Chapter

IV Fiscal Issues

Author(s):
Françoise Le Gall, L. Psalida, Pietro Garibaldi, Julian Berengaut, Jerald Schiff, Kerstin Westin, Augusto López-Claros, Richard Stern, and Dennis Jones
Published Date:
November 1998
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Author(s)
Dennis Jones and Françoise Le Gall

The fiscal issues that are of particular interest to transition economies broadly center on the role that government should play in the transition from a planned to a market economy. A key question in this regard is, “Where do the Baltic countries appear to be heading?” Resolute rejection of Soviet practices and a commitment to join the European Union imply that the Baltics are moving toward western European models of economic and financial development and that they will tend to develop institutional arrangements and policies similar to those among their Scandinavian and continental European neighbors. This may especially be true in fiscal management, given the Baltic countries’ wish to comply fully with the Maastricht guidelines and, more generally, their desire to adapt their policies and institutions to the requirements of EU membership. Notwithstanding the progress that they have made in carrying out market-oriented reforms, they are not as far along the road as the more successful early transition economies (e.g., the Czech Republic, Poland, and Hungary).1 Their underlying institutional base is still much weaker than in the EU and considerable change is required to meet its standards.

Fiscal policy has already taken center stage in the Baltics’ economic policies, largely because these countries have adopted fixed exchange rate regimes that give limited scope to active use of monetary instruments. In common with other transition economies, the Baltics initially faced the dual task of keeping their fiscal deficits compatible with macroeconomic stabilization objectives and of creating room for private initiative by reducing state involvement in the economy (reducing the size of government, raising revenue in a less distortionary manner, and improving the expenditure mix). The authorities have shown a strong commitment to fiscal discipline and, following the early transition period, achieved broad macroeconomic stabilization.

While the economies have undergone rapid and creditable transformation, the scope of the required fiscal reforms means that relative progress in this area has been somewhat slower. In keeping with most transition economies, the Baltics were quick to change major taxes, for example, abandoning turnover taxes and residual enterprise profit transfers in favor of western-style value-added taxes, personal income taxes, and parametric profit taxes. These changes, in conjunction with a strong starting position on the fiscal accounts, helped the Baltics avoid the sharp revenue decline that was evident in most republics of the Commonwealth of Independent States (CIS). Among expenditure reforms, price subsidies were either quickly removed or substantially reduced. However, there are a number of important expenditure reforms that are necessary but politically and administratively complex to implement.

Fiscal reforms in the Baltics would yield two principal benefits. First, they would facilitate economic stabilization, and thus help improve prospects for long-term economic growth, particularly in fostering an economic environment conducive to private saving and investment.2 Growth is likely to be enhanced by well-planned public spending aimed at building market-based institutions, strengthening government administration, improving physical infrastructure, and setting up a viable social safety net (Fischer, Sahay, and Végh). Second, over the medium term, they could contribute to the development of sustainable fiscal policies.

Fiscal reform will involve both policies and institutions. The main focus of reform needs to be on strengthening the budget processes; maintaining the current high degree of revenue mobilization; and reexamining expenditure priorities. On the latter, there is a pressing need to reassess social safety net provisions, notably pensions as these are already exerting heavy pressure on public finances.3

The remainder of this section will look briefly at progress to date in each of these three areas and outline the main challenges facing the Baltic countries.

Budget Processes

Substantial reform of public sector financial management in the Baltics is an important part of their transition to market economies. Expenditure management reforms would help move policies away from ad hoc expenditure cuts and improve the allocation of public resources, in particular toward projects and activities that continue the process of economic restructuring and promote economic growth. These reforms will involve both budget preparation and execution.

The literature on budget processes notes that (hierarchical and) transparent procedures are associated with greater fiscal discipline, especially when more power is concentrated with the treasury than with spending ministries, and the role of parliament is limited to amending the budget proposed by the government.4

Overview of Budget Procedures

The constitutions and budget laws set the legal framework for budget formulation in each of the Baltic states. These pieces of legislation define the institutional coverage of the national and local budgets, and the main legislative procedures for their approval. The procedures and timetables for budget approval seem to be clear in all three countries. Each has provisions for the draft national budget to be submitted for approval some three months before the start of the new fiscal year. Supplementary provisions cover the eventuality that a new budget may not be approved on time and call for monthly expenditure to continue at the rate of one-twelfth of the allocation of the last approved budget. Since the introduction of new budget laws at the start of the transition, there have been no major changes in any of the countries in the structure and form of budget procedures.

Each country has a different view of what constitutes the official national budget.5 In Estonia, parliament approves the “state” budget, which covers central government, and the Social Insurance and Medical Insurance Funds. The state budget must be balanced, with revenue matching expenditure as defined in the budget laws (these classify a drawdown of bank deposits as revenue). In Latvia, parliament approves a budget for the central government and national extrabudgetary funds. The budget may have a deficit to be covered by various forms of domestic and foreign financing. In Lithuania, the “state” budget approved by parliament covers only central government operations, and the budget may include a deficit and associated domestic and foreign financing.

In each of the Baltics, the role of parliament is to consider the budget proposed by the government, which legislators may amend so long as funding for any additional expenditure is identified. Parliament also considers requests to change overall expenditure once the budget is approved, in view of actual or expected revenue developments.

Parliament, despite the large amount of revenue received through sharing revenue from national taxes or transfers, has no role in approving local government budgets in any of the three countries; they are approved by local councils (with some central government oversight). The size of local budgets is constrained by the size of transfers from central government, revenue-sharing arrangements for national taxes, and limits imposed on their borrowing ability—though these are somewhat ineffective. Local governments do not appear to be bound into an overall fiscal strategy in any of the Baltic countries. In Estonia, local government budgets can include borrowing from domestic or foreign institutions, subject to thresholds related to projected annual revenue. In Lithuania, however, local government budgets must be in balance and municipalities are not allowed to borrow. If they have a financing gap, it must be filled by transfers from the state budget. In Latvia, local governments can only borrow from the treasury and for investment projects that meet certain criteria.

Official definitions of revenue and financing in all three countries are not fully in accordance with international standards. For example, as noted above, the drawdown of financial balances is viewed as a source of revenue rather than as financing. Nevertheless, budget classifications are moving toward standards and practices accepted in countries of the Organization for Economic Cooperation and Development (OECD).6

In addition, the official budgets have no consistent treatment of foreign financing. In Estonia, foreign loans are not part of the approved state budget; however, they are on-lent to municipalities or enterprises, or used directly by central government institutions. In Latvia, domestic and foreign loans are part of the official budget and treated in the same way. In Lithuania, while foreign loans are not part of state budget financing, some are used for direct lending to enterprises, and others for direct government expenditure.

The national borrowing strategy is formulated early on in the budget preparation in Lithuania. It also (though more indirectly) forms part of budget formulation in Estonia, at least in determining how much domestic revenue will go to cover investment projects. In Latvia, overall borrowing needs are considered explicitly in preparing the budget.

