This Selected Issues paper focuses on sustainability of public finances and low inflation in Lithuania. Lithuania aims to adopt the euro in 2015. Over the medium term, inflation in Lithuania will likely run somewhat higher than in the euro area on average, but this will be driven by continuing income convergence. The long-term inflation track record is favorable, and Lithuania has demonstrated the ability to deliver adjustment when needed without recourse to exchange rate depreciation. The benign outlook for public finances and inflation is contingent on historical patterns of economic policymaking and private sector behavior remaining in place after euro adoption.

Abstract

This Selected Issues paper focuses on sustainability of public finances and low inflation in Lithuania. Lithuania aims to adopt the euro in 2015. Over the medium term, inflation in Lithuania will likely run somewhat higher than in the euro area on average, but this will be driven by continuing income convergence. The long-term inflation track record is favorable, and Lithuania has demonstrated the ability to deliver adjustment when needed without recourse to exchange rate depreciation. The benign outlook for public finances and inflation is contingent on historical patterns of economic policymaking and private sector behavior remaining in place after euro adoption.

Sustainability of Public Finances and Low Inflation on the Eve of Lithuania’s Euro Adoption Application

1. Lithuania aims to adopt the euro in 2015—it would be the fifth EU member state in Central and Eastern Europe to do so after Slovenia in 2007, Slovakia in 2009, Estonia in 2011, and Latvia in 2014. Lithuania already tried to join the euro area back in 2007 but narrowly missed the inflation entry criterion when it was assessed in the spring of 2006. Indeed, inflation ended up rising further thereafter as domestic overheating intensified up until the height of the global financial crisis in 2008/09, which plunged the economy into a deep recession.

2. This time Lithuania seems on track to meet all four quantitative entry criteria for euro adoption. The European Commission and the ECB will formally assess Lithuania’s readiness in their June 2013 convergence reports, which form the basis for a final ECOFIN decision in July. At the heart of the assessment will be four entry criteria: (i) a fiscal deficit below the Maastricht threshold of 3 percent of GDP in 2013; (ii) a debt-to-GDP ratio of no more than 60 percent of GDP at end-2013; (iii) annual average inflation below the average of the three “best performing” EU countries plus a margin of 1.5 percentage points; and (iv) interest rates on long-term government debt below the average of the same “best performers” plus a margin of 2 percentage points. Available data suggest compliance with all four criteria.

3. This set of Selected Issues Papers assesses the sustainability of sound public finances and low inflation—necessary in staff’s view for successful euro area membership beyond the entry criteria.1 The strictures of monetary union make it difficult to deal with high public debt—ensure its continued rollover or reduce the debt ratio—underscoring the heightened need to avoid the accumulation of excessive public debt in the first place. Similarly, any erosion of competitiveness from periods of excessive price and wage inflation become particularly costly to correct in a monetary union because exchange rate depreciation is no longer an option, thereby putting a premium on steering clear of inflationary bouts.

4. The chapter on fiscal sustainability speaks to Lithuania’s overall sound public finances. While the government rightly aims for further fiscal consolidation to achieve the medium-term objective of a broadly balanced budget, the deficit has already been reduced to stabilize debt under reasonable assumptions for future economic growth. At some 40 percent of GDP, public debt is relatively low by both EU and emerging market standards and its structure is favorable. Downside risks to public finances over the medium term seem limited. Moreover, there is ample room to further improve fiscal performance to achieve the consolidation objectives, address the fiscal challenges associated with population aging, and deal with eventualities.

5. Over the medium term, inflation in Lithuania will likely run somewhat higher than in the euro area on average, but this will be driven by continuing income convergence, according to the chapter on inflation sustainability. The long-term inflation track record is favorable and Lithuania has demonstrated the ability to deliver adjustment when needed without recourse to exchange rate depreciation. Past inflation differentials with the euro area are found to be well explained by productivity catching-up in the tradable goods sector—the “Balassa-Samuelson effect.” However, in the shorter run, inflation differentials are strongly driven by divergent business cycle positions and asymmetric effects of commodity price developments. The latter seem responsible for inflation in Lithuania falling below that of the euro area in early 2014. As they run their course, underlying Balassa-Samuelson effects are likely to come to the fore and restore the historical pattern of somewhat higher inflation in Lithuania.

