executive Civil Service: Radical versus Moderate Pay AdjustmentSource: Staff estimates.

Pay reform pace and overall affordability of reforms. A brief review of summary results for all 36 scenarios presented in Table 5.4 points to several reform combinations that do not seem at the moment affordable to the Russian government budget. If we assume that the increase in total fiscal costs should be lower than 1.7 GDP p.p.102 in 2004 as compared to See the previous footnote for a description of the scenarios.

Significant pay increase in core government administration and civilian public sector implemented in October 2003 already suggests substantial increase of financing in 2004 as compared to 2003. Therefore, the assumption for fiscal costs growth for 2004 is set at quite a high level.

2003, and/or in 2006 2.3 p.p. of GDP respectively, and/or in 2010 2.7 p.p. of GDP, then the following two groups of scenarios become hardly affordable for the budget:

(i) scenarios assuming implementation of radical pay reforms (Scenarios 1-4, 1316 and 2628103) especially those assuming implementation of radical pay adjustments at a high speed, i.e., within 20042006 (Scenarios 3, 4, 15, 16, 27, and 28);

(ii) implementation of pay reforms without any administrative reform actions (Scenarios 5, 7, 10, 17, 19, 22, 29, 31, 34) regardless of options for private wage growth dynamics.

This preliminary review leads us to two major conclusions. Firstly, significant attrition in civilian public sector and at least some attrition in core government administration is a precondition for successful implementation of civil service reform.

Secondly, radical pay increase for public servants is not affordable to the budget, especially if considered in the 3-year implementation framework.

Taking the above into account, we focus on a moderate pay reform with fair administrative reform efforts to illustrate the impact of the pay reform pace on fiscal costs in 20042010 (Figures A2.10 and A2.11).

Figure A2.10: Distribution of Total Fiscal Burden of Civil Service Reform Scenarios, Depending upon Pay Reform PaceSource: Staff estimates.

Figures A2.10 and A2.11 illustrate that although there is some variation in annual fiscal costs depending on the pace of reform implementation, and it should be taken into account in the context of other forthcoming fiscal challenges (such as peaks in public debt reduction), yet the variation is not very large. This can be explained by the fact that the fiscal implications of the civil service reform consist mostly of the increased current expenditures:

indeed, the only type of one-time expenditures captured by our simulations are the costs associated with attrition, and those are not very high (see Table 2.12)105. Moreover, to sustain the reform achievements, the consolidated budget would have to accommodate annual indexation of pay in the core government administration and civilian public sector in line However, the simulations show that implementation of radical pay adjustments at moderate pace is a viable option in case the share of the real wages in GDP remains constant (see Scenario 25).

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