Republic of Lithuania
Selected Issues

In Lithuania, the case for complementing the on going fiscal adjustment with revenue measures is strong. In addition to supporting the adjustment, options to raise revenue need to be tailored to enhance growth and export competitiveness. International and empirical evidence suggest important scope for revenue-enhancing tax reforms in Lithuania. Lithuania is in a position to rebalance growth towards exports. Executive Directors suggest a broad tax reform strategy that could raise revenue and tax new revenue sources while supporting growth, competitiveness, and equity to substantially bolster revenues.

Abstract

In Lithuania, the case for complementing the on going fiscal adjustment with revenue measures is strong. In addition to supporting the adjustment, options to raise revenue need to be tailored to enhance growth and export competitiveness. International and empirical evidence suggest important scope for revenue-enhancing tax reforms in Lithuania. Lithuania is in a position to rebalance growth towards exports. Executive Directors suggest a broad tax reform strategy that could raise revenue and tax new revenue sources while supporting growth, competitiveness, and equity to substantially bolster revenues.

I. Lithuania: Options for Revenue-Supported Fiscal Adjustment1

A. Introduction

1. Recent international experience suggests a clear supportive role for revenue measures in fiscal adjustment. Revenue measures play an important role when large fiscal adjustment is needed and/or in countries with low initial revenue-to-GDP ratios (Tsibouris et al., 2006). Successful adjustments saw the introduction of broad-based tax measures and improvements in tax administration, while unsuccessful consolidations where characterized by dependence on narrow tax bases. Countries such as Canada, Finland, Ireland, and New Zealand eliminated exemptions and expanded tax base towards previously non-taxed sources, to create fiscal space and to reform the tax system to be more growth-friendly.

2. In Lithuania, the case for complementing the on-going fiscal adjustment with revenue measures is strong. Although the large increase in spending during the boom warrants an expenditure-led approach, the scale of adjustment still needed and the still low tax burden suggest revenue should play a greater role:

  • Further adjustment of about 5½ percent of GDP is still required to reduce the headline deficit to the authorities’ 3 percent target by 2012. In cases of prolonged adjustments, tax and expenditure measures better secure the sustainability of public finances (see IMF, 2010). So far, less than 15 percent of the adjustment in 2009 and 2010 has come from revenue measures. A greater reliance on revenue would help shield core public services and create fiscal space for a better social safety net and future costs of aging. It would also generate resources pending gains from slower yielding structural reforms.

  • Lithuania’s tax burden, already low by international standards, will be even lower post-crisis due to the dissipation of windfall revenues from the boom as well as the reorientation of GDP towards tradables—generally a sector less intensely taxed.

3. In addition to supporting the adjustment, options to raise revenue need to be tailored to enhance growth and export competitiveness. This could be done by (i) relying on less distortionary and more growth-friendly tax instruments; (ii) ensuring the tax system is supportive of the reorientation of the economy to tradables; and (iii) diversifying a relatively concentrated tax structure that is reliant on mobile tax bases. The tax reforms can also be designed to ensure the most vulnerable are protected. Beyond the need to support the adjustment, growth, and to safeguard the poor, further strengthening of tax compliance is crucial to maximize gains from tax reforms.

B. Lithuania’s Current Tax Level and Structure Scope for Improvement

The Overall Level and Structure of the Tax System

4. At just under 30 percent of GDP, the overall tax burden is lower than in EU comparators. In percent of GDP (Table 1):

  • The lower burden of direct taxes on labor largely reflects the low and flat PIT tax rate and the number of exemptions in force in 2007, but also a much lower labor share compared to EU average. Post-EU accession, higher labor mobility put downward pressure on tax rates as the domestic economy faced labor shortages, while there was a desire to remain attractive to investors via a simple tax system.

  • Consumption taxes, while comparable to the EU average, are below Central European Economies (CEE) with similar per capita income levels. This reflects the impact of preferential rates and exemptions in 2007 as well as on-going problems in compliance.

  • Property and capital taxation are significantly lower than EU and Eastern European comparators. Residential real estate, cars and net wealth are not taxed, while capital transfers, capital gains, and corporate profits enjoy various exemptions.

Table 1.

Level of taxation in Europe (2007)

(Percent of GDP)

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Source: Eurostat.