Purpose of the Budget

In general, the budget should enshrine the important elements of fiscal policy; it may be used for several purposes, notably to facilitate macroeconomic stabilization or to further certain redistributive objectives. Its preparation should provide ample opportunity for the government to delineate its fiscal priorities, and provide a well-ordered system—through careful review of existing programs and the introduction of new programs—for managing government activities. The effectiveness of the budget will also depend on commitment both to the underlying policy package and the manner of fiscal management. In most countries, the budget process is also a tool for political negotiation.

Given these general arguments, the reality in the Baltics so far appears to be that the “state” budget has mainly amounted to an extensive listing of central government or ministerial spending, or both, for which it is believed revenue can be found. In other words, few priorities, if any, have really been identified during the preparation. Consequently, in its execution, the approved budget merely constrains ministerial operations in overall allocation and in categorical allocation.

One area of possible reform therefore is for the Baltic countries to begin to use their budget processes as a means of addressing some of the difficult choices that the transition poses. This means imposing realism and setting priorities about expenditure and funding.

Form of Budget Execution

The manner of budget execution is now changing rapidly in the Baltic countries with the recent introduction of state treasuries, which have provided a significant amount of control over central government expenditure.7 Previously, there was in general no central control by a “treasury.” Instead, each ministry had its own account from which it disbursed its allocated revenue, and the ministry of finance was not fully aware of the financial position of ministries and other spending units. Although monthly reports of budget execution were made, they did not provide a reliable control tool or means of assessing fiscal developments.

Governments’ banking arrangements have also undergone significant changes from the days of central planning when government financial operations were conducted through the Gosbank, a practice that persisted with the fledgling central banks during the initial period of transition. Currency board arrangements in Estonia and Lithuania mean that their central banks do not perform the fiscal agent function for budget operations, although they cooperate with the ministry of finance and have oversight of the impact of government operations on the banking system.8 In Estonia, the treasury operates through several commercial banks. In Lithuania, the State Commercial Bank is the fiscal agent, and in Latvia, it is the central bank. In all cases, the form of banking arrangements has had little detrimental effect on the conduct of government financial operations.

Main Weaknesses of Current Arrangements

Despite the progress that the Baltic countries have made in strengthening budget procedures and enhancing transparency in government finance, there are a number of areas where weaknesses remain.

Adherence to Fiscal Policy Objectives

It has been well stated that a government must give a clear statement of its intentions—its macrofiscal targets in particular—if there is to be transparency and accountability in government operations (see Garamfalvi and Allan). These targets may be set either in the annual budget or in a medium-term financial plan. For several years, each Baltic country has had an IMF-supported economic program, which provided a broad economic policy framework and specific annual fiscal targets. However, notwithstanding such programs, an inability to mobilize the required political consensus in favor of the “real” fiscal targets (both within the government and parliament) during the budget approval process, partly because of fragmentary political alliances, has made adherence to fiscal policy objectives difficult. There are signs that significant positive changes toward achieving this consensus have been taking place. Given the primacy accorded to fiscal policy within the eonomic policy arsenal used by the Baltic countries and the limited flexibility of other policy instruments, slippages (actual and perceived) in the fiscal area can be critical.

Lack of Comprehensiveness

Only recently have the authorities in the Baltics fully appreciated the need to consider general government operations. The focus on a narrow institutional coverage of government, together with the lack of a policy framework, can severely limit the assessment of problems and discussion of policy options. The limitation may pose greater problems as structural deficits in social funds place strains on governments’ room for maneuver. It is impractical (and not necessarily desirable) for the central government to have full control over local government operations, but there is a need to ensure that all government institutions operate within a common policy framework and to place tighter constraints on local government operations (at least in Estonia). In short, the government and parliament need to show a keener awareness of how municipalities can derail overall fiscal targets.

In discussions about fiscal operations, there is still some confusion over deficit concepts and a narrow view taken of relevant revenue, expenditure, and financing, which stems in part from differences between national and international definitions of these variables. Disagreement over the financial coverage of fiscal operations affects the nature of the dialogue both between the authorities and international agencies such as the IMF, as well as the internal debate that is conducted in parliament or other public forums, and has hampered assessment of the macroeconomic impact of fiscal operations.

Lack of Auditing

Each Baltic country has a legal requirement for the government to present an annual report to parliament on budget execution. This is consistent with the traditional basis of reporting to parliament, in particular its emphasis on compliance with parliamentary authority to spend and transparency in handling public money. However, in the process of creating new fiscal institutions, the Baltics have good opportunities to move away from these past practices, and could consider offering some critical assessment of the worth of government operations and their “value for money”; this would be a move in the direction of “better” practices and could be seen as enhancing the whole process of governance.9

Lack of Coherence and Realism

The underlying budget outlook is often unrealistic as reflected in revenue and expenditure projections that at times merely extrapolate past trends, and may therefore institutionalize practices rather than promote any reevaluation of operations. For example, in Estonia, revenue targets in the budget, based each time on figures that are not up to date, have been lower than actual revenues for several years in a row, partly because the underlying data have not fully reflected the strong pickup in economic growth. This inertia is partly due to a lack of analytical capabilities to develop good revenue forecasts and political will to spell out policy priorities and dispense with less worthy programs.

Important Reforms for the Future

As noted above, substantial reforms that will involve overlapping legislative, institutional, and operational changes are still needed in the Baltic countries. These are outlined below.

Budget exercises should be used as an opportunity for governments to forge a consensus for short- and medium-term priorities in their economic policies and, in the process, encourage efficient use of budget resources. Establishing such priorities could involve development of an early “annual government economic policy statement.” The statement could be a means of outlining the main public sector activities and pointing to areas where operations could be phased out or eliminated. It could then form the basis for discussion of fiscal policy and prospects at various levels of government. The discussion should provide ample opportunity for consultation with “cabinet” ministers, local government representatives, and possibly representatives of major segments of the private sector and labor unions. At the end of the process, the budget proposal should reflect clear identification (and acceptance) of priority programs and operations. It is notable that the Estonian government produced such a statement for the first time in 1997 as a prelude to discussions for the 1998 budget. Latvia intends to introduce two-year budgets, starting in 1998–99, to strengthen the medium-term focus of fiscal policy, and Lithuania is likewise engaged in the preparation of a medium-term fiscal program, the first version of which was discussed in the context of the 1998 budget preparations.

Government institutions should be bound to an overall macroeconomic and fiscal framework. Part of this binding process will be based on (1) the obligation of ministries to work within the macroeconomic guidelines provided by the ministry of finance; and (2) development of controls such as limits on general government borrowing that are made binding by requiring that the ministry of finance give its prior approval to borrowing proposals (and that transgressions be met with effective penalties, for example, the risk of losing transfers from the central government, or the real risk of bankruptcy if there is default).10 Part of this process will be achieved less directly. In setting up the framework, it is important that the ministry of finance establish units responsible for developing a macroeconomic framework for the budget projections. Fledgling units of this kind have now been established in each country, but need to feature more prominently in the development of policy.

Budget laws should be changed to incorporate (1) a broader definition of government; (2) internationally accepted definitions of revenue and financing; and (3) comprehensive coverage of fiscal operations. These elements would then ensure that budgets cover (1) all sources of revenue (tax and nontax); (2) all expenditure, current and capital, whether associated with wholly domestically funded or foreign funded operations, plus any government lending operations; and (3) all forms of domestic and foreign financing.

