Lithuania -- 2004 Article IV Consultation: Concluding Statement of the IMF Mission
December 10, 2004
1. In acceding to the European Union on May 1, 2004, Lithuania symbolically completed its transition to a market economy and embarked on a new effort to catch-up with more advanced European nations. By also entering the ERM-II mechanism on June 28, 2004-with a view to an early adoption of the euro-Lithuania reinforced its commitment to this new transition.
2. An IMF mission team visited Vilnius between December 1 and December 10 to discuss with the authorities recent economic developments, policy priorities for 2005, and longer-term strategies for maintaining productivity-led growth. The team is grateful to the authorities for the preparatory work they undertook (including extensive written responses to questions), for their warm hospitality and generous cooperation, and for the cordial and candid discussions. The mission reached three conclusions:
· Recent growth has been based primarily on domestic consumption and investment demand, reflecting a high level of confidence in future growth prospects. To prevent overheating of the economy, increased national savings and continued productivity growth will be essential.
· In particular, to maintain the stability needed for growth, the recent demand pressures should be contained, which implies a fiscal adjustment more ambitious than that necessary for adopting the euro in early 2007.
· Urgent attention to modernizing the fiscal system and implementing other structural reforms is required to enhance incentives for increased employment and for investment in productivity growth.
3. Lithuania achieved robust, non-inflationary growth between 2000 and 2004. During that period, the economy redeployed existing resources to new and more productive activities.The impressive structural change was thus marked by remarkable productivity growth. Fiscal prudence, privatization, and improvements in business climate were factors that contributed to this outcome.
4. Now, with less slack resources in the economy, a more challenging task is to maintain steady growth at the economy's potential. GDP is expected to increase at 6½ percent in 2005. In the medium term, the economy's annual growth potential is likely to be in the 5-6 percent range. Stimulating aggregate demand to grow above potential would lead either to destabilizing inflation or to greater external vulnerability with higher current account deficits and external debt. Short-term stability, therefore, remains crucial. Failure to institute structural reforms would lower the long-term growth potential.
5. Though it is premature to conclude that the Lithuanian economy is overheating, all indicators point to important risks that require close monitoring. As the ability to use slack resources is coming to an end, confidence in the future has also stimulated domestic consumption and investment, placing further demands on productive inputs. The risk the economy may overheat is reflected in high capacity utilization, continued robust growth of credit driven by low interest rates, decline in unemployment, acceleration in wage growth, increases in property prices, rapid growth in the current account deficit, as well as in technical indices that suggest that output is currently above potential. The mission focused on the implications of these pressures on inflation and the current account.
6. In an economy as open as Lithuania, with the additional discipline of its currency board arrangement, inflationary pressures arise principally from supply-side shocks and demand pressures on non-traded goods. After negative inflation in 2003, the average inflation rate in 2004 is likely to be just under 1½ percent and year-end trends point to inflation reaching above 2½ percent in 2005. To be clear, there is, as yet, no risk of high or persistent inflation. However, because of the demanding standard set, the risk exists of breaching the Maastricht criterion. The recent increases in excise taxes and the increase in oil prices had the effect of raising domestic prices, in particular because of the high energy intensity of Lithuania's productive activities. But, equally, domestic demand pressures are influencing inflation developments. In common with other countries that have acceded to the European Union, real estate prices in Lithuania have gone up sharply. Risks of price increases in other non-traded goods, especially utilities, remain.
7. The current account deficit has widened sharply, reflecting the increased gap between the higher domestic investment rate and the falling savings rate. The current account deficit, which rose in 2003 to 6.9 percent of GDP, is expected to further increase this year to about 8½ percent of GDP and then remain in the 7-9 percent range for the next few years. Once again, such a development has been observed in the context of other countries in the immediate run-up to and aftermath of acceding to the European Union. Lithuanians are, in effect, borrowing from the rest of the world to consume and invest today in the expectation that continued high growth would allow the repayment of obligations incurred. From a medium-term perspective, this development is broadly in line with the experience in other European countries at earlier stages of their development. However, recognizing that short-term developments in the global economy and in international capital markets could generate risks, the mission recommends close monitoring of external debt obligations, measures to raise the private savings rate, and especially a reduction in the government's fiscal deficit that contributes significantly to the demand pressures underlying the current account deficit.