5. Comparisons of average effective tax rates suggest there has been significant leakage of tax potential. The implicit tax rate captures the proportion of the total potential taxable base that is being successful tapped (Table 2). In 2007, the effective tax rate on corporate income in Lithuania was 10.7 percent, well below the statutory rate of 15 percent. The implicit VAT tax rate in 2007 was well below both the statutory rate, as well as the EU average and other Baltic comparators.

Table 2.

Implicit tax rates in Europe (2007) 1/

(Percent of taxable base)

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Source: Eurostat.

Defined as the ratio of total tax revenues to a proxy of the potential tax base.

6. The tax structure is reliant on the taxation of income and consumption, and not stocks of wealth (Figure 1). The dominance of direct and indirect taxes in overall revenue collections reflects a reliance on taxation of flows (earned income and consumption) relative to stocks (property and net wealth). As suggested in IMF (2010), in such circumstances there are many choices to increase the tax ratio while being guided by principles of efficiency (long term growth prospects) as well as equity (more equal income distribution). Recent evidence from OECD countries suggests that taxing consumption has a significantly smaller adverse impact on GDP per capita growth than income taxation (Johansson et al, 2008). Moving from income to consumption taxation can also improve competitiveness; Blanchard (2007) argues that shifting the tax base towards indirect taxation supports the realignment of tradable versus non-tradable prices. Consumption taxes are less distortive and thus efficiency promoting, but are generally more regressive. Direct taxes could be used to promote equity, but are distortive. Property taxes (taxation of accumulated stocks), which are underutilized in Lithuania, are found to be the least distortive (Arnold, 2008) and thus can be used to promote growth and equity.

Figure 1.
Figure 1.

Structure of Taxation in Selected European Countries

Citation: IMF Staff Country Reports 2010, 202; 10.5089/9781455203802.002.A001

Source: Eurostat, IMF Staff calculationsNote: CEE 5 comprises of Czech Republic, Hungary, Poland, Slovakia and Slovenia.

7. Diversifying the tax structure towards less mobile and distortive bases, like immovable property, would help insulate revenue from volatility. Lithuania, in common with Estonia and Latvia, has a very open economy with a high degree of mobility in its labor and capital tax bases (Figure 2). Its wage determination system is characterized by a low degree of unionization, and nominal wage levels highly flexible in both directions. As a result, tax revenue in Lithuania is about 3–4 times more volatile than in the euro area, because GDP, private consumption, and the wage bill are about 3, 6, and 8 times more volatile, respectively (Table 3). Expanding wealth-type tax instruments, like car and inheritance taxation, would help insulate revenues from volatility by tapping less mobile tax bases.

Figure 2.
Figure 2.

Emigration and the Business Cycle

Citation: IMF Staff Country Reports 2010, 202; 10.5089/9781455203802.002.A001

Source: Eurostat; WEO.
Table 3.

Cyclical Volatility of Major Macro Aggregates and Tax Revenues 1/

(Standard deviations)

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Source: Haver; and IMF staff calculation.

Table reports standard deviations of cyclical components of real variables, derived through HP filter for 1995–2009 conditional on available data. Results do not account for discretionary changes in tax codes etc. and thus are indicative only.

8. The following section explores in more detail the potential to enhance both revenue performance and the efficiency of the tax system. It examines each of the key tax bases starting with those that are most efficient, are underexploited, and have the potential to yield substantial revenue in a pro-growth and equitable manner. Staff estimates suggest the options discussed to expand the tax base and improve administration could yield a total of about 3 percent of GDP in the near-term (Table 4).

Table 4.

Yields of Options for Revenue-supported Adjustment

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Source: IMF staff estimates.

Options for Reform by Tax System

Taxation of Capital Stock: Scope to Broaden the Base

9. The share of taxes raised from the capital stock and other forms of wealth is low. As a proportion of GDP, wealth taxes are less than 25 percent of the EU average suggesting a source of tax revenue with the smallest adverse effect on growth is being underexploited. Expanding the tax base to tap wealth, mainly through residential property and car taxation, would diversify the tax base and counter volatility by relying on a less mobile and more predictable tax base. Measures to expand the tax base on wealth could be further complemented by strengthening inheritance, gifts and land taxation.

