## 1. Lithuania’s Current Pension System

## Source details

**Canonical URL:** [1. Lithuania’s Current Pension System](https://www.imf.org/-/media/files/publications/cr/2024/english/1ltuea2024002.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/cr/2024/english/1ltuea2024002.pdf.md)
- [Structured JSON version](/-/media/files/publications/cr/2024/english/1ltuea2024002.pdf.json)

---

### Demographic Dynamics
- Fertility rate fell from 2 in 1991 to less than 1.3 in 2023—below the fertility-replacement rate of 2.1.
- Median age increased by 12.5 years from 31.5 to 44 between 1991 and 2023.
- Old-age dependency ratio (population aged 65+ as share of population aged 20-64) rose from 18 percent in 1991 to 33 percent in 2023.
- For the first time in history, more workers will retire than those entering the labor market in 2024.
- European Commission projections (subject to uncertainty):
  - Population projected to fall by 18.9 percent to 2.3 million in 2050 and by 13.7 percent to 2 million by 2070.
  - Median age projected to rise over 48 by 2050.
  - Those aged 65 and above will constitute 57.9 percent of the working age population by 2050.
- Life expectancy:
  - Increased from 70.5 years in 1991 to 75.3 years in 2022 (below EU average of 80.7 years).
  - Gender gap: men 71.4 years, women 80.1 years.
- Workforce trends:
  - Workforce reduced by 20.6 percent from 1.9 million in 1991 to 1.5 million in 2023.
  - By 2050, workforce projected to shrink by 27.7 percent to 1.2 million.
  - Share of prime-age workers (25-54 years) projected to decline to 40.1 percent of population in 2023 and to 33.1 percent by 2050.
  - Economically inactive population aged 65+ as share of employed population 20-64: 38.3 percent in 2023, projected 68.8 percent by 2050.
  - Labor force participation: 90.3 percent for ages 25-54; 18.7 percent for ages 65-74.

### Short-Run and Long-Term Expenditure Pressures
- Aggregate spending pressures over the next 25 years could be between 5 percent of GDP and 10 percent of GDP relative to the 2023 level.
- Key near-term pressures: national security needs and higher cost of borrowing; these add to preexisting long-term ageing pressures.
- Under the baseline scenario, pension expenditures could increase by about 3 percent of GDP over the next two decades.
  - This projected increase of about 3 percent of GDP is more than double the projected increase of 1.3 percent of GDP in the 2021 Aging Report.
- Without the gradual increase in the retirement age to 65 by 2026 to absorb the impact of increased longevity, the balance of the pension system deteriorates rapidly with projected deficits starting by the end of this decade.

### Defense Spending (interaction with fiscal pressures)
- Russia’s invasion of Ukraine (2022) prompted a large increase in military expenditures.
- Lithuania raised defense spending to 2.5 percent of GDP by 2023 and announced plans to increase it permanently to 3 percent of GDP by 2030.
- Permanent increase in defense outlays from NATO commitment implies about 1 percent of GDP additional spending.
- Financing measures:
  - A temporary levy on banks raised around 0.4 percent of GDP in 2023.
  - Financing for military spending beyond 2 percent of GDP has not been fully identified and approved by parliament.
  - Parliamentary discussions include revenue measures such as a 1 percentage point increase in the corporate income tax rate.
- Note: Some call for increasing military spending to 4 percent of GDP.

### Interest Payments
- ECB short-term interest rates rose from 0 percent in 2022 to 4.5 percent by end-2023.
- Lithuania’s public debt stock was 36 percent of GDP in 2023 with high average maturity.
- Interest expenditure projected:
  - 0.4 percent of GDP in 2022.
  - 0.7 percent of GDP in 2023.
  - About 1.2 percent of GDP by 2030.

### Pension Spending and System Risks
- 2018 social security reform features:
  - Pensions indexed to the overall wage bill.
  - Retirement age gradually increased to 65 by 2026 for both men and women.
  - Contributions required for a full pension increased from 30 to 35 years by 2027.
  - If indexation formula results in a deficit, law establishes that pensions would be left unchanged.
- Consequences and risks:
  - Declining replacement ratios over time due to demographic dynamics and indexation rules.
  - Discretionary increases in benefits (up to 75 percent of short-term surpluses of social security) have been approved, increasing accrued total pension entitlements:
    - Accrued total pension entitlements increased from 217 percent of GDP in 2019 to 275 percent of GDP in 2021.
  - System ensures short-run financial sustainability but not social sustainability because replacement ratios are low and declining.
  - Lithuania has one of the highest old-age poverty risks in the EU.
  - Relatively modest pension benefits contribute to higher labor force participation among older workers than EU peers.
- No-policy-change projection:
  - The net replacement rate of Pillar I pensions declines from the current 28.9 percent to 20 percent in 2050.

### Box — Lithuania’s Current Pension System (Structure and Features)
- Evolution and architecture:
  - System established in 1995 with a single pay-as-you-go pillar.
  - 2000: new pension system adopted.
  - 2004: introduction of quasi-mandatory Pillar II (voluntary enrollment but mandatory participation until retirement once enrolled except in exceptional circumstances) and voluntary Pillar III.
  - 2018 reform aimed to ensure financial sustainability (indexation to wage bill; retirement age 65 by 2026; contribution years 30→35 by 2027).
  - Since 2022, a full pension (without reduction of the basic part) is paid for everyone with 15 years of contributions; the obligatory period of contributions affects basic pension and supplements for lowest contributory pensions.
- Assessment of 2018 reform:
  - Delivered a pay-as-you-go system that does not ensure socially sustainable benefits.
  - Replacement rate at about 30 percent for future retirees under Pillar I—below ILO recommended minimum of 40 percent.
  - Under UN median population projections and baseline assumptions, replacement ratios for workers opting out of Pillar II projected to decline to slightly above 20 percent by 2050.
- Pillar details:
  - Pillar I (pay-as-you-go, administered by State Social Insurance Fund Board (Sodra)):
    - Comprises base part (fixed benefit for individuals with at least 30 years of contribution expected to increase to 35 by 2027), basic part linked to income and length of service, and individual part depending on accrued pension points.
    - Relatively weak link between contributions and benefits; large redistributive component; insufficient to address old-age poverty.
  - Pillar II (defined-contribution personal accounts):
    - 2013 reform applied “2+2+2” formula to new participants; later changed to “3+1.5” after 2019 tax reform; pre-reform equivalent “4+2”.
    - Existing participants (more than 60 percent as of 2017) could opt out to have only 2 percent of social contributions transferred to private funds.
    - At retirement individuals can choose annuities or lump sums; those with accumulated returns lower than a threshold receive lump sums only.
    - Pillar II allows diversification; entitlements depend solely on contributions proportional to wages and have no redistributive effects.
    - As of 2023, number of participants was 760,000 (about half of the labor force).
    - State subsidy for Pillar II is flat and plays a redistributive role; periods of maternity, paternity, and childcare covered by state contributions.
  - Pillar III (voluntary supplementary accumulation):
    - Contributions by individual or employer with tax benefits.
    - Considered regressive and benefiting primarily high-income earners.

### Drivers of Public Pension Expenditure (formulation)
- Public pension expenditure as a share of GDP depends on four key components:
  - (i) the average pension over average output per worker;
  - (ii) the share of pensioners in the total population above the retirement age;
  - (iii) the share of population above 65 to the working-age population;
  - (iv) the share of workers in the total working-age population.
- Public pension spending grows in line with the old-age dependency ratio, which may increase due to aging and/or a shrinking workforce.
- Example: assuming constant benefit and coverage ratios, an increase in the population aged 65 and above due to higher longevity would translate into higher public pension spending for the same level of GDP.

