Pension reform in Armenia will further widen the gap between the rich and the poor

ArmInfo. Interview with professor of economics at Ventura College, California, Ara Khanjian

Ara Khanjian has represented the ARF-Dashnaktsutyun in the Socialist International Committee on Economic Policy, Labour and National Resources

Dr. Ara Khanjian

Do you share the concern of Armenian authorities on aging of the population in the next few years, which will challenge the State’s capacity of paying pensions? Do you agree that any raise of pensions will thus fail to entirely solve the problem, and the transition to the new system is therefore a must?

An aging population could challenge the State’s capacity of paying pensions; however the solution of this problem is not necessarily the adoption of an extreme version of privatization of the pension system that Armenia’s government is proposing. I call it an extreme version, because according to the government’s version, in about 25 years, every employee in Armenia would be obliged to be part of the mandatory, funded, private pension system. There are few countries in the world, where the mandatory part of the pension system is based solely on the private individual pension accounts. Instead of adopting this extreme version of pension system, the Republic of Armenia, similar to many other countries, could address the problem of the aging population through a combination of different steps. One possibility that could have a significant effect on the ability of the state to pay pension benefits is to gradually increase the retirement age. The United States in 1984 decided to slowly increase the retirement age from 65 to 67. Another possibility is to slightly increase the pension contribution or pension taxes.

In the case of Armenia a major concern is to increase the government’s ability to generate more pension tax revenues. A major challenge with this respect is the extent of the shadow or underground economy, where the employers and employees avoid paying social security (pension) taxes. This implies that the government should take measures to reduce the level of shadow economy and corruption. One aspect of Armenia’s pension system that gives incentive to employees to avoid paying social security taxes is the fact that the social security (pension) taxes that the employees pay and the retirement benefits, pensions that the employees receive when they retire are not linked. Currently the amount of pension that a retiree receives depends only on the number of years that the employee worked. It doesn’t depend on the amount of social security taxes that the employee paid during his/her lifetime. This implies that if two employees worked the same number of years, but one employee earned 300,000 AMD per month, while the other employee earned 30,000 AMD per month and paid much less social security taxes than the first employee, both of them will receive the same pension when they retire. The problem of this is that it would give incentive to the first employee to hide his/her income and avoid paying social security taxes. There is hardly any other country in the world that has such a pension system. Therefore Armenia should introduce changes in its pension system and should link the pensions with the amount of pension taxes that the employees pay during their lifetime. There are many countries that have such system and some of these systems are called “notional” pension system. Armenia, similar to many countries in the world, could do this without adopting the extreme privatization system that the government is proposing. The U.S.A. refused to adopt even a partial privatization of the pension system in order to address the concern of aging population. There are only a few countries in the world where the mandatory pension system is based entirely on private pension accounts.

Another unusual characteristic of the government’s proposal is that the government is going to contribute 5% of the worker’s wages to his/her private pension account. I don’t know any other country in the world which has a similar system. One way that the government could generate funds to make these 5% donations to the employees’ private pension accounts is to collect additional taxes, such as income taxes, VAT, customs etc., from the general public. In my opinion this 5% government contributions to the employees’ individual pension funds, is a bribe to entice the current workers to join the mandatory private pension accounts. What is the justification for the government to collect taxes from the rest of the population, including people in vulnerable positions such as non-working population, housewives, disabled etc., and then give those tax dollars to the working people? Another way that the government could deal with the 5% donations to private pension accounts would be to borrow and to make the government budget deficit even worse. The privatization of the pension system would make the government budget deficit even worse, because the government on top of making 5% donations to the current employees’ individual pension accounts is going to continue paying the pensions of the current retirees. The government is going to pay the pensions of the current retirees, who don’t have private pension accounts, through the general taxes collected from the general public. Clearly the privatization of the pension system will make the government budget deficit worse and the government would be obliged to borrow more and at the same time would be obliged to reduce government expenditures in education, health care, roads, infrastructure, poverty programs, or even defense. Therefore the privatization of the pension system would have a negative effect on education, health care and other government expenditures.

