PENSION REFORM FAILING TO SOLVE PROBLEMS

DAVID GELASHVILI

During the first hearing, the Georgian Parliament has passed bills of the Georgian Government on social insurance.

In fact, this legislative package signifies beginning of pension reform in Georgia representing one of large-scale economic reform though we should note that this package has not yet attracted much attention of the Parliament or society.
The mentioned requires binary explanation: on the one hand, interest of Parliament members and parties in long-term reform (its results exceed 3-4 year period of politics) is low; at the same time, former Parliament members have high pensions (their pension equals salaries of Parliament members).
On the other hand, population and majority of population have developed distrust towards current economic reforms in the background of hard economic situation. For example, increase of pension age from 60 to 65 would cause sharp debates in most countries of the world. However, proceeding from the symbolic nature of pensions in Georgia, this issue does not yet attract any interest. On the contrary, most of employed population would not oppose this decision due to the symbolic nature of pensions in our country. Growth of pension age would be more acceptable for them.
We should hereby mention the inconsistent policy of the government with regards to the strategic vision of pension reform.
Project on the purposefulness of forming three-dimensional pension system was mentioned in the discussion material of “Poverty reduction and economic growth programme of Georgia”. By the President’s order of 7 April, 2002 pension indebtedness was to be covered by 2003 in accordance with the “strategic plan of implementing President’s social development programme in 2002-2006” (meaningful headline). In accordance with this programme, it was planned to form a commission that would be responsible for the preparation and implementation of pension reform. The Commission had to choose and submit pension model that would be acceptable for the government. The document also provided for changes in the tax code aimed at the development and encouragement of pension funds. Neither of these logical requirements has been fulfilled.
Finally, compulsory social insurance fund of Georgia has prepared a legislative package. As far as we can see, the government has not considered pension reform in macroeconomic context. This package is another example of the obvious trend of the government towards seeming goodwill in the initial stage. However, wishes will not turn into political as soon as this issue affects decision-taking and realisation.
The social insurance system is observed in many segments of economy, f.e. in the wish of employer to employ workforce, in the stimulus of people to work on the level of national savings and fiscal situation of budget.
I think that implementation of the offered pension reform since 1 January 2004 would have a negative effect on all of the above-mentioned segments and consequently on GDP growth rates and the absolute amount of pensions. There is an impression that state apparatus tries to preserve maximal control over the existing pension system. It ignores global trends and the experience of pension reform in most countries of the world.
It is noteworthy that in 1994 the World Bank made a large-scale research as a result of which three-dimensional system was recommended in the background of two world trends – decrease of birthrate and duration of life. Its optimal variant consists of three dimensions:
First: state-controlled compulsory distribution component, i.e. the present system that is in force in Georgia today. Second: accumulative dimension controlled by non-state sector when share of social fee rates goes to individual accounts. Third -voluntary private pension accumulative system encouraged by an appropriate tax stimulus.
The term “accumulative” implies compulsory or voluntary accrual of pension allocations in the form of capital with the purpose of providing retirees with pension income.
Accumulative dimension can be especially effective (in appropriate conditions of regulation) in countries of transition economy and in particular, in Georgia where earnings ratio of financial instruments is higher than in industrial countries. Such countries as Hungary, Poland, Russia, Kazakhstan, Latvia, Khorvatia, Rumania, Bulgaria gradually transit to three-dimension system.
If share of compulsory social fees will be aimed at individual pension accounts and accumulation in the form of real pension capital, it will be difficult to cover shortages. The simplest way out is to finance transition period expenses by issue of state treasury liabilities the most part of which might be purchased by pension funds. It is an approved method leading to the transformation of concealed indebtedness into open debt owed by the state to employees and future retirees. As a result of it, accumulative system will help to avoid crash of social security system and sharp increase of taxes in the perspective by means of the system of individual and capitalised accounts that will have a qualitatively high financial flexibility.
At the same time, accumulative compulsory pension dimension can be introduced in stages when fee meant for accumulation will gradually increase in the total volume of social fees (introduction of three-dimension pension system is considered in detail in the second volume of collected scientific works of the Economic Institute of Georgian Academy of science, 2002).