### Baseline Projections and Scenarios (pension-specific)
- Baseline: pension expenditures could increase by about 3 percent of GDP over the next two decades.
- Comparison: projected increase of about 3 percent of GDP is more than double the projected increase of 1.3 percent of GDP in the 2021 Aging Report.
- Replacement ratio scenarios:
  - Constant replacement ratio at 30 percent would require around 2 percent of GDP in additional spending compared to the no policy change scenario.
  - Increasing replacement ratio to 40 percent (ILO recommended level) would require around 4 percent of GDP in additional spending compared to the no policy change scenario.
- Parametric scenario:
  - Linking retirement age to longevity: statutory retirement age is set to gradually increase to 65 years for both men and women by 2026; linking it to longevity would have a significant effect on pension spending as a share of GDP and help maintain actuarial balance over the long run.
  - Example: increasing the retirement age for both men and women gradually to 75 by 2070 could close the deficit by 2040 (everything else held constant).
- Other projections:
  - No policy change scenario: the net replacement rate of Pillar I pensions declines from the current 28.9 percent to 20 percent in 2050.

### Other Age-Related Spending Pressures and Green Transition
- The 2024 EU Ageing Report projects long-term care and healthcare spending pressures could gradually increase to 0.7 percent of GDP per year over the next two decades with long-term pressures up to 1.7 percent of GDP.
- Education spending pressures will fall by around 0.3-0.4 percent of GDP per year over the medium-term and beyond due to the decrease in the population at student age.
- Green transition fiscal implications:
  - EIB study estimate: gross costs could amount to around 2.2 percent of GDP by 2050.
  - Authorities are already making investments (e.g., around €900 million of EU funds). Net spending pressures from the green transition could be lower than the gross estimates.

### Comprehensive Fiscal Strategy (components)
- Strategy components:
  - (i) structural reforms that would reduce some pressures, particularly regarding pensions;
  - (ii) improved spending efficiency in healthcare and education where quality of outcomes lag peer countries after controlling for spending;
  - (iii) revenue mobilization; and
  - (iv) recalibration of fiscal targets.
- Final objective: address long-term pressures without introducing distortions or disincentives that would worsen growth potential; preserve fiscal sustainability; and maintain a pro-active fiscal policy.

### Pension Reform Options and Trade-offs
- Policy levers listed:
  - Raising the retirement age.
  - Financing SODRA’s deficit by higher tax revenues.
  - Increasing social security contributions.
  - Increasing the scale and returns of Pillar II.
- Specific considerations and findings:
  - Strengthening links between contributions and benefits in Pillar I reduces redistribution and potentially affects old-age poverty.
  - A more generous basic pension could reduce labor supply and induce underreporting of income.
  - Increasing the retirement age can deliver significant resources, but replacement ratios high enough to reduce old-age poverty would likely result in further costs.
  - Since social security contributions are already high, higher budgetary transfers appear inevitable to increase the replacement ratio for Pillar I going forward.
- Additional policy options:
  - Means testing of basic pensions to align benefits by individual economic status and mitigate fiscal cost while enhancing progressivity.
  - Incentivizing delayed retirement: deferring retirement for five years could raise benefits by almost 8 percent per year.
  - Increasing contributions: to deliver socially acceptable replacement ratios, social contributions, already high above 30 percent of gross wages, would have to increase to more than 40 percent by 2050.
  - Subjecting pensions to the personal income tax (PIT): pensions are currently exempt from PIT in Lithuania; subjecting pensions to the standard PIT could provide budgetary resources to support non-contributory pensions.
  - Strengthening and providing stability to Pillar II: mandatory participation incentives and strong disincentives to early withdrawals suggested to stabilize replacement ratios and reduce pressure on Pillar I.
- Governance and credibility:
  - Any future reform should aim to reduce uncertainty around pension entitlements and seek broad consensus. Regulatory or parametric changes are costly to credibility and should be preceded by broad discussion involving all social agents and political parties.
- Demographic measures:
  - Increasing fertility and migration would help reduce the old-age dependency ratio, but given the extent of negative demographic dynamics, these measures alone will not be sufficient.

### Education and Healthcare Reforms: Efficiency and Outcomes (relevance to fiscal and pension sustainability)
- Health sector findings:
  - Share of out-of-pocket spending over total health expenditure is 15 percentage points higher than peers’.
  - Lithuania invests more in hospital beds: 7.5 beds per 1,000 people while the rest of Europe averages less than 5 beds per 1,000 people.
  - Acute care (curative) inpatient beds in Lithuania: 5.1 per 1,000 people (comparable with 5.5 in Romania, 5.8 in Germany, 6.6 in Bulgaria).
  - Staffing (as of 2023): for every 1,000 people Lithuania employs one additional physician but almost 2 fewer nurses compared to peers.
  - Healthy life expectancy in 2021: 57.6 years vs. EU average 63.6 years (difference 6 years); men: 55.4 years vs. 63.1 years (difference 7.7 years); women: 59.8 years vs. 64.2 years (difference 4.4 years).
  - Lithuania has higher rates of smoking, alcohol, heart and circulatory diseases, and suicides.
  - Policy recommendations: stronger focus on primary care and mental health; more extensive public health initiatives; consider increases in excise taxes on alcohol and tobacco.
  - Potential: these measures can potentially increase healthy life expectancy in Lithuania to that of peer countries (some 7 years higher) even within a similar spending envelope.
- Education sector findings:
  - Education spending is about 0.5 percent of GDP lower than the euro area.
  - Expenditure per student, after adjusting for PPP, is below the EU average.
  - Government allocates more towards tertiary education compared to peers; share of public spending on primary and secondary education is the seventh lowest among 45 OECD countries while spending on tertiary education is close to the OECD average.
  - Outcomes: high enrollment and quantitative outcomes but poor qualitative ones—PISA scores place Lithuania among the bottom 25 percent of EU countries; financial literacy underperforms controlling for math and reading; tertiary education outcomes lag EU countries.
  - Lithuania has the third highest level of skills mismatch in the labor market.
  - Policy recommendations: rationalization of the extensive school network to provide savings redirected to improving school quality, especially elementary and secondary education; focus on improving quality and efficiency of the school network as per the 2019 education reform package.

### Revenue Measures and Revenue Mobilization (options and figures)
- Scope to increase tax revenues while preserving the competitive tax environment.
- Lithuania increased tax revenues as a percent of GDP including through improved compliance, but still collects less tax revenue as a share of GDP compared to other EU countries.
  - 2022 tax-to-GDP ratio: 31.6 percent in Lithuania vs. 40.3 percent in the EU.
- Lithuania’s tax system is heavily tilted towards taxation of labor income, which accounts for over 55 percent of total tax revenue.
- Consumption-related taxes:
  - Consumption-related taxes would follow a similar pattern to direct taxes but not as steep because of consumption smoothing over time.
  - Increasing the tax burden on a smaller base of taxpayers to pay for additional age-related expenditures, without implementing structural reforms, would exacerbate economic distortions and cause a further drop in labor force participation.
  - Population aging has the least effect on environmental and real estate taxes, which are currently underutilized in Lithuania compared to other EU countries.
  - Shifting the tax base away from labor-related taxation remains an important objective.
- Revenue mobilization policy options outlined:
  - Introducing a PIT on pensions, including voluntary pension savings.
  - Raising the CIT rate (CIT yields around 2 percent of GDP in revenues; potential to raise by up to 1 percent of GDP).
  - Eliminating tax expenditures (tax concessions and exemptions amount to around 3 percent of GDP).
  - Introducing an economy-wide carbon tax of US$75 per metric ton of CO2 emissions (would raise about 1.5 percent of GDP).
  - Modernizing the property tax regime (property tax revenue amounts to 0.2 percent of GDP; potential to raise up to 0.8 percent of GDP).
  - Increasing the standard VAT rate (potential revenue: 0.3-0.5 percent of GDP per 1pp increase).
- Tax revenue items (exact values reported):
  - Value Added Tax 489 0.7
  - Excise Duty 337 0.5
  - Corporate Income Tax 491 0.7
  - Personal Income Tax 1,702 2.5
    - of which from non-taxable income 1,030 1.5
  - TOTAL 3,018 4.5
  - Source: Ministry of Finance.
- Tax expenditures in 2022 (comparative figures reported in source):
  - VAT 21 20 21 25 21
  - CIT 15 20 15 22 22
  - PIT 20 20 23 25 34
  - Real Estate 0.3 - 32.5 32.84
  - Source: Eurostat; and IMF staff calculations.

