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1.39 Overall, the Chapter suggests that broad reforms in the core government administration and in the civilian public sector at large may be implemented within five to seven years but should be differentiated by the scope of the pay adjustment in various subsectors of civilian employment, closely monitored for non-wage expenditure growth, and complemented by significant staffing adjustments in the civilian public sector as well as by at least some staff reductions in the core government administration. The implementation of such reforms would require additional budget financing as compared to the 2003 expenditure levels, but fiscal costs could be sustained within a reasonable range. Sustainable public administration reform in Russia cannot be cheap, especially in the environment of rapidly growing real wages. Additional spending on public administration is the only way to ensure a better quality of policymaking and public service delivery in the country. However, this is a necessary but not a sufficient condition. The successful implementation of the budget process reform, the introduction of performance budgeting, and the creation of incentives for better performance in the public sector would also be needed.

Reforms in the housing and utility sector 1.40 Chapter 3 of the report analyses the potential fiscal and social impacts of advancing housing and utility sector (HUS) reforms in Russia under the different macroeconomic and reform scenarios. The simulations are based on the disaggregated model of the full costs of operating the countrys residential housing and the allocation of the costs among the major sectoral stakeholders households, government, and service providers. For each scenario the This Chapter does not attempt to estimate the one time investment costs associated with the modernization of public service, including the introduction of electronic administrative operational manuals, etc.

model estimates the expected demand in overall budget support for the HUS, including all types of budget programs in the sector. The baseline scenario suggests that as a result of the proposed reforms the real unit cost to households in the HUS would increase by about percent relative to the prevailing 2002 level. However, given the tariff adjustments that took place in 2003-04, it is expected that future tariff increases would be limited to, on average, about 40 percent relative to their levels at the end of 2004.

1.41 This Chapter argues that, in the current environment of high growth in household incomes, it is affordable (both politically and financially) to attain 100 percent cost recovery in tariffs with the simultaneous elimination of all quasi-fiscal financing (cross-subsidization) and the adjustment in domestic energy prices. Moreover, the reforms in residential housing could be made budget neutral in the medium term, and they would bring considerable savings in the long term. However, the analysis revealed a high sensitivity of the results to income dynamics. If household income growth slows down, this may generate incremental budget costs of 0.4-0.5 percent of GDP per annum in the medium term. The high sensitivity of the results to income dynamics suggests that the government should establish an efficient monitoring system to track the affordability of tariff increases for both the population in general and specific household groups. The Chapter also emphasizes the need to restructure the financing mechanisms in the sector to ensure a higher degree of accountability for both municipal governments and service providers.

1.42 An increase in energy and utility tariffs would make the delivery of utility services to budget organizations more expensive by about 0.7-0.8 percent of GDP per annum. Some of these costs could be compensated through the increased taxation of energy and utility providers and, later on, through the rationalization of the public sector. However, we estimate that in the medium term a fiscal gap in public sector financing of 0.4 percent of GDP could emerge as a result of tariff increases in the HUS and energy sectors.

1.43 The analysis suggests that the elimination of housing privileges could be affordable for most of the current lgoty recipients, while the housing allowance program would be capable of taking care of those who face too high a housing cost burden. However, given the political sensitivity of entitlement reforms, there may be a case for reforming the lgoty in a more gradual way. As a starting point, the government should monetize the lgoty to transform them into explicit subsidies and link them directly with the system of personal accounts. Moreover, to reduce political costs, phasing out the lgoty should be coordinated with other structural reforms, including wage increases in the public sector, and increases in pensions and child benefits.

Pension reforms 1.44 The analysis in Chapter 4 aims at estimating the potential fiscal costs associated with various developments in Russias pension system based on the comprehensive actuarial model. It finds that such fiscal costs are likely to emerge as a result of the declining relative value of old age pensions and associated political pressures for budget support to the pension system.

1.45 The Chapter is focused on the sensitivity of current trends in the pension system to changes in macroeconomic performance and various combinations of potential reform measures, such as proposed cuts in contribution rates, as well as possible increases in the retirement age. The core variables analyzed in the model are (i) the potential affordable replacement rate, and (ii) the expected ratio of the pension and subsistence minimum. Most of the simulations cover a period up to 2050. However, the analysis is focused mainly on the first half of the period (up to 202530), which is of larger interest to policymakers.

1.46 The structural nature of the pension reform in Russia relates primarily to the introduction of the 2nd fully funded pillar, which fundamentally changed the structure of pension financing in the country. According to the estimates in this report, by contributions to the second pillar may reach 1 percent of GDP a year, while this amount increases to 1.25 percent of GDP by 2015. Respectively, the reform reduces the amount of funds available for paying the benefits to current pensioners through the 1st pay-as-you-go pillar, thus creating temporarily financing needs in the pension system.

1.47 The Chapter concludes that without additional reforms, the existing pension system, even under the most optimistic assumptions, is not capable of closing the growing gap between growth in wages and pensions, which is reflected in the declining replacement rate.

In the baseline without the reforms scenario the average replacement rate declines from percent in 2002 to 24.4-27.8 percent in 2030. At the same time, a gradual increase in the value of the 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 regarding the patterns of this future growth: (i) in the initial period up to 2015, despite a low level of current pensions, the growth will be rather slow, and (ii) because the growth in pensions will be lagging the growth in real wages, it may become a politically sensitive issue.