Fiscal Restraint for Short-Term Stability
8. By committing to adopt the euro as early as 2007, Lithuanian authorities wisely accepted the fiscal discipline of the Maastricht criteria but current conditions require even more ambitious fiscal restraint. For 2004, a budget deficit of 2.95 percent of GDP was originally projected, just under the Maastricht criterion of 3 percent. However, favorable revenue developments during the course of the year allowed a scaling back of the projected deficit. In particular, the delay in the utilization of EU grants-not uncommon in the early period after accession-has implied that amounts budgeted for domestic cofinancing will not be needed this year. With continued strength in revenues because of rapid growth, the mission estimates that the deficit could be as low as 2-2¼ percent this year. The mission recommends that the savings be used to keep the deficit as low as possible and cofinancing funds be transferred to next year.
9. The planned deficit for 2005 is 2½ percent, but that risks adding to demand pressures. With all indicators suggesting that output will remain above potential in 2005, a portion of the high projected revenue realization should be treated as a temporary windfall that cannot be sustained and, as such, is best saved for the future when output is below potential. While the proposed deficit for 2005 would be below the Maastricht limit, the cyclically-adjusted deficit would be substantially higher, possibly reaching 3½ percent of GDP. The continued stimulus thus provided would add to inflationary pressures and to the current account deficit, without contributing to long-term growth.
10. A lower deficit than that planned is, therefore, necessary to insure against future instability, which would be inimical to growth. Lithuania has a commitment to a balanced budget in the medium-term as part of its obligation under the Stability and Growth Pact and an early effort to move in that direction would be appropriate. Currency board arrangements place the full burden of adjustment on fiscal policy, leading other European countries with such arrangements to run more conservative fiscal policies than in Lithuania. Such conservatism now will prevent overheating while also allowing the possibility of increasing the deficit to stimulate demand if domestic confidence unexpectedly falls. Considering these factors, aiming to achieve a deficit of under 2.0 percent would aid stability and medium-term growth. The reduction of the fiscal deficit target from 2½ to 2.0 percent would present an extra fiscal challenge at a time of increasing demands on the budget, but should be possible with careful fiscal management.
11. While the mechanisms to exercise fiscal restraint will reflect domestic priorities and consensus, certain areas may merit particular consideration. Despite rapid growth and generally buoyant revenues, a shortfall in value-added tax (VAT) revenues requires attention. The authorities recognize the urgency and steps to identify the reasons for the shortfall are underway. Additional realized revenues from these efforts, as well as windfall revenues from other taxes, could be earmarked for deficit reduction. A mid-year reopening of the budget to allow additional expenditures should be avoided. With the deployment of EU funds for enhancing agricultural productivity and EU income transfers to farmers, the need for additional top-up payments from government resources to farmers is reduced. Examining the possibility of savings in current expenditures would be desirable.
Fiscal Modernization for Long-Term Growth
12. Having largely completed its privatization program and having made considerable progress in improving its business environment, the next major task is a bold fiscal modernization. Structural fiscal reforms are required to ensure a stable base of revenues that would allow the funding of legitimate social and infrastructure expenditures in an efficient manner, while creating incentives for private entrepreneurs to increase employment, invest in upgrading the quality of the labor force, and move up the quality ladder to compete in international markets as competition from lower-wage economies is stepped up. The pressure to reform also arises from the need to keep pace with other countries undertaking important-and sometimes far reaching-reforms. The task is urgent not only to help improve the budget position immediately but also because postponement of reforms will make them increasingly harder to enact and implement.
13. Crucially important is undertaking well-recognized reforms in the VAT taxation system and administration. Three features of the VAT tax design and outcomes highlight the importance of urgent action. First, the shortfall in VAT revenues in 2004 reflects a more worrisome secular decline in VAT revenues and the Finance Ministry's continued efforts to improve collection deserve more wide-spread support. Second, and partly related, differentiated VAT tax rates make administration more difficult, but they also distort the incentives for resource allocation. Finally, arrears have built up on account of refunds due to those who have overpaid their VAT liabilities.
14. The reduction in the rate of the personal income tax (PIT) has deservedly been on the Government's agenda. Many considerations go into the design of the PIT: higher rates can generate higher revenues, but also raise the tax on labor and so discourage employment; at the same time, the structure of the tax can allow for progressivity so that the more affluent pay higher tax rates. On balance, the mission views as appropriate a significantly lower and unified single rate-phased in appropriately to limit disruption to revenues-while maintaining the current exemption threshold. In conjunction with the social security taxes, the personal income tax rate makes Lithuania's tax on labor income one of the highest in Europe. This is not compatible with the need to include more of the population in the labor force and to remain competitive in international markets. However, the authorities have been rightly concerned about the decline in revenue that would result from a decrease in the rate. The unification of the rate would broaden the tax base and so help raise additional revenues. Innovative proposals should be considered, including the possibility of simultaneously moderating gross public sector wages to offset some of the gains accruing because of reduced employee tax liabilities. The recent experience in other countries that have lowered rates, moreover, suggests that the revenue decline need not be large if a concurrent effort at enforcement leads to greater tax compliance.