### Realigning Fiscal Targets and Fiscal Rule Summary
- The current fiscal rule is a form of structural balance rule with an expenditure correction mechanism and a debt anchor imposed by the EU framework.
- The rule targets a structural balance or surplus of the general government except when the output gap is negative, when the deficit cannot exceed the medium-term objective (currently at -1 percent of GDP).
- Given relatively low debt and deficits, Lithuania complies with the reference values in the EU economic governance framework; the structural fiscal target can be set at the current level—at around -1 percent of GDP even when the output gap becomes positive—consistent with steady state public debt at around the current level (36 percent of GDP) and providing space to support the economy during downturns without exceeding the 3 percent of GDP deficit under the EU framework.
- Key provisions of the fiscal rules (CLIFT and LFD) include:
  - Fiscal anchors: Medium-Term Objective (MTO) and EU-imposed debt anchor.
  - Operational target: annual conditions regarding structural balance, improvement, and special treatments when output gap is negative.
  - Expenditure growth limit: budget appropriations growth constrained when average general government balance in previous 5 years is negative, with five specified escape clauses.
  - Rules apply to all general government budgets except the state pension fund (and smaller units) with structural balance targeting; pension fund’s structural deficit can deteriorate only when projected output gap is negative.

### Long-term Fiscal Challenges, Projections, and Risks
- Demographics and long-term pressures:
  - Lithuania’s population declined by almost 25 percent from 3.7 million in 1991 to 2.8 million in 2023, and it is projected to contract by about 20 percent to 2.3 million over the next two decades and a half.
  - Long-term spending pressures in Lithuania are projected to amount to between 5 and 10 percent of GDP over the long-term.
- Debt projection absent measures:
  - Gross public debt would increase by 36 percentage points of GDP from 35.6 percent in 2023 to 71.5 percent by 2050, absent expenditure and revenue measures.
- Economic and distributional risks:
  - A shrinking and aging labor force could limit innovation and productivity growth, increase labor costs, reduce international competitiveness, and raise risks to public debt sustainability.
  - Some measures may have distributional consequences that require careful design (for example, property tax enhancements require care given large home ownership).

### Potential Measures, Impacts, and Estimated Revenue Contributions (summary)
- Link retirement age to longevity:
  - Impact: Partially absorbs the impact of demographic changes on pension spending.
  - Impact on economic efficiency: Positive impact on participation rate.
- Increase payroll contributions:
  - Impact: Narrows the pension deficit, but payroll taxes are already high.
  - Impact on economic efficiency: Decrease participation and increase non-compliance.
- Subject pensions to PIT:
  - Impact: Creates additional revenue that can help support low income pensioners.
  - Impact on economic efficiency: Neutral.
  - Distributional impact: Positive if resources are channeled to low income pensioners.
- Education reform / Healthcare reform:
  - Impact: Would improve human capital and support productivity.
  - Distributional impact: Could disproportionately benefit low income households.
- Raise the CIT rate:
  - Potential revenue: Up to 1 percent of GDP.
- Reduce tax expenditures:
  - Potential revenue: Up to 3 percent of GDP.
- Introduce carbon tax/environmental taxes:
  - Potential revenue: Up to 1.5 percent of GDP.
- Enhance property taxes:
  - Potential revenue: Up to 0.8 percent of GDP.
- Increase the standard VAT rate:
  - Potential revenue: 0.3-0.5 percent of GDP per 1pp increase.
- Moderately reduce the fiscal target:
  - Potential impact: Up to 1 percent of GDP (with caveats regarding counter-cyclicality).

*Source: 1ltuea2024002 - 1. Lithuania’s Current Pension System (PDF chapter).*

### 1. Lithuania’s Current Pension System __________________________________________________ 7

### 1. Lithuania’s Current Pension System

### A. Demographic Dynamics
- Fertility rate fell from 2 in 1991 to less than 1.3 in 2023—below the fertility-replacement rate of 2.1.
- Median age increased by 12.5 years from 31.5 to 44 between 1991 and 2023.
- Old-age dependency ratio (population aged 65+ as share of population aged 20-64) rose from 18 percent in 1991 to 33 percent in 2023.
- For the first time in history, more workers will retire than those entering the labor market in 2024.
- European Commission projections (subject to uncertainty):
  - Population projected to fall by 18.9 percent to 2.3 million in 2050 and by 13.7 percent to 2 million by 2070.
  - Median age projected to rise over 48 by 2050.
  - Those aged 65 and above will constitute 57.9 percent of the working age population by 2050.
- Life expectancy:
  - Increased from 70.5 years in 1991 to 75.3 years in 2022 (below EU average of 80.7 years).
  - Gender gap: men 71.4 years, women 80.1 years.
- Workforce trends:
  - Workforce reduced by 20.6 percent from 1.9 million in 1991 to 1.5 million in 2023.
  - By 2050, workforce projected to shrink by 27.7 percent to 1.2 million.
  - Share of prime-age workers (25-54 years) projected to decline to 40.1 percent of population in 2023 and to 33.1 percent by 2050.
  - Economically inactive population aged 65+ as share of employed population 20-64: 38.3 percent in 2023, projected 68.8 percent by 2050.
  - Labor force participation: 90.3 percent for ages 25-54; 18.7 percent for ages 65-74.

### B. Short-Run and Long-Term Expenditure Pressures
- Aggregate spending pressures over the next 25 years could be between 5 percent of GDP and 10 percent of GDP relative to the 2023 level.
- Key near-term pressures: national security needs and higher cost of borrowing; these add to preexisting long-term ageing pressures.

### C. Defense Spending
- Russia’s invasion of Ukraine (2022) prompted a large increase in military expenditures.
- Lithuania raised defense spending to 2.5 percent of GDP by 2023 and announced plans to increase it permanently to 3 percent of GDP by 2030.
- Permanent increase in defense outlays from NATO commitment implies about 1 percent of GDP additional spending.
- Financing measures:
  - A temporary levy on banks raised around 0.4 percent of GDP in 2023.
  - Financing for military spending beyond 2 percent of GDP has not been fully identified and approved by parliament.
  - Parliamentary discussions include revenue measures such as a 1 percentage point increase in the corporate income tax rate.
- Note: Some call for increasing military spending to 4 percent of GDP.

### D. Interest Payments
- ECB short-term interest rates rose from 0 percent in 2022 to 4.5 percent by end-2023.
- Lithuania’s public debt stock was 36 percent of GDP in 2023 with high average maturity.
- Interest expenditure projected:
  - 0.4 percent of GDP in 2022.
  - 0.7 percent of GDP in 2023.
  - About 1.2 percent of GDP by 2030.

