Abstract

Fiscal policy represents the main macroeconomic policy instrument at the disposal of the authorities in the Baltics. This is due to their decision to anchor their macroeconomic stabilization efforts with the adoption of hard exchange rate regimes, which have served the countries well and allowed them to withstand some crisis situations, such as the Asian and Russian financial crises in 1997 and 1998.

Fiscal policy represents the main macroeconomic policy instrument at the disposal of the authorities in the Baltics. This is due to their decision to anchor their macroeconomic stabilization efforts with the adoption of hard exchange rate regimes, which have served the countries well and allowed them to withstand some crisis situations, such as the Asian and Russian financial crises in 1997 and 1998.

Since the mid-1990s, the Baltics have been approaching a balanced-budget position, with Estonia and Latvia actually achieving a surplus in 1997. This trend was interrupted only in the wake of the Russian crisis, when the resulting economic slump, among other things, triggered a significant, yet temporary, rise in fiscal deficits in 1998 and 1999 in all three countries. The general government fiscal deficit in Lithuania soared to 8 ½ percent of GDP. while Estonia’s and Latvia’s deficits rose to about 4 ½ percent and 4 percent of GDP. respectively, in 1999. This reflected, to some extent, the automatic stabilizers at work, but also a discretionary easing of fiscal policy through significant increases in public pension benefits and public sector wages in Estonia and Latvia and savings restitution payments and net lending in Lithuania.

Subsequently, when economic conditions improved, all three governments embarked upon considerable fiscal adjustment. The fiscal deficits were reduced to about 3 percent of GDP in Latvia and Lithuania and 0.3 percent of GDP in Estonia in 2000, Such efforts reflected the improved economy and. in the case of Latvia and Lithuania, a recognition of the need to contain domestic demand and rein in the sizable external current account deficits (see Figure 1).

Most of this fiscal adjustment took place through expenditure restraint. This was most noticeable in Lithuania, where the expenditure-to-GDP ratio dropped from about 40 percent in 1999 to 33 percent in 2000. But Estonia and Latvia also succeeded in compressing spending by 4 percentage points each during the period. Apart from reducing capital spending programs, restraint was exercised mainly in the area of pensions and public sector wages, essentially the same categories that had driven up the deficits a year earlier.

The fiscal adjustment continued in 2001, and all three countries aim at moving toward a balanced budget. While Estonia is projected to record a moderate surplus in 2001, Latvia and Lithuania have targeted deficits of about 1 ½ percent of GDP each. This provides the Baltics with a comfortable starting position to achieve a balanced budget over the next few years. Efforts have been made to contain the wage bill, initiate civil service reform, overhaul the national pension systems (see Schiff and others. 2000), and rationalize other spending through targeted public sector reforms. At the same time, efforts to enhance the tax systems and tax administration have been initiated. Strong economic activity also has helped to sustain high tax receipts in all three countries.

The Baltic countries’ expenditure and tax structures are similar to those in current EU countries and have little resemblance to those in countries of the Commonwealth of Independent States (CIS). Nevertheless, the composition of spending provides some scope for reprioritization and enhanced efficiency, which will be the focus of the medium-term fiscal frameworks presented in Section V. By contrast, the Baltics will be required to make only relatively marginal changes to their tax systems to meet the requirements of EU membership (Box 1).

Structure of Expenditure

The Baltics, like other transition countries, need to determine the appropriate size of their respective governments. Although there is no normative guideline on the optimal size of government, from a positive perspective a variety of political and economic factors could be assessed to determine such size: per capita GDP. the openness of the economy, the extent of unemployment, dependency ratios, and political variables. Begg and Wyplosz (1999) found that, except for Bulgaria, all transition economies included in their sample had oversized governments (when political and economic variables were controlled for).

Most transition economies have experienced a decline in the size of government during the past ten years. At end-2000, the unweighted average of current spending in the CIS was about 26 percentage points of GDP lower than in the euro area and about 16 percentage points lower than in the Baltics (Figure 2). This fairly low expenditure ratio in the CIS has been driven largely by a lack of revenue and available financing, but it also reflects some real expenditure cuts, including subsidies and transfers, in the early transition years mandated by the significant drop in output.6

Figure 2.
Figure 2.

The Baltic Countries and Selected Other Countries: General Government Expenditure and Tax Structure, 20001

(Percent of GDP)

Sources: IMF, Government Finance Statistics, International Financial Statistics, IMF Country Reports, and FSU Database; OECD, Revenue Statistics; and European Central Bank, Monthly Bulletin1 Definitions across countries may differ because of different sources and methodology applied. CIS, Commonwealth of Independent States.

