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1.79 This safeguard policy would sterilize the part of the revenue windfall which is an indirect result of high oil prices, and would limit spending expansion taking place in the course of budget execution in cases when oil prices and tax revenues turn out to be higher than assumed in the budget law. Presently, the Ministry of Finance makes quarterly projections of expected tax revenues. Therefore, it appears to be quite possible to use these projections as benchmarks for assessing the amounts of the general tax revenue windfall to be transferred to the stabilization fund on a quarterly basis. Such quarterly transfers should replace the current practice of a single annual transfer to stabilization fund made in February of the following year.1.80 Notably, besides playing the role of fiscal stabilizer, the stabilization fund should also perform an important function of a macroeconomic stabilizer by sterilizing the oil revenue windfall. Increasing the share of the actual windfall accumulated in the stabilization fund would help the authorities to maintain the policy aimed at the relative stability of the real exchange rate to prevent the development of Dutch Disease.

1.81 Moreover, the current cap on the size of the stabilization fund in the amount of Rb billion (which is 3.8 percent of 2003 GDP), imposed by the Budget Code, is too small. It may become a serious constraint to an efficient long term fiscal policy. This cap has to be either revised or eliminated as early as 2005, when it is expected that the accumulated reserves in the stabilization fund will exceed Rb 500 billion.

Technically, the amount of the quarterly transfer would be equal to the positive balance between the actual and counter-factual tax revenues for that quarter net of transfers of oil export duty and tax on the extraction of mineral resources that have already been transferred to the stabilization fund during that quarter.

1.82 Expenditure control. At oil prices standing above 20 US$/bbl, the second rule would help in maintaining overall fiscal discipline, especially with respect to control over expenditure levels. During the previous years, when actual oil prices turned higher than stipulated in the budget laws, the government demonstrated little resistance to pressures on expenditure increases in the course of the budget execution. In both 2002 and 2003, amendments to the budget laws considerably increased the expenditure amounts relative to the original budgets. It means that a considerable portion of the total oil revenue windfalls was actually spent on the basis of within-the-year decisions and without proper strategic prioritization. As a result, at a counterfactual oil price of 20 US$/bbl the general budget would have been executed with a deficit of 1.25 percent of GDP in 2003 (IMF, 2004).

1.83 Tax policy. A recent government initiative to lower the social tax rates in 2005, compensating for foregone revenues of the Pension Fund from the general revenues of the federal budget, represents a suboptimal solution. In essence, this decision means that instead of accumulating a higher proportion of the oil revenue windfall in the stabilization fund, the government returns a part of the windfall to the private sector through lower taxes. To date, the private sector in Russia has demonstrated quite prudent financial behavior it has saved almost its entire share of the windfall and invested a good chunk of it in net foreign assets stretching its use in time (World Bank, 2004b). Therefore, for the time being this suboptimal solution could indeed generate serious potential macroeconomic benefits.

1.84 Yet for the government the flipside of this policy is that, when oil prices eventually fall, the foregone revenues will sooner or later have to be raised. This implies that the government should have an up front commitment to raise taxes in the future, and, respectively, the government should not make the commitment that all of the tax cuts it suggest in times of oil windfalls will be permanent. Given the present high level of the marginal social tax rate and the problems with administrating this tax, it would appear more appropriate to raise the rates on other taxes when time comes.

1.85 Public investment programs. Using the commodity price windfall to finance public investment has been quite a common practice for large commodity exporters around the world. However, only a few countries have succeeded in doing this in a non-distorting way.A few factors led to poor results. First, the investment usually went to build structures rather than to purchase equipment, implying a lower rate of return (both financial and economic) on the investment. Second, the investment contributed to economic overheating by provoking higher inflation in the construction sector. This additionally reduced the efficiency of public investment. Third, the typically weak institutional capacity of the governments resulted in poor prioritization and in implementation inefficiencies that led to considerable waste and misuse of public funds.

1.86 This is another reason why Russia should pursue an opposite, countercyclical, policy in the area of public investment being rather conservative during booms, while protecting the levels of public investments (including reform-related spending) during bad times by investing a part of the saved windfall. This would allow for better selection of public investment projects and improved predictability of their financing and it would help to smooth In the 1970s-80s Senegal and Botswana managed to avoid inflating relative prices on investment goods while increasing public investment during positive trade shocks. The reason was that in both countries investment booms were heavily concentrated in purchases of machinery and equipment, i.e., tradable capital (Collier and Gunning, 1999).

the fluctuations of activities in the construction sector. Moreover, such investment policies would be consistent with the lessons learned from earlier fiscal adjustments to external shocks (Easterly and Serven, 2003).

1.87 Managing external shocks. In the oil price range of US$16-20 per barrel, the proposed second fiscal rule would imply that the actual budget would be executed with a deficit of up to 4 percent of GDP. This deficit would have to be financed by a reverse transfer from the stabilization fund, which would be sufficient to maintain the level of budget expenditures stable in real terms.

1.88 Should oil prices temporary fall below 16 US$/bbl, the government could employ the same mechanism of financing budget expenditures from the stabilization fund in order to maintain the constant level of expenditures in real terms.13 If the government faces an extended period of depressed oil prices, it should trigger additional adjustments in its fiscal policies by raising general taxation, cutting the least efficient expenditures, and borrowing.

The cut-off time for switching to such a supplemental policy package would depend on the amount of resources accumulated in the stabilization fund -- the more reserves that are accumulated, the later the policy would have to be launched.

1.89 Specifically, a temporary increase in taxes should (i) be accruable to the federal budget, and (ii) target taxes that have a stable and broad base and those that have the least distorting effect on the real sector, such as VAT and excises.