We should note that if transition period expenses are financed by means of taxes or by reducing state expenses, this approach would increase national savings. This can not be realised in Georgia. Therefore, proceeding from the simple macroeconomic model, financing via increased state debt will not entail the increase of national savings at first sight as sums attracted by the state through securities for repaying the debt to pensioners will serve to reduce the volume of private savings in other direction. Yet, it is known that accumulative pension system is a powerful impulse of the so-called “institutional capital” for creating public good necessary for the development of financial markets. It is interpreted as “regular and institutional environment where investor, firms and authorities interact with each other” (Walker, Pension reform and capital market; 2001). It is especially actual in Georgia with its investment environment being in a difficult situation. Thus, accumulation level in economy (norm of savings) will grow in the future.
At the same time, increased accumulation of significant sums in the first dimension of pension system during the distribution system (it is lost capital from the viewpoint of effective use for economic development) and introduction of accumulative dimension along with the strengthening of the first one (that will sooner or later be inevitable) will be more difficult due to the great burden of expenses involved by the transition to accumulative system.
As far as we know from macroeconomic theory, high norm of savings stipulates fast economic growth before reaching new stable situation. At the same time, recent years’ experience of Georgia reveals the fact that this proportion has remained stable, as capital return is much higher than the economic growth rate. As a result of it, natural capital of economy gained at the expense of savings increases production in the future. Therefore, volume of investments and savings necessary for the preservation of additional capital items is lower than the volume of additional production. Thus, accumulative pension system will promote effective use of capital.
The most important thing is that pension funds change type of savings – they transform it into a long-term one that can be used for private investments, long-term national debt and construction of strategic objects of economic infrastructure.
At the same time, accumulative pension system should be competitive from institutional point of view so that to enable capital investments in accordance with economic and not with political criteria.
We will try to enumerate fundamental drawbacks of new legislative packages despite the positive idea that pension should depend on person’s work experience and salary history. We think that the least acceptable model has been chosen in this stage that would meet this purpose in long perspective.
1. The compulsory social insurance bill provides for division of state budget and fund liabilities as a result of which welfare benefit that do not belong to insurance case (f.e. pension rise for representatives of law enforcement agencies) will be financed by state budget. This means that this year state budget undertakes 40 million GEL additional liabilities. We can say that these sums are unavailable in the budget due to present permanent budget crisis (104 million GEL) with all political forces undertaking gradual increase of minimal salary in the nearest period.
2. Two global world trends – decrease of birthrate and duration of life due to achievements of medicine – endanger viability of pension systems in many countries. Georgia will not be able to avoid these problems, either. Therefore, the strategic purpose should be three-dimensional pension system contributing to the increased diversification of different risks and reliability of pension system. I think that the above-mentioned 40 million GEL are enough for gradual transition to three-dimensional pension system.
The scenario should be as follows: repayment of pension indebtedness in 2004-2005; optimisation of the rate of social insurance fees; development and improved regulation of voluntary non-state pension indebtedness that will pave the way for the establishment of the second accumulative dimension.
Private sector has proved to be effective of late years. Leading commercial banks are a clear example of it. We are sure there will be the same in pension insurance sphere in case of appropriate regulation.
Non-state pension insurance law was passed by the Parliament in 30 October 1998. It is limited as no amendments have been made to the Tax Code after the passage of the law though the issue of amendments has been considered.
This resulted in the loss of entrepreneurs’ stimulus to provide employees with pensions. When state does not manage to issue pensions that would satisfy subsistence level, it should include private and state pension fees in one regime. We should also note that in other countries of the world voluntary insurance did not develop without the appropriate tax stimulus.
According to the above-mentioned law, presently only one insurance company and the National Bank have formed voluntary pension scheme in Georgia. The insurance company has approximately 2500 participators while the National Bank uses this scheme only for its collaborators.
