Republic of Lithuania: Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix analyzes economic developments in Lithuania during 1996–99. The paper discusses macroeconomic developments and policies in detail. It discusses the importance of fiscal prudence in maintaining sustainable fiscal and external positions over the medium term, and emphasizes that reining in budgetary spending will be a key challenge in the period ahead. The paper reviews external competitiveness and concludes that Lithuania’s competitiveness has remained adequate through early 1999, although there remains little room for further real appreciation and wage rises that are not related to productivity increases.

Abstract

This Selected Issues paper and Statistical Appendix analyzes economic developments in Lithuania during 1996–99. The paper discusses macroeconomic developments and policies in detail. It discusses the importance of fiscal prudence in maintaining sustainable fiscal and external positions over the medium term, and emphasizes that reining in budgetary spending will be a key challenge in the period ahead. The paper reviews external competitiveness and concludes that Lithuania’s competitiveness has remained adequate through early 1999, although there remains little room for further real appreciation and wage rises that are not related to productivity increases.

III. Medium-Term Fiscal Issues

19. A restrained fiscal policy will be essential in preserving a sustainable external position and preventing an excessive accumulation of public debt. This will be a challenging task over the next several years and require a careful assessment of expenditure priorities. Spending pressures will arise from the medium-term policy objective of European Union (EU) and NATO accession, the continuation of the Savings Restitution Plan, greater need for social transfers because of structural unemployment and the rising demand for old-age pensions, and land restitution. Moreover, fundamental reforms will be needed to avoid increases in implicit and explicit subsidies to public and quasi-public enterprises, notably in the energy and agricultural sectors. Given the need to close the fiscal gap, there is also limited latitude for government revenue reductions. This chapter discusses fiscal issues in a medium-term perspective. Sections A and B examine revenue and expenditure prospects and policies, respectively. These sections also highlight the reform agenda, and discuss measures that could be taken in order to ensure a sustainable fiscal position over time. Section C examines overall fiscal objectives from the perspectives of fiscal sustainability and external adjustment.

A. Revenue Prospects and Policies

20. The main factors that will affect revenue are the government’s tax policy strategy, the growth performance of the economy, and the ability of the authorities to capture the revenue yield from the base. On current policies, the tax base is likely to shrink in the short-term because of economic slowdown. However, revenue would be expected to recover as economic growth resumes. It will also be affected by planned tax rate changes18 and improvements in tax administration. Taking into account these factors, total revenue is projected not to change much as a share of GDP between 1999 and 2004. On balance, planned changes in tax rates would contribute to a 1 percentage point of GDP decline in overall revenue from 1999 to 2004, but this would be offset by a similar increase in revenue intake because of a projected increase in the tax base in relation to GDP and strengthening of tax administration.

21. The government plans to introduce a number of changes to the tax system, including: (i) reduction in the Corporate Income Tax (CIT) as of 2000, from 29 percent to 24 percent;19 (ii) reduction in the Personal Income Tax (PIT) from the current level of 33 percent to 31 percent as of 2001 and 25 percent as of 2002, and unification of the PIT rate across most categories of incomes; (iii) introduction of a new real estate tax for properties above a certain nominal value; and (iv) increases in excise rates that would bring the rates in line with those of the EU (for example, excise rates on cigarettes and diesel fuel are scheduled to increase to 56 percent and 32 percent, respectively by 2001).

22. The main elements contributing to an expected reduction in overall revenue in 1999 are the declines in the tax bases for VAT and excises because of low growth in retail sales, in payroll tax due to declining wage growth, and income tax owing to an increase in unemployment. The medium-term scenario envisages some increases in these tax bases in relation to GDP with the turnaround in the economy. Also, tax policy changes will affect the tax bases. Specifically, the government has under consideration extending tax breaks to families with children, while, on the other hand, expanding the tax base to include farmers, lottery gains, interest gained on deposits, and dividends paid out to individuals. Also, the revenue intake may be helped by the revoking of all VAT preferences that are not applied in the EU.

23. Some revenue gains should follow from the ongoing strengthening of tax administration. In 1998 and early 1999, the authorities have taken steps that will likely result in enhanced tax collection, including the formation of an anti-smuggling unit and improvements in its information systems. The State Tax Inspectorate plans to increase staff training and improve its auditing process. Efforts also are underway to improve the revenue collection of the Customs Department, which is in charge of collecting revenues from the VAT, excises, and trade taxes. The STI in conjunction with the Labor Inspectorate, the Tax Police, and the Social Insurance Fund (SoDra) are coordinating efforts to increase the revenue intake from the payroll tax.

24. A goal of the government is to gradually reduce the burden of the government on the economy, by bringing down labor and capital taxes in the medium term. However, a comparison with other countries suggests that the current tax burden in Lithuania is lower than that of the OECD and Central European transition economies (Table 2). By international standards, marginal labor and capital tax rates and social security contribution rates are low in Lithuania (Tables 3 and 4). These considerations suggest that lowering of tax rates should not be a priority in the period ahead. Indeed, given the government’s aim to close the fiscal gap and the expenditure needs discussed below, there is limited latitude for revenue reductions, and any tax reforms should be designed with a view not to reduce the revenue intake. One possible approach would be to leave the PIT and the CIT rates unchanged, which could result in an increase in revenue by about 1½ percentage point of GDP between 1998 and 2004.