### E. Pension Spending and System Risks
- 2018 social security reform:
  - Pensions indexed to the overall wage bill.
  - Retirement age gradually increased to 65 by 2026 for both men and women.
  - Contributions required for a full pension increased from 30 to 35 years by 2027.
  - If indexation formula results in a deficit, law establishes that pensions would be left unchanged.
- Consequences and risks:
  - Declining replacement ratios over time due to demographic dynamics and indexation rules.
  - Discretionary increases in benefits (up to 75 percent of short-term surpluses of social security) have been approved, increasing accrued total pension entitlements:
    - Accrued total pension entitlements increased from 217 percent of GDP in 2019 to 275 percent of GDP in 2021.
  - System ensures short-run financial sustainability but not social sustainability because replacement ratios are low and declining.
  - Lithuania has one of the highest old-age poverty risks in the EU.
  - Relatively modest pension benefits contribute to higher labor force participation among older workers than EU peers.

### F. Box 1 — Lithuania’s Current Pension System (Structure and Features)
- Evolution:
  - System established in 1995 with a single pay-as-you-go pillar.
  - 2000: new pension system adopted.
  - 2004: introduction of quasi-mandatory Pillar II (voluntary enrollment but mandatory participation until retirement once enrolled except in exceptional circumstances) and voluntary Pillar III.
  - 2018 reform aimed to ensure financial sustainability (indexation to wage bill; retirement age 65 by 2026; contribution years 30→35 by 2027).
  - Since 2022, a full pension (without reduction of the basic part) is paid for everyone with 15 years of contributions; the obligatory period of contributions affects basic pension and supplements for lowest contributory pensions.
- Assessment of 2018 reform:
  - Delivered a pay-as-you-go system that does not ensure socially sustainable benefits.
  - Replacement rate at about 30 percent for future retirees under Pillar I—below ILO recommended minimum of 40 percent.
  - Under UN median population projections and baseline assumptions, replacement ratios for workers opting out of Pillar II projected to decline to slightly above 20 percent by 2050.
- Current three-pillar architecture:
  - Pillar I (pay-as-you-go, administered by State Social Insurance Fund Board (Sodra)):
    - Comprises base part (fixed benefit for individuals with at least 30 years of contribution expected to increase to 35 by 2027), basic part linked to income and length of service, and individual part depending on accrued pension points.
    - Relatively weak link between contributions and benefits; large redistributive component; insufficient to address old-age poverty.
  - Pillar II (defined-contribution personal accounts):
    - 2013 reform applied “2+2+2” formula to new participants; later changed to “3+1.5” after 2019 tax reform; pre-reform equivalent “4+2”.
    - Existing participants (more than 60 percent as of 2017) could opt out to have only 2 percent of social contributions transferred to private funds.
    - At retirement individuals can choose annuities or lump sums; those with accumulated returns lower than a threshold receive lump sums only.
    - Pillar II allows diversification; entitlements depend solely on contributions proportional to wages and have no redistributive effects.
    - As of 2023, number of participants was 760,000 (about half of the labor force).
    - State subsidy for Pillar II is flat and plays a redistributive role; periods of maternity, paternity, and childcare covered by state contributions.
  - Pillar III (voluntary supplementary accumulation):
    - Contributions by individual or employer with tax benefits.
    - Considered regressive and benefiting primarily high-income earners.

### G. Key Policy Considerations Highlighted
- A comprehensive fiscal strategy to address short-run and long-term spending pressures should include:
  - Structural reforms to reduce pressures, particularly regarding pensions.
  - Improved spending efficiency in healthcare and education where outcomes lag peers after controlling for spending.
  - Revenue mobilization.
  - Recalibration of fiscal targets.
- Final objective: address long-term pressures without introducing distortions or disincentives that worsen growth potential; preserve fiscal sustainability; and maintain a pro-active fiscal policy.

*Source: 1ltuea2024002 - 1. Lithuania’s Current Pension System (PDF chapter).*

### 9.      Public pension expenditure as a share of GDP depends on four key components: (i)

### 9.      Public pension expenditure as a share of GDP depends on four key components: (i)

### Drivers of public pension expenditure
- Public pension expenditure as a share of GDP depends on four key components: (i) the average pension over average output per worker; (ii) the share of pensioners in the total population above the retirement age; (iii) the share of population above 65 to the working-age population; and (iv) the share of workers in the total working-age population.
- Public pension spending grows in line with the old-age dependency ratio, which may increase due to aging and/or a shrinking workforce.
- Example: assuming constant benefit and coverage ratios, an increase in the population aged 65 and above due to higher longevity would translate into higher public pension spending for the same level of GDP, thereby increasing pension expenditure as a share of GDP.

### Baseline projections and scenarios
- Under the baseline scenario, pension expenditures could increase by about 3 percent of GDP over the next two decades.
- This projected increase of about 3 percent of GDP is more than double the projected increase of 1.3 percent of GDP in the 2021 Aging Report.
- Without the gradual increase in the retirement age to 65 by 2026 to absorb the impact of increased longevity, the balance of the pension system deteriorates rapidly with projected deficits starting by the end of this decade.
- Spending pressures could be larger if replacement ratios for the pay-as-you-go system remain constant around the current level of 30 percent or increase to the ILO recommended level of 40 percent:
  - Constant replacement ratio at 30 percent would require around 2 percent of GDP in additional spending compared to the no policy change scenario.
  - Increasing replacement ratio to 40 percent (ILO recommended level) would require around 4 percent of GDP in additional spending compared to the no policy change scenario.
- No policy change scenario: the net replacement rate of Pillar I pensions declines from the current 28.9 percent to 20 percent in 2050.

### Other age-related spending pressures
- The 2024 EU Ageing Report projects long-term care and healthcare spending pressures could gradually increase to 0.7 percent of GDP per year over the next two decades with long-term pressures up to 1.7 percent of GDP.
- Education spending pressures will fall by around 0.3-0.4 percent of GDP per year over the medium-term and beyond due to the decrease in the population at student age.

### Green transition fiscal implications
- Over the next couple of decades, green transition for climate change adaptation and mitigation will become a growing source of expenditure pressures.
- Enhancing structural resilience requires infrastructure and other ex-ante investments; building financial resilience involves creating fiscal buffers and using prearranged financial instruments to manage recovery costs.
- European Investment Bank (EIB) study estimate: gross costs could amount to around 2.2 percent of GDP by 2050.
- The estimates are highly uncertain and authorities are already making investments (e.g., around €900 million of EU funds). Net spending pressures from the green transition could be lower than the gross estimates.

### Comprehensive fiscal strategy to address long-term pressures
- Strategy components:
  - (i) structural reforms that would reduce some pressures, particularly regarding pensions;
  - (ii) improved spending efficiency in healthcare and education where quality of outcomes lag peer countries after controlling for spending;
  - (iii) revenue mobilization; and
  - (iv) recalibration of fiscal targets.
- Final objective: address long-term pressures without introducing distortions or disincentives that would worsen growth potential; preserve fiscal sustainability; and maintain a pro-active fiscal policy.