6. The benign outlook for public finances and inflation is contingent on historical patterns of economic policy making and private sector behavior remaining in place after euro adoption. The disciplined approach to fiscal policy is assumed to continue after 2015 rather than giving way to complacency after passing the milestone of euro adoption. On the inflation front, wage setting behavior is assumed to conform to historical patterns. Productivity catching-up is also set to match past patterns. Considering Lithuania’s two-decade success under the currency board arrangement—which imposes strictures similar to those of membership in a monetary union—continuity appears a fair assumption.

7. A common finding of both chapters is the need to strengthen policy frameworks to reduce the volatility in fiscal and inflation performance. Long-term average performance has been favorable, but the volatility of fiscal deficits and inflation has been much higher than in the euro area. This is largely related to Lithuania’s boom-bust cycle during the past decade, which allowed structural fiscal deficits to build up under the surface and inflation to escalate in the boom years. While Lithuania has demonstrated the economic flexibility and the political grit to deliver the needed adjustment thereafter, this has imposed costs on the economy that could have been partly avoided under better policy frameworks to smooth the business cycle.

Sustainability of Lithuania’s Public Finances1

1. This chapter aims to assess Lithuania’s fiscal sustainability. Section A evaluates Lithuania’s track record of fiscal performance, with a focus on the period since the 2008/09 crisis. Section B presents medium-term projections for public finances, including all major downside and upside risks to them. Conclusions and policy recommendations are offered in Section C.

A. What Has Been Achieved Since 2008/09 and Where Do We Stand Now?

2. Lithuania’s public finances are back on track thanks to a tremendous post-crisis consolidation effort. With deficits of around 1 percent of GDP in the boom years 2003–08, the public debt ratio declined to just 15 percent of GDP. But much of the improvement proved cyclical and went into reverse when the economy fell into deep recession in 2009. Despite emergency consolidation measures, the deficit deteriorated sharply to 9.4 percent of GDP and it took a determined multi-year effort to put public finances back on track. In 2012, the general government deficit had declined to 3.2 percent of GDP—just enough for the Excessive Deficit Procedure to be abrogated in spring 2013, taking into account the net cost of Lithuania’s systemic pension reform. The deficit declined further to an estimated 2.1 percent of GDP in 2013, ahead of the 2½-percent-of-GDP target in the budget (Text Figure 1). The bulk of the improvement in the fiscal position has so far been driven by expenditure-side measures, with none of the major spending categories spared (Text Figures 2 and 3).

Text Figure 1.
Text Figure 1.

General Government Fiscal Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Sources: Eurostat and IMF staff estimates.1/ Calculatio η takes into account standard cyclical adjustments as well as absorption gap,
Text Figure 2.
Text Figure 2.

Composition of Cumulative Fiscal Adjustment after Crisis: Revenue vs. Expenditure-Eased

(Excl. temporary measures on transfers to Pillar II pension funds)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: IMF staff estimates.
Text Figure 3.
Text Figure 3.

Structure of Expenditure-Based Measures in Lithuania 1/

Percent of total, 2009–12

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: IMF staff estimates.1/ Percent of GDP in parentheses.

3. Gross public debt remains low by EU standards and EM thresholds; interest rate, exchange rate, and rollover risks are well contained. The ratio of public debt to GDP increased rapidly in the post-crisis period, but remained well below the 60 percent mark of the Stability and Growth Pact. By 2013 it had stabilized at some 40 percent of GDP, and steers well clear of the threshold considered prudent for emerging market economies (Text Figure 4). Rollover and interest rate risks are limited, considering the small shares of short-term debt (6.1 percent of total) and floating-rate debt (1.1 percent of total) (Text Figure 5). The share of foreign currency-denominated debt is considerable, but exchange-rate risks remains muted because it is either denominated in Euros (Text Figure 6)—the anchor currency of Lithuania’s currency board arrangement—or fully hedged through derivative transactions. Lithuania’s public debt is mainly foreign held, primarily by institutional and long-horizon investors that have demonstrated commitment to their positions (Text Figure 7). Soon after the depth of the crisis, Lithuania managed to tap capital markets again in June 2009, thereby avoiding recourse to an international financial assistance program. Interest rates were initially elevated, but came down quickly with Lithuania placing a 10-year Eurobond at a record-low yield of 3.46 percent this January. Thus far, the tapering of unconventional monetary policy in the U.S. has had little repercussions for Lithuania.