1.48 In the baseline scenarios, the annual fiscal costs to the government, associated with a need to address the problems accumulated in the pension system, amount to 0.25-0.55 percent of GDP in 2020 and to 0.55-0.90 percent of GDP in 2030. These costs are measured against a target of maintaining the replacement rate at 30 percent. However, the potential costs would increase rapidly in all scenarios with the reduced contribution rates. In the low case, the annual costs to the budget would exceed 2 percent of GDP in 2030.

1.49 Overall, without additional policy changes, any significant cuts in the contribution rates would result in a further decline in the replacement rate relative to the baseline. To avoid a drastic widening of the gap between wages and pensions, a reduction in the contribution rates has to be supplemented by additional reforms, including a decision on a gradual increase in the retirement age. The scenarios with the increased retirement age do not require any budget support to provide a replacement rate of 30 percent.

1.50 It is quite likely that the cut in the contribution rates of 8 percentage points under the latest government proposal would lead to an immediate and considerable decline in the Pension Funds collections relative to the baseline. To avoid either a decline in the real value of current pensions or an accumulation of pension arrears, such a cut would require a substantial fiscal transfer (in the magnitude of 1 percent of GDP a year) to the Pension Fund.

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 the Pension Funds financing needs.

1.51 The analysis also suggests that trends in the share of the taxable payroll in GDP play a critical role in determining the future results of the pension reform. This highlights the importance of policies aimed at stabilizing payroll and income taxation, as well as at the removal of various administrative barriers in the economy that currently hold back the reduction of shadow incomes and wages.

Cost summary for the analyzed set of structural reforms 1.52 Table 1.3 summarizes our estimates of the total potential costs of selected structural reforms analyzed in this report. We estimate that the full annual costs to the federal budget could be limited to 1.5 percent of GDP. Given the current fiscal and macroeconomic performance of Russia, this cost level appears to be affordable.

Table 1.3: Summary of Incremental Annual Fiscal Costs for the Set of Analyzed Fiscal Reforms (relative to the 2004 budget baseline) (% of GDP) a. Pension reform (effect of the cut in contribution rate) 1.0-1. a1. Cut in contribution rates - medium-term effect 2.2-2. a2. Cut in contribution rates plus long-term effect a3. Increase in retirement age b. Housing and utility reforms b1. Residential housing b2. Maintenance of budget organizations 0.4-0. o/w: federal budget 0.c. Civil service 0.4-0. o/w: federal budget 0.18-0.Total (medium-term) for the selected sub-set of reforms 1.8-2. o/w: federal budget 1.33-1.Source: Staff estimates. See Chapters 2-4 of the report.

D. THE CHALLENGE OF FINANCING STRUCTURAL REFORMS: CAN FISCAL RULES HELP 1.53 As mentioned above, Russia, as a country in transition, faces the challenge of catching up with the developed economies in many areas simultaneously. This creates a demand for an active government structural policy aimed at the acceleration of a broad range of structural reforms. Such reforms in many cases require incremental financing, which may add too many extra claims on the budget envelope. Without financing, the implementation of many structural reforms cannot be effective. But funding the reforms without proper fiscal discipline and prioritization could be fiscally distractive. This presents a challenge for a fiscal policy in Russia.

1.54 In our analysis we consider government spending on implementation of core structural reforms to be a sort of public investments in Russias institutional infrastructure that ultimately have rather a high rate of economic return. Delaying or under-financing such spending could be a sub-optimal longer term fiscal policy because it may affect longer term growth prospects of the economy. In this sense, budget financing of structural reforms could be treated as public investment in conventional infrastructure. As shown by Easterly and Serven (2003), under-investing in infrastructure too often creates an illusion of the sustainable fiscal policies. While it may help to reduce the current budget deficits, it often brings too high costs in terms of lower future growth, which undermines longer term fiscal sustainability. At the same time, there is sufficient evidence that successful infrastructure investments have rates of return that are higher than prevailing costs of borrowing in the middle income economies, such as in Latin America. From this perspective, a certain level of funding of infrastructure investments through public borrowing is fully justifiable because it improves, not damages longer term sustainability of public finance.

1.55 Therefore, we believe that earmarked well-planned and accountable budget financing of core structural reforms is justifiable in principle because these are the investments with high rate of return. In addition, Russias strong fiscal position suggests that the government could afford some incremental spending without generating significant risks for macroeconomic stability. In other words, we do not consider an affordability argument as a reason to postpone key reforms. However, the number of simultaneous reform initiatives should be kept rather limited to ensure that the accumulation of new commitments do not undermine fiscal sustainability. Besides, the government capacity limitations also suggest a need for a strict prioritization of the reform process.

1.56 In addition, as argued in this report, governments commitment for explicit reform financing should be accompanied by additional steps in strengthening the fiscal management system. The challenges of structural reforms are too numerous and most of them create considerable longer-term and sometimes overlapping government commitments. This raises requirements to the quality of the fiscal framework, within which various reform strategies could be analyzed, compared and eventually prioritized.

1.57 Moreover, fiscal challenges in Russia are not limited to the financing of structural reforms. As past Russian experience has demonstrated, world oil price volatility, not subdued by the proper macro policies, has translated into significant economic and fiscal volatility in Russia, which has brought high economic and social costs to the country. In fact, oil price volatility is the second and largest fiscal challenge that Russia (like any large oil exporter) faces.

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