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1.20 The financing of structural reforms belonging to the first group could come from the following possible sources: (i) a stabilization fund, and (ii) government borrowing. This would give rise to a temporary structural budget deficit, which is discussed below in this Chapter. Structural reforms belonging to the second group should be largely financed through compensatory policies such as: (i) savings on other, less efficient, expenditures, (ii) savings achieved during the implementation of the third group of structural reforms, and (iii) revenues from additional taxes. In this case, incremental expenditures and the compensatory increase in taxes could be justified by the expected reform gains namely, the growing efficiency of the public sector, including the provision of better quality public services. However, it is likely that the financing of these structural reforms through compensatory policies will become available with a delay, because some time will be needed for the development and implementation of such policies. Therefore, in this case a structural budget deficit may emerge as well, but it will gradually be phased out with the help of compensatory policies.

1.21 From the institutional viewpoint, it seems appropriate to channel budget resources to finance the implementation of structural reforms through a special structural reforms fund (SRF) in the federal budget. This would ensure that budget resources are earmarked for the implementation of the agreed structural reforms that are considered to be a priority. The government will have to control the size of the SRF in line with its general principles of fiscal policy (see more on this subject below in this Chapter).

1.22 It follows that the existing Federal Fund for Regional Fiscal Reforms (FFRFR) or a similar structure should become one of the components of the SRF, as well as resources raised as loans from the IFIs that aim at the acceleration of subnational reforms. As discussed earlier, a FFRFR-type facility would provide partial financing for subnational reforms within the first group of reforms.

1.23 The issue of costing structural reforms is not absolutely new for Russia. The government itself estimated foregone revenues or costs of some structural reforms (e.g. tax reform and pension reform). Yet, this work has never been done systematically and put in a proper fiscal framework, which would allow comparing different reform scenarios and different structural reforms and provide proper links between the costs of reforms and the overall budget process. In addition, the earlier research in this area government (including the most advanced analytical exercise to date undertaken by the Expert Institute (Yasin, 2003)) relied mostly on rough expert estimates. The present report suggests a much more rigorous multi-factor approach and models, which allow (i) tracking expenditure changes at the disaggregated level for every specific structural reform, and (ii) presenting and estimating multiple reform scenarios.

1.24 Yasin (2003) analyzed risks associated with the unfinished structural reform agenda in Russia for the countrys longer-term growth prospects. He argues that low gas and energy prices, together with low salaries, are the fundamental barriers for raising competitiveness in Russian manufacturing. Depressed prices for production inputs are not conducive to the development of domestic industries as they destroy incentives to save energy and raise productivity. He develops a detailed argument to support two fundamental claims:

acceleration of structural reforms in energy and housing sectors, as well as related measures in the areas of wage policy and social security is the core policy challenge for the Russian government;

there reforms are closely inter-related and should be advanced in parallel within the single financial framework, where higher domestic energy prices would bring additional taxes to pay higher pensions, social benefits and wages in the public sector.

1.25 Yasins paper also develops some aggregate estimates for the above mentioned financial framework within the 3-year time horizon, which are based on specific assumptions on expected increases in domestic energy prices, housing costs, as well as wage and pension levels. In our report we intend to advance this work further, including through a generation of more accurate set of estimates on potential costs of particular structural reforms within this single framework under different sets of assumptions.

1.26 The specific choice of the key structural reforms analyzed in this reportpublic administration, housing and communal services, and pensionswas determined by the Russian Ministry of Finance in consultation with the World Bank team. This choice reflects both the importance of these particular reforms for the medium term government program, as well as perceived scale of potential fiscal implications in case if these critical reforms are mishandled.

C. COSTS OF STRUCTURAL REFORMS: EXAMPLES OF REFORMS IN THE CIVIL SERVICE, PENSION SYSTEM, AND RESIDENTIAL HOUSING 1.27 This section summarizes the results of the simulation of the individual structural reforms that were developed in this report for three specific sectors, such as the civil service, the pension system, and residential housing. The remaining Chapters of the report present a full description of the respective results, including the assumptions, data and models used in the analysis.

Reforms in the civil service 1.28 The Russian government considers the implementation of the comprehensive civil service reform as one of the key priorities in the mid-term reform agenda. The objective of Chapter 2 of the report is to help the government with the planning and sequencing of its reform effort by (i) developing a general framework for costing-out the direct fiscal effects of various reforms in the area of public administration, (ii) using this framework for generating consolidated estimates for the incremental fiscal costs of specific reform scenarios, and (iii) developing recommendations on the feasibility of different reform options.

1.29 The Chapter presents more than 40 different reform scenarios as well as the potential results of their step-by-step implementation through the period 200410. The scenarios differ considerably in terms of the pace and scope of relative pay increases in the public sector, the scope and pace of attrition, changes in the share of non-wage costs, etc. In addition, the Chapter analyzes the sensitivity of potential reform costs to changes in the basic macroeconomic parameters. It identifies the future growth rate in private sector wages as the most important macroeconomic factor: the higher the wage growth in the private sector is, the more expensive it would be for the government to close the existing pay gap.