1.90 The cuts in expenditures should target (i) white elephant expenditures with the least transparency (and, most likely, the least efficiency), such as, the current federal targeted programs, and (ii) spending under the line other expenditures. The real expenditure cut could also be achieved by freezing specific expenditures in nominal terms. As opposed to the method of achieving fiscal consolidation after the 1998 crisis, social expenditures should be marginally affected at the time of future fiscal adjustments.

1.91 An efficient way of reactivating public borrowing could be through using the deferred drawdown option (DDO) offered by IFIs. The benefit of this option is that it can be agreed on well ahead of time at low cost. At the same time, borrowing commercially on capital markets in the period of low oil prices would be much more expensive for Russia, which is an unavoidable reflection of the increased country risks during bad times.

1.92 When the rule #3 is adopted, it would have an additional impact on the management of fiscal flows. During booms the structural fiscal surplus would have to be transferred to the stabilization fund as another funding source. Similar to that, during recessions the reversed transfers from the stabilization fund would prevent expenditures from falling in real terms. In addition, recessions usually bring about incremental expenditures (e.g., on benefits and retraining for the unemployed, capital investment projects and public works). This is why running a countercyclical policy during recessions usually leads to an increase in government borrowing (if the stabilization fund quickly diminishes). At the same time, recessions are the best times from a political economy viewpoint for identifying and eliminating inefficient expenditures. When an economy prospers, this is much more difficult to do.

Depending on the amount of resources accumulated in the stabilization fund, this policy could be sustained for 6-12 months.

1.93 Managing market expectations. As far as the policy of maintaining a strong fiscal balance is not fixed in the law, it remains unclear how strongly the government is committed to continuing this policy in the future. Making the fiscal rule into law could be helpful in terms of improving the perceptions of various market players, including potential investors.

1.94 As far as the third fiscal rule is concerned, if and when the government decides to follow it, it would be very important to adopt this rule while the economy is in a growth phase. This step would send a strong signal demonstrating governments commitment to smoothing the influence of economic cycles on the economy. In this case, market participants would have stronger confidence in overall government fiscal discipline despite the governments expansionary, countercyclical fiscal policy during a period of recession.

1.95 The role for the IFIs. The fiscal framework for structural reforms, which is analyzed in this Chapter, suggests considerable variation in budget expenditures (i.e. their fluctuation in response to various challenges and shocks). However, to ensure that these expenditure interventions are timely and efficient, there should be appropriate institutional capacity within the public sector for strategic management of financing of both public investment programs and structural reforms. In this area the World Bank and other donors could offer their expertise and project management experience. For instance, joint investment projects with the World Bank in support of various structural reforms and infrastructure upgrades could be designed in such a way that the Bank would provide only the start-up and pilot financing and would help to set up project implementation mechanisms. Scaling-up the projects would become entirely the governments responsibility. For this purpose, the government could use the same project preparation and implementation mechanisms that would be jointly established under the initial World Bank projects. Such a project framework may significantly increase the efficiency of government spending on investment and structural reforms if relatively large volumes of government co-financing would leverage the World Bank funds.

In addition, the Bank and other IFIs, and the donor community in general, might provide direct technical assistance to public sector institutions to address the binding capacity constraints.

1.96 The government could keep the amount of tied borrowing from IFIs stable, but at the same time could vary its contribution to joint investment projects by reducing co-financing of structural reforms during recessions. Thus, the governments share in IFI projects could be lower during recessions and higher during high growth phases. This would help when necessary to free the money for maintaining the stability of vital current expenditures in real terms. Operationally, this could be done, for example, by varying the number of regions in which original pilot projects are replicated.

F. CONCLUSION 1.97 The outcomes of the proposed second and third fiscal rules can be summarized in Table 1.4.

Table 1.4: Matrix of the Proposed Fiscal Rules for Russia oil price, US$/bbl Budget balances under different fiscal rules, % of GDP 20+ 16-20 12-1. Oil price adjusted budget balance balanced balanced Balanced 2. Oil price adjusted budget balance with the ceiling for structural reforms costs (2nd fiscal rule), not more than -1-2 -1-2 -1-3. Savings/expenditures from counter-cyclical policy (3rd fiscal rule), not more than +1+2 0 -1-4. Baseline budget balance estimated at actual oil price (excluding surplus -0-2 -2-spending on both structural reforms and counter-cyclical policy), % of GDP Overall actual budget outcome (= 2+3+4) surplus -1-4 -1-Source: World Bank staff estimates.

1.98 It follows from the last column of Table 1.4 that the combination of all three fiscal rules may give rise to an actual budget deficit of up to 8 percent of GDP if the period of very low oil prices and output fall coincides with the implementation of structural reforms.

Specifically, fiscal sustainability rule would generate a budget deficit of up to 4 percent of GDP. Oil price rule would add to the deficit up to 2 percent of GDP, and structural balance rule would add another 2 percent of GDP. However, in the terms of structural budget balance, the deficit would not exceed 4 percent of GDP - 2 percentage points stemming from financing structural reforms under oil price rule and another 2 percentage points stemming from countercyclical policy (structural balance rule). It should be recognized though that during the periods of low oil prices the authorities could draw from the oil stabilization fund and, in this sense, a portion of respective deficits would be self-financed. Following the same fiscal rules during a period of high oil prices exceeding 24 US$/bbl requires that the federal budget is executed with a surplus.1.99 In terms of sequencing, the first two fiscal rules address the most crucial fiscal risks that the Russian fiscal policy faces, and therefore they have to be adopted first. The third fiscal rule is somewhat supplementary and could be adopted thereafter.

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