EU Accession Requirements on Taxation

EU accession will require some changes in the composition of revenue for the Baltics. It can be expected that tax revenues will be strengthened from efforts to meet these requirements, and that a positive impact on tax administration may also materialize. Briefly, these requirements can be summarized as follows:

  • Adoption of the Common External Tariff (CET) and implementation of the institutional arrangements necessary to administer the EU’s tariff and trade system;

  • Harmonization of indirect taxes through the application of minimum excises; adoption of a standard rate of value-added tax (VAT) of at least 15 percent; limitation of the reduced rate, exemptions, and zero-rating for VAT to those goods approved by the EU; establishment of a minimum turnover threshold for VAT registration; and

  • As regards direct taxation, countries need to ensure that their tax systems are nondiscriminatory (between residents and nonresidents); consistent with freedom of capital movements within the EU; and in compliance with the EU’s “Code of Conduct on Business Taxation” (which guards against harmful tax competition).

By contrast, the expenditure structure of the Baltics and other leading EU accession candidates largely resembles the one in the euro area. However, total spending, especially in Lithuania, is still significantly below the euro-area level. Capital spending is higher in most accession countries than in the euro area, largely reflecting the need for EU-related investments and the transition process more generally, but it is noteworthy that such outlays account for a smaller share in total spending in the Baltics relative to the other accession candidates. Given the relatively low debt indicators, interest payments account for only a small part of the Baltics’ spending, comparable only to that in the Czech Republic and Slovenia.

The share of spending on goods and services in total spending is relatively large in the Baltics. Social spending is comparatively low in Estonia and Lithuania, limiting the scope for reductions, although improved targeting, together with the impact of the pension reforms being undertaken, may yield some savings. By contrast, social spending in Latvia is close to euro-area levels, with correspondingly larger room to improve its targeting.

Structure of Taxation

The tax structures of the Baltic countries are similar to those in other EU and EU-accession countries and carry relatively few vestiges of the pre-transition systems (see Figure 2). Some features still bear traces of the old system, including high payroll tax rates, which continue to generate a greater share of tax revenues than in most EU and other Organization for Economic Cooperation and Development (OECD) countries, and in Lithuania the maintenance of a schedular system of personal income tax.

For the most part, however, the Baltics moved quickly to dismantle the system inherited from the former Soviet Union and adopted new tax laws that reflected the needs of a market-based economy and that were also designed to be consistent with the tax systems prevailing in western Europe, As a result, unlike some CIS countries, the Baltics did not experience a precipitous decline in tax receipts in the 1990s. A decline in corporate tax receipts (reflecting poor coverage of the emerging private sector and, to some extent, tax exemptions granted to promote investment) was compensated by the good performance of labor and consumption taxes in response to strong growth and rising real incomes. As with the recovery of economic activity more generally, substantive and sustained reforms in the Baltics led to a better tax performance than more gradual reforms in the CIS (Ebrill and Havrylyshyn, 1999).

The structure of the tax systems in the Baltics compares with that of most OECD countries. The overall tax burden in Estonia is close to the OECD average, and it is somewhat below the OECD average in Latvia and Lithuania. Although below the EU average, the tax burden in the Baltics is similar to that in the lower-income EU member states but much higher than observed in almost all advanced economies when they were at similar stages of development. Of the four EU accession countries of the 1970s and 1980s, all had a lower average tax burden at that time than the Baltic countries do now. Indirect taxes are a significant source of tax revenue in the Baltics, accounting for 42 percent of total tax revenues compared with 31 percent on average across the EU.

The tax mix in the Baltic countries is fairly diversified, with personal income, social security, and consumption taxes accounting for the major part of revenues. By comparison with EU countries, the share of corporate income tax is low, whereas the share of consumption taxes is relatively high. As noted above, the Baltics (especially Estonia and Latvia), like other transition economies, have typically relied on payroll taxes as a major source of revenue, and the share of social security taxes in the Baltics is similar to the EU average. The share of other taxes, including those levied by local governments, is very small.

Medium-Term Fiscal Issues Related to EU and NATO Accession
  • View in gallery

    The Baltic Countries and Selected Other Countries: General Government Expenditure and Tax Structure, 20001

    (Percent of GDP)

  • Åslund, Anders, 2001, “The Myth of Output Collapse after Communism,” Working Paper 18 (Washington: Carnegie Endowment for International Peace).

    • Search Google Scholar
    • Export Citation
  • Baldwin, Richard, and Paul Krugman, 2000 , “Agglomeration, Integration, and Tax Harmonization,” CEPR Discussion Paper No. 2630 (London: Centre for Economic Policy Research).

    • Search Google Scholar
    • Export Citation
  • Bank of Estonia, 2000, “On Nominal and Real Convergence: The Case of Estonia,” paper presented at the Seminar on Accession Process: Price Dynamics in Accession Countries, Vienna, Austria, December 15, 2000. Available via Internet: http://www.ee/epbe/en/art010117_2/.

