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Scenarios 18, 20, and 23 assume different pace of pay reforms, but all provide for a moderate pay adjustment, fair administrative reform effort, and medium growth in private sector wages.

As discussed above, we do not try to evaluate investment costs associated with public service modernization in the scope of this Note.

with real wage growth in the private sector. Because in our example the scenarios 18, 20, and 23 are implemented under the conditions of accelerated real wage growth as compared to GDP growth, the fiscal costs of reforms in scenario 18 and 20 (which assume the completion of reforms in 2006 and 2008, respectively) continue growing even after the reforms have been completed.

Figure A2.11: Distribution of Fiscal Burden of Civil Service Reform Scenarios, Depending upon Pay Reform Pace (Only Core Government Administration Covered)1.1.0.Scenario 0.Scenario Scenario 2005 2006 2008 Source: Staff estimates.

Administrative reform magnitude. Three additional scenarios illustrate potential cost differences associated with different scopes of administrative reform:

(i) scenarios with no administrative reforms assumed some increase in the employment levels in core government administration and civilian public sector with a reduction of the share of non-wage expenditures in total expenditures on core government administration to 25 percent;

(ii) fair effort in administrative reform assumed that executive core government employment will be slightly reduced, and employment in the civilian public sector will be reduced (based on the defined ratios between staffing levels in the sectors that provide these services and numbers of their clients) with the share of nonwage expenditures in total costs on core government administration moderately reduced to 32 percent from 37 percent in 2002;

(iii) significant administrative changes that assume, in addition to the adjustment for civilian public sector employment described above, higher attrition rates for core government administration and sustainability of the share of non-wage expenditures in total costs of core government administration at the level of percent.

To illustrate the cost variation under different scenarios of administrative reform implementation, we compared three options Figure A2.12) for a moderate pay reform scenario implemented at a medium pace (i.e., between 2004 and 2008) and accompanied with: (i) no administrative reform (scenario 19); (ii) fair administrative reform (scenario 20);

and (iii) significant administrative reform (scenario 21).

See the previous footnote for a description of the scenarios.

Increase in E xpe nditures on Core Gove rnment Administration, p.p. of GDP Figure A2.12: Total Fiscal Costs of Civil Service Reform for Different Scenarios of Administrative Reform Implementation (p.p. of GDP as compared to 2003) 2.2.Scenario 1.Scenario 2005 2006 2008 Source: Staff estimates.

Figure A2.12 shows that pay reform implemented without attrition clearly drives the total fiscal costs of the reform too high (with additional costs reaching about 2 percent of GDP by 2010). The results of the estimates for fair and significant reform scenarios (20 and 21) do not vary significantly because the key administrative reform component (attrition rates for the civilian public sector employment) is the same for both scenarios. Civil service reform with significant administrative changes requires more financing for non-wage expenditures, which makes scenario 21 slightly more expensive than scenario 20.

Scenarios 19, 20 and 21 assume different scope of administrative reform, but all provide for a moderate pay adjustment, medium pace of pay reforms, and medium growth in private sector wages.

Total Expenditure Increase, p.p. of GDP Figure A2.13: Fiscal Costs of Civil Service Reform in Core Government Administration for Different Scenarios of Administrative Reform Implementation, p.p. of GDP1.1.1.Scenario 0.Scenario 0.Scenario 2005 2006 2008 Source: Staff estimates.

Similar estimates for the same reform scenarios but applied only to core government administration surprisingly yield a different cost pattern: in this case scenario 19 is less expensive than scenario 20 (see Figure A2.13). To explain the reason for such a difference between the results in Figures A2.12 and A2.13, we looked at the structure of this expenditure increase. Figure A2.14 illustrates the dynamics of the two key components of total fiscal expenditures on core government administration: increased spending for cash compensation of employees (depicted by columns) and increased financing of non-wage expenditures (depicted by lines).

Figure A2.14: Fiscal Costs of Civil Service Reform in Core Government Administration: Dynamics of Cash Compensation and Non-Wage Expenditure Increase for Different Administrative Reform Scenarios (p.p. of GDP as compared to 2003)1.1.Sc. 19, compensation 0.Sc. 20, compensation Sc. 21, compensation 0.Sc. 19, non-wage costs Sc. 20, non-wage costs 0.Sc. 21, non-wage costs 0.0.2004 2005 2006 2008 Source: Staff estimates.

Figure A2.14 illustrates two trends. Firstly, the more significant the administrative changes and respectively employment cuts are, the lower is the fiscal burden caused by pay increase. Secondly, the more significant the administrative changes are, the higher is the See the previous footnote for a description of the scenarios.

See footnote 10 for a description of the scenarios.

of GDP Expenditure Increase in Core Government Administration, p.p.

Expenditure increase, p.p. of GDP pressure to increase non-wage expenditures on core government administration and finance public service modernization, HR reforms, etc. Therefore, the total fiscal implications of the civil service reform in core government administration will highly depend on the dynamics of the share of non-wage expenditures in total structure of core government administration financing this dependence is in fact so high that it reversed the costs pattern and brings a different trend for the total increase in fiscal expenditures on core government administration as illustrated by the difference between Figures A2.12 and A2.13.

Given that the scenario of pay reform without any administrative changes is unlikely to be selected because of the higher overall fiscal costs (i.e., when increased financing of the civilian public sector is taken into consideration), we did additional analysis of the fair and significant administrative reform scenarios in order to find a breaking point the share of non-wage expenditures in total expenditures on core government administration that would still make the significant administrative reforms scenario more affordable than the scenario with the fair administrative reforms. To do this, we modified the assumptions used for estimating the costs of scenario 21. The estimates showed that when the share of non-wage expenditures is equal or lower than 35 percent in the total structure of core government administration expenditures, the scenario with significant administrative reforms becomes less costly than the one implying lower attrition rates (Figure A2.15).