10. To garner the maximum revenue potential from a property tax, a new residential property tax would need to be levied at a low rate on as broad a base as possible. While commercial real estate is taxed, Lithuania is one of a few countries in Europe where individual property is not, while existing mortgages still benefit from mortgage interest relief. Extending the property tax to residential housing could yield substantial revenue: other countries at Lithuania’s income level generally collect about ¾ percent of GDP in revenue from the taxation of residential property (Table 5). The housing stock in Lithuania is conservatively valued at about 100 percent of GDP at end-20092 with approximately ⅔ of the housing stock valued at less than LT 200,000. To yield a similar amount of revenue to that obtained in other countries, the structure of housing values suggests imposing a very low tax rate of about 1 percent on a broad base, with an exemption only for a minimum surface area per property (to protect the most vulnerable). If designed in this matter, the tax could yield up to ½ percent of GDP in the near-term.3 Exempting all primary residences, however, would erode the yield substantially and unduly benefit middle and high income earners, while duplicating personal income and capital gains taxation exemptions. The authorities’ estimates suggest that such a generous exemption would reduce the yield of the property tax to less than 0.1 percent of GDP.

Table 5.

International Comparisons: Property Taxes’ Revenue Importance

(Percent of GDP)

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Source: Bahl, R. and Martinez-Vazquez, J. (2008). “The Property Tax in Developing Countries: Current Practice and Prospects” in Making the Property Tax Work: Experiences in Developing and Transitional Countries, ed. by Roy Bahl, Jorge Martinez-Vazquez and Joan Youngman. (Cambridge: Lincoln Institute of Land Policy).

11. A new annual green tax on cars would help expand the revenue base in an efficient and equitable manner. In the European Union and the OECD, annual vehicle registration fees are an important revenue earner for governments. Nearly an equal number of OECD member states impose vehicle registration taxes by cylinder capacity with a minimum charge. Others differentiate between fuel efficiency and CO2 emission standards. An annual motor vehicle fee graduated per engine size has many properties of an immovable property, consumption, luxury and green tax, and would be easily implementable given the car registry is fully operational. The revenue yield from such an instrument would be sizeable; a simple structure that assumes a minimum charge of one full tank of fuel (60 liters) per active car would yield an estimated 0.4 percent of GDP in revenue.4 The yield could be larger and more equitable if the tax was then graduated by vehicle weight (a proxy for the value of the car) or engine capacity. Also here the long-term revenue potential is much higher as many countries also apply higher rates (for example, the vehicle tax fee in New Zealand is just below 2 full tanks, whereas Norway applies a rate equivalent to more than 6 full tanks of gas).

12. The framework for administrating these new taxes is already in place. Bahl (2008) finds Lithuania has a well-prepared and operating institutional framework for the administration of a property tax. It has a modern property cadastre and register, as well as computerized systems to identify, record, and manage its mass appraisal system. Likewise, it maintains a register of active cars.

Consumption Taxation: Scope to Strengthen Tax Compliance

13. The reforms implemented in 2009 sought to improve efficiency and support growth by shifting the tax burden from direct income to consumption taxation, in common with reforms undertaken by other open economies (Figure 3). In 2009, the statutory VAT rate was raised by 3 percentage points to 21 percent. Exemptions were eliminated and preferential rates abolished with the exception of heating and school books that are set to sunset in 2011. Looking ahead, with VAT and excise tax rates broadly in line with those in the region, the scope to increase rates further will need to be coordinated regionally to minimize the risk of cross border competition. Nonetheless, were the standard VAT rate to be raised to the EU maximum it would potentially raise 1.2 percent of GDP.

Figure 3.
Figure 3.

Reliance on Consumption Based Taxes and the Degree of Openness

(Percent)

Citation: IMF Staff Country Reports 2010, 202; 10.5089/9781455203802.002.A001

Source: Statistics Lithuania; WEO; and IMF staff calculations.

14. Despite the recent reforms, VAT revenue performed poorly in 2009, suggesting scope for administrative improvements. Widening output and absorption gaps around 2007 led to a cyclical increase in effective VAT rates, thus generating temporary windfall revenue that was later unwound during 2009. VAT cash collections fell by some 26.4 percent in 2009, even though nominal private consumption and GDP declined by 13.1 and 17.2 percent, respectively. This, combined with the evidence on the relatively low effective tax rate on consumption even prior to the crisis, suggests VAT compliance could be significantly improved to enhance collections.