    • Search Google Scholar
    • Export Citation
  • Barro, Robert J., 1989, “Economic Growth in a Cross Section of Countries,” NBER Working Paper No. 3120 (Cambridge, Massachusetts: National Bureau of Economic Research, September.)

    • Search Google Scholar
    • Export Citation
  • Barro, Robert J., Xavier Sala-i-Martin, 1992, “Public Finance in Models of Economic Growth,” Review of Economic Studies, Vol. 59 (March), pp. 64561.

    • Search Google Scholar
    • Export Citation
  • Barry, Frank, J. Bradley, and E. O’Malley, 1999, “Indigenous and Foreign Industry: Characteristics and Performance,” in Understanding Ireland’s Economic Growth, ed. by Frank Barry (New York: St. Martin’s).

    • Search Google Scholar
    • Export Citation
  • Begg, David, and C. Wyplosz 1999, “How Big a Government? Transition Economy Forecasts Based on OECD History,” paper prepared for the Fifth Dubrovnik Conference on Transition Economies, Dubrovnik, Croatia, June 2325.

    • Search Google Scholar
    • Export Citation
  • Berengaut, Julian, and others, 1998, The Baltic Countries: from Economic Stabilization to EU Accession, IMF Occasional Paper No. 173 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Blanchard, Olivier J., Jean-Claude Chauragui, and Robert P. Hajeman, 1990, “Sustainability of Fiscal Policy: New Answers to an Old Question,” OECD Economic Studies, Vol. 15 (Autumn), pp. 736.

    • Search Google Scholar
    • Export Citation
  • Blanchard, Olivier J., and Stanley Fischer, 1993, Lectures on Macroeconomics (Cambridge, Massachusetts: MIT Press).

  • Boadway, Robin, and David Wildasin, 1993, “The Political Economy of Government Debt: A Survey,” in The Political Economy of Government Debt, ed. by Harrie Verbon and Frans A.A.M. Winden (Amsterdam and New York: North-Holland).

    • Search Google Scholar
    • Export Citation
  • Callen, Tim, and Christian Thimann, 1997, “Empirical Determinants of Household Saving: Evidence from OECD Countries,” IMF Working Paper 97/181 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Chalk, Nigel A., and Richard Hemming, 2000, “Assessing Fiscal Sustainability in Theory and Practice,” IMF Working Paper 00/81 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Daseking, Christina, and Costas Christou, 2002, “Balancing Fiscal Priorities” (unpublished; Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Diamond, P.A., 1965, “National Debt in a Neoclassical Growth Model,” American Economic Review, Vol. 55, No. 5, pp. 112650.

  • Ebrill, Liam, and Oleh Havrylyshyn, 1999, Tax Reform in the Baltics, Russia, and Other Countries of the Former Soviet Union, IMF Occasional Paper No. 182 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • European Commission, 2000, Public Finances in EMU—2000, European Economy: Reports and Studies, No. 3 (Luxembourg: Office for Official Publications of the European Communities).

    • Search Google Scholar
    • Export Citation
  • Eurostat (Statistical Office of the European Communities), 1996, European System of Accounts: ESA 1995 (Luxembourg: Office for Official Publications of the European Communities).

    • Search Google Scholar
    • Export Citation
  • Frankel, Jeffrey A., and Andrew K. Rose, 1996, “Currency Crashes in Emerging Markets: An Empirical Treatment,” Journal of International Economices, Vol. 41 (November), pp. 35166.

    • Search Google Scholar
    • Export Citation
  • Georgakopoulos, T., 1994, “Fiscal Policy,” in Greece and EC Membership Evaluated, ed. by Panos Kazakos and Panayotis Ioakimidis (New York: St. Martin’s).

    • Search Google Scholar
    • Export Citation
  • Gerson, Philip, 1998, “The Impact of Fiscal Policy Variables on Output Growth,” IMF Working Paper 98/1 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Gupta, Sanjeev, Luc Leruth, Luiz de Mello, and Shamit Chakravarti, 2001, “Transition Economies: How Appropriate Is the Size and Scope of Government,” IMF Working Paper 01/55 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Haque, Nadeem UI, Hashem Pesaran, and Sunil Sharma, 1999, “Neglected Heterogeneity and Dynamics in Cross-Country Savings Regressions,” IMF Working Paper 99/128 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hendricks, Lutz, 1999, “Taxation and Long-Run Growth,” Journal of Monetary Economics, Vol. 43 (April), pp. 41134.

  • Honohan, P., 1999, “Fiscal Adjustment and Disinflation in Ireland: Setting the Macro Basis of Economic Recovery and Expansion,” in Understanding Ireland’s Economic Growth, ed. by Frank Barry (New York: St. Martin’s).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 1996, World Economic Outlook (Washington, May).