The authorities should be encouraged to move permanently away from using cash control and sequestration as a method of expenditure management in place of setting priorities properly within the budget.11 Sequestration and cash limits clearly have relevance in the very short term, especially when opportunities to borrow are limited. However, such practices are not adequate substitutes for proper identification of medium-term budgetary priorities and adequate funding for the resultant programs.

The authorities should begin a review of revenue sharing arrangements and assess the need to reform local government finance. Such a review is already under way in Lithuania; and a World Bank study of Estonia has made several proposals to address these issues.12

There should be fuller auditing and evaluation of government operations. Nonpartisan governmental commissions already exist to perform audits of fiscal operations. But these are meant to focus on whether budget appropriations have been used as intended, that is, on accounting for expenditure rather than on valuating the worthiness of spending. Such commissions could serve a useful function if they were redirected toward evaluations, and could thus help in better identifying appropriate priorities for expenditure.

Fiscal Revenue Mobilization

A high degree of fiscal revenue mobilization may be necessary if the Baltic countries are to achieve a western European standard of living and level of services. Given the proximity of the Baltics to Scandinavia, they may wish to emulate the latter countries’ fiscal policies, which have necessitated ratios of fiscal revenue to GDP in the range of 50 percent to 60 percent. If the Baltics were to follow the example of European countries in general or smaller OECD countries, they would have to mobilize fiscal revenue in the range of 45 percent of GDP.13 However, such levels of revenue mobilization tend to be high for countries at income levels similar to the Baltics.

Within the Soviet system, the Baltic countries had attained high levels of fiscal revenue mobilization during the decade prior to the start of transition. In the early years of transition, the Baltics have broadly maintained high levels of fiscal revenue relative to GDP compared with Russia and other countries of the CIS.14 In the process, there has been some slight shift in the structure of revenue in the Baltics since 1993 (Table 4.1). Direct taxes (mainly on corporate and personal income, and on payrolls) have stabilized or declined in the three countries. There has been a tendency for indirect taxes (mainly VAT and excise taxes) to gain in importance. The significance of the corporate income tax has plummeted, while the personal income and payroll taxes have not declined as dramatically. With these changes, the structure of revenue has become closer to that of western economies.

Table 4.1.Fiscal Revenues(Percent of GDP)
1991199219931994199519961997
Total revenue
Estonia41.034.638.541.339.939.038.9
Latvia37.428.236.436.535.536.839.9
Lithuania32.030.232.632.329.632.7
Direct taxes1
Estonia24.622.324.624.623.822.722.1
Latvia21.517.823.219.718.718.519.3
Lithuania18.717.719.318.417.418.9
Indirect taxes2
Estonia13.49.411.213.613.013.413.9
Latvia10.16.58.811.211.813.413.5
Lithuania11.09.311.012.410.612.5
Sources: Country authorities; and IMF staff estimates.

Income, payroll, and land taxes.

Value-added taxes, excises, and taxes on international trade.

Sources: Country authorities; and IMF staff estimates.

Income, payroll, and land taxes.

Value-added taxes, excises, and taxes on international trade.

How Were High Levels of Revenue Sustained During Early Transition Years?

Early in the transition, the Baltic countries introduced comprehensive tax reforms, adopted marketstyle tax regimes, and subsequently sought to keep their tax systems simple. Estonia initiated its tax reform in 1991 with the introduction of a new social tax on employers, a progressive personal income tax (PIT), and a broad-based western style VAT (at an initial unified rate of 10 percent), which replaced taxes on turnover and mark-up margins. Additional tax reforms in 1992 involved the introduction of a new medical insurance tax, an increase in the unified VAT rate to 18 percent, and consolidation of the corporate income tax (CIT) rates into a single rate (35 percent). New VAT and income tax laws in 1994 eliminated exemptions and provisions for special treatment (e.g., the removal of investment incentives); reduced and simplified rates further (e.g., introduced a single PIT rate of 26 percent); and generally adopted market principles and practices in line with western European countries. Estonia has no import duties (except on furs and water pleasure craft), and only a few duties on exports of items of cultural value.

Lithuania began to replace its Soviet tax laws as of mid-1990. A simplified VAT (replacing the general excise tax) was introduced in December 1991—initially at a rate of 20 percent, which was quickly changed to 15 percent, and then raised to 18 percent in July 1992; it became a fully fledged VAT in 1994. Specific excise taxes were also developed and, in due course, were changed to ad valorem taxes—on alcohol from September 1992, and on petroleum products from March 1993. All excises now have ad valorem rates, ranging from 10 percent to 50 percent. The operation of the PIT and CIT has been relatively complex, with numerous rates and preferential treatment (e.g., for joint ventures and enterprises that reinvest profits). But there have been attempts to simplify the laws; amended draft laws on the PIT and CIT have been submitted to parliament and redrafted several times in the past two to three years, including in 1997. The latest draft incorporates a unified rate. There are import tariffs, which are applied using a three-tier system dependent on country of origin, and which embody a wide mixture of rates for different products as well as preferential treatment for certain countries.

Latvia set up a new tax system in January 1991. At the beginning of 1992, the authorities introduced a VAT with a 10 percent standard rate (and various surcharges) to replace the turnover tax. A new excise tax law was adopted in October 1992. The income tax system was not reformed until early 1995, when a unified, standard rate of 25 percent was introduced. A new set of excise tax rates was implemented in 1996—on gasoline, diesel, and alcohol—which boosted revenue significantly. Latvia levies both import and export duties, the former geared more toward protection of agriculture, the latter geared toward minerals, forestry products, and art. The rate structure of such duties is relatively simple.

Now all Baltic states have average tax rates that are broadly consistent with the average in the EU and their industrial European neighbors (e.g., a VAT rate of 18 percent in all three countries; income tax rates of about 25 percent (in Latvia and Estonia)). Lithuania is considering a uniform income tax rate.15 The structure of revenue is also now closer to the OECD average.

Tax reforms in the Baltics have tended to remove many exemptions and forms of special treatment. Agriculture (small farmers) remains the one sector that regularly receives exceptional treatment. There are also many instances where groups of ailing enterprises or specific commodities are given preferential treatment, for example, income or VAT exemptions for agricultural enterprises, and tax exemptions for food and some fuel. In Latvia, these are in addition to high external tariffs. Lithuania eliminated the VAT exemptions with the 1997 budget.

Tax collection has been bolstered by mandatory use of tax withholding for income taxes and the fact that there is little need for individuals to complete tax returns. The role of banks in tax collection has been relatively limited.

In all three countries, the process of substantial reorganization of tax administration has begun, with the objective of developing services that are related to tax types rather than taxpayers. Estonia established an aggressive approach to nonpayment of taxes and resolution of payment arrears, including attempts to use the legal system, though with mixed success and some opposition from the courts, which were concerned with protecting debtors. Consequently, the stock of tax arrears is not a major problem, with total tax arrears on the order of 3–4 percent of GDP. In addition, mechanisms for working out arrangements to settle overdue tax liabilities have been instituted (or in some instances, the liabilities have been forgiven as part of privatization). However, at some 10 percent of GDP, tax arrears are a greater problem in Latvia, notably in relation to particular sectors (such as energy enterprises). While arrears to the central government in Lithuania are not large (around 2 percent of GDP), periodic tax amnesties have played a role.

