A quarterly magazine of the IMF

September 2001, Volume 38, Number 3

Transition countries need to reform their social sectors to promote the welfare of their citizens and spur economic growth. In part, this means building up and redesigning social safety nets and addressing problems in such areas as social insurance, budgetary transfers, health care and education, labor markets, and tax administration. It also requires cutting some benefits and privileges.

The initial years of transition

Unlike most developing countries, transition countries had well-developed social sectors before the onset of transition. Their social safety nets covered the same risks as social insurance plans and transfer programs in developed countries, and considerable resources were devoted to health care and education. But the transition countries' institutional arrangements—which provided "cradle-to-grave" protection to the entire population—had been designed for a very different economic system. Incompatible with the incentive mechanisms of a market economy and ill prepared to cope with the enormous pressures that emerged in the transition to a market economy, existing social sector institutions and policies were significantly eroded and severely affected by the transition process.

First, the real value of social transfers was reduced by inflation. With the purchasing power of benefits becoming dependent on indexation mechanisms or politically motivated ad hoc adjustments, insurance schemes and welfare programs failed to protect the vulnerable from poverty. Rapid price increases affected the health and education sectors. Medical supplies and drugs were no longer affordable for some.

Second, social insurance systems were being used for purposes other than those originally intended. For example, countries sought to deal with surging unemployment caused by declining economic activity, privatization, and enterprise restructuring by forcing public pension schemes to absorb older workers through early retirement schemes and by relaxing the eligibility criteria for disability benefits. Such policies were reflected in these countries' very low average retirement ages and the excessively large share of pensioners receiving disability benefits. The ratio of contributors to pension plans to the number of pensioners deteriorated as a consequence.

In addition, large segments of the population were granted special privileges in the form of reduced rates for energy, telephone service, housing, communal services, and transportation. Too low to cover costs, such rates not only generated losses for service providers and, in turn, put pressure on the budget but also encouraged overconsumption and misuse.

Third, resource allocation in the health and education sectors became skewed. Trying to free themselves from dealing with mounting costs for health care and education, central governments decentralized public hospitals and schools, passing responsibility for them to local governments. The merits of decentralization notwithstanding, local governments were not in a better fiscal position to support these facilities—hospitals with excess bed capacity, extensive spa and recreation services, redundant health practitioners, and schools with many teachers and small classes. Their task was complicated by demands for higher wages, as workers tried to cope with inflation, and by opposition to privatization, which many workers feared would lead to large-scale layoffs. Resources were typically channeled toward curative care, leaving little for primary health and preventive services. Similarly, a large share of educational spending went to universities at the expense of primary and secondary education. Moreover, utility costs and wages absorbed most of the funds allocated to schools, while spending on teaching materials and maintenance of the educational infrastructure plummeted.

While the transition process increased demand for social benefits, it also undermined the availability of financing. The drop in economic activity reduced the revenue base of many countries, triggering, in combination with rising expenditure obligations, a vicious circle. As statutory tax and contribution rates increased, taxpayers tried to avoid paying such charges by moving into the informal sector. Partly because nascent tax administrations were still weak and authorities often lacked the political will to enforce the rule of law, tax compliance decreased and the shadow economy grew.

Fiscal agencies frequently resorted to collecting taxes and social contributions in kind. Social funds became reliant on extensive barter operations. Moreover, providers of health and education services were encouraged to charge user fees to generate their own revenue. Often, the result for poor households was heavy out-of-pocket expenses for basic health care and education.

The results of the above developments can be summarized—somewhat provocatively—as follows: Social insurance schemes in transition countries have become warped. Instead of covering well-defined risks and thus facilitating economic restructuring—for example, by providing income to laid-off workers while they look for new jobs or to individuals who are truly no longer able to work—the schemes often redistribute income in a way that favors relatively well off groups. Similarly, budgetary transfer programs are not targeted and therefore provide inadequate support to the most vulnerable groups, even though these programs account for significant shares of budget expenditures. Education and health services are not only delivered inefficiently but also no longer cover the basic education and health care most needed by the populations of the transition countries. Finally, high statutory tax and contribution rates have created significant disincentives in the labor market, impeding employment creation.