Table 2.

Comparative Levels of Tax Revenue: Selected OECD Countries and Lithuania 1/

(In percent of GDP)

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Sources: OECD, Revenue Statistics, 1965-97; and Fund staff estimates.

1996 data unless otherwise specified.

From 1997 contributions to the Health Insurance Fund are reclassified from income tax to payroll tax.

Unweighted average of United Kingdom, Spain, Portugal, Ireland and Switzerland.

Table 3.

Lithuania: Top Marginal Personal Income Tax and Corporate Income Tax Rates for Selected Countries, 1997

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Sources: Deloitte Touche Tohmatsu International (1997) and Owens (1997).

Based on data for 1995.

United States, Japan, Germany, France, Italy, United Kingdom, and Canada.

Flat rate that applies to all taxable income.

Salary tax.

Table 4.

Lithuania: Social Security Contribution Rates for Selected Countries, 1997 1/

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Source: Deloitte Touche Tohmatsu International (1997).

All contributions are made on gross salaries unless otherwise indicated.

Employers also pay a fixed contribution of Ft 3,600 per employee

Employers contributions are based on gross salaries and other remuneration paid.

B. Expenditure Prospects and Issues

25. Over the medium term, total expenditure could increase by as much as 3 percentage points of GDP, driven by a number of factors:

  • The upgrading of military defense as part of the bid to become a NATO member is likely to entail significant budgetary costs.

  • The accession process to the EU is expected to take several years, and will require implementation of the policies and programs identified in the Accession Partnership that was approved by the European Union on March 1998 (see Appendix II). Over the medium term, budgetary costs are likely to increase further due to the required increase in public sector investment on infrastructure, and restructuring of the energy sector. The recurrent expenditure burden on the budget is also likely to increase, reflecting the need to comply with EU standards and the creation of the necessary legal and institutional preconditions for EU membership.

  • Based on the current policies, the government will continue to compensate individuals for savings lost at the start of the transition process.20

  • As part of the land reform and farm restructuring process, restitution of land ownership and the settlement of claims is scheduled to re-start in 1999.

  • Social transfers paid through the social insurance fond (SoDra), in the form of old- age, disability, and survivors pensions, unemployment and retraining benefits, family benefits and social assistance to low-income families, are expected to increase over time due to higher unemployment benefits, retraining benefits, and old-age pensions.

  • The fiscal burden of the pension system is likely to grow. The system support ratio, defined as the number of contributing workers per pensioner was 56 percent in 1996 and is expected to decline rapidly, as employment growth lags the increase in pensioners. Meanwhile, the increase in the share of self-employed in the labor force is likely to reduce the average payroll contributions, since the self-employed are eligible for the full pension and only pay for the basic pension.

  • Fundamental reforms of enterprises in the energy and agriculture sectors, are needed to avoid increases in subsidies. Both the Lithuanian Gas Company (LGC) and the Lithuanian Power Company (LPC) face financial difficulties. Significant cash injections may be required for the LPC to meet its financial obligations. Meanwhile, Lithuania may have to close the Ignalina nuclear power plant for safety reasons, which may entail large budgetary costs on top of any bilateral assistance for this purpose.21 Regarding the agricultural and agro-processing sectors, the various support programs for export subsidies on agricultural goods, which was increased in the second half of 1998 in the wake of the Russian crisis, is expected to remain in place at least until end- 1999. These subsidies are channeled in part through the Rural Support Fund, Market Support and Export Promotion Agency, Agriculture Guarantee Fund and Marketing Regulation Agency.

  • Public investment would need to increase by at least 1 percentage point of GDP over the medium term, mainly in priority areas, including energy, transport, and environmental protection, reflecting in part the preparation of for EU and NATO membership.

26. This overview shows that the achievement of overall fiscal objectives will require a careful assessment of expenditure and its composition, and will involve difficult choices. A rationalization of the size, staffing, and functions of the general government would help improve efficiency, reduce the government work force, and lead to saving in the medium term. Meanwhile, streamlining of social benefits and increased allocations for means-tested social benefits would help improve the targeting of transfers. The long-run sustainability of SoDra can be addressed by increasing the pension eligibility age and changing the indexation mechanism to keep pensions within available resources. Reform of the social system could be supplemented by the introduction of a three-tier pension system, including private pension schemes, as is envisaged by the newly approved Law for Private Pensions.

27. Expenditure management could be helped through a number of structural reforms, These include the approval of the revised Budget Law that will be presented to Seimas shortly that would, among other things, (i) incorporate extrabudgetary funds—including the Privatization Fund, but excluding the Health Insurance Fund and SoDra—in the budget by 2002; and (ii) set limits on line ministries’ end-year spending and includes carry-over provisions, to avoid the end-year spending surge that has complicated budget management in recent years. Also, reforms of the energy sector would help reduce both implicit and explicit government subsidies. Such reforms could include the liberalization of the energy prices, privatization of parts of the LPC and LGC, removal of energy subsidies, and improved corporate governance.