On October 31, 2008 the IMF and the IDA (part of the World Bank group) experts published a Joint Staff Advisory Note on the Second Poverty Reduction Strategy Paper, PRSP, where they expressed their opposition against the privatization of Armenia’s pension system, specifically in paragraphs 23 and 31. Among other reasons for their concerns about the privatization of the pensions, the staff of the IMF and the World Bank was also concerned with the negative impact of the privatization of the pension system on the government budget.

In conclusion, aging population could generate pressure on the government’s budget; however the privatization of the pension system is not the answer to that problem, because the privatization itself would have a negative impact on the government’s budget. Instead the government should link pension taxes to pension benefits, giving incentive to the employees to pay their pension taxes. Also the government should increase its revenues by reducing the level of corruption and the shadow economy.

To finance state donations to pensions, the government designed a united income tax, a merge of social security payments and income tax. Do you think it will cover the necessary expenses?

Let me take this opportunity and say that in the case of united tax, the government is proposing a flat income tax of 26%, without any exemption, which is unfair, because there is no progressivity. The purpose of having a progressive tax system, where the tax rate goes up when income increases, is to distribute the burden of taxes more equally among the rich, middle class and poor taxpayers and achieve some level of fairness. Most advocates of flat tax or income tax with just one tax rate support the exemption of certain amount of income from income tax, usually an amount equal to the poverty line. This exemption generates mild level of progressivity. According to my information, in the case of Armenia, the government’s proposal doesn’t include any exemption; therefore even if someone earns just 20,000AMD a month he/she will pay 26% of income tax, while someone who earns 400,000 AMD will again pay 26% income tax. This is highly unfair, because it imposes very heavy burden on the poor and the lower middle class. In order for the person who earns 20,000AMD to pay 26% tax or 5200 AMD he/she should reduce the expenditures on food and basic necessities, while the person who earns 400,000 AMD could pay 26% or 106,000 AMD without being obliged to cut the expenditures on food and other basic necessities. I don’t know any country in the world which has such an unfair income tax system.

In general indirect taxes, such as VAT or taxes on specific products are regressive, which implies that when an individual’s income goes down, the percentage of his/her income that goes to taxes increases. Most people agree that this is unfair for the poor. Therefore the vast majority of countries in the world adopt progressive income taxes in order to offset the regressiveness of VAT, sales or excise taxes and have overall progressive or proportional tax system. When Armenia adopts a proportional income taxes, overall taxes in Armenia becomes regressive, because there will not be major progressive taxes, which would offset the regressiveness of the VAT. This implies that the tax structure in Armenia would be unfair and the poor, lower and middle classes will suffer.

This indicates that government’s proposal, makes the upper middle class and the rich better off twice and makes the middle, lower middle class and the poor worse off twice. First, when it replaces the existing pension system based on the solidarity system, with mandatory private pension accounts, which favors the interest of the people with high income, and second, when it replaces the current mildly progressive income tax structure with flat, single rate, 26%, income taxes, which hurts the interests of the lower middle class and the poor. Therefore the changes that are being introduced in the pension system and in the income tax system, favor the upper middle class and the rich at the expense of the middle and lower middle class.

Within the new system, citizens will be able to deposit their pension savings in banks and other financial institutions (credit organizations, etc) that are authorized to manage financial assets. Do you think that a license of the Central Bank to operate in Armenian financial market is sufficient to trust them pension savings?

The licensing process is useful to eliminate some risky financial institutions; however it is not sufficient. Companies operating in the financial markets must be regulated throughout the year. A major source of financial markets’ problems is asymmetric information, when one group in the market, usually the financial company’s top executives, has more information than the rest. The solution of this type of market failure is government regulations of the financial market, by making more information available to the public. In the U.S., companies are obliged to provide a prospectus, which describes the fund’s goals, risks, investments strategies, fees and expenses of the companies. The companies are obliged to provide annual and semiannual shareholder reports, which analyze the funds’ performances and provide funds’ financial statements. Also companies must provide detailed information about the members of the board of directors. At the same time there should be clear accounting regulations, and companies must be audited regularly.

