Pension reform, growth, and the labor market in Ukraine

\/PS 173\ POLICY RESEARCH WORKING PAPER 1 7c; i Pension Reform, Growth, requ .is-, 1 T u ar 1 r~~~~~~~~~~~estc {C. to........ >'.'!e t ' and the Labor Market ys!e,.-- in Ukraine Michelle Riboud t . -: Hoaquan Chu The World Bank Europe and Central Asia Country Department IV Country Operations Division II February 1997  POLICY RESEARCH WORKING PAPER 1731 Summary findings In recent years - as a result of economic contraction, Reform is essential. Restoring the former system declining employment and real wages, and changes in the would be too costly, and maintaining the status quo behavior of the labor market - Ukraine's tax base of the would make the system unsustainable. social security system has declined, threatening its * Reforms which focus on short-term budgetary sustainability. About 40 percent of the labor force works effects and neglect the interactions between the social in the informal sector, paying no taxes, and many security system and the labor market are likely to fail. members of the formal workforce underpay taxes a Raising the retirement age to 65 would have a because they also do informal work. significant financial impact but would need to be Using a model that links the social security system, the accompanied by deeper structural reforms. Raising the labor market, and the macroeconomy, Riboud and Chu retirement age quickly may entail the least political cost, ran simulations to assess the sustainability of the current as many old people are currently working. pension system and the relevance and viability of possible * For the deeper structural reforms needed, reforms. All simulations assume economic reform and introducing a funded-tier should be considered. It would the resumption of growth. They conclude: be an effective way to correct distortions and restore * Economic contraction is not the only cause of credibility. problems with the pension system. To reverse current - Introducing such reforms will be costly and affect trends, most of the labor force would need to be working several generations of workers and pensioners in in the formal sector - an unlikely event, given current different ways. Tradeoffs must be carefully evaluated. incentives. This paper - a product of the Country Operations Division 2, Country Department IV, Europe and Central Asia - is part of a larger effort in the department to foster pension reforms. The study was funded by the Bank's Research Support Budget under research project "Social Safety and Growth: An Analysis of Interactions and Tradeoffs" (RPO 680-35). Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rosario Hablero, room H5-163, telephone 202-473-3971, fax 202-477-3378, Internet address rhablero@worldbank.org. February 1997. (46 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center  PENSION REFORMS AND GROWTH IN UKRAINE: An Analysis Focusing on Labor Market Constraints by Michelle Riboud and Hoaquan Chu *The authors thank Afsaneh Farzin for her valuable contribution to this paper. They also thank Sweder van Wijnbergen, Wafik Grais, and Tom Hoopengardner for helpful comments and suggestions. This research has benefitted from a grant (BB68035M) provided by the Research Committee. Country Department IV Europe and Central Asia   I. Introduction The social security system in Ukraine has many components that are carried over from the Soviet era. The benefits provided by the system include pensions; maternity, sickness, and other employee benefits; unemployment insurance benefits and job search assistance for unemployed workers; and allowances for the elderly and families with children. In addition, a special fund has been set up to assist the victims of the Chemobyl accident. About 80 percent of benefits are financed through payroll taxes amounting to 52 percent, while the remaining is financed out of general revenues of the state or from local government budgets. Overall, about 15 percent of GDP is spent on the various programs in 1996 (see Table 1). By far the most important program is the pension system which represents about 8 percent of GDP and provides benefits to more than a quarter of the population (over 14 million Ukrainians in 1996). Over recent years, in Ukraine as in many other FSU countries, economic and political developments - in particular the sharp economic contraction experienced since 1990 - have put under strain the social protection system. Resources shrank sharply at a time when the claim for these resources increased, raising issues of coverage, benefit adequacy and sustainability. The major concerns have been on the one hand, the contribution of the social security system to massive budget deficits, and on the other hand, the failure to provide an adequate safety net. These issues have been at the center of all discussions regarding stabilization and structural reforms and the proposed solutions have mostly consisted of expenditure cuts accompanied by improved targeting of limited resources toward a smaller group of