Each country has developed expertise in tax administration through use of technical assistance from the IMF and extensive training provided by other national tax agencies. In addition, the Baltic tax authorities have used limited amounts of collaboration and international information sharing to establish a firmer base for their knowledge of taxpayers’ taxable income and activities (e.g., in association with Scandinavian countries and INTERPOL).

Overall, the Baltic countries have quickly developed good tax systems in terms of tax structure and rates. Their bigger problem at present is in the administration of taxes, in particular to ensure full collection. This reflects at its simplest the effect of exemptions, but also greater sophistication in finding ways to avoid taxes, and more intractable problems of tax evasion that result from fraud and corruption.

What Are the Immediate and Medium-Term Problems?

The burden of payroll tax rates is high by international standards (currently 31 percent in Lithuania; 33 percent in Estonia; and 37 percent in Latvia but scheduled to decline gradually to 33 percent by 2001). Such high tax rates (borne almost exclusively by employers in the first instance) create incentives to distort the labor market through alternative or irregular forms of employment and compensation.

Evasion and avoidance remain widespread. Notwithstanding progress in some areas (e.g., Lithuania's impressive efforts in 1997 in addressing tax administration deficiencies), there is a risk that such practices could become entrenched. Incentives to engage in evasive activities need to be removed and official tolerance of this behavior likewise should be reduced. The governance problems that emerge when public sector institutions and top officials are the culprits must be addressed promptly. It is important that tax treatment be even handed and that particular groups not receive favorable treatment when they are guilty of evasion. Penalties need to be effective, visible, and easy to implement.

Opposition from vested interests to the introduction of new or wider taxation or to changes in expenditure priorities has been strong. It has come in particular from (1) groups of enterprises (e.g., ailing state-owned operations and successful enterprises wishing to see their foreign earnings remain untaxed); (2) certain economic sectors (e.g., agriculture); and (3) politicians or political groups (who do not appear to be concerned about conflicts of interest, e.g., in Estonia, the many national politicians who are also local government politicians) that benefit unduly from existing fiscal arrangements. Associated with this is the considerable political fear of the inflationary impact of tax changes, which may induce delays in making necessary changes.

How Can High Levels of Revenue Mobilization Be Sustained?

It is necessary to build on elements of good design (e.g., simple tax systems) and carry out stricter enforcement (e.g., nontolerance of blatant tax evasion) as indicated in the following recommendations.

  • Further improve tax administration, in particular, coordination between tax collection agencies (i.e., national tax boards and customs administrations) so that there will be consistent data on taxpayers, and a regular and comprehensive exchange of information. In Estonia, there could also be better coordination of taxes collected from the same or similar revenue bases (i.e., income taxes and payroll taxes, responsibility for which is separated between the National Tax Board (NTB) and the Ministry of Social Affairs, respectively; only the former has the legal right to pursue delinquent payers). Moreover, there is scope for better coordination on issues of goods valuation, where substantial VAT or excise tax revenue may leak away through the acceptance of bogus valuations.

  • Strengthen cooperation between the tax authorities and banking system in an effort to assess the reliability of income declarations, while protecting the confidentiality of banking transactions.

  • Improve coordination between the tax authorities and the legal system. In Estonia, for example, the aggressive approach of the NTB has been thwarted by opposition in the courts, where judges have made it difficult to pursue even flagrant cases of tax evasion. Lack of capacity and expertise in commercial courts may also be an important problem.

  • Increase the effectiveness of taxes by better covering the emerging private sector, perhaps with the use of tax payer identification numbers and more aggressive monitoring of enterprise registration. In addition, the buoyancy of taxes could be improved by making excises ad valorem rather than specific. All three countries have experienced significant problems in identifying new enterprises and taxable activities. Furthermore, the relatively open borders make it difficult to counteract the high degree of smuggling that apparently exists. There is some evidence that technical assistance to overcome some of these customs-related problems, in particular by the British Crown Agents (in Latvia and Estonia), can be effective.

  • Widen the tax net, notably to better cover energy products (e.g., gasoline) and (all) forms of unearned income. Extending taxes on land and property would also be desirable, but must perhaps await further progress in land privatization. In addition, the authorities should extend taxes to cover new activities to prevent the creation of loopholes for tax avoidance or evasion.

  • Keep taxes on the use of natural resources and creation of pollution up to date to encourage efficient use of natural resources and accumulate funding for environmental protection measures.

  • Ensure that taxes are not disguised trade barriers by, among other things, equalizing taxes on domestic and foreign goods, simplifying forms, and providing information to taxpayers.

  • Reduce the burden of compliance on taxpayers by indexing or periodically changing thresholds (this may be important for new, small enterprises in the context of the VAT).16

  • Improve compliance through operational changes, for example, use of cash registers and invoices to provide audit trails for excises and the VAT, development of large tax payer units, and special tax arrears collection units.

  • Reduce the use of revenue sharing and improve local governments’ own tax base. The desirability of such measures must be tempered by the need for a proper evaluation of government functions, and appropriate expenditure assignment and reorganization of local government and intergovernmental fiscal relations. Internationally, local governments tend to function better when they have adequate local taxes to cover local services. In this regard, property and land taxes as well as some element of local income or sales taxes are appropriate. However, bestowing more financial powers on local government may have implications for macroeconomic and fiscal management in the medium term. Already, Latvia has land and property taxes that accrue wholly to local government. Estonia has only a land tax that previously accrued to both central and local governments, but now goes entirely to municipalities. A range of minor local taxes (in terms of their revenue potential) is now available to municipalities in Estonia.

  • Improve tax analysis to better assess the impact of policy options. This is already beginning to be done in Lithuania through the establishment of a macroeconomic policy department at the Ministry of Finance, the aim of which is to evaluate the revenue implications of alternative tax policy scenarios and, more generally, to assess the macroeconomic implications of a particular budgetary stance.

Expenditure Management and Rationalization

While the authorities in the Baltic states have made considerable progress in reforming revenues, they have made few attempts at fundamentally changing the level or structure of expenditures. This section examines some of the key issues that the Baltic countries face in expenditure management.

Recent Developments and Policy Issues

The size of government in the Baltics, with government expenditure representing about 40 percent of GDP in Estonia, 38 percent in Latvia, and some-what less in Lithuania, 34 percent, is higher than in countries at similar income levels, and almost as high as in lower income members of the EU (Table 4.2).17 In this regard, the Baltic countries seem to have bucked one trend prevalent in the CIS during the transition, that is, a considerable decline in the level of expenditure. In all countries, general government expenditures as a share of GDP actually increased between 1992 and 1996, although in Lithuania the increase was smaller in magnitude.