Text Figure 4.
Text Figure 4.

General Government Gross Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Sources: IMF World Economic Outlook; and IMF staff calculations.
Text Figure 5.
Text Figure 5.

General Government Gross Debt by Original Maturity, 2013

(Percent)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Ministry of Finance of Lithuania.
Text Figure 6.
Text Figure 6.

Central Government Gross Debt by Currency Denomination, 2013

(Percent)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Ministry of Finance of Lithuania
Text Figure 7.
Text Figure 7.

Investor Base of General Government Debt

(Percent, end-2012)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Bank for International Settlements.

B. Fiscal Prospects, Debt Sustainability, Risks, and Policy Room

Baseline Projections

4. In the baseline projections deficits remain well below the Maastricht threshold (Text Figure 8). Baseline projections reflect a passive scenario that accounts only for announced budgetary measures. It incorporates the budgeted deficit of 1.9 percent of GDP for 2014. Beyond 2014, only a few fiscal policy changes with very limited impact have been announced and are incorporated. Otherwise, most revenue and expenditure categories are assumed to grow in line with GDP, but VAT and excise tax collections are projected to expand somewhat faster as tax administration improves and the absorption gap closes. As a result, the deficit is projected to improve to 1.5 percent of GDP by 2019.

Text Figure 8.
Text Figure 8.

General Government Fiscal Deficit: Baseline Projections Under Passive Scenario

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: IMF staff estimates.1/ Calculation takes into account standard cyclical adjustments as well as absorption gap.

5. The debt ratio is set to decline over the medium term. The deficits under the baseline would be sufficient to reduce the debt ratio to some 35 percent of GDP over the next five years, mainly on account of GDP growth, which is projected to gradually pick up from 3.3 percent in 2014 to 3¾ percent over the medium term (Text Figures 9 and 10). In their 2013 Convergence Program, the authorities pledged a medium-term structural deficit objective of 1 percent of GDP. Approaching it in annual consolidation increments equivalent to ½ percent of GDP would secure a somewhat faster debt reduction trajectory than under the baseline (indicated by the dashed line in Text Figure 9). Moreover, the authorities have indicated that their next Convergence Program will target a more ambitious consolidation path.

Text Figure 9.
Text Figure 9.

General Government (GG) Gross Debt and Primary Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Sources: Eurostat; Ministry of Finance of Lithuania; and IMF staff calculations.1/MTO scenario assumes structural adjustment of 0.5% of GDP until MTO of 1% of GDP structural deficit is reached.
Text Figure 10.
Text Figure 10.

Debt-Creating Flows

(Percent of GDP, baseline scenario)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Sources: National authorities; and IMF staff calculations.

Resilience of Baseline Projections to Adverse Shocks

6. Applying both standard and customized shocks under the IMF’s debt sustainability analysis shows that the public debt ratio would remain below the 60-percent-of-GDP Maastricht threshold in all cases. Even in the unlikely event that key parameters such as the primary balance and real growth went back to their ten-year historical averages, which include the challenging crises years, debt would not breach the 50-percent of GDP mark by 2019 (Text Figure 11). The debt trajectory would remain essentially unchanged from the baseline if primary deficits remained pegged to their 2014 value (Text Figure 12). A combined shock of fiscal relaxation, lower GDP growth, and higher interest rates would set public debt on an upward trajectory, but even without any corrective action it would remain below 50 percent of GDP over the next five years and below 60 percent of GDP over thirteen years (Text Figure 13).

Text Figure 11.
Text Figure 11.

Debt-to-GDP Ratio under Customized Alternative Scenario 1 2/

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

1/ Under this shock scenario, real GDP growth, real interest rate, and primary balance are set at historical averages.
Text Figure 12.
Text Figure 12.