### Pension reform options and trade-offs
- Trade-offs: reigning fiscal costs vs. reducing old-age poverty; increasing redistribution vs. ensuring participation and compliance.
- Policy levers listed:
  - Raising the retirement age;
  - Financing SODRA’s deficit by higher tax revenues;
  - Increasing social security contributions;
  - Increasing the scale and returns of Pillar II.
- Specific considerations and findings:
  - Strengthening links between contributions and benefits in Pillar I reduces redistribution and potentially affects old-age poverty.
  - A more generous basic pension could reduce labor supply and induce underreporting of income.
  - Increasing the retirement age can deliver significant resources, but replacement ratios high enough to reduce old-age poverty would likely result in further costs.
  - Since social security contributions are already high, higher budgetary transfers appear inevitable to increase the replacement ratio for Pillar I going forward.
- Demographic measures:
  - Increasing fertility and migration would help reduce the old-age dependency ratio, but given the extent of negative demographic dynamics, these measures alone will not be sufficient.
- Parametric and policy options described:
  - Linking the retirement age to longevity: statutory retirement age is set to gradually increase to 65 years for both men and women by 2026; linking it to longevity would have a significant effect on pension spending as a share of GDP and help maintain actuarial balance over the long run. Example: increasing the retirement age for both men and women gradually to 75 by 2070 could close the deficit by 2040 (everything else held constant).
  - Reducing benefits: Lithuania’s pay-as-you-go replacement rate of about 30 percent is already one of the lowest in the EU and significantly below the ILO minimum of 40 percent. Means testing of basic pensions would align benefits by individual economic status and mitigate fiscal cost while enhancing progressivity.
  - Incentivizing delayed retirement: deferring retirement for five years could raise benefits by almost 8 percent per year. Effective retirement age is lower than statutory age; main early retirees are older workers facing long-term unemployment risks or very low future benefits.
  - Increasing contributions: to deliver socially acceptable replacement ratios, social contributions, already high above 30 percent of gross wages, would have to increase to more than 40 percent by 2050. A significant informal sector adds challenges.
  - Subjecting pensions to the personal income tax (PIT): pensions are currently exempt from PIT in Lithuania; subjecting pensions to the standard PIT could provide budgetary resources to support non-contributory pensions but should minimize labor supply disincentives.
  - Strengthening and providing stability to Pillar II: Pillar II stabilizes replacement ratios of participants; investments are largely abroad providing risk diversification; issues such as initial large management fees are largely transitional; strong incentives to participate (ideally mandatory participation) and strong disincentives to early withdrawals would help risk diversification and reduce pressure on Pillar I.
- Governance and credibility:
  - Any future reform should aim to reduce uncertainty around pension entitlements and seek broad consensus. Regulatory or parametric changes are costly to credibility and should be preceded by broad discussion involving all social agents and political parties.

### Education and healthcare reforms: efficiency and outcomes
- Health sector:
  - Public spending on education and health is evaluated using the Expenditure Assessment Tool (EAT).
  - Share of out-of-pocket spending over total health expenditure is 15 percentage points higher than peers’, indicating a high burden on patients.
  - Lithuania invests more in hospital beds: 7.5 beds per 1,000 people while the rest of Europe averages less than 5 beds per 1,000 people.
  - Acute care (curative) inpatient beds in Lithuania: 5.1 per 1,000 people (comparable with 5.5 in Romania, 5.8 in Germany, 6.6 in Bulgaria).
  - Staffing: as of 2023, for every 1,000 people Lithuania employs one additional physician but almost 2 fewer nurses compared to peers; over past 10 years, physician ratio uptick mainly due to secular population decline; large dispersion in coverage of medical staff between urban and rural areas and decline in nurses per capita.
  - Lithuania lags the healthy expectancy frontier: healthy life expectancy in 2021 is 57.6 years vs. EU average 63.6 years (difference 6 years). For men: 55.4 years vs. 63.1 years (difference 7.7 years). For women: 59.8 years vs. 64.2 years (difference 4.4 years).
  - Lithuania has higher rates of smoking, alcohol, heart and circulatory diseases, and suicides; maternal deaths improved relative to EU average.
  - Policy recommendations: stronger focus on primary care and mental health; more extensive public health initiatives; consider increases in excise taxes on alcohol and tobacco to discourage unhealthy behavior.
  - Potential: these measures can potentially increase healthy life expectancy in Lithuania to that of peer countries (some 7 years higher) even within a similar spending envelope.
- Education sector:
  - Education spending in Lithuania is about 0.5 percent of GDP lower than the euro area.
  - Expenditure per student, after adjusting for PPP, is below the EU average.
  - Government allocates more towards tertiary education compared to peers; share of public spending on primary and secondary education is the seventh lowest among 45 OECD countries while spending on tertiary education is close to the OECD average.
  - Outcomes: high enrollment and quantitative outcomes but poor qualitative ones—PISA scores place Lithuania among the bottom 25 percent of EU countries; financial literacy underperforms controlling for math and reading; tertiary education outcomes lag EU countries.
  - Lithuania has the third highest level of skills mismatch in the labor market.
  - Policy recommendations: rationalization of the extensive school network to provide savings redirected to improving school quality, especially elementary and secondary education; focus on improving quality and efficiency of the school network as per the 2019 education reform package.

### Revenue measures
- Scope to increase tax revenues while preserving the competitive tax environment.
- Lithuania increased tax revenues as a percent of GDP including through improved compliance, but still collects less tax revenue as a share of GDP compared to other EU countries.
- 2022 tax-to-GDP ratio: 31.6 percent in Lithuania vs. 40.3 percent in the EU.
- Lithuania’s tax system is heavily tilted towards taxation of labor income, which accounts for over 55 percent of total tax revenue.
- A shrinking and aging population will reduce in particular personal income tax (PIT) and social security contributions.

*Source: IMF staff and referenced studies in the provided chapter.*

### 23.      Consumption-related taxes would follow a similar pattern, but not as steep as the

### 23.      Consumption-related taxes would follow a similar pattern, but not as steep as the

### Consumption-related taxes and labor taxation
- Consumption-related taxes would follow a similar pattern to direct taxes but not as steep because of consumption smoothing over time.  
- Increasing the tax burden on a smaller base of taxpayers to pay for additional age-related expenditures, without implementing structural reforms, would exacerbate economic distortions and cause a further drop in labor force participation.  
- Population aging has the least effect on environmental and real estate taxes, which are currently underutilized in Lithuania compared to other EU countries.  
- Shifting the tax base away from labor-related taxation remains an important objective; a balanced revenue mobilization strategy should consider a wide spectrum of measures.

### Revenue mobilization measures (policy options outlined)
- Increasing social security contributions and taxing pensions:
  - There is limited space to increase social security contributions in Lithuania.
  - Introducing a PIT on pensions, including voluntary pension savings, would generate additional revenue and make the social security system more progressive. This would need to be done in a wider reform of the PIT regime.
- Raising the CIT rate:
  - The CIT regime yields around 2 percent of GDP in revenues, compared to an average around 3 percent in the EU.
  - Lithuania has some room for additional revenue mobilization from CIT by raising the effective tax rate and eliminating exemptions.
- Eliminating tax expenditures:
  - Tax concessions and exemptions (excluding the non-taxable allowance) amount to around 3 percent of GDP.
  - Simplifying tax expenditures could generate potentially significant additional revenue and make the tax system more efficient and equitable.
- Introducing a carbon tax and increasing other environmental taxes:
  - Currently, environmental taxes in Lithuania amount to 1.5 percent of GDP, but merely 0.2 percent excluding taxes on transportation fuel.
  - Introducing an economy-wide carbon tax of US$75 per metric ton of CO2 emissions would raise about 1.5 percent of GDP in revenues and contribute to climate change mitigation.
- Modernizing the property tax regime:
  - Property tax revenue amounts to 0.2 percent of GDP, in line with Estonia but three times lower than Latvia and around 0.8 percent of GDP lower than the EU average of around 1 percent of GDP.
  - Property taxes are only applied to high-value real estate (buildings and land) and paid by a relatively small fraction of the population.
- Indirect taxes (VAT):
  - Lithuania relies heavily on VAT revenues around 8.5 percent, or a fourth of total tax revenues, compared to an average of 7.5 percent of GDP in the EU.
  - There seems to be limited scope to increase VAT further.