Table 4.2.General Government Expenditures in the Baltics and Selected EU Countries(Percent of GDP)
199119921993199419951996
Estonia
Total expenditure and net lending35.734.839.140.141.240.6
Total expenditure35.733.736.938.540.840.5
Current31.932.334.134.336.135.6
Goods and services17.422.121.522.024.323.8
Wages and salaries14.57.87.110.610.39.4
Transfers to households211.78.310.210.410.811.2
Of which: Pensions2.95.56.46.57.07.6
Interest payments0.10.30.40.3
Capital3.81.42.84.14.64.9
Net lending1.12.21.60.40.1
Memorandum item Health and education10.012.412.3
Latvia
Total expenditure and net lending31.130.035.740.538.838.2
Total expenditure31.128.235.338.238.238.0
Current28.026.733.737.137.336.2
Wages and salaries4.66.27.78.710.28.7
Transfers to households211.49.614.216.316.016.2
Of which: Pensions6.29.69.89.610.2
Interest payments0.10.90.61.21.3
Capital3.01.51.21.10.91.7
Net lending0.80.42.30.60.2
Memorandum item Health and education10.110.210.59.9
Lithuania
Total expenditure and net lending30.235.437.436.834.1
Total expenditure29.830.133.834.932.1
Current27.326.031.029.929.4
Wages and salaries5.98.79.29.6
Transfers to households26.29.610.89.99.9
Of which: Pensions5.54.76.36.26.1
Subsidies to enterprises2.01.41.71.11.3
Interest payments0.10.40.9
Capital2.53.43.93.82.7
Net lending0.45.43.61.92.0
Memorandum item Health and education9.48.9
Selected EU countries
Total expenditure and net lending
Greece51.152.455.355.053.251.2
Ireland40.541.140.941.344.644.6
Portugal46.546.547.545.846.347.3
Spain45.346.349.548.047.345.4
Sources: Country statistical authorities; and IMF staff estimates.

A portion of wages and salaries is classified under purchases of goods and services.

Comprising pensions, family allowances, unemployment compensation, and other transfers to households.

Sources: Country statistical authorities; and IMF staff estimates.

A portion of wages and salaries is classified under purchases of goods and services.

Comprising pensions, family allowances, unemployment compensation, and other transfers to households.

Expenditure patterns in the Baltics—with some variation among the three states—have mirrored those in the CIS in several respects. First, spending in Latvia in particular has tended to favor current over capital outlays, which have fallen to low levels (1–2 percent of GDP). By contrast, public investment has been maintained at respectable levels in Estonia (4–5 percent of GDP) and Lithuania (3–4 percent of GDP). Second, outlays on the social safety net (comprising pensions, family allowances, unemployment compensation, and other transfers to households) have been high in Estonia and Lithuania (averaging 11 percent and 10 percent of GDP, respectively, in 1993–96) and especially in Latvia (rising from 14 percent of GDP in 1993 to 16 percent in 1994–96). Some of these expenditures have been desirable, for example, energy and housing allowances replacing subsidies, and social assistance and unemployment benefits going to vulnerable households hit by income declines. But rising pension payments are a key factor behind high social, and total, spending. Third, expenditure on health and education continues to absorb large amounts of resources, reflecting a system inherited from the planned economy that is characterized by excessive staffing and physical capacity, misdirected spending, and declining attainment indicators. During the period 1992–95 in Estonia and Latvia, spending on health and education rose in relation to GDP, and in addition, real spending on these two sectors appears to have increased substantially.18

A notable feature of general government expenditures in the Baltics is the relatively large wage bill. At about 10 percent of GDP, the wage bill in those three countries compares with wages and salaries equivalent to 5 percent of GDP in the CIS, and 12 percent of GDP for smaller and European OECD countries. Taking the case of Estonia, the size of the wage bill mainly reflects a large public service, which represents about 18 percent of the labor force and 8 percent of the population, levels that prevail in the OECD (Table 4.3). In addition, public sector wages have increased as a share of the national average wage level, that is, roughly from 80 percent in 1993 to 95 percent in 1996.19

Table 4.3.General Government Wage Bill and Employment in the Baltics and Selected European Countries
General Government

Wage Bill1
As Percent

of GDP
As Percent of Total

Expenditure
Estonia29.423.0
Latvia8.723.0
Lithuania9.629.8
Belgium10.117.8
Germany8.114.8
Spain9.919.6
United Kingdom10.418.6
General Government

Employment, 1995
As Percent

of Population
As Percent of Total

Employment
Estonia8.018.0
Latvia8.317.7
Lithuania8.418.8
Denmark13.426.5
France7.719.6
Germany4.910.4
Sweden18.134.9
OECD average8.118.4
Sources: IMF staff estimates; and World Bank (1997).

1996 data for the Baltic countries, and 1992 data for European countries.

Estimate.

Sources: IMF staff estimates; and World Bank (1997).

1996 data for the Baltic countries, and 1992 data for European countries.

Estimate.

Key Policy Choices

The Baltic countries are reaching the stage where they have to address basic questions about overall expenditure patterns and priorities. Simply increasing expenditure is not a credible option for several reasons: (1) there are limits to revenue mobilization, and as noted above, revenues in the Baltics are already high; (2) there is every indication that these states will continue to follow a cautious borrowing policy; and (3) there is a need to contain the size of government in line with the workings of a market economy. This section does not tackle the question of the appropriate level of expenditures (which encompasses many different cultural and economic factors), but with reform, it may well decline in all countries.20

The focus of reforms must be on overhauling budget institutions and procedures (see Section II) and restructuring expenditure programs, especially to improve the cost effectiveness of current operations and to provide for infrastructural investment, which is critical to economic growth. In reviewing their expenditure priorities, the authorities will face myriad decisions, for example, on the split between current and capital spending, and between wage and nonwage current spending; the scale and nature of social protection; and the expenditure responsibilities of the central and local governments. In addition, they will undoubtedly continue to face great pressure to support nonfinancial public enterprises that are struggling, an important issue in the energy sector in Latvia and Lithuania, and to protect the program of various extrabudgetary funds. But there is little, if anything, to gain from inaction (”postponing unpopularity”), including the use of underbudgeting and sequestration to postpone curbing expenditure (see Cheasty and Davis, 1996).

Pension Systems

This section limits itself to two areas that will have a significant influence on future trends in expenditures, that is, social benefits, notably pensions, because these have placed a growing burden on public finances in the Baltics, and intergovernmental fiscal relations, because experience in Estonia in particular has shown that local government spending can quickly become a serious problem.

Current Status

As in many other transition economies, the pension funds in Estonia and Lithuania still operate on a pay-as-you-go (PAYG) basis. Latvia adopted a major pension reform in late 1995, but shares a number of the following problems with the other Baltic states:

  1. High old age and child dependency ratios. The ratio of pensioners to contributors to the social insurance system has reached 0.5 inEstonia (1996) and 0.87 in Latvia (end-1995), that is, one pensioner is supported by only two contributors in Estonia and just over one contributor in Latvia.21

  2. High statutory tax rates, notably for the payroll tax, which create incentives for employers to shift components of labor compensation out of the wage fund—the very basis for the payroll tax.22

  3. The increase in unemployment (and underemployment) and the fall in real wages compared with the pretransition era23 have boosted the number of households in need.

  4. The increasing importance of informal sector activities and private transfers, and the decline in the share of wages and government cash benefits in average household income. This has made it harder for governments to identify the poor.