Debt-to-GDP Ratio under Customized Alternative Scenario 2 1/

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

1/ Under this shock scenario, primary balance is set as constant as in the first year of projection.
Text Figure 13.
Text Figure 13.

Debt-to-GDP Ratio under Customized Alternative Scenario 1/

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

1/ Real GDP grows 2 ppts lower, primary balance is 2 ppts worse and interest rate is 25 bps higher than baseline under the shock scenario.

Downside Risks to Baseline Projections

7. There are small Lithuania-specific downside risks, but these would not make a material difference to debt projections. These include:

  • Difficulties in controlling local government deficits, with spending overruns and arrears accumulation. While problematic, to put this issue into perspective, it is useful to recall that arrears accumulation accounted for 0.2 and 0.15 percent of GDP in 2012 and 2013, with the stock now standing at 1 percent of GDP. Explicit local government debt currently stands at 1.6 percent of GDP. In terms of their spending, local governments account for a moderate 9 percent of Lithuania’s public sector.

  • The fiscal cost of bank restructuring related to the interventions of Snoras and Ukio banks in 2011 and 2013. In this context, the government extended loans to the Deposit Insurance Fund for bank resolutions, with outstanding balances of 1.5 and 0.7 percent of GDP, respectively. Snoras-related loans are expected to be fully repaid by the bankruptcy estate. It is less clear whether this would also be possible for the Ukio-related loan, but other revenues of the Deposit Insurance Fund are a secondary line of defense.

  • Revenues from the sale of carbon emission rights. These amount to around 0.3 percent of GDP, but the associated earmarked spending has yet to take place, which would push up the deficit somewhat if not offset elsewhere in the budget.

  • Finally, the government has yet to implement the court-mandated compensation of disproportionate pension and wage cuts during the crisis years, which were found to be unconstitutional. Compensation payments are not reflected in the 2014 budget or incorporated into the baseline projections. They are estimated to amount to between 0.8 and 1.5 percent of GDP, but would be a one-off expense (Text Table 1).

Text Table 1.

Constitutional Court Rulings on Restoration and Compensation of Disproportionate Public Sector Pension and Wages Cuts

article image

8. The risk that post-crisis expenditure compression unwinds could be defused by careful changes in the composition of spending. Post-crisis consolidation left Lithuania with the lowest ratio of public spending to GDP in the EU, together with Bulgaria (Text Figure 14). This raises the question whether such low spending is sustainable or advisable. Cuts in certain areas have been substantial—capital spending declined by 21 percent in real terms compared to the 2006–08 average and outlays for goods and services are down 7 percent—while real GDP has increased by 3 percent (Text Tables 2, 3 and 4). Anecdotal evidence suggests that cuts have gone too far in some areas, with complaints that roads are no longer properly maintained or that the resources of the anti-corruption agency have been unduly curtailed. On the other hand, the share of population drawing disability benefits remains much above international norms (Text Table 5) and Lithuania maintains a large number of universities compared to its small population size. A public expenditure review would help identify ways to reallocated spending within an overall tight envelope to improve sustainability and increase the quality and efficiency of public spending more generally.

Text Figure 14.
Text Figure 14.

Size of Public Sector, 2012

(General government expenditure as percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Sources: WEO and IMF staff estimates.
Text Table 2.

Lithuania General Government Expenditure by Economic Classification

article image
Sources: Eurostat and IMF staff calculations.
Text Table 3.

Lithuania General Government Expenditure by Functional Classification

article image
Sources: Eurostat and IMF staff calculations.
Text Table 4.

General Government Expenditure by Functional Classification: Lithuania vs. EU27

article image
Sources: Eurostat and staff calculations.
Text Table 5.

Disability Benefit Claims by Age Groups

article image
Sources: OECD database on programs for disabled persons; Lithuanian SoDra; and Statistics Lithuania.

9. This leaves the long-term concern how to deal with mounting fiscal costs related to population aging. According to the 2012 Ageing Report by the European Commission, Lithuania’s old-age dependency ratio is expected to rise from 1:4 currently to 1:3 by 2030 and to 1:1.5 by 2060, significantly more than elsewhere in the EU. If unaddressed, this would add 5–6 percent of GDP to public spending on pensions and health between 2014 and 2060, again significantly above the EU average (Text Table 6). While the bulk of these additional costs will only materialize after 2030, it remains important to address it through pension reform early in view of the usually long lead time for such reforms. In addition, it may be necessary to fall back on some of the upside potential in Lithuania’s public finances (see below) to deal with the fiscal fallout from the aging challenge.