Without such a regulatory environment, introducing a new pension system, based on mandatory private pension accounts, could be dangerous. It would be much better if the government of Armenia first introduces and promotes voluntary private pension accounts and generates corresponding adequate regulatory mechanisms. Initially the volume of voluntary private pension accounts would be small; therefore relatively easy to regulate. Even if there are mistakes or failures, the damage in such a small market will not be great.

Unfortunately a major problem in Armenia is that the level of corruption is high. Therefore when Armenia adopts mandatory private pension accounts, in few years, large amounts of funds will be accumulated, which could create huge temptation for company executives or even government officials including regulators to engage in illegal or risky activities and waste employees hard earned pension savings. During fall 2006 China’s ruling Communist party fired one of the Politburo members, Chen Liangyu, who was guilty for mismanagement and theft of Shanghai’s pension fund.

The problem with pension funds and financial market regulations is that it could give the impression that abuses and wrongdoings are not possible. Executives of financial companies could find ways of avoiding regulations and try to generate personal gains at the expense of the account holders and shareowners. For example in the case of Armenia, pension fund managers are allowed to allocate pension funds only in the stock markets of OECD countries. But it is possible that a manager of a pension fund company violates the law and instead of investing in the OECD stock markets, which are relatively safer, invests billions of the dollars from pension fund accounts in some risky stock market in Asia or Latin America. The probability for this kind of behavior to occur in Armenia is relatively high, because of the high level of corruption and shadow economy. Even if such a person is caught, there is a possibility that he/she could avoid punishment if this person has strong ties with the oligarchs of the country. Therefore, once again, before trying to privatize the pension system, it is essential to develop the necessary legal and financial institutions in Armenia, and to reduce the level of corruption and shadow economy, because high level of corruption and shadow economy could make adequate regulations irrelevant.

Do you think that legislative requirements to the security of pension savings (and responsibility of managing company in case of insolvency) must be firmer than requirements to bank deposits? What is the experience of foreign countries?

Theoretically, no, banks should be more regulated than private pension funds, because bank accounts are guaranteed by the state up to a certain amount, while pension fund accounts are not guaranteed by the state. Individuals will have the option of choosing specific pension fund options. Some of these funds will be invested in the stock markets of OECD countries. If the stock markets in the OECD countries go down, then the value of individual pension fund account will go down. In general, states and taxpayers do not protect such individual pension accounts against this type of losses, because individual account owners are making decisions about investing in risky and high yield markets. They could invest in less risky lower yield markets. Also, when the stock market goes up, all the benefits will almost exclusively go to the individual account owner; therefore why should taxpayers support the account owner, if the financial markets go down and the value of the funds drops? However after the 2008 stock market crash, many politicians and economists in the U.S. argued that we need stronger regulations of stock, bond and insurance markets, and stronger regulations of the individual private voluntary pension accounts, which in the U.S. are called 401K accounts. At the end of 2008, after witnessing a drastic drop in the value of their private voluntary pension accounts, many individuals transferred their pension funds from risky stock funds to safer, low yield pension funds and missed the rise of the stock market from March 2009 until today. The end result was that many individuals in the U.S. experienced real losses in their voluntary private pension funds. The public still remembers that during 2000, the Nasdaq stock index was about 5,000, while today after ten years it is still 2,300!, which implies that if during early 2000, someone invested his/her pension accounts in a fund linked to Nasdaq, then after ten years his/her account will still be 50% smaller! For these reasons, the public in the U.S. does not support the privatization of the current public pension system, which is fairly similar to the current system in Armenia. One of the major differences between the current pension system in Armenia and the system in the U.S. is that, in the U.S. the benefits that the retirees receive and the pension taxes that they have paid while they were working, are linked through a complicated formula.