Against this backdrop, pension systems in the Baltics have carried on as under the old system, typically providing generous benefits: almost universal coverage; special privileges for a broad range of groups (e.g., as in Estonia, individuals entitled to early retirement such as parents of disabled children, dwarfs, participants in the Chernobyl rescue operation, and those illegally detained; or for whom non-contributing periods count toward length of service, such as members of the armed forces and of artistic and professional unions); and an early retirement age.24 The result is that the pension funds are in financial trouble. In Estonia, after accumulating reserves for three years in a row, the Social Insurance Fund drew down reserves in 1996 to finance a growing deficit on its operations.25 In Latvia, the Social Insurance Fund also ran a deficit in 1996. Lithuania introduced a restructured social security scheme in 1994, and the Social Insurance Fund was able to at least maintain balance in 1995 and 1996, but experienced some problems in early 1997 linked to increases in pensions and other benefits.

The pension funds in Estonia and Lithuania—the new Latvian system is discussed below—provide defined benefits that depend on workers’ earnings rather than on contributions and that are financed by payroll taxes on a PAYG basis. This system results in a wide array of problems, that is, high payroll tax rates; misallocation of public resources (directed to pensions rather than education, and so forth); a lost opportunity to increase long-term saving; failure to redistribute resources to low income groups; and unintended intergenerational transfers. As a consequence, existing systems have not always protected the elderly and will not protect those who will be old in the near future.

In the absence of major policy initiatives, the nearterm prospects for these funds, as in other transition economies, are bleak. Given demographic trends, the current PAYG systems cannot continue to provide the generous benefits common under central planning. In fact, they are not fiscally sustainable. There appears to be no scope for raising payroll taxes further without a substantial negative impact on wages or labor demand. And at present, central government budgets cannot be expected to fill the gap between pension fund obligations and revenues. Without reform, pensioners and the unemployed will bear the brunt of the income decline.

Reform Options

The reform of social protection needs to take place within a broad policy framework. First, it requires the establishment of clear priorities among budgetary expenditures and improvements in domestic resource mobilization. For example, it may be less distortive to cut government expenditure or even to increase consumption taxes than to raise payroll taxes to contain a pension-related deterioration in fiscal balances. Second, it must take into account the growing importance of informal activity. Third, it entails better targeting of existing benefits and the use of the resultant savings to shield the truly vulnerable as well as greater reliance on self-targeting (though this could increase the stigma for beneficiaries). In this regard, policymakers need additional information to determine who are the needy and underemployed; who is participating in the informal sector; the number of social benefit recipients; and the number of enterprises obliged to pay payroll taxes. Finally, it must be based on careful examination and calculations of the costs of different pension promises and reform options, and their impact on the overall fiscal position.26

Without detailed studies of the pension systems in the Baltics, it is difficult to be prescriptive beyond stating that all three Baltic states should strengthen their existing systems and also move toward some form of funded scheme to supplement current arrangements. It may be useful to sketch the main steps and their sequencing that have come out of international experience, as well as the three broad models of reform that have emerged (including the Latvian concept).

A first step: parametric reform. This step would consist of implementing measures to change the parameters of the existing pension system. Given that the contribution rates (payroll taxes) are high, the focus is on expenditure-reducing measures such as increasing the statutory retirement age to slow down the growth in the number of beneficiaries and tightening the eligibility criteria for early retirement and disability pensions (and in the process removing most special privileges). Additional measures would aim at lowering the level of per capita benefits by modifying either the mechanism determining increases in the benefits of existing pensioners (e.g., curbing the power of parliament in Estonia to determine pension increases) or the initial benefit for new pensioners (e.g., extending the period of a worker's earning history used to establish the assessed income in determining the initial pension).

A second step: systemic reform. This step would involve replacing the defined-benefit approach with a defined-contribution system. Such a move would be based on the dual premise that the financing mechanism of a PAYG system lies at the root of the financial imbalances and that the development of financial reserves (through partial or full funding) would reduce the need for unsustainable increases in payroll or contribution rates. Phased in over a longer period, these measures would be aimed at putting in place:

  1. A first-tier mandatory pension scheme that provides a fixed minimum social pension for all those eligible (financed from general revenues). It would resemble existing pension plans but focus on the redistribution of resources.

  2. A second PAYG tier offering earnings-related benefits with strict caps. This scheme, with its emphasis on saving, would differ significantly from the current systems in Estonia and Lithuania, and link benefits actuarially to contributions (to discourage evasion). It would be made mandatory so as to compensate for individual “short-sightedness.” Private management of the funds would promote economic over political considerations and encourage investment diversification.

  3. A fully funded third tier based on individual savings retirement accounts. This voluntary scheme would supplement the first two tiers and provide benefits proportional to the amounts contributed over the individual's working life.

Several countries have adopted variations of the multipillar system; the way in which their reforms were implemented reflects different initial conditions and political economies. There are three basic models:

The Latin American model. Under this approach, pioneered in Chile in 1980, workers are able to choose the investment managers of their own individual accounts. This model is being actively considered in Hungary and Poland but has not been adopted outside Latin America. The countries that adopted this approach started with bloated public pillars and high contribution rates.

The OECD model. Many employer-sponsored pension plans, which existed on a voluntary basis, became the foundation for a mandatory second pillar; a combination of employer and union trustees choose the investment manager. At the outset, these countries had a modest redistributive pillar and a small “implicit pension debt”; they could therefore retain the first pillar and add a second pillar.

The partial European model. This approach rests on notional-defined contribution plans or large tax incentives for voluntary funded plans. Countries with large public pillars and implicit pension debt are having great difficulty in making the transition to a scheme with both a partially funded and a mandatory private pillar—partly because of financing problems, partly because of political interests. The notional account system was pioneered (though not yet adopted) by Sweden.

Latvia, the only Baltic state to have implemented a far-reaching pension reform, provides a concrete example of a “notional-defined contribution” pension system.27 The Latvian approach directly links benefits to individual contributions and the retirement age. It also provides for the introduction of funded pension programs, initially as a supplement to the public system. In 1998, contributors will be allowed to allocate a portion of their payroll tax to individual, privately managed accounts. In essence, the approach mimics the contribution-based pension that would be offered in the private sector. The system starts by giving everyone paying the social tax an individual account. As contributions earmarked for the pension system are paid, the account is credited as if it were a savings account. The “capital” in the account earns a rate of return just like a savings account. This rate of return is equal to the growth of the wage base on which contributions are collected (the contribution wage base). At retirement, the pension paid is equal to the total capital in the person's account divided by the expected postretirement life span for all those of that person's age. The pension will be indexed, fully adjusting for price changes. In the new system, there is no mandatory retirement age and no “full pension.” The minimum retirement age will be 60 years for most participants, but the system offers strong incentives to work longer.

The government in Lithuania is considering a form of the three-tier option, possibly with a privately funded third tier. Two independent non-government teams are currently preparing drafts for private pension options to be discussed for implementation. The authorities in Estonia have also indicated their intention of moving to a partially funded system and have begun to take steps in this direction.

Financing the Transition.

In moving from a PAYG scheme to a new defined-contribution scheme, benefits to existing pensioners (under the defined-benefit system) would continue to be the responsibility of the government (or the former pension funds). Yet contributions of some (to be determined) component of the labor force would be channeled, not for the financing of these pension outlays, but for investment into some form of pension-related, individually linked savings accounts. Thus, the government would be faced with the obligation of having to meet continuing pension liabilities for what might be a lengthy period, but without the offsetting flow of payroll contributions. The size of the deficits that would emerge would depend on how quickly the funded schemes are introduced. There are two options:

  1. A “sudden” transition, where the switch to a partially funded, defined-contribution system is made at one point in time, and applies to all pensioners and future beneficiaries.