Text Table 6.

Projections of the Ageing-related Fiscal Cost

(Percent of GDP)

article image
Source: “The 2012 Ageing Report”, European Commission, 2011.

Policy Space to Improve Upon the Baseline

10. Lithuania’s public finances have ample room for further improvement, mostly related to underexploited tax revenue potential (Geng, 2013). At about 26 percent of GDP in 2011, Lithuania’s overall tax take is the lowest in the EU—some 13, 6 and 4 percentage points of GDP lower than EU, CEE, and the other Baltics averages, respectively. To a large extent, the gap reflects generous allowances, exemptions, and preferential rates in Lithuania’s tax system, thereby shrinking the tax base and complicating compliance while not always being effective in achieving economic or social objectives. Lithuania’s large shadow economy, which mostly escapes taxation, is another key factor (Text Figure 15).

Text Figure 15.
Text Figure 15.

Shadow Economy, 2012

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Schneider, F. (2012), “Size and development of the Shadow Economy from 2003 to 2012: some new facts”.

11. Generous tax policy provisions, a large shadow economy, and weak tax administration then lead to an overall low “tax effort” in Lithuania. It is defined as the ratio between actual tax revenue and the tax capacity—the maximum tax revenue that a country can collect given its economic, social, institutional, and demographic characteristics (Pessino and Fenochietto, 2010). At 60.8 percent in 2011, Lithuania’s tax effort is well below the average of 77.1 percent for its CEE peers (Text Figure 16). Hence, if Lithuania raised its tax effort to the CEE level, tax revenues would be 27 percent, or 7 percentage points of GDP, higher than currently.

Text Figure 16.
Text Figure 16.

Tax Effort in CEE Countries, 2011 1/

(Percent)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Sources: Eurostat; and IMF staff calculations.1/ Tax effort is defined as the ratio between actual revenue and tax capacity. Tax capacity is from Pessino & Fenochietto (2010), estimated as a function of variables determining tax-to-GDP potential using panel data of 96 countries.

12. The taxation of capital and wealth is particularly underdeveloped. In comparison with the EU average, Lithuania’s tax structure remains heavily reliant on labor and consumption taxes, while taxation of capital remains very light and wealth attracts almost no taxes (Text Figures 17 and 18).

Text Figure 17.
Text Figure 17.

Tax Structure in Lithuania

(Percent, 2011)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.
Text Figure 18.
Text Figure 18.

Average Tax Structure in EU Countries

(Percent, 2011)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.
  • Lithuania’s revenue from taxing capital and wealth is only one quarter of the euro area average and one half of the CEE average (Text Figure 19). The OECD (2010) ranks capital and wealth taxes as the least-distortive and most growth-friendly source of tax revenue. But it remains the least exploited tax base in Lithuania, especially when it comes to recurrent property taxes. Residential properties valued below one million litas (about €290,000) are not taxed, and neither are motor vehicles nor is net wealth. Property tax collections amount to less than 0.5 percent of GDP, compared to about 2 percent of GDP in the EU (Text Figure 20).

Text Figure 19.
Text Figure 19.

Taxation of Capital Stock/Wealth, 2011

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.
Text Figure 20.
Text Figure 20.

Revenue from Property Taxes, 2011

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.
  • At only 0.8 percent of GDP, Lithuania’s corporate income tax (CIT) revenue collections are half those in CEE and one third those in the euro area (Text Figure 21). Apart from the difference in statutory rates, Lithuania’s wider gap between statutory and implicit rate contributes to its relatively low revenue take. At only one fifth of its statutory rate, Lithuania’s low implicit CIT rate could reflect various exemptions and preferential rates on capital transfers, capital gains, and corporate profits.2 Loopholes and compliance gaps likely also play a role (Text Figure 22).

Text Figure 21.
Text Figure 21.