### Tax revenue and tax expenditure figures (exact values reported)
- Tax revenue items (in EUR million and Percent of GDP):
  - Value Added Tax 489 0.7
  - Excise Duty 337 0.5
  - Corporate Income Tax 491 0.7
  - Personal Income Tax 1,702 2.5
    - of which from non-taxable income 1,030 1.5
  - TOTAL 3,018 4.5
  - Source: Ministry of Finance.
- Tax expenditures in 2022 (comparative figures reported in source):
  - VAT 21 20 21 25 21
  - CIT 15 20 15 22 22
  - PIT 20 20 23 25 34
  - Real Estate 0.3 - 32.5 32.84
  - Source: Eurostat; and IMF staff calculations.

### Realigning fiscal targets and fiscal rule summary
- Fiscal targets can be set around current levels, safeguarding fiscal sustainability and preserving the rule’s counter-cyclical stance.
- The current fiscal rule is a form of structural balance rule with an expenditure correction mechanism and a debt anchor imposed by the EU framework.
- The rule targets a structural balance or surplus of the general government except when the output gap is negative, when the deficit cannot exceed the medium-term objective (currently at -1 percent of GDP).
- Given relatively low debt and deficits, Lithuania complies with the reference values in the EU economic governance framework; the structural fiscal target can be set at the current level—at around -1 percent of GDP even when the output gap becomes positive—consistent with steady state public debt at around the current level (36 percent of GDP) and providing space to support the economy during downturns without exceeding the 3 percent of GDP deficit under the EU framework.
- Key provisions of the fiscal rules (CLIFT and LFD) include:
  - Fiscal anchors: Medium-Term Objective (MTO) and EU-imposed debt anchor.
  - Operational target: annual conditions regarding structural balance, improvement, and special treatments when output gap is negative.
  - Expenditure growth limit: budget appropriations growth constrained when average general government balance in previous 5 years is negative, with five specified escape clauses.
  - Rules apply to all general government budgets except the state pension fund (and smaller units) with structural balance targeting; pension fund’s structural deficit can deteriorate only when projected output gap is negative.

### Long-term fiscal challenges, projections, and risks
- Demographics and long-term pressures:
  - Lithuania’s population declined by almost 25 percent from 3.7 million in 1991 to 2.8 million in 2023, and it is projected to contract by about 20 percent to 2.3 million over the next two decades and a half.
  - Long-term spending pressures in Lithuania are projected to amount to between 5 and 10 percent of GDP over the long-term.
- Debt projection absent measures:
  - Gross public debt would increase by 36 percentage points of GDP from 35.6 percent in 2023 to 71.5 percent by 2050, absent expenditure and revenue measures.
- Economic and distributional risks:
  - A shrinking and aging labor force could limit innovation and productivity growth, increase labor costs, reduce international competitiveness, and raise risks to public debt sustainability.
  - Some measures may have distributional consequences that require careful design (for example, property tax enhancements require care given large home ownership).

### Potential measures, impacts, and estimated revenue contributions (as presented)
- Link retirement age to longevity:
  - Impact: Partially absorbs the impact of demographic changes on pension spending.
  - Impact on economic efficiency: Positive impact on participation rate.
  - Distributional impact: Not clear; it reduces years of retirement but could support higher pensions.
- Increase payroll contributions:
  - Impact: Narrows the pension deficit, but payroll taxes are already high.
  - Impact on economic efficiency: Decrease participation and increase non-compliance.
  - Distributional impact: Negative.
- Subject pensions to PIT:
  - Impact: Creates additional revenue that can help support low income pensioners.
  - Impact on economic efficiency: Neutral.
  - Distributional impact: Positive if resources are channeled to low income pensioners.
- Education reform / Healthcare reform:
  - Impact: Would improve human capital and support productivity.
  - Distributional impact: Could disproportionately benefit low income households.
- Raise the CIT rate:
  - Potential revenue: Up to 1 percent of GDP.
  - Note: Corporate income taxes are relatively inefficient; ultimate incidence unclear.
- Reduce tax expenditures:
  - Potential revenue: Up to 3 percent of GDP.
  - Note: Tax expenditures tend to be inefficient and favor specific groups.
- Introduce carbon tax/environmental taxes:
  - Potential revenue: Up to 1.5 percent of GDP.
  - Note: Reduces an externality and increases efficiency; distributional impacts depend on rechanneling.
- Enhance property taxes:
  - Potential revenue: Up to 0.8 percent of GDP.
  - Note: Economically efficient tax; design should avoid negative distributional impact given large home ownership.
- Increase the standard VAT rate:
  - Potential revenue: 0.3-0.5 percent of GDP per 1pp increase.
  - Note: Relatively efficient but tends to disproportionately affect the less well off.
- Moderately reduce the fiscal target:
  - Potential impact: Up to 1 percent of GDP.
  - Note: None as long as fiscal policy remains counter-cyclical.

*Source: Ministry of Finance; Eurostat; and IMF staff calculations.*

### 4.      The positive performance of the Lithuanian economy was interrupted by Russia’s

### 4.      The positive performance of the Lithuanian economy was interrupted by Russia’s

### Economic performance and labor market developments
- GDP and income per capita flattened since 2022 after a rapid post-pandemic recovery.
- Labor utilization (activity rate, employment rate and hours worked per employee) grew above economic activity, resulting in negative labor productivity growth for the last two years.
- Labor productivity has fallen by 5 percent until end-2023, accumulating 7 quarters of negative growth.
- Contrary to previous downturns, negative labor productivity growth in 2022 and 2023 coincided with strong employment growth and higher participation rate.

### External position and current account evolution
- Lithuania moved from a large current account deficit pre-GFC to surpluses since 2018.
- Pre-GFC current account deficit reached 15 percent of GDP in 2007.
- In the decade after the post-GFC correction, the current account deficit averaged 0.1 percent of GDP.
- The current account jumped from a balanced position by end-2018 to a surplus above 4 percent of GDP in early 2020, supported by favourable terms-of-trade gains and increasing surpluses in services.
- Pandemic-specific exports (components related to vaccine production) contributed to a historic, albeit temporary, surplus of around 10 percent of GDP.

### Terms-of-trade shock and impact on domestic income
- Lithuania recorded the largest negative terms-of-trade shock in recent history over the last two years.
- By end-2023 the terms-of-trade in Lithuania was still 7.3 percent below its pre-pandemic level.
- The terms-of-trade shock in 2022 led to a deterioration of the current account to a deficit not seen since 2008, with a deficit of around 6 percent of GDP in 2022 and a swing to a surplus of close to 3 percent of GDP in 2023.
- Real gross domestic income (GDI) fell 4.5 percent during 2021-22 and was 10 percent below real GDP at its trough.
- With a partial correction in 2023, real domestic income remains 4 percent below GDP.

### Baltic comparisons: pass-through, prices and market shares
- Estonia and Latvia did not experience terms-of-trade deterioration over the last two years due to a larger pass-through of import prices into export prices.
- At the peak in 2022Q3, the increase in import prices in Lithuania was around 10 percentage points higher than in Estonia and Latvia.
- Export price increases in Lithuania occurred later (around two quarters) and were lower than in Estonia and Latvia.
- Export market share losses over 2021Q3 to 2023Q4: around 7 percent in Latvia and Lithuania, and 23 percent in Estonia.
- Lithuania’s loss of export market share was smaller than in Latvia and Estonia despite suffering a worse terms-of-trade shock.

### REER, inflation differentials, and labor costs
- The severity of the energy shock produced the highest inflation rates in the eurozone for the Baltics.
- Combined with large nominal wage growth and negative labor productivity, external competitiveness eroded, reflected in the largest REER appreciation in the EU, around 10-15 percent.

### Sectoral drivers of productivity and employment shifts
- Aggregate labor productivity was previously driven by positive contributions from both tradables and non-tradables.
- Since 2022 there has been an increasing allocation of employment to non-tradable sectors.
- Shift-share decomposition shows limited quantitative impact from sectoral labor shifts historically, but an increasing employment share in non-tradable sectors since 2022.
- Manufacturing accounted for a larger share of value added in Lithuania and faced a deeper and more persistent terms-of-trade deterioration: the manufacturing terms-of-trade remain 15 percent below its prepandemic level.