  2. A “gradual” transition, where only new entrants to the labor force become members of a partially funded, defined-contribution scheme (this may take several years depending on survival rates for beneficiaries still subject to the defined-benefit, PAYG system). In view of the large pension liabilities and the early stage of development of the financial system, this option is the more attractive of the two for the Baltics.

The strategies adopted in Latin America have dealt with all the major issues involved in pension reform and may have something to offer Estonia and Lithuania in particular. The principles underlying these strategies are as follows:

  • Before the transition, reform the old system by reducing benefits; raise the retirement age and penalties for early retirement; tighten eligibility requirements for disability benefits; and change the method of indexation to prevent unrealistic benefit promises from becoming entrenched.

  • Build up a primary surplus in the general treasury that can be used to pay part of the liabilities to existing pensioners (perhaps also use any existing surplus in the social security system or privatization proceeds for this purpose).

  • Keep certain workers in the old system (e.g., military personnel).

  • Educate the public on the need for and desirability of change.

  • Minimize evasion, and modernize tax collection and information systems.

Family Benefits

Current Status

Family benefits in the Baltics comprise sickness, maternity, and universal family benefits, and constitute about 3–4 percent of GDP. Most of these benefits are not means-tested. In Lithuania, for example, this is true of the “categorical” benefits (allowances to single mothers, birth grants and child care allowances, funeral grants and guardians' allowances). The top three income deciles received 25 percent of the cash benefits during 1994. Further progress has been made in targeting social assistance more effectively toward those with clear needs and limited incomes, namely, by introducing (and targeting better) the special social benefit that provides basic income support to those on low incomes and that is tested on the basis of household income per capita.28 In Estonia, about 40 percent of all benefits accrue to the richest 50 percent of the population. Child benefits, potentially the most progressive assistance, are universal. Moreover, the heavy emphasis on housing assistance and institutional care programs constrains the ability of social assistance offices to respond to the needs of the population. The only social assistance program where poorer counties receive a larger share of per capita cash benefits than better off countries is the income support program; it is meanstested and aims at raising household income levels to a minimum standard but accounts for less than one-third of all social assistance.

Reform Options

Experience so far suggests the following ways of strengthening family benefits in the Baltics:

  • Enhance administrative efficiency by simplifying the structure of the numerous family benefits that government ministries and social insurance funds finance, and by consolidating them into a smaller number of benefits whose maximum size is larger.29

  • Improve monitoring of living standards and its link to policy formulation. Analysis of data from household budget surveys could play a larger role in spending decisions on social cash benefits. At present, decisions are driven almost exclusively by budget considerations. While this supports fiscal discipline, it provides little guidance to benefit targeting. Another important step would be to improve the household surveys themselves.

  • Review eligibility less frequently for those benefits of longer duration, but require beneficiaries to advise the ministry if their eligibility or circumstances change.

  • Extend the scope of means-testing to target a greater share of social assistance on people with the least resources and, in this way, facilitate larger benefits for those without other income. Two possible approaches are noted here. First, the authorities could choose to improve targeting to families with many children, a proxy for poverty. Accordingly, they could means test child benefits, with the threshold set at a high enough level that only children of the richest 50 percent of households are screened out. Second, the authorities could consider allowing local-level social assistance offices to allocate funds between social assistance programs according to local needs. For example, the funds for social assistance could be inversely related to per capita personal income tax revenues of the local government.

Intergovernmental Fiscal Relations

Intergovernmental fiscal relations have been a major problem in the Baltics, particularly in Estonia where local government autonomy has had the potential to derail fiscal policy. The main problem relates to control over local government borrowing (an issue that could be considered part of the budget process).

Cross-country experience suggests that direct controls over local government borrowing tend to be looser where overall financial discipline is poor, and fiscal and macroeconomic disequilibria have not been addressed (typically in transition and developing economies), or where well-developed and relatively transparent financial systems can rely on the market to discipline subnational government borrowing. This experience (described in Ter-Minassian, 1996) may hold some lessons for the Baltics:

  • Greater transparency and dissemination of information on recent and prospective developments in subnational government finances is highly desirable; governments should be encouraged to change the legal and institutional framework to promote these objectives.

  • Sole reliance on market discipline is unlikely to be appropriate in many circumstances, but may be a useful complement to other controls.

  • Rules-based approaches to debt control appear preferable in terms of transparency and certainty. There is a clear macroeconomic rationale for barring all local government borrowing from the central bank; borrowing abroad by subnational government, if not consolidated through the central government, should be strictly limited.

  • There is a case, in principle at least, for limiting all borrowing to investment purposes where there are adequate rates of economic and social return.

These guidelines seem to argue for global limits on the debt of individual subnational jurisdictions on the basis of criteria that mimic market discipline (e.g., current and projected levels of debt service in relation to revenue using a comprehensive definition of debt subject to the ceiling). An alternative may be for the central government to set restrictions on transfers to local governments. However, administrative controls by central governments on subnational borrowing seem likely to conflict with the increasing trend worldwide toward devolution of spending and revenue raising responsibilities to subnational governments.

Finally, there is scope for increased cooperation at all levels of government in containing the growth of public debt and for greater involvement of subnational governments in formulating and implementing medium-term fiscal adjustment programs.30 In this regard, it might be useful to bring the key players (e.g., the ministry of finance, the central bank, local governments) together in a multilateral forum to discuss budgetary policies and prospects of various government levels.

How the central government manages fiscal policy through revenue sharing, expenditure assignments, and transfers to local governments is a vast area in research. The experience of Estonia in the past few years illustrates some of the issues involved. Estonia began the transition to a market economy with a highly centralized system of public finances local governments acting mainly as administrative units with no independent fiscal responsibility. Since then, it has made considerable progress in carrying out fiscal decentralization and, in particular, has promoted institutional settings and processes that allow for the articulation of interests and policymaking based on consensus building. There has also been a move to match public services more closely with local demands. The design of transfers from the central to local governments, with its emphasis on equalization, attempts to place limits on the level of open-ended transfers that could create incentives to attract and self-generate local demand. Moreover, the transfer mechanism in Estonia has served to reduce the horizontal imbalances of the fiscal system: it lessens the fiscal disparities among local governments with different tax bases and closes the revenue gap of local governments (i.e., the imbalance between expenditure responsibilities and the funding available).

The system of intergovernmental relations in Estonia needs, however, to exploit more fully the benefits of fiscal decentralization. It must also ensure that local governments support the general effort to increase public saving and that budget constraints are enforced at each level of government. Given the passive role of local government over a 50-year period under Soviet times, this will require in part a concerted move to build up local capacity and a local civil service trained to design, monitor, and implement expenditure programs in its areas of responsibility. Against this backdrop, there are a number of steps that the authorities could take:

  1. Consolidation of local governments and increased cooperation among them in the delivery of public services would improve the efficiency of municipalities. The number of local governments in each of the Baltics is large (e.g., 254 in Estonia).