In the IMF and the World Bank report mentioned above, their staff expressed concerns that in order to implement a successful privatization it is essential to be able to collect pension taxes adequately, to collect adequate data on individual employees and to maintain the pension accounts of individual employees accurately. Also the IMF and the World Bank staff argued, and most economists would agree with them, that in order to implement a successful privatization of pension accounts, it is essential to have well developed and regulated government debt/bond market in Armenia. The reality is that the government debt/bond market in Armenia is still in its infancy.

It seems that the government is trying to develop the bond market in Armenia through the privatization of the pension system, instead of the other way around. The new mandatory private pension accounts would generate so much funds in a short period of time, that it would stimulate the development of the financial markets, such as the bond and stock markets, in Armenia. It is interesting to note that during the past five years the Central Bank of Armenia, which is highly interested and concerned with the development of debt/bond markets, was aggressively trying to promote the idea of privatization of the pension system. It was the CBA, not the Ministry of labor and social affairs, that during March 2008 published a detailed, 208 pages of study about the privatization of the pension system. At that time the current prime minister was the chairman of the Central Bank. Most economists would agree that the main and the only goal of a pension system should be the well being of the pensioners and not some other goal, such as the creation or the development of stock and debt/bond markets. The government should take other steps in order to develop the debt/bond markets in Armenia, such as reducing the level of corruption and shadow economy and to give incentive to the rich people and businesses to reveal their money and deposit them in banks and financial institutions. The reduction of the shadow economy would have a positive and significant effect on the development of bond and stock markets.

In conclusion, in Armenia, the lack of developed legal and financial institutions, the lack of developed and well regulated bond markets and at the same time the high level of corruption and shadow economy makes the adoption of mandatory funded private pension system very risky.

Once the new system is in force, the non-working population (housewives, disabled, etc) will find themselves in a vulnerable position, as they will have to be content with a zero-level social pension. Population engaged in farming, who do not get a salary, will only be able to enjoy third-level pension, e.g. from voluntary contributions. How can the vulnerability of all those be addressed?

With a privatized pension system, widows and disabled people will be able to use whatever funds are still available in their or their deceased spouse’s private pension accounts. Once these funds are depleted, the widows and the disabled will be treated similar to the poor people and they will get the payments that the state provides to the poor people. Supporters of privatization of the pension system, suggest that if just before retirement a worker ends up with only a small amount of private pension funds and becomes poor including his/her survivors and employees with disability, then the government would provide poverty support to them. Those who criticize the mandatory private pension system argue that this arrangement could be against the interests of the employees, because when the government is experiencing fiscal difficulties, then social programs designed for the poor tend to be reduced. In other words during economic difficulties the political will to protect the poor diminishes.

Do you believe Armenian government will keep its declared intention to leave social spending intact, despite the crisis?

In general, when a country, where the political party in power is not a socialist party, is facing economic crisis, then government programs designed for the poor would become vulnerable and the poor would suffer. Currently the state of California in the U.S. is experiencing economic crisis and the state government is in a financial crisis. In California there is no major socialist party. Therefore instead of collecting more taxes from the rich, the conservative governor of California, Arnold Schwarzenegger is cutting social spending and social program. For example, according to Los Angeles Times, during the past six months, in California 3 million low income adults lost health benefits, such as dental and vision care. The governor is proposing to close 328 centers that serve about 37,000 disabled and old people. Also he is proposing to reduce the financial aid to 200,000 low-income college students. If in a rich country such as the United States, during economic crisis the government is reducing its social spending, then in Armenia if the economy continues to experience economic crisis, I wouldn’t be surprised if the government slashes programs designed to help the poor. For this reason pension benefits should not be transformed to poverty programs. Instead they should be considered as the right of the retired employees to collect decent pension.