Voluntary private pension systems have appeared since 70s in the USA, then in Great Britain, Continental Europe and Japan. Presently, there are approximately 13 trillion dollars’ private pension assets in the world, of which 7,8 trillions belong to the US, 15 trillions to Japan and 1,1 trillion – to Great Britain. It is known that each third share quoted in the US stock market and 40% of bonds are in the ownership of pension funds (Dresden Bank AG; Group economics, Frankfurt/main 2000; Pension Fund Systems in the World).
It is also noteworthy that countries with the strongest social protection systems in the world make for the creation of such legal framework that would encourage people to voluntarily provide for themselves in old age by means of tax mechanism.
Other important kinds of tax stimulus for the development of private voluntary pension systems are to be found in such countries as Australia, Switzerland, Brazil, Canada, Czechoslovakia, Denmark, Hungary, Slovakia, Bulgaria, Sweden, Russia. The tax stimulus with different combinations consists in the following:
– Sums paid by employers for provision of retirees will be specified in the article of enterprise expenses in accordance with volume limit and it will not be subject to social insurance tax;
– Sums paid by employees in accordance with limit volume as well as non-state pension will not be subject to income tax.
The income gained from investment of pension assets will not be subject to tax.
At the same time, these benefits should be applied in case sums are not used before reaching the pension age. We should note that the negative effect of this tax stimulus on budget would be minimal. It will take years before the tradition of making long-term investments in pension assets will be formed. In the initial stage a greater share of pension assets might be invested in state securities. This will also be used for financing budget deficit.
3. Certainly, it would be a progressive step to determine the maximal amount of the charge base of social insurance fees in accordance with the amount of ten average salaries in Georgia, which equals approximately 1000 GEL. However, we should also say that confinement to this base reduces the development potential of pension system. First of all, it is necessary to gradually reduce the existing 33% rate. Statement of the minister of labour, health and social protection about the preservation of this rate and distribution of theburden from employee to employee will not change the situation. Preservation of 33% rate will not eliminate shade economy and have a negative effect on economic growth.
For your information, tax on salary fund in many countries is 30% more than in our region. For example, it is 15% less in Asia. There is a regressive scale of social taxes in Russia. In accordance with the scale, the minimal rate reaches 2%. At the same time, the Russian government has already taken decision to reduce the rate of single social tax from 35,5% to 26% since 2005. Russia has transited to three-dimension pension system since 2002 and share of social tax is accumulated in individual pension accounts.
The interest rate of pension fees in Georgia is on the level of some developed European countries (for example, Italy). This amount is great for low-income countries leading to especially negative effect in countries with weak administration. We should hereby mention that the total rate of social fees is 15,3% in the US while it is 19,1% in Germany. However, this interest rate does not ensure self-financing of pension system in Germany.
4. Much disagreement can be caused by the issue of self-employers under article 10 of compulsory social insurance bill.
According to the interpretation of the bill, most of farmers and their families will, in fact, be included into the group of self-employers. Under the law, they must pay single social insurance fee in the amount of 18% of average salary in the country totalling approximately 18 GEL each month. We think self-employers should not be included into the new system, i.e. their participation in this system should be voluntary. In other case, this will turn into another source of corruption. Moreover, according to the attached calculation of the bill, authors suppose that 5 thousand insured will join the system in the initial stage while in subsequent year their number will increase by 50% annually. On the one hand, a compulsory norm is passed and on the other hand, the authors do not hope that this norm will work. We should note that inclusion of self-employers in compulsory social insurance system has always given rise to great problems. This will be even more problematic in Georgia due to the weak administration. For instance, Chile has refused their compulsory participation during the pension reform.
4. The transfer of the function of collecting social fees to social insurance funds would not be a logical step in the background of difficult situation in tax administration. This means formation of new structure when tax inspection can easily fulfil the same function. This can not be called a step forward in establishing order in the fiscal sphere of the country. We should also say that the law does not provide for the responsibility of insurer towards insured, which will serve to strengthen distrust towards the new system.
Thus, we think that package of pension reform documents requires serious consideration and development. The present package will hardly contribute to either the formation of effective pension system or economic growth of the country and legalisation of shade economy.