Comments: Mikhail Dmitriev

Ke-young Chu, Sanjeev Gupta, and Vito Tanzi
Published Date:
May 1999
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Since my policymaking experience relates to transition economies, I will focus on a number of challenges and problems that policymakers in transition economies are facing. These problems are closely related to the issues discussed by Grzegorz Kolodko in his paper. The transition countries have inherited from their communist past a welfare system that is much more advanced, comprehensive, and mature than those of developing countries, many Latin American economies (e.g., Chile), and Southeast Asian countries. In fact, during the transition, these welfare systems did not shrink. Actually, during the first years of transition they grew sharply, in relative terms, in most of the Central European countries and in many members of the Commonwealth of Independent States (CIS). The share of social spending in Russia, for example, increased by 5 percent of GDP in the three years after market reforms began (1991), and the share of social spending exceeded 60 percent of the overall spending of the general government.

The problem with this spending increase in transition countries was not only its size but also its failure to solve equity problems or improve the social climate. This spending followed the traditional patterns of the communist economy, which had extracted huge resources from the real sector and redistributed them equitably among the population but without regard for household income or other indications of wealth or social position. These distributions were mostly in the form of universal subsidies or allocations to certain population categories, and it did not matter much whether these categories included rich or poor households. This system was fairly effective during the communist era because, as Kolodko indicated, the general level of poverty was relatively small and communist societies were relatively equitable. But in the transition economies, inequality has sharply increased, which means that a significant part of these countries’ welfare spending is being wasted.

We see that these huge social transfers, which were designed to assist the poor, are actually working regressively. In most of the transition economies, these transfers are not fairly means-tested. Although I have no corresponding figures for other transition economies, in Russia we have a clear picture of how the system is working; for example, many more households in the upper three than in the lower four deciles have access to child allowances. A similar situation exists with many other transfers; for example, for certain transportation subsidies, 90 percent of transfers go to well-to-do families. Seventy percent of subsidies for holiday resorts, the so-called compulsory tourism, is being consumed by the wealthiest 30 percent of households. The share of nonpoor receiving social transfers is almost 10 percentage points higher than the share of the very poor. Thus, in Russia and other transition countries, this welfare system should be reformed, or it will continue to increase poverty and prevent significant improvements in income equality.

This welfare system also creates a difficult public choice problem. In Russia, for example, more than 100 million people receive some type of benefit. This means that two-thirds of the population has a vested interest in social transfers, and it is, therefore, politically difficult to reduce benefits or make them better targeted to the poorest. The electorate can make it difficult for politicians to introduce means-testing or retarget transfers.

Perhaps not in Poland and Hungary, where significant progress in curbing inefficient welfare spending has been achieved in recent years, but in most CIS countries, pressure is mounting for governments to increase social spending, despite its being inefficient and poorly targeted. At present, Russia’s total commitment for categorical benefits is about 350 billion rubles, or 15 percent of GDP, of which only about 20 percent is actually financed. The unfunded 80 percent either becomes arrears or is simply ignored, thus contributing to the economy’s general fiscal imbalances.

In the Central European countries, past pressures to increase public spending were usually met by raising taxes. However, when taxes were increased in the transition economies—and on this point, I do not completely agree with Kolodko—it worsened income inequality. As recent Russian surveys show, most of the individual income and payroll taxes—the source of more than 30 percent of general government revenues—are collected from below-average wages. Therefore, the poor and the middle class are paying these taxes, which are then unevenly redistributed in favor of the richer and well-to-do families. Thus, increased taxation does not improve equity in transition economies.

The last observation relates to the problem of health and education. Supply-oriented financing policies, also inherited from the communist past, have significantly contributed to inequality among the beneficiaries of health and education services. This has happened in two ways. First of all, supply-oriented financing presumed that fiscal allocations were being provided to mirror the supply of services—for example, the number of hospital beds or hospitals and clinic staff. In fact, however, resources were thinly scattered among providers, many of them redundant, and some providers gave inferior service, some of which was not needed. This resource misallocation generated enormous shortages of funds, resulting in relatively low wages for health workers. These employees became more impoverished than those in other sectors of the economy.

The problem in Russia and many other transition economies is that only a few gain access to health and education services without paying informal charges. This situation has exacerbated the second system-generated contribution to inequality: because of insufficient government resources, households have had to pay a significant amount of their own health and education costs. A recent survey in Russia by Boston University shows that household spending on health care is about equal to overall public spending, that is, about 3.5 percent of GDP is spent by government and slightly less than 3.5 percent of GDP is paid by households. This ability to cofinance is strongly dependent on family income and is strongly regressive in itself. As the same survey reveals, private spending on health is 3.5 times higher in the highest income quintile than in the lowest one. According to another survey, the same ratio for primary and secondary education is about 4. Many poor households have no access to even basic health and education services, because they cannot cofinance them. The incidence of abstinence from medical treatment due to income constraints is 2 to 7 times higher in the lowest-income quintile than in the highest one. Ironically, well-to-do households, on average, enjoy a higher share of public subsidies because they consume higher amounts of health and education services from the public sector.

Comprehensive welfare system reforms are needed in many transition economies if these systems are to help reduce poverty and inequality. To conclude on a more optimistic note, I would like to point out two things that I believe are helping the transition economies to reform their welfare systems.

First, in transition economies there is a huge drive for transformation and reform. Economic reforms are being undertaken in many areas, creating a sort of reform momentum that makes it easier to implement social reforms.

Second, the crisis of the underfinanced welfare systems is forcing governments to reform these systems. For example, Hungary and Kazakhstan have begun to implement comprehensive pension reforms, because they could no longer sustain huge pension system deficits. In Hungary, financial pressures forced the government, within the short span of five years, to reconsider almost annually the pay-as-you-go benefit formula in order to reduce government expenditures on pensions. In Kazakhstan, financial pressures caused by huge arrears delayed pensions for many months. Thus, we can expect that these financial crises will put pressure on the transition economies for welfare reform, which is needed to make social transfers more efficient and better targeted to the poorest households.

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