I would argue that if Armenia adopts the extreme privatization model that the government is proposing, then even the working population will find themselves in a vulnerable position. With mandatory private pension accounts, each month the employees would make payments to their private pension accounts. In the case of Armenia the government also is going to contribute 5% of the employees’ wages to their private accounts. Just before retiring, the pension company that is managing the pension accounts, based on the amount accumulated, would determine a specific monthly pension that the worker will receive for the rest of his/her life. The problem is that if just before retirement, for some reason the amount of funds accumulated in the employee’s pension account is not large enough, then he/she will receive small pension for the rest of his/her retirement life and suffer. Privatization of the pension system would generate two major risks that could reduce the size of the employee’s pension account and pension benefits: labor market risks and financial market risks.

First, labor market risks. Employees during their lifetime could have difficulties with their jobs. They might lose their job or be obliged to leave the labor force for sometime, because of illness or for some other reason. Private pension accounts do not protect workers from these kinds of labor market risks. During years that an employee is not working, he/she will not be able to make contributions to his private pension account and before retirement his/her cumulated private pension fund will be smaller. The result will be smaller pension benefits and lower standard of living when the employee retires.

Second, financial market risks. With private pension accounts, the pension benefits that a retiree receives would depend on the timing of his/her retirement. If the employee retires after a few bad years in the financial markets, then his accumulated pension funds would be smaller and the retirement benefits would replace only a small part of his/her pre-retirement income. The result would be a lower standard of living for the retiree. He/she could even live in poverty. On the other hand if the employee retires after many good years in the financial markets, retirement benefits would be larger.

Another concern is that employees could switch between risky funds with high yields and safe funds with low yields at the wrong moments and decrease the value of their pension funds. For example, imagine that an employee has his/her pension funds in a risky stock fund and then the market starts to go down. Let us assume that the employee hopes that the market will go up again and stays in the stock market, while the stock market continues to decline. During this period the value of his/her pension fund goes down. Let us assume that finally she/he gives up and transfers his/her funds from the risky high yield fund to a safe low yield fund. Then let us assume that after a few months the stock market starts to go up. Let us assume that our employee is scared that the stock market once again could go down; therefore stays in the safe low yield fund. But let us assume that the stock market continues to go up. Finally our employee realizes that the stock market is not going down, therefore decides to move back to the stock market. The result of these transactions is that the cumulated value of his/her pension fund before retirement would be smaller. During the last eighteen months, when the stock markets went down and up, many individuals in the U.S. behaved exactly like our imaginary employee and transferred the funds of their voluntary individual pension accounts between risky and safe funds such that they ended up losing significant portion of their voluntary pension accounts.

Another problem of mandatory funded private pension accounts is inflation. If just before retiring the employee buys annuities that are protected from inflation, then he/she must pay high fees, which would reduce the amount of the annuity or the monthly payment that he/she would receive until he/she dies. However if the pension benefits of the employee are not protected from inflation and the retiree receives a fixed monthly payment, then the retirees’ pension benefits would be severely vulnerable from inflation. If during one year the rate of inflation goes up drastically, for example because the price of wheat and bread or energy sources go up, then the purchasing power of the monthly pension benefit that is generated from individual private pension accounts would go down and the standard of living of the retiree would go down. Public pension funds in most countries are protected and adjusted for inflation. On the other hand in many cases private pension funds are not adjusted for inflation and are vulnerable to inflation. An employee who works for 35-40 years and retires should be entitled or should have the right for a reasonable pension and not a handout designed for the poor. Unfortunately with the mandatory funded private pension system, after working for 30 or 40 years and paying taxes, if the funds accumulated in the personal pension account of an employee are relatively small, because of labor market and financial market risks, then that employee will retire poor. The advantage of state sponsored, public pension systems is that all retirees, including disabled and widows are treated with dignity, instead of being treated like poor people, who depend on the handouts of the state.

State authorities say that with the new system, wage earners will be more interested in proper declaration of their incomes by the employer. Do you think such a motivation will be enough to affect the behavior of most employers and stop them from declaring “chopped” salaries?