It is important to note that these developments, although rooted in the transition process itself, have been exacerbated by poor policy implementation. Allowing the real value of benefits to erode for some groups while providing generously for others and keeping vulnerable groups waiting for their monthly wages or transfers while tolerating the accumulation of large tax arrears by certain industries are not the inevitable consequences of transition but the results of policy choices. Vested interests often stymied the implementation of reforms in the social sector, as they have in other sectors.

Current reform efforts

The governments of most transition countries recognize that reforms of social insurance schemes, budgetary transfer programs, and health and education services are vital for social welfare and economic growth. Many have already taken steps to reverse some of the policies pursued during the initial phase of transition. Even the argument that past policies may have been the only politically feasible choice during the early days of transition has lost its appeal one decade into the process.

Social sector reform—like the transition process itself—is not uniform across countries. However, a direct comparison or even a ranking of countries is difficult. Countries started from different positions and the magnitude of the social problems they face varies greatly. Moreover, a country's reform effort rarely has the same intensity in every area of the social sector but is contingent on the country's particular circumstances. With this in mind, a comparison of social sector reform in 11 transition countries (Albania, Bosnia and Herzegovina, Bulgaria, the Czech Republic, Georgia, Lithuania, Moldova, Poland, Romania, the Slovak Republic, and Slovenia) illustrates some common trends while shedding light on country-specific problems and different approaches to reform.

Bulgaria and Poland have embarked on comprehensive pension reforms based on the three-pillar model described in a 1994 World Bank study. Alongside existing pay-as-you-go schemes (the first pillar), they have introduced a mandatory prefunded public pillar (second) and a voluntary private pillar (third). At the same time, they are reforming their pay-as-you-go schemes—for example, by raising the retirement age, tightening eligibility criteria for disability benefits, and reducing replacement rates—to generate savings that will partly offset the budgetary costs incurred as the workforce gradually begins to channel its savings to the two new pillars.

The elimination of privileges and improved targeting of public subsidies and welfare programs are on the agenda of almost all 11 countries, albeit to different degrees. Although some countries, such as Lithuania, have begun to increase energy tariffs, in others, public resistance to such measures is often stiff. Thus, Bulgaria, for example, chose to freeze prices for another heating season. Moldova managed to significantly cut the large number of special consumer privileges; however, as in other countries, there has been some reluctance to touch the privileges of traditionally favored groups, such as former parliamentarians. Notably, even an advanced transition country like Slovenia maintains a large portfolio of mostly non-means-tested transfer programs. In countries that have experienced conflict, such as Bosnia and Herzegovina and Georgia, reforms have involved balancing the needs of those directly affected by the conflict—for example, disabled veterans and their families as well as displaced persons—against the needs of individuals who might not be considered victims of the conflict but are nonetheless in need of assistance. A particular challenge for Romania was the severe crisis in the country's many orphanages. Its first steps were to consolidate the functions related to the care of orphans in a single agency and to increase funding.

The development of health insurance systems has generally proved difficult. Although many countries (for example, Bulgaria, Lithuania, Poland, Romania, and Slovenia) have introduced autonomous health insurance funds as they begin to redefine the government's role in the health sector, many issues have not yet been fully resolved, including viable financing mechanisms, cost control in hospitals, allocation of resources to regional funds, and regulation of the internal market between buyers and sellers of health services. Deductibles, higher copayments, and risk-related premiums with transparent cross-subsidization have been introduced in an attempt to address financial imbalances.

Many countries have introduced simple measures to improve cost efficiency in the education sector, but public education objectives still often appear expansive. By shifting school vacations to the winter, shortening the school week, and installing energy meters, several countries have managed to curb utility costs. Yet, all too often, the general objective of education policies seems to be free education for students at all levels, including university education and even—as, for example, in Lithuania—day-care systems.

Finally, tax administration reform designed to increase tax revenues has complemented social sector reform. Bulgaria, for example, created a unified revenue agency to deal more effectively with the persistent problem of arrears by integrating the collection, audit, and enforcement of taxes. Albania took measures to increase compliance with contribution obligations by introducing social security identification numbers for individuals and strengthening the authority of inspectors collecting social security contributions.

Interestingly, although efforts in social sector reform are still limited in countries like Albania, Georgia, and the Slovak Republic, other countries—Bulgaria for one—have embarked on some reforms that are among the most ambitious in the transition world. At the same time, important social sector reforms seem to have lost momentum in some of the more advanced transition economies. No transition country can therefore afford to be complacent about social sector reform, which should be high on a government's policy agenda.