beneficiaries. While defining these recommendations, the analysis has focused on the immediate trade-offs between the fiscal adjustment and the establishment of a comprehensive social safety net. Little attention has been paid to the possible impact of the proposed changes on the rest of the economy - in particular on the labor market, savings and investment, and the growth path of the economy. Now that Ukraine seems more firmly engaged into a reform process and that economic prospects are improving, increasing attention needs to be paid to the issue of long-term sustainability and adequacy of system design. In this context taking into account the interactions between the social security system and other key economic variables becomes increasingly important. The objective of this paper is to examine the viability of the current pension system and the relevance of possible pension system reforms by integrating the social security system within a macroeconomic framework which reflects the specific features of the Ukrainian economy. The analysis focuses on the main component of the social security system, the pension system, and explicitly takes into account the links that exist between the various parameters which determine in the short and medium term the balance of the pension fund and other key economic and demographic variables which affect the growth path of the economy, notably labor force participation behavior, unemployment, the size of the informal sector and the path of real wage growth. This approach allows for taking into account incentive effects and measuring trade-offs between various goals.  2 TabIle1 Social Protection Expenditures as % of GDP 1992 1993 1994 1995 1996 (est Total 16.2 13.1 13.7 13.6 14.5 Financed out of payroll taxes 13.2 10.6 11.4 11.1 11.4 Pension Fund 8.8 8.3 8.0 7.9 8.1 Social Insurance Fund 1.2 0.8 1.1 1.0 1.0 Employment Fund 0.2 0.2 0.3 0.3 0.3 Chernobyl Fund 3.0 1.3 2.0 1.9 2.0 Financed out of general budget revenues Allowance for elderly & children 3.0 2.5 2.3 2.5 3.1 Other social spending Health, Education, & Culture 11.2 9.6 11.3 11.7 10.5 Consumer subsidies 5.6 10.3 6.7 3.2 2.5 Memo: GDP (trillions of Kbv) 5.033 148.3 1138 5293 8686 Source: Data Provided by the Ukrainian authorities and World Bank estimates. The following section provides a brief description of the structure and features of the pension system in Ukraine. Section 3 analyzes the impact of recent macroeconomic trends and transformation of the labor market on the balance of the pension fund. It also documents the changes introduced in the system since the country's independence. Section 4 describes the model and contains an analysis of the medium-term sustainability prospects. The analysis is made assuming that Ukraine will pursue its reform efforts and recover a growth path. The first question examined in the paper is whether sustained growth and macroeconomic stability over a period of about 30 years would make possible the restoration of benefit levels and features prevailing in the past. It will be shown that this option needs to be ruled out even in the context of a fairly optimistic growth scenario. Section 4 then turns to a second question: whether it would be viable to maintain the system "as it is" currently, that is, with the less generous features introduced recently. The answer will be again negative based on expected behavioral changes. As reforms appear unavoidable, Section 5 analyzes several alternatives. The first part of the section deals with reforms of limited scope which focus on reducing coverage and expenditures without changing the nature of the system. Particular attention is paid to a possible increase in the retirement age. An attempt is made to assess whether these reforms would be  3 effective and sufficient to ensure the sustainability of the pension system. The second part of Section 5 examines more radical reforms consisting of shifting from the current PAYG to a fully- funded system. Several transition paths and their associated costs are analyzed taking into account the specificity of local conditions. Section 6 provides detailed conclusions. II. Description of the Pension System. 2.1. Types of Pensions. The Ukraine Pension system is similar to public pension schemes in many industrialized countries (World Bank, 1993). It is based on the pay-as-you-go (PAYG) principle. Workers and their employers make contributions to the program over their active careers. These contributions finance benefits to current pensioners. The present employer contribution rate is 32.56 percent of workers' salaries; employees contribute 1 percent of their wages. The pension system currently offers five types of pensions to more than 14 million beneficiaries (Kane 1996): Old age pension. Men over the age of 60 and women over 55 are eligible to receive an old age pension. For the full standard pension, men must have worked for 25 years, and women 20 years, in covered employment. The level of a standard old age pension equals 55 percent of reference