### Trade openness, energy dependence and vulnerability
- Trade openness increased from 84 to 154 percent of GDP over 1995-2013 and has remained around that level since.
- Goods trade openness is higher in Lithuania: 110 percent of GDP vs 104 and 94 in Estonia and Latvia, respectively.
- Lithuania has one of the largest energy import dependency ratios in the eurozone.
- Lithuania’s energy mix is more reliant on gas, oil and electricity; Latvia and Estonia have a more diversified profile with a larger use of renewables and other energy sources.

### Key quantitative highlights (preserved exactly)
- Current account deficit of 15 percent of GDP in 2007.
- Current account deficit averaged 0.1 percent of GDP in the decade after the post-GFC correction.
- Surplus above 4 percent of GDP in early 2020.
- Temporary surplus of around 10 percent of GDP during the pandemic.
- Terms-of-trade still 7.3 percent below its pre-pandemic level by end-2023.
- Current account deficit of around 6 percent of GDP in 2022; close to 3 percent of GDP surplus in 2023.
- Import price increase in Lithuania around 10 percentage points higher at its 2022Q3 peak.
- Real GDI fell 4.5 percent in 2021-22 and was 10 percent below real GDP; after 2023 correction, real domestic income still 4 percent below GDP.
- REER appreciation in the EU around 10-15 percent.
- Labor productivity fell by 5 percent until end-2023, accumulating 7 quarters of negative growth.
- Export market share losses over 2021Q3 to 2023Q4: around 7 percent (Latvia and Lithuania) and 23 percent (Estonia).
- Trade openness moved from 84 to 154 percent of GDP over 1995-2013.
- Goods trade openness: 110 percent of GDP (Lithuania) vs 104 (Estonia) and 94 (Latvia).
- Manufacturing terms-of-trade remain 15 percent below its prepandemic level.

*REPUBLIC OF LITHUANIA  INTERNATIONAL MONETARY FUND*

### 18.      In contrast to Estonia and Latvia, price effects explain most of the deterioration of

### 1ltuea2024002 - 18.      In contrast to Estonia and Latvia, price effects explain most of the deterioration of

### Trade balance and terms-of-trade dynamics
- Lithuania: deterioration of the trade balance by 6 percent of GDP in 2022 is largely driven by price developments, while volume effects helped narrow the deficit.
- Latvia: experienced a moderate overall trade balance deterioration of 1.2 percent of GDP over the same period.
- Estonia: experienced a small improvement of 0.6 percent of GDP over the same period.
- Unit Value Indexes (UVIs) provide a contemporaneous measure of the direct impact of the terms-of-trade shock on the economy; under this measure, the terms-of-trade in Lithuania was fully restored by end-2023.
- In Estonia and Latvia, the observed improvement in the terms-of-trade measured with export and import prices is mostly eliminated when using UVIs, consistent with higher pass-through of import to export prices in these two countries that resulted in a larger increase in import than export volumes and lower export shares.

### Export market shares and drivers of change
- Decomposition methodology (market-shift) separates changes in market shares into:
  - intensive margins — competitiveness effect (penetration margins),
  - extensive margins — composition effect (change in demand from trading partners relative to the rest of the world),
  - interaction of both factors.
- Lithuania: loss in export shares of goods mostly reflects demand developments in trading partners, particularly sanctions on Russia and Belarus (a large share of which are re-exports with little value added).
  - Around two thirds of the market share loss is attributed to depressed external demand; only one third is driven by competitiveness.
- Estonia: strong deterioration of market share mostly explained by losses in competitiveness.
- Sectoral distinction:
  - Loss of export shares was concentrated on goods.
  - Services continued strong pre-pandemic trend: Lithuania’s export share in services increased by 32 percent mostly in the EU and the UK.
  - Exports of services experienced robust expansion mostly driven by competitiveness gains, supporting a structural shift towards higher value-added services such as Information and Communication and Financial Services from low-tech manufacturing.

### Corporate sector capacity to absorb cost shocks
- Lithuanian non-financial corporates strengthened balance sheets significantly since the GFC and, supported by public measures in 2020 and 2021, reduced leverage and improved liquidity and solvency compared to 2019.
- Corporates enjoyed historically high profitability when the inflationary shock occurred, allowing exporters to partially absorb the shock and avoid a big impact on price-competitiveness.
- Net profit margins in 2022 were, on average, still above pre-pandemic levels despite expected continued deterioration of profitability in 2023.
- Manufacturing sector: the strong correction in 2022 largely undone the increase in profitability observed in 2020-21.

### Real Effective Exchange Rate (REER) and competitiveness implications
- Lithuania: appreciation of the REER over the last two years eliminated the overvaluation with which it entered the energy shock, moving it close to equilibrium; the initial undervaluation helped absorb the cost-shock with significantly less pass-through to export prices than Estonia and Latvia, resulting in a lower decline in market shares.
- Latvia and Estonia: appreciation of the REER is quantitatively similar, but resulted in a significant overvaluation, particularly for Estonia.

### Outlook: expected corrections and structural challenges
- Factors expected to partially correct going forward:
  - With external demand recovering, market share losses in countries other than Russia or Belarus should recover; loss in market access to Russia and Belarus is likely to be permanent.
  - As the economy recovers, labor productivity is expected to grow again: previously strong labor-market performance largely explained by labor hoarding; hours worked may increase closer to pre-pandemic levels.
  - Inflation is now below the euro area average; below-euro-area inflation is projected to persist for a few months but will only partly compensate for the permanent price level shock experienced over the last two years. With inflation moderating and strong wage growth slowing down, real wages are starting to ease to rates more consistent with productivity.
  - With the reversal of the terms-of-trade shock, real domestic income is recovering and the gap with real GDP is narrowing, correlating with recovery of real disposable income supported by high wage growth and easing inflation since mid-2023.
- Structural and medium-term challenges:
  - Economic structure remains less sophisticated than the euro area despite a gradual transition to a more service-oriented economy; share of manufacturing in GDP remains above the euro area (with a note that in 2023 the share of manufacturing in Lithuania was slightly below the EA due to temporary factors).
  - Manufacturing in Lithuania is dominated by low-tech industries with a larger share on GDP, employment and concentration of enterprises than the eurozone average, and a smaller share of high and medium high-technology intensive industries, explaining a large manufacturing technological gap with peers.
  - High-tech and knowledge-intensive services showed remarkable dynamism since 2013; the number of enterprises in this sector more than double over 2013-2019, recording the largest growth in the EU, supporting aggregate productivity and trade surpluses in services.
  - Capital investment has been growing fast, but capital deepening is still low compared to European peers.
  - Lithuania has one of the highest skill mismatches in Europe: labor shortage of high-skilled workers and oversupply of medium and low-skilled workers; shortcomings in the education system, high emigration, restrictions on non-EU workers, and limited participation in life-long learning contribute to the mismatch. Finding workers with the right skills is a significant constraint for over 40 percent of firms.
  - TFP growth has slowed since the GFC: from averaging around 5 percent before the GFC to 1.5 percent in 2013-19; TFP growth fell by -4 percent in 2022-23 following the energy shock.
- Policy-relevant implications implied by the analysis:
  - Recovery of external demand and reallocation toward higher value-added services can help restore export performance.
  - Addressing education, healthcare, and labor market inefficiencies and raising capital deepening are key to improving medium-term growth potential and correcting the skill mismatch.
  - Maintaining corporate balance-sheet resilience and managing REER developments are important for absorbing future cost shocks with limited pass-through to prices and preserving market shares.