Taxation of Corporate Income, 2011

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.
Text Figure 22.
Text Figure 22.

Tax Rates of Corporate Income, 2011

(Percent)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.

13. There also appears to be room to raise more revenue from the taxation of consumption, especially through improvements in tax administration. Overall consumption tax collection is comparable to elsewhere in the EU, but this reflects relatively high rates, while the tax yield given these rates remains comparatively poor. For the VAT, a study by the European Commission estimates a compliance gap as high as 4.4 percent of GDP—considerably above the estimates for most other EU countries (Text Figure 23). Meanwhile, smuggling and cross-border shopping are draining excise tax collection.

Text Figure 23.
Text Figure 23.

VAT Compliance Gap, 2011

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: CPB/CASE (2013): Study to quantify and analyse the VAT Gap in the EU-27 Member States http://ec.europa.eu/taxation_customs/resources/documents/common/publications/studies/vat-gap.pdf.

14. Finally, generous exemptions and deductions reduce revenue from the taxation of labor. At around 13 percent of GDP, Lithuania’s labor tax revenue is 8 percentage points of GDP below the euro area average and 2 percentage points lower than in CEE peers (Text Figure 24). Various exemptions and deductions drive a large gap between implicit and statutory rates in Lithuania—32 percent against 55 percent from social security contributions (40 percent) and PIT (15 percent), although a relatively low labor share in national income also likely plays a role (Text Figure 25). Pensions are neither taxed at the contribution, accumulation, nor payout stage. The PIT largely exempts capital gains and allows deductions of interest payments on mortgages contracted prior to 2009.

Text Figure 24.
Text Figure 24.

Taxation of Labor, 2011

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.
Text Figure 25.
Text Figure 25.

Implicit Tax rates on Labor, 2011

(Percent)

Citation: IMF Staff Country Reports 2014, 114; 10.5089/9781484375051.002.A001

Source: Eurostat.

15. In sum, considerable revenue potential in Lithuania’s public finances provide ample scope to advance fiscal consolidation to reach the medium-term objective and deal with downside risks should they materialize. This space reflects primarily scope to broaden tax bases and strengthen tax administration. It will require policy efforts to exploit this space, although some of the tax administration gains could materialize automatically as income convergence advances and the shadow economy recedes. Text Table 7 summarizes options for revenue-enhancing measures, which give a total annual yield equivalent to 3–4 percent of GDP.

Text Table 7.

Lithuania: Options for Revenue-Enhancing Measures

article image
Source: IMF staff estimates.

C. Conclusions and Policy Implications

16. Decisive policy has put Lithuania’s public finances back on track after the setback of the 2008/09 crisis. Even without new consolidation measures, public finances would be sustainable in the sense that the ratio of public debt to GDP would decline over time. However, the authorities are rightly targeting a more ambitious adjustment path that would achieve a material reduction of the debt ratio, build fiscal buffers, and guard against easy derailment by adverse shocks. But the underpinning measures to achieve this more ambitious adjustment path have yet to be specified. The authorities would be well-advised to strengthen fiscal frameworks further—including through putting in place a countercyclical rule—to minimize implementation risk.

17. Downside risks to Lithuania’s public finances appear manageable. Most of them prove quantitatively small when put into perspective. Expenditure compression of the past appears sustainable, but improvements in the composition of spending are needed to guard against partial unwinding of past consolidation efforts or poor spending quality. The main downside risk to public finances is age-related spending that would rise steeply after 2030 if left unaddressed until population aging intensifies. This calls for timely pension reform, together with steps to mobilize some of Lithuania’s currently underutilized revenue potential.

18. At the same time, there exists ample policy room to further improve Lithuania’s public finances and deal with downside risks. Tax revenues could be boosted considerably by addressing exemptions and loopholes in tax legislation, weaknesses in tax administration, and the large shadow economy. Just closing the tax effort gap with regional peers would yield additional revenue of 7 percent of GDP. Hence, Lithuania’s public finances have the potential to deliver remaining fiscal consolidation and to deal with eventualities.

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1

The chapters benefitted from the discussions with the Ministry of Finance and the Bank of Lithuania during the 2014 Article IV Consultation. The research assistance of Bartek Augustyniak and Felix Winnekens is gratefully acknowledged. Fernando Morán’s and Solange de Moraes Rego’s support was instrumental in finalizing this document.