15. VAT collections in Lithuania have been historically very cyclical. During the boom, compliance problems were masked as cheap credit helped boost consumption and led to windfall tax collections. Table 6 provides regressions of the cyclical component of real VAT revenue to the output gap in selected European economies.5 It shows that in countries with consumption booms and high volatility in revenue-to-GDP ratios (Greece, the Baltics, and UK), VAT collections were strongly influenced by the economic cycle, rising strongly above trend in the boom. The results also show that countries that became more export orientated (for a given level of imports) exhibited less cyclical and more stable VAT collections over the cycle.

Table 6.

Cyclical Response of VAT to Output Gap in Selected European Countries 1/

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Source: IMF staff calculations.

VAT cycle is derived with applying HP filter to deflated and seasonally adjusted revenue. Baseline time period for regressions is 1996 q1 – 2009 q2, few observations from the beginning as well as end are dropped to alleviate the endpoint problems.

16. VAT compliance in turn has been strongly related to the economic cycle, improving in the boom and falling sharply in the downturn (Figure 4). Plotting the cyclical response of VAT collections to the output gap against the compliance gaps suggests that countries where VAT collections are more sensitive to the business cycle, such as the Baltics, UK, Greece, Italy, Hungary and Slovakia, also experience substantially larger tax compliance problems. Relatedly, VAT arrears in Lithuania have almost doubled when compared to pre-boom levels. Thus, administration problems not only entail direct revenue losses but also serve as an amplifier of the business cycle impact on collections.

Figure 4.
Figure 4.

VAT Compliance and its Relation to the Output Gap

Citation: IMF Staff Country Reports 2010, 202; 10.5089/9781455203802.002.A001

Source: IMF staff calculations.

17. Strengthening tax administration to improve VAT compliance would yield substantial revenue over the medium-term The C-efficiency ratio, which measures the VAT effective rate as a ratio to the statutory rate, is considerably lower in Lithuania than in the EU on average. Table 7 provides a decomposition of VAT C-efficiency into compliance gap and policy gap,6 and the compliance gap is one of the highest in Europe matched only by Latvia, Italy, and Hungary. With elimination of most of the VAT exemptions in 2009, the policy gap relative to the EU average is likely to have substantially narrowed, but the aforementioned evidence suggests the compliance gap remains. Closing the compliance gap by ⅓ would yield about of 0.7 percent of GDP in additional revenue; reducing the gap further to the levels of France or Estonia would double that yield.

Table 7.

Private Consumption Based VAT Efficiency Decomposition

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Source: Reckon (2009), IMF staff computations.Note: all estimates and calculations refer to year 2006.

Direct Taxation of Labor Income: Scope to Close Loopholes and Improve Compliance

18. The income tax burden is low and its role in the tax system declined over the boom. Since 2000, the implicit tax rate on labor has fallen from about 40 to 32 percent in Lithuania. By end-2009, PIT revenues and social security contribution collections comprised about 16 percent of GDP. This declining trend over the boom mainly reflected reductions in the standard PIT rate.7 Social security contribution rates remain high, at almost 40 percent of gross income (Table 8). These trends follow the experience of most advanced countries that have considerably reduced top marginal rates, while raising social security contribution rates (Johansson, 2008).

Table 8.

Personal Income Tax and Social Security Contribtuion Rates, 2010

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Source: International Bureau of Fiscal Documentation.

Health includes health insurance; and sickness and maternity insurance.

For Lithuania, it is the average of a variable contribution. According to the actual number of accidents at work at the employer’s enterprise during the last 3 years, it ranges from 0.18 to 0.9.

19. The 2006–09 income tax reforms have gone a long way in broadening the income tax base. Reflecting this and the impact of earlier reforms, the PIT gap—the difference between the statutory and effective rates (vis-à-vis the economy wide wage bill)—has fallen to 3.5 percentage points in 2009 from a high of around 12 percentage points in the mid-2000s (Figure 5). Part of the declining trend is attributable to improved compliance during the boom as under-the-table wage payments were declared in response to the reductions in the statutory PIT. The 2009 reform further streamlined many of the exemptions, including eliminating the tax-exempt minimum income allowance for high income earners and making it applicable only to income from employment, while increasing it slightly for low income earners and families with multiple children. Eligibility for tax exemptions on agricultural income were scaled back to small farmers, while the exemptions for interest payments on new mortgages and spending on personal computers were eliminated.