*Source: IMF staff analysis in the provided content unit.*

### 26.      Some factors play a key role in shaping TFP growth.

### 1ltuea2024002 - 26.      Some factors play a key role in shaping TFP growth.

### Factors driving TFP growth
- TFP growth is largely driven by the extent to which countries are involved in scientific and technological innovation.
- The technological gap—measured by a country’s TFP distance to the frontier—is a highly signigficant factor determining TFP growth as countries move towards the technological frontier by adopting innovations.
- Increased investment in information and communication technology (ICT) capital and research and development (R&D) reinforces TFP growth.
- The effect of human capital skills—measured by the intensity of high-skilled labor at the industry level—becomes more important as a country gets closer to the technological frontier, especially in non-tradable sectors.

### Policy implications and recommendations
- Priority: create a conductive environment to raise business investment and improve capital allocation by:
  - modernizing regulations,
  - lowering trade barriers,
  - increasing public investment in physical infrastructure,
  - strengthening capital accumulation through education and healthcare,
  - provide incentives for capital investment and R&D.
- Maintaining competitiveness and ensuring fast income convergence requires productivity-enhancing structural reforms.
- Specific context for Lithuania:
  - Lithuania has experienced an impressive income convergence towards Western Europe, but the process is not complete and structural issues—most of which pre date recent shocks—persist.
  - Eroded buffers used over the last two years include lower corporate profitability and a real effective exchange rate that is now in line with fundamentals.
  - The economy has limited further ability to absorb shocks.
  - Adverse demographic trends make reinforcing productivity growth key to ensure balanced and sustainable growth.
  - Reforms are key to: enhance private sector-led growth, promote investment to support further capital deepening and mitigate or reverse negative demographic dynamics.

### Annex I — Sectoral Shift Share Methodology (summary)
- Aggregate (hourly) labor productivity (LP) defined as output (Y, measured with gross value added) divided by labor input (L, measured as hours worked).
- Productivity can be written as a weighted sum of intra-industry productivity rates:
  - 퐿퐿퐺퐺
    푡푡
    =
    ∑
    퐿퐿퐺퐺
    푖푖,푡푡
    퐿퐿
    푖푖,푡푡
    퐿퐿
    푡푡
    푖푖
- Decomposition of productivity growth into three components:
  - Intra-industry productivity growth effect:
    - Equal to the sum of productivity growth rates of individual sectors in the absence of changes across sector employment shares.
    - Formally: the first component is the intra-industry effect, calculated as the sum of individual sectors’ productivity growth rates weighted by the output share in the initial period, i.e., assuming there is no change in the economic structure.
  - Structural shift effect (changes in labor shares):
    - Quantifies the contribution to overall productivity growth of a shift of labor resources across sectors.
    - The second component is the shift effect, which captures the change in the labor shares of each industry weighted by the relative productivity level, this is, the ratio of the industry productivity to average productivity.
    - Positive when labor moves from low- to high-productivity growth sectors and vice versa when the shift is towards lower-productivity sectors.
  - Interaction effect:
    - Residual term that measures the correlation between productivity and employment changes, as well as additional productivity gains associated with qualitative factors.
    - Positive when the intra-industry effect and structural shifts across sectors are complementary (productivity growth positive in expanding activities and negative in contracting sectors).
    - Typically negative when an increase in productivity is related to a decrease in labor use.
    - The third term is the interaction component, that measures the correlation between productivity and employment changes, as well as additional productivity gains associated with qualitative factors affecting TFP.

- Mathematical form (as presented):
  - ∆퐿퐿퐺퐺
    푡푡
    =
    ∑
    ∆(퐿퐿퐺퐺
    푖푖,푡푡
    )
    퐿퐿
    푖푖
    푖푖,푡푡−1
    퐿퐿
    푡푡−1
    푖푖
    +
    ∑
    퐿퐿퐺퐺 퐿퐿
    푖푖,푡푡−1
    ∆(
    퐿퐿
    푖푖,푡푡
    퐿퐿
    푡푡
    −
    푖푖
    퐿퐿
    푖푖,푡푡−1
    퐿퐿
    푡푡−1
    ) +
    ∑
    ∆(퐿퐿퐺퐺퐿퐿
    푖푖,푡푡
    )∆(
    퐿퐿
    푖푖,푡푡
    퐿퐿
    푡푡
    푖푖
    −
    퐿퐿
    푖푖,푡푡−1
    퐿퐿
    푡푡−1
    )
  - Growth rate expression (as presented):
    - ∆퐿퐿퐺퐺
      푡푡
      퐿퐿퐺퐺
      푡푡−1
      =�
      ∆퐿퐿퐺퐺
      푖푖
      퐿퐿퐺퐺
      푖푖,푡푡−1
      푌푌
      푖푖,푡푡−1
      푌푌
      푡푡−1
      푖푖
      + 
      �
      퐿퐿퐺퐺
      푖푖,푡푡−1
      퐿퐿퐺퐺
      푡푡−1
      (
      퐿퐿
      푖푖,푡푡
      퐿퐿
      푡푡
      −
      푖푖
      퐿퐿
      푖푖,푡푡−1
      퐿퐿
      푡푡−1
      ) + 
      �
      ∆퐿퐿퐺퐺
      푖푖,푡푡
      퐿퐿퐺퐺
      푖푖,푡푡−1
      (
      퐿퐿
      푖푖,푡푡
      퐿퐿
      푡푡
      푖푖
      −
      퐿퐿
      푖푖,푡푡−1
      퐿퐿
      푡푡−1
      )

### Annex II — Market Share Methodology (summary)
- Constant Share Analysis (CSA) illustration:
  - For an economy r exporting one product to one partner p:
    - Total exports of the economy: 푋푋
      푟푟
    - Total world exports: 푋푋
      푊푊
    - Country’s export share: 푋푋
      푟푟
      푋푋
      푊푊
      ⁄
    - Rewritten using world exports to country p: 휃휃
      푟푟
      =휃휃
      푟푟푊푊
      ×훿훿
      푊푊
    - Change decomposition: ∆휃휃
      푟푟
      =∆휃휃
      푟푟푊푊
      훿훿
      푊푊
      0
      +∆훿훿
      푊푊
      휃휃
      푟푟푊푊
      0
      +∆휃휃
      푟푟푊푊
      ∆훿훿
      푊푊
- Three components of export market share change:
  - Intensive margin / competitiveness effect:
    - Effect of expanding in the partner market holding the size of the partner constant.
    - Measures portion attributable to higher penetration of r’s exports in destination market (competitiveness gains).
  - Extensive margin / composition effect:
    - Effect of growth in the size of the export partner holding relative penetration constant.
    - Measures portion attributable to change in size of destination market.
  - Interaction term:
    - Interaction of the two effects above.
- Interpretation:
  - The economy can increase export market share by getting a larger share of its partner market, by having the partner market grow overall, or both.
  - CSA allows disentangling these effects.
- Limitations of CSA (as provided):
  - Assumes market structure remains unchanged over the analyzed period, ignoring effects of technological advancements, changes in consumer preferences, and regulatory changes.
  - Focuses on changes in market share attributable to internal factors (price competitiveness and product quality), but does not account for external factors (global economic conditions, exchange rate changes, competitor actions).
  - Assumes products within the market are homogeneous, ignoring product differentiation.
  - Provides information on changes in market share but does not offer insights into the underlying causes; disentangling effects requires additional analytical techniques or qualitative research.

*Source: 1ltuea2024002 - 26.      Some factors play a key role in shaping TFP growth.*

---


_Source: https://www.imf.org/-/media/files/publications/cr/2024/english/1ltuea2024002.pdf_