With the new system, wage earners will be more interested in proper declaration of their incomes by their employers for two reasons. First, because of the five percent donation that the government will make to the individual’s pension accounts. I already mentioned that, this could be considered a bribe to make the new pension system attractive to the employees. This is unfair for all those individuals who are not part of the pension system and don’t have a mandatory pension account, because they will pay taxes, such as VAT, and the government will use tax revenues to donate 5% to those who have mandatory pension account. This will reduce government’s available funds for other expenditures, such as education, health care, transportation, etc. Second, there will be a link between the contributions that the employees will make to the pension system while they are working and the pension benefits that they will receive when they retire. However this link could be achieved without the adoption of the private mandatory pension accounts. Currently, there are many countries in the world, including in the U.S., where the pension system is not based on the mandatory private accounts, but there is a link between the employees’ pension taxes and the pension benefits that they receive when they retire. This link and not the private accounts is the main reason why employees will have incentive to declare their income. Therefore if Armenia, without adopting the mandatory private pension accounts, reforms its current pension system and generates a link between the pension taxes that employees pay and the pension benefits that they receive, then the wage earners will be more interested in proper declaration of their incomes by their employers.

I should add that in Armenia unemployment is high, except in areas which requires specialized skills, and that there are no strong workers’ organizations, such as unions, which protect the interest of the workers; therefore employees’ power relative to employers is weak. This implies that employers could ignore the interests of the wage earners and that wage earners wouldn’t have much influence on the behavior of the employers.

I would like to make two additional points. First, unfortunately in Armenia the government is able to collect relatively small amounts of taxes. According to the latest information provided by the Heritage Foundation, in Armenia the total amount of taxes collected as a percentage of the GDP is just 14%. This is very low compared to other countries, including former Soviet Republics. For example Azerbaijan collects taxes equal to 18% of the GDP, Georgia 22%, U.S. 28%, Estonia 31%, Russia 37%, France 46% and Sweden 50%. One explanation that the amount of taxes collected in Armenia is small is the level of corruption, where rich families and powerful businesses are able to evade paying taxes. It is argued that government tax collectors are not able to collect taxes from powerful businesses; therefore they focus on small and medium size businesses. If large and powerful businesses are able to avoid paying taxes, then they will be even more successful in avoiding making the payments to their individual employees’ private pension accounts, because the government tax collectors have more incentive in collecting government taxes, than making sure that the businesses are making the payments to the employee’s pension accounts.

Second, according to the Armenian economist from Chile, Armen Kouyoumdjian, many Chilean businesses deduct pension payments from the employees’ paycheck, but fail to send the funds to the pension companies. In such cases, employees could hire a lawyer and sue the employer, but it would be difficult or it could take a long time for them to win the case and make the employers pay the employee’s pension payments. In the case of Armenia, it is true that the privatization of the pension system, could give incentive to employees to put pressure on the employers to declare the correct income of the employees, but there is no guarantee that the employers would comply and make the pension payments even after declaring the true income of the employees. What could the employee do if the employer is not making the pension payments to the authorities on behalf of the employee? Some employers could argue that they couldn’t make the pension payments, because they are experiencing business problems and that if they make the pension payments, the business might go bankrupt. The employee could go to court, but unfortunately there is a significant amount of corruption in the court system in Armenia, which will make it expensive and difficult for the employees to win their pension funds back from the employers.

We could conclude that government’s suggestion of privatization of the pension system in Armenia and generating a system based on mandatory funded private pension accounts is against the interests of the retirees, because these private pension accounts suffer labor market, financial market and inflation risks, which could reduce the size of the accumulated private pension funds and reduce the monthly pension benefits of the retirees, and because in Armenia the necessary legal and financial institutions aren’t developed yet and there is a significant amount of corruption and shadow economy. Instead, Armenia should adopt a non-funded pension system, where the pension contributions and benefits are linked. At the same time Armenia should reduce the level of corruption and shadow economy in general and specifically in the areas of business tax collection, court system, etc., also it is essential to develop financial markets, such as government bond markets and their corresponding government regulations.

Aram Gareginyan, ArmInfo News Agency 17.02.10