15. The mission also concurs with the authorities' proposal to institute a more wide-ranging property tax, not merely as a revenue source, but to improve the incentives of municipalities for the more efficient delivery of public services. International evidence shows that where local governments generate their own revenues, they are more likely to be responsive to the needs of their populations. For Lithuania, municipal governments will be crucial to meet the social security and social safety net requirements of local populations with widely varying requirements, as well as in the design and provision of growth-enhancing investments in education and infrastructure. As such, their role in ensuring inclusive participation in Lithuania's growth is crucial. A mission from the IMF's Fiscal Affairs Department (FAD) is currently exploring alternative approaches to boost the revenue base of municipalities and raise efficiency of expenditures.
16. Reforms of public expenditure design and management are required, in the first instance, to achieve greater transparency and control. At the present time, government expenditures and cash flows are not documented in sufficient detail to allow for efficient management. In particular, contingencies and buffers are not explicitly identified for dealing with an unexpected requirement to reduce government expenditures. As such, if the need for such a reduction were to occur, economically valuable capital expenditures are the most likely to suffer. In addition, consolidating various government accounts into a single account and instituting modern methods for cash control could achieve considerable savings. Another mission from the IMF's FAD recently made several recommendations in this respect, which the authorities have welcomed and expect to implement.
17. The authorities should build on recent efforts to balance social protection with financial viability of the social security system. Though Lithuanian public pensions are relatively low and though the pension system currently receives more revenues than the pensions it pays out, the system will face a financial crunch in the next 15-20 years. Raising pension contributions is not recommended because of the already high tax on labor this imposes (along with the PIT). As such, an increase in pension obligations within the current framework would be financially unsound. The move to a "second-pillar," whereby participants have the option to invest a portion of their pension contributions into a private account has been successfully implemented, with a bigger than expected response. The recent introduction of the "third-pillar" is a welcome development that could encourage private savings. However, this effort is insufficient to ensure long-term financial viability of the pension system. The implication is that more wide-ranging reforms, including accelerated increases in the retirement age, are needed.
18. A social safety net based on tax exemptions and a higher minimum wage is an inefficient approach to achieving the legitimate objective of income support to the poor and needy. Tax exemptions are a blunt instrument and, typically, do not help those who most need them. The minimum wage is already at a high level (as a ratio of the county's average wage) relative to that prevailing in other countries. While a higher minimum wage provides necessary support to low-income families, it also discourages employment growth. Increasing the level of employment, desirable in itself, will also benefit the long-term viability of the social security system. The objective of income support is best met through a means-tested targeting system towards which Lithuania must move as it rationalizes and stabilizes its tax revenue system and improves the efficiency of its expenditures.
19. To ensure that these long-term fiscal reforms are undertaken and maintained, the government should consider proposing a Fiscal Responsibility Act to parliament. Under a Fiscal Responsibility Act, the government commits to targets, procedures, and transparency of budget revenues and expenditures as well as of debt. With a currency board already providing discipline to monetary policy and the commitment to the convergence program guiding the medium-term fiscal objectives, a Fiscal Responsibility Act adopted by parliament would provide a comprehensive and transparent framework for efficiently conducting fiscal policy at all levels of government to ensure credibility of fiscal commitments. As a new member state of the European Union, Lithuania would be a pioneer in adopting such discipline, which would send a positive signal to domestic and international investors.
20. A wide range of reforms has made Lithuania's business environment more attractive to investors but the task remains unfinished and new challenges are arising. The business environment remains challenging for small and medium enterprises, who still have to deal with complex and time-consuming regulations, especially those related to land use and construction. Private initiative in sectors such as the health and education is needed to help improve services but equally importantly to stem the emigration of highly-skilled, but underpaid, workers. Consideration should also be given to the recommendations of a World Bank study to promote research and development and the knowledge economy.
21. Lithuania has undergone an extraordinary transformation in just over a decade, weathering in this process a virulent financial crisis in 1998-1999. It is a testimony to the vision and resolve of its leadership that today it is in a position to choose how fast it wants to move towards advanced European living standards. A political consensus that recognizes the long-term pay-off from continued focus on short-term fiscal discipline and needed fiscal reforms will remain essential. We wish the current leadership and authorities well in their endeavors.