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«Organisation de Coopération et de Développement Économiques Advisory Group on Privatisation Thirteenth Plenary Session Privatisation, Capital ...»

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Organisation for Economic Co-operation and Development

Organisation de Coopération et de Développement Économiques

Advisory Group on Privatisation

Thirteenth Plenary Session

Privatisation, Capital Market Development and Pension

Systems Reform

Peter MIHALYI

Department of Economics

Central European University

(Hungary)

Privatisation and Pension Reform in Transition Economies

Maison de la Chimie

Paris (France)

21-22 September 1999

AGP 13 - Privatisation, Capital Market Development and Pension Systems Reform Paris, France 21-22 September 1999 I. Background Across the OECD countries, now including three former socialist countries (Hungary, the Czech Republic and Poland), the design of old-age security systems varies widely. Behind this diversion, however, only two major paradigms can be discerned.

a) The origins of the German Bismarckian system go back to the series of social security reforms of the 1880s. In its pure form, this system is contribution-financed. The burden is directly levied on dependent employees and their employers. In the scientific jargon of our times, this principle is often referred as the ‘pay-as-you-go’ principle (PAYG). The link between employment and pension eligibility is very important, since the prime objective of the Bismarckian scheme was to maintain the accustomed living standard of the insured employees.

b) By contrast, the Beveridgean concept of 1942 put an other social objective in the focus. In line with its famous slogan ‘freedom from want’, the scheme implanted in Britain was designed to guarantee an adequate income support in old age – irrespective of the preretirement earning levels. In its practical applications, the Beveridgean system boils down to a tax-transfer system, where the tax base is extended beyond the world of employment.

As time passed, the flaws of these two models have become manifest in many ways. There are five salient

facts affecting most countries:

(1) the demographic trend of decreasing fertility rates;

(2) the advancement of medical science in lengthening the life of retired people;

(3) the return of unemployment levels back to pre-World War II levels.

(4) the weakening of trend rate of economic growth in Western Europe;

(5) long-lasting rise of stock prices on several markets, and in the US in particular.

Since the middle of the 1970s long-term growth rates are in the 3-4 percentage range – at best.

Simultaneously, the past 20 years saw a boom of stock markets world wide and in the US in particular.

Affluent, well-educated retirees have started to discover that PAYG schemes perform poorly in such a comparison. Their conclusion is that they would have been better off, if instead of paying mandatory insurance contributions, they had invested the money on the stock exchange.

Thinking on the role of government has changed, too. It has become a widely held view that elected governments are the prisoners of pressure groups and this prevents them to pursue rational, long-term policies. For similar reasons, the confidence has been eroded in the usefulness of tri-partite decisionmaking, which is an important component of the Bismarckian model.

Beyond the facts (1)–(5) mentioned above, transition economies (TE) suffer from other problems. It was clear from the onset of the pro-market reforms that the ‘premature welfare-state’ (Kornai 1992), as enshrined into the laws and regulations of most countries was unsustainable. Market pressures and the competing political pressure of other interest groups have pushed down the real value of pension entitlements. There is a sever compliance problem. Tax evasion, non-payments of social security contributions, misuse of disability pension provisions are widespread. The state is weak. The lack of administrative capacity to monitor a rapidly changing enterprise sector and the will to enforce regulations hampered greatly the existing PAYG system to function (see Box 1). In worse cases, pensions are not paid This is true foremost in Western Europe. Unemployment levels in the US are at historically low levels. By contrast, the threat of mass unemployment as a serious possibility is a new development in Japan and South Korea.

As Martin Feldstein (1997) put it “The problem with the [US] Social Security program is not its prospective bankruptcy but that it has become a bad deal for participants.” Copyright © OECD All rights reserved AGP 13 - Privatisation, Capital Market Development and Pension Systems Reform Paris, France 21-22 September 1999 regularly at all (e.g. Russia and several other successor states of the former USSR). In countries like Poland or Slovenia, successive governments were willing to protect the acquired rights of pensioners. But the price was high: 14-15 % of GDP. This is not sustainable for long.

Box 1.

Evasion of contribution payments in the transition economies A major difficulty has arisen in all TEs from the unexpected depth and prolongation of the output decline after 1990 and the ensuing rise in unemployment. When policy makers opted for the reintroduction of Bismarckian-type, payroll based social security systems, nobody counted with the possibility that a shrinking labour market would not be able to generate the expected volume of contributions.





In the period 1990-94, this problem became acute in most TEs (perhaps the two successor states of Czechoslovakia being an exception), as large industrial enterprises were closed or shed workers in large numbers in order to remain viable. This was the beginning of a vicious circle. In some TEs non-payment of contributions was more or less limited to the circle of bankrupted companies. If this was the case, sooner or later, non-payment of contributions became a stock problem (i.e. as arrears of defunct companies). In many less fortunate TEs, non-payment of contribution became a flow problem, as nonpayment became widespread even among relatively well working companies. The mechanism was simple: first, the troubled enterprises failed to pay contributions (and taxes) to the central government.

Then the central government stopped paying for its purchases to enterprises and discontinued regular payments to its own employees. Once this happened, state-financed institutions (e.g. army, police, railways, and schools) suspended their contribution payments, which in turn somehow legitimised the nonpayment of the enterprise sector as well.

Grey economy and moonlighting are hotbeds of evasion, too. In the de novo private sector only 30-50% of the business are rendered against proper invoices. For the rest, neither taxes, nor contributions are paid.