Figure A2.15: Fiscal Costs of Civil Service Reform in Core Government Administration for Different Scenarios of Administrative Reform Implementation (measured in p.p. of GDP as compared to 2003)1.1.0.Scenario 0.Scenario Scenario 21 (adjusted) 2005 2006 2008 Source: Staff estimates.

This observation underlines the fact that, while non-wage expenditures are often neglected in policy debates, they do play a key role in determining overall trends in costs of core government administration, and thus they should be fully taken into account at the design stage of civil service reforms. This finding also suggests that the total fiscal costs of reforms (that account for the entire civilian public sector costs) may be underestimated in our See footnote 10 for a description of the scenarios. Scenario 21 (adjusted) is similar to Scenario 21, but has a share of non-wage spending reduced to 35%.

Expenditures, p.p. of GDP Increase in Core Government Administration model because the simulations do not take into account the dynamics of non-wage expenditures for the civilian public sector.

ANNEX 3.MACROECONOMIC FRAMEWORK USED FOR THE ANALYSIS OF FISCAL COSTS OF STRUCTURAL REFORMS This work is based on the following approach to the development of macroeconomic scenarios for the analysis of the fiscal costs of structural reforms. We took the governments baseline macroeconomic projections for the period 2004-06, and used them as a basis for building a set of macroeconomic scenarios, each of which reflects a specific combination of factors that are primary determinants of Russias macroeconomic performance. We identified two such determinants of Russias performance in the medium to longer term: external, which is outside the government control, and internal, which depends on government policies.

Given the high dependency of both the Russian economy and the government budget on world oil prices, their level was used as the external determinant of macroeconomic trends. Following the governments macroeconomic projections, we selected the same two benchmark values for the Urals oil price: US$18.5 per barrel and US$22.5 per barrel. With ongoing global economic recovery, it seems unlikely that oil prices might decline below US$18.5 per barrel in the next two to three years. Beyond that, temporary price drops are possible, but it is still unlikely that they would reduce the 10-year moving average of the Urals oil price to below the benchmark US$18.5 per barrel, which was the long-term average price before 1999. Thereby, our assumptions about future oil prices appear to be fairly conservative and to allow a rather accurate reflection of the possible low case, (i.e., a macroeconomic slowdown caused by low oil prices).

The speed of implementing reforms was the internal determinant of macroeconomic dynamics. For this determinant we distinguish two cases: no reforms and advanced reforms scenarios. The scenario without reforms reflects an inertial strategy of dealing with major structural challenges, which is similar to the reform strategy pursued by the government in 2001-03, when progress in most key structural reform areas was slow and incomplete. The advanced reforms scenario was built on the assumption that the implementation of reforms would be accelerated, primarily in sectors such as energy, housing and utilities, public administration, pensions, and the investment climate. The characteristic features of the advanced reforms scenario include, inter alia higher growth in domestic energy prices in the initial period (owing to aggressive reforms in energy and utilities) and high investment rates (owing to improvements in the investment climate and, more generally, to improved investment confidence in the environment of stronger government reform commitment). At the same time, in the advanced reforms scenario we assume that the acceleration of reforms may cause some shocks for the real sector, which would result in lower growth rates for the initial period. However, growth is expected to pick up considerably in the medium term, when structural reforms would bring a significant pay-off. It is assumed that by 2010 the annual rates of GDP growth under the advanced reforms scenario would exceed the rates under the no reforms scenario, and by 2015 cumulative GDP growth under the advanced reforms scenario, would exceed that under the no reforms scenario.

The detailed presentation of specific quantitative macroeconomic parameters used in simulations could be found in Tables 2.5, 3.13, 3.15, and 4.4 of the main text.

It is worth noting that GDP growth rates assumed in our scenarios for the period 2004-06 are lower than those assumed in the corresponding government projections. Overall, we believe that without advancing the reforms growth rates will be declining: better utilization of existing reserves in the economy, which was a critical growth factor in 19992003, cannot support future growth in the same way as before because the reserves are to a large extent exhausted. At the same time, the advance reforms scenario implies that reforms are likely to temporarily slow down GDP growth compared to the no reform scenario, other things being equal. Therefore, in this case growth rates will also be lower than those assumed by the government.

The consensus medium-term estimates for Russias economy made by investment companies, IFIs and NGOs for 2004-05 are rather favorable; everyone expects that in the most likely scenario the economy would grow at about 5.2 percent a year under the assumption of a modest reform effort (no breakthrough) and favorable oil prices (23-$/bbl). At the same time, almost all of them predict the slowdown of economic growth along with declining oil prices. In this respect, our growth scenarios would not differ much from the alternative projections if the latter are recalibrated at our lower oil prices.

At the same time, it is worth noting that the two out of three models, used for costing structural reforms in this report, designed in a way that the main results (i.e. incremental fiscal costs) are not sensitive to the assumptions on economic growth. The growth parameter is critical only for modeling the pension reform in Chapter 4. To reflect this, in the latter case we undertook an alternative set of simulations based on the assumption of 6 percent average growth for the period 2004-09. But even in this case we found quite a modest sensitivity of the results to the variation in the growth rate.

A combination of the oil price scenarios with the reforms speed scenarios provides for the following set of four possible macroeconomic scenarios. While each of these four scenarios is internally consistent, their combination allows the consideration of rather a broad variation in possible macroeconomic trends. For instance, across-scenario variation in the projected average growth rate for 2004-06 would be between 2.3 and 5.0 percent, annual average inflation would vary between 9.0 and 12.3 percent, and real investment growth would be between 5.7 and 7.7 percent.

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