earnings (an index of 5 peak years of earnings), plus 1 percent for each year over the minimum standard pension employment years. The normal ceiling of a standard pension is 3 times the minimum pension. People who have not worked long enough to earn a standard pension but have reached the retirement age are eligible for a partial pension. The level of a partial pension depends on the number of employment years but is no less than 50 percent of minimum old age pension. The old age pension program is by far the most important since it benefits about 80 percent of all pensioners (about 11 million individuals). Invalidity pension. This type of pension is available for those who are injured or too sick to work (that is, about 10 percent of all pensioners, or about 1.4 million individuals). Depending on the invalidity category and the number of years of covered employment, the pension level can vary from half the minimum wage to 3 times the minimum wage. Survivor's pension. This pension is available for the spouse or minor children of deceased workers (currently about 800 thousand beneficiaries). Survivor's pensions are in general lower than old-age or invalidity pensions. The average survivor's pension is only about two-thirds of the average old-age pension. For minor children the maximum eligible age of receiving the survivor's pension is 18. Social pension. This pension is for those who have not worked in covered employment but who meet certain conditions, such as being over the normal retirement age or disabled from birth. As social pensions are made available to those who are not contributing to the fund they  4 are a form of social assistance payments which has a wide coverage. The level of a social pension is equal to 50 percent of the minimum old age pension, and can be between 30 and 200 percent of the minimum old age pension for invalids and disabled. About half a million persons receive social pensions. Service pension. This program is the smallest (only about 40 thousand. beneficiaries). These pensions are a particular type of old-age pensions for workers in special occupations (such as aviators, truck drivers, lumbermen etc..). These workers can retire at a younger age or with shorter duration of employment. In addition, the pension fund is made responsible for paying certain child allowances (IMF, 1996). However, these allowances represent a relatively small amount (about 3 percent of total Fund outlays). 2.2. Main Features of the Pension System. Compared with many equivalent systems in OECD countries, Ukraine's pension system is generous in several aspects: Low retirement age. The normal retirement age is 60 for men and 55 for women. In many OECD countries such as Germany, Italy, and Japan, the normal retirement age is 65 for both men and women. As noted below, the actual age at which people can start collecting a pension can be even younger. Generous eligibility conditions. The generosity of the system is also reflected in several additional characteristics. First, people can start collecting a pension before the retirement age if they have accumulated enough years of covered employment. Second, people in certain occupations and industries are permitted to retire before the regular retirement age. These workers may receive privileged pensions that are higher than the maximum standard old age pension. Third, people can continue to work even after they have started collecting old age pensions. If they work in a covered sector the post-retirement working years still count in the pension level calculation. Fourth, covered employment includes non-contributing activities, such as higher education, armed services, and caring for disabled person or a child under the age of 3. High replacement ratio. The level of pension compared with the wage level is relatively high' in Ukraine. After working for 25 years, a male worker is eligible to receive an old-age pension that is 55 percent of his reference earnings. Women receive the same percentage after working for 20 years. For each additional year worked, the replacement rate increases by 1 percentage point. Thus, for a typical full career worker who has worked for 40 As will be explained below, this feature has been modified since 1993.  5 years, a full pension replaces about 70-75 percent of previous earnings. In advanced industrialized countries, a public retirement pension replaces only about 40-70 percent of their average wages while at work. All these factors have contributed to a high level of spending for pensions and to a situation whereby pensioners have come to represent over a quarter of the population. Pension expenditures in Ukraine - as in many other transitional economies (Fox, 1994) - represent a higher proportion of GDP (about 8 percent) than the average observed in countries with comparable income per capita (2.9 percent in lower-middle income countries, 6.9 percent in upper-middle income countries). III. Recent Macroeconomic and Labor Market Trends and their Impact on the Pension System. 