1

Prepared by Nan Geng (EUR).

2

In Lithuania, small enterprises enjoy a preferential 5 percent rate instead of the 15 percent statutory rate; companies in free economic zones are CIT exempt for 6 years, and taxed at half the statutory rate for the following 10 years; there are also various investment incentives, e.g., taxable profits are reduced by up to 50 percent for ‘high-tech’ investment expenses.

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1

Prepared by Hélène Poirson (EUR).

2

According to the BS hypothesis, productivity catching-up occurs mostly in the tradable goods sector. The resulting pressure on wages economy-wide is passed through to prices in the nontradable sector, which has less scope for productivity catching-up, resulting in overall higher inflation.

3

This expression does not fully capture inflation associated with price level convergence. To the extent that price and income are related, price convergence can arise in economies whose incomes are below the average of the monetary union. Nor is the model equipped to identify nontradable goods inflation associated with an economy running ahead of the monetary union’s business cycle. In practice, those can be important. Thus the empirical application (Section D) controls additionally for broader price convergence effects and for the contribution of short-run imbalances to inflation differentials.

4

For simplicity, the calculations assume equal labor shares across sectors. In practice, the tradable goods sector is generally more capital-intensive, making the estimate of the domestic BS effect a lower bound.

5

Differential inflation in nontradables vs. tradables also turned negative in 2008–12 in the other Baltic countries (IMF, 2013).

6

Post-crisis, the effect of nominal exchange rate changes is nil, reflecting the exchange rate peg to the euro since February 2002.

7

It may be more appropriate to use the NEER (Nominal Effective Exchange Rate) in the estimation instead of the bilateral exchange rate, but following Mihaljek and Klau (2008) the latter is used in the baseline regression as it is derived from equation (1′) where all the variables are expressed relative to the EA. Results with the NEER are also presented as a robustness check.

8

The growth in ULC and the change in unemployment rate were also included as measures of business cycle divergence, but found to be insignificant; hence results are only reported for the remaining four variables.

9

This likely reflects the stability of the exchange rate after Lithuania repegged its currency board to the euro from the U.S. dollar in 2002.

10

The inclusion of the real wage variable helps fully eliminate serial correlation of the residuals and achieves the second best fit in Table 1 (as measured by the adjusted R2). Estimates of the other specifications are less satisfactory, showing residual serial correlation issues. The presence of heteroskedasticity was also tested using both the Breusch-Pagan and Cook-Weisberg and White tests. The null of no heteroskedasticity could not be rejected in all cases.

11

Mihaljek and Klau (2008) also find that BS effects in Lithuania tend to exceed those in the other countries; however they focus their discussion more on the average results. Possibly due to omitted variable bias, their results for Lithuania imply an unrealistically high persistence of inflation and thus extremely large long-run BS effect (of 4.6 ppts).

12

The results are not reported to save space, but available upon request from the author.

13

For the last quarter of 2013 and 2014, out-of-sample predictions are used based on BS effect equal to historical average; output gaps returning to zero in both Lithuania and the EMU; and the wage setting behavior remaining the same after euro adoption (see section E for a detailed discussion).

14

These estimates are likely to provide a lower bound, given that the preferred specification fails to fully capture the pass-through of energy prices (see Section D).

15

Folkertsma et al. (2002, as reported in Hüfner and Koske, 2008) find that the rounding behavior accounts for about two-thirds of switchover related retail price increases. The remainder is attributable to retailers passing on the menu costs of adjusting their businesses to the euro on to their customers.

16

Changeover effects were noticeable for certain services sectors including restaurants and catering, hairdressers, cinemas, and dry cleaning, which experienced significant price increases, not compensated by lower inflation later on. Nonetheless, overall inflation was lower in the two years following euro introduction than in the two years preceding it, as the Statistical Office underscores.

17

See European Commission (2007) for an analysis of the lessons that can be drawn for other countries from the successful introduction of the euro in Slovenia.

Republic of Lithuania: Selected Issues
Author: International Monetary Fund. European Dept.