1.30 Overall, the results of the simulations show that the reform may be implemented without a significant increase in overall fiscal costs. The Chapter argues that a fiscally affordable reform should be based on moderate pay adjustment and should assume significant staff reductions in the core government administration, and especially in the civilian public sector. Under the most realistic set of assumptions, the incremental costs for the consolidated budget would amount to 1.22.3 percentage points of GDP by the end of the reform (depending on the macroeconomic scenario) as compared to 2003. These costs do not look prohibitively high when considered in the international context. 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. At the same time, the remaining one-third of the total reform costs must be added to ensure full financing.

1.31 The Chapter also argues that the future reform package should not be applied to the core government administration only, but should cover the entire civilian public sector.

Otherwise, politically it would be quite difficult for the government to sustain a drastic increase in the compensation gap between the civil servants and the rest of the public sector employees. Moreover, our modeling suggests that the expected fiscal gains from more aggressive staff attrition in the civilian public sector would help to finance a portion of the costs related to the implementation of civil service reform in the core government administration. At the same time, it seems desirable to synchronize primary components of the reform, such as pay and staffing adjustments. Such synchronization would allow the stabilizing of the overall level of employment-related expenditures on the civilian public sector. On the other hand, de-linking the reform measures might create unnecessary expenditure fluctuations, which could be an additional risk to reform sustainability.

1.32 To achieve its objectives, the reform strategy has to differentiate across the sub-sectors of public employment. The pay increase should be the most significant for the headquartersbased civil servants, lower for the deconcentrated units and regional and municipal parts of the core government administration, and lowest for the rest of the civilian public sector. The last could be justified in part by the growing share of fee-based services provided by this sector, which would become an increasing source of compensation for its employees. Inside the headquarters-based federal civil service, the pay increase should emphasize a larger and faster increase in compensation for decision makers. Such a focus of the pay reform would allow addressing the key constraints of the low policymaking capacity inside the government and would help retain highly qualified public officials in key positions in the federal civil service.

1.33 The results of our simulations suggest that over the period up to 2010 it would be unlikely for the Russian budget to be able to afford a full closure of the current public-private pay gap through a radical pay adjustment in the entire public sector. It seems more realistic to expect that the average residual pay gap for core government administration would remain significant (in the 100 percent range of the public sector wage). However, recent surveys of public officials reveal that such a gap may be quite acceptable, because it seems to reflect the existing expectations of the public officials. A stronger effort to close the gap (to the average level of 50 percent) would raise the costs of the proposed reforms to about 2.23.3 percentage points of GDP as compared to 2003.

1.34 Still, the proposed moderate pace of pay reform suggests that the average wage in the core government administration would grow at a rate that is 25 percent higher than the growth of the average wage in the economy, while the average pay in the civilian public sector would grow at a rate that is 17 percent higher. Moreover, it is recommended to complement this average increase by a more radical pay adjustment for a small number of decision makers in the headquarters of the federal executive authorities. The recommended scenarios would result in an increase in the decompression coefficient for headquarters-based civil servants from 2.5 in 2002 to 6.89.0 in 2010.

1.35 A significant adjustment in employment levels is critical to making the reform sustainable. Even a moderate pay adjustment 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.

The largest reductions are expected in the civilian public sector, where, in part, they could be implemented through the commercialization of some of the budget sector entities.

1.36 Implementation of the broad reform agenda in the core government administration would entail significant additional non-wage expenditures. The full-scale modernization of public service would require both significant investment costs3 and significant recurrent costs for the operation and maintenance of computer systems and physical infrastructure, as well as the implementation of modern HR practices (including competitive recruitment, staff rotation, and training). However, the existing budget constraints suggest that the issue of non-wage expenditure control would be quite important in the course of reform implementation. It is expected that the non-wage expenditure share would have to go down from the current percent of total costs to at least 35 percent, which would still represent a significant increase in financing in real terms.

1.37 A more detailed analysis of the incremental fiscal costs, undertaken for several median scenarios, suggests that the costs to the federal budget would amount to about 4045 percent of the total cost increase, while the rest would become a responsibility of subnational budgets.

About two-thirds of all incremental costs would be linked to the additional funding of the core government administration, while the rest of the civilian public sector would benefit from a smaller share of the expenditure increase.

1.38 Chapter 2 also recommends that additional analysis would be desirable to overcome the important limitations of this set of results. In particular, regional comparative pay and compensation surveys would be critical to better measuring both the current actual value of in-kind benefits and the overall current compensation gap in regions. Further costing of particular investments associated with the modernization of public service (such as the introduction of administrative operational manuals, etc.) would also be helpful to policy deliberations.

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