Figure 5.
Figure 5.

Trends in the Personal Income Tax Gap 1/

Citation: IMF Staff Country Reports 2010, 202; 10.5089/9781455203802.002.A001

Source: Lithuania and Estonia Authorities.1/ Difference between the statutory and effective rate.

20. There is however further scope to broaden the income tax base. In particular, steps could be taken to eliminate exemptions, deductions, and allowances for expenses which are in the nature of consumption or providing a double benefit.

  • Deductibility of mortgage interest payments for existing mortgages on primary residences. Given that imputed rent and capital gains on all primary residences are exempt from taxation, full elimination of the deductibility of mortgage interest payments would eliminate the double exemption from taxation.

  • Income tax exemption for pension income. Currently all pay-as-you-go pensions as well as those received from private pension funds are tax exempt, while contributions are not taxed and contributions made by employers on behalf of employees are fully deductible from profits and are also exempt from income tax. Taxing pension income would be both efficient and equitable as this constitutes privately earned income. When compared to a proportional across-the-board pension cut yielding the same amount of revenue, the tax-exempt minimum would unambiguously better protect the low-income pensioners while bringing working pensioners and those with multiple pensions more fully under the tax net. In the case of pension taxation, the poorest 5 percent of the pensioners would not pay any tax, 50 percent of pensioners would be strictly better off than under a proportional cut, and the average pensioner would pay less than LT 50 per month in total tax (Figures 6 and 7).

  • Other deductions and allowances. Exemptions for interest paid for leasing of a dwelling should be eliminated for symmetry with mortgage interest. Deductions for professional training or higher educational studies can be phased-out on the grounds that these expenses constitute consumption.

  • Measures to prevent unlimited exemptions on donations by taxpayers. This would help minimize the risk of tax avoidance.

Figure 6.
Figure 6.

Distribution of Old-age Pensions

Citation: IMF Staff Country Reports 2010, 202; 10.5089/9781455203802.002.A001

Source: Sodra.
Figure 7.
Figure 7.

Tax vs Proportional Cut: Old-age Pensions

(Litas per month)

Citation: IMF Staff Country Reports 2010, 202; 10.5089/9781455203802.002.A001

Source: Sodra.

21. There is still scope to strengthen the administration of income taxes. There is indicative evidence of continued underreporting of wages especially during the crisis. The share of those declaring income out of total taxpayers reached 47 percent in 2009, down slightly from 51 percent recorded during the boom. However, the total amount of income declared in 2009 has fallen by more than the economy-wide wage bill, especially for higher income earners. The latter are also likely to get higher share of the income from capital and have greater opportunities to benefit from various loopholes. To strengthen tax administration, it would be advisable to make income declarations mandatory—complemented by regular life-style surveys—to ensure maximum yields from further revenue measures over the medium-term.

Direct Taxation of Corporate Income: Scope to Make the System More Pro-Growth

22. Given that the effective CIT rate in Lithuania is well-below the statutory rate, there is scope to raise collections without increasing tax rates, by removing exemptions. The adverse effects of CIT on the cost of capital, investment, and productivity are well documented8 and, as capital has become increasingly mobile, the scope to raise CIT tax rates has become increasingly constrained by tax competition. Seen from this perspective, the recent move to re-establish the 15 percent statutory CIT rate, after temporarily increasing it to 20 percent in 2009, can be understood. However, the implicit tax rate on corporations that was already relatively low at 10.7 percent in 2007 is expected to fall further to about 8 percent in the coming years, due to new tax incentives granted for investment in 2009.

