Republic of Lithuania: Selected Issues

This Selected Issues paper examines inflation dynamics over the past five years for Lithuania. A decomposition of inflation into its components provides clues to its main causes. It shows that energy price increases and convergence to European Union (EU)-wide price levels have been important factors driving inflation, but domestic demand pressures—and wage growth, in particular—have also contributed to inflation. The types of possible efficiency gains are illustrated in the context of health care and social assistance. The paper also examines migration and its long-term fiscal implications.

Abstract

This Selected Issues paper examines inflation dynamics over the past five years for Lithuania. A decomposition of inflation into its components provides clues to its main causes. It shows that energy price increases and convergence to European Union (EU)-wide price levels have been important factors driving inflation, but domestic demand pressures—and wage growth, in particular—have also contributed to inflation. The types of possible efficiency gains are illustrated in the context of health care and social assistance. The paper also examines migration and its long-term fiscal implications.

I. Introduction

1. Lithuania’s economy has performed strongly over the past few years, with robust growth and low inflation. Recently, however, short-term inflation developments have moved into the spotlight as meeting the Maastricht criterion on inflation for early euro adoption has proven a challenge. The first chapter examines inflation dynamics over the past five years. A decomposition of inflation into its components provides clues to its main causes. It shows that energy price increases and convergence to EU-wide price levels have been important factors driving inflation, but that domestic demand pressures—and wage growth, in particular—have also contributed to inflation. To limit the upside risks to inflation, a conservative fiscal stance would be helpful.

2. More efficient delivery of government services can help contain short-term demand pressures and deal with medium-term fiscal challenges. The types of possible efficiency gains are illustrated, in the second chapter, in the context of health care and social assistance. In the health care system, overcapacity and poor quality service coexist with queues and informal fees. Among other things, the introduction of co-payments could help formalize some of the informal payments and improve service delivery while protecting the most vulnerable groups. Social assistance is currently provided through many small benefits that, together, create labor market disincentives. These disincentives can be reduced by consolidating the benefits. Improved targeting of the existing resource envelope for social assistance could improve support for the most vulnerable groups.

3. While Lithuania does not face a serious ageing problem in the medium-term, long-term fiscal challenges arise from migration. The third chapter examines migration and its long-term fiscal implications. Emigration, mostly driven by aspirations for higher incomes, has contributed importantly to the steady decline in Lithuania’s population. Based on projections of the income gap between Lithuania and the EU-15 countries, emigration incentives may last for the next 25 years during which period around 8 percent of the current working-age population could emigrate. Since emigrants are mostly of working age, their departure creates pressures on the labor market and public finances, especially the pension and health insurance funds.

4. An expansion of the revenue base by drawing more economic activity out of the shadow economy could help ease mounting medium- and long-term fiscal pressures. The fourth chapter provides a brief description of the shadow economy in Lithuania and examines possible policies to shrink its size. Three policy areas stand out as potentially effective: reducing the fiscal burden, easing labor market restrictions, and easing entry barriers for new businesses. The evidence suggests that the most effective policies are those that reduce the effective minimum wage and ease barriers to business entry. Less effective are cuts in personal income tax and social security contributions, which have the added disadvantage of causing substantial net revenue losses.

Republic of Lithuania: Selected Issues
Author: International Monetary Fund