C. Fiscal Objectives and Sustainability

28. Several objectives would guide fiscal policy in the years ahead. First, the authorities’ overriding short-term objective is a reduction in the current account deficit. Recognizing that fiscal policy is a key instrument for achieving external adjustment in the short run, the authorities adopted a balanced budget for the national government for 1999 and intend to do the same for 2000.22 Second, actions will be needed to ensure a sustainable government debt position, a sustainable fiscal position is traditionally judged in terms of the criterion of stabilizing net public debt in relation to GDP at a level that does not require excessive interest cost.23 As long as the real interest rate on public debt exceeds real GDP growth rate, a primary fiscal surplus would be required to offset the growth in the debt ratio induced by interest payments.24 The larger the wedge between the interest rate and the real GDP growth rate, the larger the primary surplus needed to stabilize the debt-to-GDP ratio. This implies that a country for which the primary balance is negative, such as Lithuania, will need to undertake fiscal consolidation in order to stabilize the public debt ratio.

29. A mechanical medium-term projection—based on annual real GDP growth of 5-6 percent, annual inflation of 2-3 percent, an annual nominal interest rate of 10 percent on domestic debt and 8 percent on foreign debt, respectively, and primary fiscal deficits based on current policies as described above25—suggests that the annual fiscal deficits could be as high as 5 percent of GDP over the medium term, and that the public debt stock could rise to over 30 percent of GDP by 2004 and continue rising thereafter. Interest payments would increase from 1.2 percent of GDP in 1998 to 3.2 percent in 2004. This underscores that the debt-to- GDP ratio may not be on a sustainable trajectory, and that interest payments are likely to exert excessive pressures on the budget. Under these conditions, real GDP growth would slow down, further exacerbating the problem. Also, this scenario may not be consistent with the government’s own debt strategy. In sum, major fiscal measures are needed to limit the government debt-to-GDP ratio over the medium term.

30. The size of the fiscal adjustment needed depends upon the level of public debt considered sustainable. A fiscal deficit of 4½-5 percent of GDP in 1999 and 0-1 percent of GDP in 2000 followed by a fiscal balance in subsequent years would be consistent with reducing the debt-to-GDP ratio gradually over the medium term (Table 5). Given the medium- term spending pressures discussed above, it will be important to achieve fiscal adjustment early on. The need for fiscal adjustment in the short term is further reinforced by the importance of reducing the current account deficit. In this context, external sustainability would require a significant up-front fiscal correction, since structural reforms needed to increase non-government saving take time to have the desired effect.

Table 5.

Lithuania: Medium Term Fiscal Framework

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Sources: Data provided by the Lithuanian authorities; and Staff Projections.

From 1997, contributions to the Health Insurance Fund are excluded from income tax and included in payroll tax

From 1997, expenditures of the Health Insurance Fund are excluded from wages and salaries and included in goods and services.

18

The government’s tax policy strategy is guided by its medium-term objective of accession to the EU, which would require harmonization of taxation laws with EU directives, as well as the authorities’ view that high tax rates are obstacles to growth and conducive to tax evasion.

19

The recent decline in the CIT effective tax rate is noteworthy, from 15 percent in 1994 to 7 percent in 1998, against a statutory rate of 29 percent. Greater use of deductions against CIT liabilities, specifically, exemptions of reinvested profits from taxes, are in part responsible for the decline in the effective CIT rate.

20

According to the Savings Restitution Law, two-thirds of privatization proceeds are earmarked for restitution of savings lost by individuals to hyperinflation in the early transition period.

21

Ignalina is the world’s largest RBMK (Chernobyl-style) facility, producing enough energy to supply has 80 percent of the local market.

22

The Fund’s definition of the general government includes the state and local governments, as well as major extra-budgetary funds, notably the Social Insurance Fund, the Health Insurance Fund, and the Privatization Fund. Also, the Fund’s definition of the fiscal deficit counts privatization receipts as financing and the use of privatization proceeds on government outlays (including for savings restitution) against the deficit. Under this definition, the fiscal position in 1999 and 2000 will be in deficit to the extent that the government undertakes net lending operations and spends privatization proceeds on off-budget items.

23

The government has adopted a debt-based rule that requires that total debt public debt and external government debt do not exceed 24 percent and 16 percent of GDP, respectively, by 2001. As Lithuania is aiming for EU membership, the Maastricht criteria relating to fiscal policy may also be relevant, requiring the authorities to maintain the general government fiscal deficit under 3 percent of GDP, and the debt stock below 60 percent of GDP.

24

The change in nominal government debt evolves over time according to the following equation: Δ d = -p + (r - g) dt-1/(1 + g) + a, where d is the ratio of stock of debt to GDP in period t, p is the primary balance (i.e., before interest payments) to GDP, r is the real interest rate on government debt, g is the real GDP growth rate, and a is the ratio of other items that affect government indebtedness, such as privatization receipts and seigniorage.

25

The projections also assume that the oil refinery complex will be privatized in 1999, while the state-owned banks, (the Savings Bank and the Agricultural Bank) will be privatized in 2000, with the proceeds assumed to be coming in gradually.