3.1. Macroeconomic Trends Since its independence, Ukraine like other FSU countries experienced a sharp economic contraction and substantial macroimbalances (Table 2). Between 1991 and 1994, the macroeconomic environment deteriorated continuously. The monthly inflation rate reached an average of 47 percent in 1993 and the decline in GDP accelerated to 24 percent in 1994 leading to an accumulated 45 percent decline since 1991. It was only in October 1994 that the Government initiated serious reform efforts - including a reduction in the budget deficit to 5 percent of GDP in 1995, price and trade liberalization, and the start of mass and small-scale privatization. These efforts have resulted in a sharp reduction in monthly rates of inflation (to about 1 percent in mid-1996) and a slowdown of the decline in real GDP. However, the resumption of growth is not expected before 1997. The sharp economic contraction has put great strains on the social protection system - and in particular on the pension system. While the number of beneficiaries has continued to grow (although slowly), the revenues of the fund declined sharply as a result of significant changes in the labor market. First of all, real wages fell sharply leading to the decline of the wage bill, tax base of the pension system. The sharpest decline occurred between 1990 and 1993 with real wages falling to about 37 percent of their 1990 level. During the same period GDP fell in a lesser proportion, only to 68 percent of its previous level. Further wage decline in 1994 was compensated by an increase in 1995 leaving real wages currently at their 1993 level.  6 Table 2 Macroeconomic Indicators 1990 1991 1992 1993 1994 1995 1996 (est.) Real GDP growth rate -3.896 -8.4% -9.7% -14.2% -23.5* -11.8% -7.9% GNP per capita (US$)(Atlas) .. 2636 2753 2439 1913 1650 1514 As e of GDP Current account deficit -6.1 -4.2 -2.2 Fiscal Deficit -14 -29 -12 -8.2 -4.7 -2.8 External Debt .. .. .. .. 23.8 23.0 21.4 Real exchange rate index (1/1993=100) .. .. 125 108 54 47 39 Nominal exchange rate (1000 LC/$) 0.0006 0.0022 0.0336 1.288 49.86 147.0 200.0 Inflation rate (year average) .. .. 1210 4735 891 376 75 Data Source: World Bank Second, while total employment only fell by 10 percent between 1992 and 1995 and open unemployment remains low (2.4 percent in 1995) , significant changes have occurred in terms of labor force participation, occupational choice and allocation of time between various occupations. As explained below, these changes have induced a decline in the number of contributors to the social security system. 3.2. Changes in Labor Force Participation and Occupational Choice Labor force participation rates observed in the FSU were high, mostly due to the fact that women had reached in the early 80s the highest labor force participation rates in the world 3(see Mincer, 1985). As in other industrialized countries, women had been drawn into the labor force through the migrations from rural toward urban areas, substituting work outside the household for family agricultural work. The process had been accompanied by a marked rise in the level of women's education and a similarly sharp decline in fertility. The soviet socialist economic system, ideology and growth strategy had played an additional key role in hastening the incorporation of women in the labor force (see Ofer & Vinokur 1985). Although labor force participation rates were high over most of the life-cycle, rates were extremely low before the age of 20 and were falling sharply after the age of 55 for women and 2Estimate based on World Bank Household Survey (1995) - other estimates (See Rapawy 1996, WB Poverty Assessment 1996) are of the same order of magnitude. Inspite of low open unemployment, there is evidence of hidden unemployment. It is estimated that in 1995, approximately 2 million employees of state-owned enterprises stay on the payroll although working for shorter hours or on leave without pay. 3 except among the Moslem population who had quite different demographic and labor force behavior (higher fertility and lower labor force participation) than the rest of the population.  7 60 for men. This could be explained by the development of, and easy access to the education sector and the low retirement age. At young ages, the labor force behavior observed in the FSU was close to the one observed in European countries in which large public investments in education took place and labor force participation rates were significantly below those observed in Anglo-Saxon countries (OECD, 1994). The transition brought about several changes. As a response to the sharp income decline and cuts in public spending, labor force participation rates increased sharply for both men and women in the 15-19 age group and at old ages (see Chart 1). For example, in the age group 60- 64, rates increased from 32 to 77 percent between 1989 and 1995 for men, and from 14 to 67 percent for women. Chart 1. Ukraine Labor Force Participation Rates 100% 90% 30% \ --Fmb18 70% 60% 50% A Male 1989 40% \