23. International evidence points to limited benefits of tax incentives. Klemm and Van Parys (2009) find that only tax holidays and not investment incentives have a positive impact on FDI, but not on investment or economic growth, suggestive of crowding out effects. Klemm (2009) argues that, in general, tax holidays should be avoided as they only generate short-lived and one-off investment. Possible options to streamline exemptions include: (i) reconsidering the preferential tax rate treatment of small enterprises that has been found inefficient,9 (ii) reconsidering or reducing the investment incentive, (iii) withdrawing the 6-year tax holiday scheme on companies in free economic zones to close loopholes in the overall tax system, while grandfathering the existing qualifying firms. In any case, introducing a tax expenditure budget for taxpayers receiving beneficial treatment could help assess the cost of these tax incentives and over time serve as an input to measure their effectiveness.

24. There may also be scope to enhance the efficiency of the CIT by reconsidering distortions that impact decisions on financing and leverage. The deductibility of interest from taxable profits as well as the double taxation of equity/dividends has, as in other countries with classical CIT systems, favored debt over equity financed investment. In Lithuania, the tax wedges calculated based on the King and Fullerton (1983) methodology suggest the CIT, inclusive of the impact of exemptions and the depreciation allowance, subsidizes debt financed investments (Table 9). Although the wedge turns positive once the impact of PIT is taken into consideration (due to the taxation of dividends under the PIT) the system is still biased towards debt financing. Besides potentially distorting the allocation of investment against ‘equity-intensive’ (e.g. knowledge-based) companies, it can also contribute to excessive leverage. Further, as the final owners of corporations are ultimately households, debt-biased corporate taxation is not consistent with mortgage interest deductibility under PIT.

Table 9.

Tax wedges in Lithuania, 2009

(Percent)

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Source: IMF Staff Calculations.

C. Conclusion

25. International and empirical evidence suggest important scope for revenue-enhancing tax reforms in Lithuania. A broad tax reform strategy that could raise revenue and tax new revenue sources while at the same time supporting growth, competitiveness and equity could consist of the following:

  • Decisively increasing the share of property—in particular real estate and car—taxation in the overall tax structure.

  • Consider increasing the progressivity of the tax system to provide for equity through progressivity in property taxation and the application of luxury or green tax instruments.

  • Maintaining higher emphasis on consumption taxation, keeping exemptions at minimum, while addressing compliance issues.

  • Reducing and phasing out personal income exemptions that are in the nature of consumption or create an opportunity for a non-taxable income stream.

  • Offseting the revenue loss from the reduction in the CIT rate through a phasing out of inefficient exemptions and, over the longer term, considering a boarder reform to remove distortions that create biases toward debt-finance and leverage.

26. A broad-based package of this kind would substantially bolster revenues. Staff estimates suggest the revenue yield from such broad-reaching tax reform could reach between 3–3¾ percent of GDP over the medium-term, helping complement and balance the on-going adjustment on the expenditure side of the budget.

References

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1

Prepared by Alvar Kangur

2

This is based on the 2006 mass appraisal updated for recent price movements. To compare, the UK’s per capita PPP income level was 2 times that of Lithuania, but its stock of residential property was valued at about 300 percent of GDP in 2006 (RICS, 2008).

3

The long-term potential is even larger, especially if the tax was levied in a progressive manner.

4

Currently 1.7 million cars are registered in Lithuania.

5

The regressions control for (i) discretionary changes in tax rates or occasional shifts in revenue across consecutive quarters, (ii) exports-to-imports ratio to control for relative ‘export intensity’ of the economy, (iii) a trend to net out any residual non-stationary elements.

6

The compliance or ‘VAT-gap’ is taken from Reckon/EC (2009) study and refers to a percentage gap between actual and theoretical VAT receipts. The policy gap is then derived as a multiplicative residual between the efficiency and compliance gap, and shows the effect of exemptions and reduced rates.

7

In July 2006 the income tax rate was reduced from 33 to 27 percent, in January 2008 to 24 percent and then to 21 percent in 2009. In addition the tax exempt threshold was also raised from 1 May 2002 from 214 LTL to 250 LTL per month, on January 1, 2003 to 290 LTL per month with an additional TEA +29 LTL for each child; and in 2007 to 320 LTL per month with an additional TEA +32 LTL for each child;

8

See Hassett and Hubbard, 2002 and Arnold, 2008. The latter finds the negative impact of corporate taxation is almost twice of that of personal income taxation.

9

Arnold (2008) argues that investment and TFP in small firms is, in fact, less sensitive to corporate taxation.

Republic of Lithuania: Selected Issues
Author: International Monetary Fund