Another problem is the avoidance of contribution payments on the part of small entrepreneurs, farmers, individual artists, journalists, etc. In this case, “evasion” is not a proper word, since the low level of willingness to pay has been already incorporated into the legislation. E. g. in Poland farmers are not even supposed to pay, while in Hungary, farmers are allowed to pay a favourable rate – close to or identical with the minimum statutory wage. The same is true for most of the other above-mentioned categories.

In Hungary, there is a dramatic increase in the number of employees registered at minimum wage so that also a minimal contribution is paid after them. In reality, virtually all of them wage earners receive higher wages. The difference goes directly into the pocket of the employees or it is received in the form of benefits, which are not subject to social security contribution payment.

At a higher level of abstraction, the problems of arrears and evasion have the same causes. On the part of the insured and his/her employer there is virtually no incentive to pay contribution. Eligibility to pension is only very loosely related to declared lifelong earnings and earnings-based contributions.3 The other explanation is the weak – and often still weakening – authority of the state. Although there are sanctions in the legislation (e.g. bankruptcy law, penal sanctions for tax and contribution fraud), the insurance funds do not have the capacity to administer the system or to exclude non-payers.

–  –  –

Conclusions. The above mentioned developments have all contributed to the change in thinking about old-age retirement both in DMEs and TEs (Table 1). Politicians, scientist and even multilateral organisations have started de-emphasise the role of the etat provident, to depoliticise the issue of pensions and to praise the social and economic importance of linking individual effort and reward. In the context of the pension reform the new doctrine means a shift from single nation-wide pay-as-you-go systems to privately owned and privately managed, fully funded (FF) schemes, where the insured accumulates a fund over the entire working life.

–  –  –

In Western market economies, privatisation and pension reforms had distinctly different evolutions in time. Privatisation surfaced as an important policy issue already in the 1970s. The first waves of divestment of state owned enterprises (SOEs) were seen in the Anglo-Saxon countries (UK, USA).

Continental Europe followed the trend with 5-10 year delay (France, Germany, and Spain). Later, idea of SOE privatisation was embraced by many developing countries of Latin America, Africa and Asia as well.

Interestingly, privatisation had not been originally conceived as a complex theoretical problem.

Corporate governance is a buzzword of the 1990s. Prior to that, market economy and good governance of business enterprises were regarded as two sides of the same coin. Management consultants and business journalist had implicitly challenged this assumption long time ago. When differences between "good" and "bad" companies were analysed, or management forms in Japan were contrasted with standard Anglo-Saxon practices, everybody must have realised that different corporate governance schemes are equally compatible with the notion of the free market economy. But for decades, economic theory didn't react to this challenge. It happened only in the early 1990s, that mainstream economists accepted the coexistence of different market institutions. Suddenly, it became fashionable again to distinguish between ownership and control, to see a conflict between the interest of shareholders and the managers, as some authors proposed earlier. (Berle - Means 1932, Galbraith 1967). Pension reforms are the product of the late 1990s. Although, the pioneering Chilean reform had been launched as early as 1981, the issue didn’t attract much attention in Europe and the United States until recently.

In the transition economies, by contrast, privatisation, corporate governance and pension reform became topical almost simultaneously from 1990 onwards. In a way, all three issues – together with competition - were viewed as necessary elements of the ‘transition agenda’. Radical reformers as twin policy objectives treated the dismantling of state ownership in the sphere of production and in the sphere of social services. So far, only Hungary (1998), Kazakhstan (1998) and Poland (1999) have made irrevocable shift to FF systems. For solid fiscal and political reasons, however, all three countries have opted for a gradual transition, whereby the PAYG and the FF scheme are envisaged to co-exist for decades. Other countries are still in the preparation phase (Bulgaria, Slovenia).

The collapse of communist systems in East and Central Europe was an event with its own logic. But once this happened and the people of the region expressed their desire to introduce (or re-introduce) Westernstyle political institutions, to join the EU and NATO, the governments of these countries had hardly any alternative to SOE privatisation. The room of choice was limited to the modalities only. The reform of the social security systems - and within this, the introduction of pension reforms - is entirely a domestic policy issue. The adherence to Western institutional structures – or the ambition to be accepted by these institutions – does not imply an imminent need of changes in the countries’ pension systems. It is difficult to imagine that NATO or the European Union would reject the application of any Eastern European country just because the applicant did not reform its pension system.

In order to avoid unnecessary terminological debates, it is important to give a clear definition of our key

terms:

Privatisation is used hereafter to refer the divestment of existing state owned firms to private entities.

This is not self-evident. Many scholars prefer to speak of privatisation in a broader sense, which includes the creation of entirely new companies (green-field investments), the commercialisation of telecommunication wavelength, the introduction of tolls on highways, etc. In the most recent American debates on the future of the US pension system, the advocates of radical reforms go even further: e.g.

Feldstein (1998) speaks of ‘the privatisation of the social security system’.

Copyright © OECD All rights reserved AGP 13 - Privatisation, Capital Market Development and Pension Systems Reform Paris, France 21-22 September 1999 In Western market economies, SOE divestment means, in most cases, the sale of company shares owned directly or indirectly by public institutions (central government, local governments). In the countries of Central and Eastern Europe, the state owned firms had to be corporatised first. Partial or complete divestment of this portfolio could be a second step only.

The term “pension reform” will be used only to denote the switch from pay-as-you-go (PAYG) schemes to fully-funded (FF) schemes. Reforms within public PAYG schemes – e.g. a higher retirement age, a downward adjustment of benefits – are left out. Such a delineation, of course, is not intended to belittle either the actuarial importance of such changes in the old age security system, or the potential welfare redistribution effects on subsequent cohorts.

It is recognised that the choice of definition is already loaded with a certain amount of value judgement.



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