  2. For expenditure activities that are subject to overlapping or competing jurisdictions, the appropriate level of responsibility needs to be clarified.

  3. To increase the accountability of local governments and enhance their flexibility to meet the demand for services, a greater share of local expenditures should be financed with local taxes—as distinct from shared taxes, which represent a transfer from the central government (albeit out of an earmarked revenue source). Under the current system in Estonia, the proportion of local tax revenues (including transfers) under the control of municipalities is small, an average of 9 percent during 1993–96. One option for reform, already adopted in a number of countries, would be to give each local government the right to apply its own tax rate on the national income tax base. A local income tax surcharge would offer local governments a powerful revenue tool and increase the link, at least at the margin, between local public services and taxes payable. This would not exclude the use of supplementary equalization transfers for poorer municipalities. Another option would be to increase municipal user fees.

  4. The new method for determining equalization transfers, while simpler and better at targeting local governments with per capita revenues lower than the national average, leaves the door open for considerable bargaining between the central government and individual municipalities—the Estonian authorities will have to ensure that such negotiations do not undermine the objective of reducing fiscal disparities across regions.

  5. The borrowing activities of local governments need to be better monitored and the legal restraints on debt obligations vigorously enforced. The central government has followed a rules-based approach to keeping municipal borrowing in check; one such rule restricts borrowing to investment projects. In practice, this approach proved to be inadequate owing mainly to the ambiguous wording of legislation, and to behavior aimed at circumventing the regulations (e.g., the reclassification of expenditures from current to capital, and the use of local government-owned enterprises to borrow for purposes that should be funded through the budget). The government has recently taken steps to address these problems, starting with a tightening of the law on municipal borrowing. Also, local governments must forward a copy of the decision to take a loan to the county governor within three days after it becomes effective, and send a copy of the loan contract to the Ministry of Finance within thirty days after the contract has been signed. In August 1996, the Government of Estonia issued a decree clarifying that the central government would not extend state guarantees—implicit or explicit—against municipal borrowing. And as of December 1997, the Bank of Estonia, as part of its prudential responsibilities over the banking system, requires that banking groups obtain in advance a letter of no objection from the Ministry of Finance (which will not represent either an explicit or implicit guarantee) for each additional financial claim acquired on local governments. By comparison, the other two Baltic countries have instituted strict administrative controls. In Latvia, local governments can borrow only from the treasury for investment projects deemed worthy, and in Lithuania, local governments can borrow to finance investment expenditures only after receiving central approval from a State Loan Commission.

See IMF (1996b).

This focus is not meant to ignore the fact that there are other important issues to consider regarding expenditure management, such as the need to rationalize education and health expenditure, and to adequately protect capital expenditure.

See, for example, Alesina and Perotti (1996) and Miles-Ferretti (1996).

Notwithstanding the different national views of the “budget,” IMF staff analyses consolidate general government operations, which cover central and local governments plus national extrabudgetary funds.

Privatization receipts are not treated identically in each country and, in particular, are not necessarily part of the official budget. Neither is the treatment of such receipts handled consistently by industrial countries, where they may variously appear as revenue or as a financing item. In Estonia, the bulk of privatization receipts does not feature in the official budget but is handled by an off-budget fund that uses privatization proceeds mainly to defray privatization-related expenses; some small share of privatization receipts is transferred to the Social Insurance Fund. Along with part of the fiscal surpluses generated in Estonia as of 1997, a portion of the privatization receipts is also to be channeled to the Stabilization Reserve Fund, which was established in late 1997. In Latvia and Lithuania, the official budgets consider such receipts to be revenue, while IMF staff analyses usually treat privatization proceeds as financing.

Each of the Baltic countries now has a state treasury, whose functions continue to be broadened to cover at least all central government and, in some cases, national extrabudgetary fund operations. Latvia established central and regional treasury units in 1993; Estonia did likewise from April 1996; and Lithuania began to phase in its treasury operations from June 1996.

In Estonia, this situation changed in late 1997, as the Bank of Estonia was used as the government's agent for the operation of the newly created Stabilization Reserve Fund.

See Garamfalvi and Allan (1996), who argue that the recent growing complexity of the role and scope of government activities has created a need for treasuries to enhance transparency by providing better information on the macroeconomic impact of government and value for money from public activities.

Such an approach has been adopted in Latvia and Estonia in setting conditions for local government borrowing.

Even with the development of treasuries, there continues to be a tendency to control expenditure by cash limits and sequestration.

See World Bank (1995).

See IMF (1996a), Chapter III.

Lithuania experienced an early collapse of revenues that reflected a significant decline in the tax base for corporate income because profits declined sharply and exemptions were generous. VAT and exmmmcise tax income also fell markedly owing to considerable problems in tax collection and evasion.

At present, Lithuania's corporate income tax rate is 29 percent, and the peronal income tax rate is 33 percent.

Ironically, in Estonia, many enterprises chose not to deregister for the VAT when the threshold was raised, as such registration bestowed on them certain advantages such as credibility and prominence in the market place.

These numbers for the Baltics refer to 1996. The ratio of expenditure to GDP in 1994 stood at an average of 20 percent in Chile, Colombia, Korea, Thailand, and Turkey. World Bank (1996), p. 112.

Health care spending in Latvia grew by more than 20 percent in real terms in 1995, with almost all of the increase coming from spending on primary health care.

World Bank (1997).

A substantial reduction in expenditures as a share of GDP could take time, underscoring the importance of maintaining a strong revenue performance. Moreover, revenues will be needed to help finance pension reform.

These ratios are comparable with or higher than those in a number of European countries, for example, Austria (0.59), Spain (0.46), Sweden (0.37), and Switzerland (0.42). Data for European countries refer to 1993.

Social Security and total payroll tax rates are, respectively, 20 percent and 33 percent in Estonia, and 22.5 percent and 30 percent in Lithuania; the social security tax rate stands at 37 percent in Latvia. While the total payroll tax rates in the Baltics are lower than those in such countries as France, Italy, and the Netherlands (about 55 percent), they are higher or comparable to those in other western European countries, such as Norway (25 percent), Sweden (32 percent), Ireland (22 percent), and Switzerland (23 percent). Data for European countries refer to 1993.

See World Bank (1996), Table 4.3, which indicates that real wages in Estonia and Latvia in 1994 were roughly 50 percent and 60 percent of the level prevailing in 1989.

Estonia has begun to increase the retirement age by six months every year until it reaches 65 years for both men and women. Lithuania has announced the intention to proceed along the same path.

In 1997, this fund posted a small surplus owing to a large increase in revenues as the economy grew very rapidly.

Estonia initiated such a study in March 1997.

In November 1995, parliament approved legislation to create a new public system for those who retire after 1995; pensions for current pensioners were not affected.

Recent changes reduced the proportion of the population receiving the special social benefit from about 45 percent to 15–18 percent. Most of this reduction was achieved by consolidating the special social benefit payable to pensioners with the pension benefit itself.

In Lithuania, the number of state-provided social assistance benefits to families was reduced from 12 to 8 in 1994.

Estonia adopted strenthened legislation to control local government borrowing in May 1997, and Latvia has already begun implementing similar reforms.

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