  • International Monetary Fund, 1998, Trade Liberalization in IMF-Supported Programs, World Economic and Financial Surveys (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2000, “Hungary—Selected Issues and Statistical Appendix,” IMF Country Reports, No. 59 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2001, World Economic Outlook (Washington: International Monetary Fund, May).

  • Keane, M., and D. Lucey, 1997, “The CAP and the Farmer,” in The Common Agricultural Policy, ed. by Christopher Ritson and David Harvey, 2nd ed. (New York and Oxford, U.K.: CAB International).

    • Search Google Scholar
    • Export Citation
  • King, Robert G., and Sergio Rebelo, 1990, “Public Policy and Economic Growth: Developing Neoclassical Implications,” Journal of Political Economy, Vol. 98 (October), pp. 12650.

    • Search Google Scholar
    • Export Citation
  • Kneller, Richard, Michael Bleany, and Norman Gemmel, 1999, “Fiscal Policy and Growth: Evidence from OECD Countries,” Journal of Public Economics, Vol. 74 (November), pp. 17190.

    • Search Google Scholar
    • Export Citation
  • Kopits, George, 2000, “How Can Fiscal Policy Help Avert Currency Crises?” IMF Working Paper 00/185 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Kopits, George, and Steven Symansky , 1998, Fiscal Policy Rules, IMF Occasional Paper No. 162 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Krugman, Paul, 1991, Geography and Trade (Cambridge, Massachusetts: MIT Press).

  • Leibfritz, Willi, John Thornton, and Alexandra Bibbee, 1997, “Taxation and Economic Performance,” OECD Economics Department Working Paper 176 (Paris).

    • Search Google Scholar
    • Export Citation
  • Levine, Ross, and David Renelt, 1992, “Sensitivity Analysis of Cross-Country Growth Regressions,” American Economic Review, Vol. 82 (September), pp. 94263.

    • Search Google Scholar
    • Export Citation
  • Lucas, Robert E., Jr., 1988, “On the Mechanics of Economic Development,” Journal of Monetary Economics, Vol. 22 (July), pp. 342.

  • Masson, Paul, Tamim Bayoumi, and Hossein Samiei, 1995, “International Evidence on the Determinants of Private Saving,” IMF Working Paper 95/51 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Modigliani, Franco, and R. Brumberg, 1954, “Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data,” in Post-Keynesian Economics, ed. by Kenneth K. Kurihara (New Brunswick, New Jersey: Rutgers University Press).

    • Search Google Scholar
    • Export Citation
  • O’Donnell, Rory, 1991, “Fiscal/Taxation Policy” in Ireland and EC Membership Evaluated, ed. by Patrick Keatinge (New York: St. Martin’s).

    • Search Google Scholar
    • Export Citation
  • Ordaz, P., 1993, “Portugal and Trade Policy,” in Portugal and EC Membership Evaluated, ed. by José da Silva Lopes (New York: St. Martin’s).

    • Search Google Scholar
    • Export Citation
  • Plosser, C.I., 1992, “The Search for Growth,” in Policies for Long-Run Economic Growth, Symposium Series (Kansas City, Missouri: Federal Reserve Bank of Kansas City).

    • Search Google Scholar
    • Export Citation
  • Romer, Paul M., 1986, “Increasing Returns and Long-Run Growth,” Journal of Political Economy, Vol. 94, pp. 100237.

  • Rosenblatt, Julius, and others, 1988, The Common Agricultural Policy of the European Community: Principles and Consequences, IMF Occasional Paper No. 62 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Schiff, Jerald, and others, 2000, Pension Reform in the Baltics: Issues and Prospects, IMF Occasional Paper No. 200 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Slemrod, Joel, 1995, “What Do Cross-Country Studies Teach About Government Involvement, Prosperity, and Economic Growth?” Brookings Papers on Economic Activity: 2, pp. 373431.

    • Search Google Scholar
    • Export Citation
  • Solow, Robert M., 1956, “A Contribution to the Theory of Economic Growth,” Quarterly Journal of Economics, Vol. 70 (February), pp. 6594.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito, and Howell Zee, 1997, “Fiscal Policy and Long-Run Growth,” IMF Staff Papers, Vol. 44 (June), pp. 179209.

  • Tanzi, Vito, and Ludger Schuknecht, 1996, “Reforming Government in Industrial Countries,” Finance and Development, Vol. 33 (September), pp. 25.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito, and George Tsibouris, 2000, “Fiscal Reform over Ten Years of Transition,” IMF Working Paper 00/113 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Utrilla de la Hoz, A., 1993, in Spain and EC Membership Evaluated, ed. by Amparo Almarcha Babado (New York: St. Martin’s).

  • World Bank, 2002, “Real Convergence and European Integration: Lessons for the CEEC Candidates” (Washington, forthcoming).