Broad guidelines for future reform

Regardless of which pension model a country pursues, reform should focus on reducing the number of beneficiaries by limiting early-retirement options to encourage workers to remain in the workforce until the official retirement age and by tightening eligibility criteria for disability pensions to ensure that they go only to people who are really disabled. Public pension systems in some countries (for example, the Czech and the Slovak Republics) might not face any financing problems today but should still be reformed to prevent foreseeable future problems. Most of the countries discussed will need to consider raising the official retirement age and limiting benefits, in particular in cases where generous replacement rates for certain groups or programs could be decreased without causing hardship. Furthermore, adjusted pension formulas that link benefits more closely to contributions would discourage workers from seeking to evade payment.

Regarding unemployment schemes, the large portion of contributions spent on low-priority programs and benefit administration will have to be decreased. A balance must be struck so that unemployment benefits offer social protection but do not serve as disincentives for working. Governments also need to ensure that benefits are adequate in relation to prevailing wages and are paid on time and over a long enough period so that workers have the time to search for new jobs.

Budgetary transfer (welfare) programs should be clearly distinguished from social insurance schemes. Unemployment insurance schemes, for example, should provide benefits only to those who have contributed; transfer programs will have to be set up so that unemployment benefits for workers who have not participated in such schemes can be paid out of general tax revenues. At the same time, the benefits provided under such transfer programs must be better targeted. General subsidies for food, energy, and other goods should be abolished and replaced by cash transfers to those who are clearly identified as in need, ideally through means tests. These tests should be based not only on wage income in the formal economy but on all sources of income, especially in countries with a large informal sector. Otherwise, there is a risk that these benefits will reach individuals or households who are not really in need.

Public health care should, in general, focus on primary health care services, and the right balance must be struck between preventive and curative care. Considerable resources could be freed by consolidating facilities and eliminating excess hospital beds. This implies giving priority to public health and disease prevention rather than to the protection of the incomes of government-employed health practitioners. When necessary, rationalization measures should be accompanied by retraining programs. However, the financing of health care remains one of the most complex social policy issues. Health insurance plans designed to replace health care financing that comes out of general revenues must be carefully embedded in a coherent health policy framework that not only ensures adequate financing but also deals with incentive structures and establishes a regulatory framework. Issues such as resource allocation methods, price setting, and volume control all must be addressed in order to avoid potential market failures.

Education policies must ensure that available resources are effectively allocated. Tertiary (university-level) education programs should not absorb an excessively large share of education budgets at the expense of primary and secondary education. Also, resources will have to be shifted away from public preschool systems, which have traditionally been very large in both size and scope. The delivery cost of education services can be lowered in many areas—for example, by consolidating schools and reducing the number of nonteaching (and possibly teaching) staff. Finally, changing the school curriculum and ensuring that textbooks and other essential teaching materials are provided can improve the quality of spending.

Last but not least, labor market reforms will have to play a key role in social policy and antipoverty strategies. In contrast with many developing countries, poverty in transition economies is predominantly transient: vulnerability to poverty is high in transition countries because of the volatility of household consumption resulting from employment instability. The high unemployment rates seen in many of the transition economies make it difficult for households to improve their living standards and escape from poverty, while existing labor market regimes at times appear to be obstacles to job creation. Labor laws must be examined to see whether they strike the right balance between protecting workers' rights, on the one hand, and allowing for sufficient labor market flexibility, on the other. Overly restrictive employment protection legislation might have to be liberalized, minimum wage practices reevaluated, and flexible fixed-term contracts permitted in order to increase labor market flexibility and make labor codes more appropriate for prevailing labor market conditions. The transition countries' often extensive menus of active labor market policies must be continually reassessed with respect to their cost and effectiveness.

This article was based on Peter S. Heller and Christian Keller, 2001, "Social Sector Reform in Transition Countries," IMF Working Paper No. 01/35 (Washington: International Monetary Fund).

Reference:
World Bank, 1994, Averting the Old Age Crisis, World Bank Policy Research Report (New York: Oxford University Press for the World Bank).

Peter S. Heller is Deputy Director of the IMF's Fiscal Affairs Department. Christian Keller is an Economist in the Stand-By Operations Division of the IMF's Policy Development and Review Department.