Republic of Lithuania: Staff Concluding Statement of the 2018 Article IV Mission
IMF News, May 21, 2018
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- Published: May 21, 2018
Overview
- The Lithuanian economy is performing well: high growth, unemployment close to pre-crisis levels, fiscal surpluses, and a strong financial system.
- Medium-term challenges: high social disparities (magnified by the crisis and an uneven recovery) and severe demographic pressures.
- Policy priority: ambitious reforms to transition from a low-wage economy to a high-productivity one and reaccelerate convergence toward Western European living standards.
- The government's recent reform package is a step in the right direction but could be more ambitious.
Economic developments and outlook
- 2017 performance:
- Growth reached 3.9 percent, driven mainly by higher investment supported by healthy credit growth and high capacity utilization.
- Unemployment reached its lowest rate since the crisis.
- Exports rebounded due to strong external demand and past investments in export capacity.
- The economy posted a current account surplus.
- Private consumption slowed despite tightening labor markets because strong nominal wage growth was partially offset by higher inflation.
- 2018 near-term outlook:
- Growth projected at 3.2 percent with a widening output gap.
- Inflation expected to decelerate to around 2.4 percent following the 2017 excise hikes.
- Consumption growth should slow in 2018, while investment and absorption of EU funds are expected to improve significantly.
- Medium-term projection:
- In the absence of ambitious reforms, growth is expected to gradually decline to its medium-term potential rate of around 2 percent.
- Slow potential growth reflects strong demographic pressures and sluggish investment and productivity after the global financial crisis.
- Mitigating the adverse impact of a shrinking working-age population requires ambitious reforms to boost productivity.
Policy mix
- General guidance: With external and internal imbalances addressed, macroeconomic policies should preserve stability while preventing reemergence of pre-crisis imbalances.
Fiscal policy
- Lithuania needs a strong fiscal position to tackle external shocks and medium-term fiscal pressures.
- Role of fiscal policy: important for a small open economy without an independent monetary policy to guard against external shocks and create a buffer against age-related spending pressures.
- Recent stance:
- Fiscal policy has been appropriately counter-cyclical over the last few years given the strength of the recovery and ECB’s accommodative monetary policy stance.
- Resulted in general government surpluses for the first time in Lithuania’s history.
- Fiscal rule:
- The fiscal rule has helped support the recent strong budgetary stance but would benefit from a simpler design to enhance transparency and provide a stronger anchor.
- Authorities’ intention to maintain a broadly neutral fiscal stance strikes a balance between rebuilding fiscal buffers and addressing pressing social needs.
Financial sector and Macroprudential policies
- Banking system status:
- Well capitalized, liquid, and profitable; well placed to support credit growth over the near term.
- Main risks:
- Acceleration in housing prices and credit.
- Spillovers from developments in Nordic countries through parent banks.
- Recent developments and policy advice:
- Growth of housing prices and credit has moderated in recent months, but authorities should remain vigilant and continue proactive macroprudential policy to address systemic risks.
- Stock of credit and housing prices remain well below pre-crisis levels, making sizable near-term imbalances unlikely.
- Increasing reliance of Nordic subsidiaries on domestic funding is positive, limiting funding risks from adverse developments in Nordic countries.
- The Bank of Lithuania should maintain close cooperation with regional regulators via the Nordic-Baltic Stability Group.
- Ongoing reform of credit unions should gradually strengthen the sector.
Structural policies
- Objective: address medium-term challenges by implementing reforms that boost productivity and address social disparities and poverty.
Pension reform
- Current assessment:
- Pension system is fiscally sound but pensions are too low to prevent old-age poverty.
- Pension reform proposals under consideration are a step in the right direction.
- Proposed measures and expected effects:
- Increase in minimum pensions could help alleviate old-age poverty.
- Moving basic pensions to the state budget in a budget neutral way will increase the link between benefits and contributions for pay-as-you-go pensions, potentially enhancing compliance.
- Reforms to the funded pillar seek to increase the replacement rate by increasing the number of participants and their contributions, diversify risks, and reduce fees.
- Risks and policy recommendations:
- Significant risks must be addressed to deliver higher pensions while preserving fiscal sustainability.
- Consider linking the retirement age to life expectancy to ensure fiscal soundness while improving redistributive aspects.
- Raise overall pensions while subjecting them to income taxation and strengthen the redistributive component of basic pensions.
- The envisaged contribution from the state budget of two percent of average wages to the funded pillar should weigh the benefits of increasing incentives for participation against a more targeted use of those resources to reduce old-age poverty.
- High participation is crucial; consider compulsory enrollment.
- Seek broad political and social consensus to ensure long-term stability, predictability, and maximize participation.
Tax reform
- Assessment of proposals:
- Proposed tax reform would lower reliance on labor taxes but will not generate additional revenue or enhance the government’s ability to redistribute income.
- The tax system has a small degree of progressivity despite some reforms introduced last year.
- Proposed reform of property taxes is unlikely to have a meaningful impact on revenue and redistribution.
- Introduction of a ceiling on social security contributions will reduce redistribution further, though it may improve compliance and reflect existing ceilings on pension benefits.
- Tax administration and informality:
- Large informal economy: tax administration reforms should continue to fight informality and mobilize additional revenues.
- Risk that expected gains from administration reforms will not fully materialize.
- International experience suggests the proposed tax amnesty, despite focusing on fees and late interest and leaving tax liabilities unchanged, may unintentionally weaken compliance.
- Recommended direction:
- With one of the lowest tax revenue ratios in the European Union, additional resources will be needed to reduce social disparities and address poverty.
- Reform efforts should focus on further reducing reliance on labor taxes in favor of capital and wealth taxes and corporate income tax (by reducing large existing exemptions).
- Consider introduction of environmental taxes linked to vehicle pollution emissions.
- More ambitious tax reforms would generate additional revenues, increase tax progressivity, and help fund additional capital spending and targeted social assistance.
Education and healthcare reforms
- General assessment:
- Reforms have the right focus but face significant implementation risks.
- Education:
- Inefficiencies in an excessively large system result in poor outcomes and large skill mismatches.
- Reform needs: reduce the number of teachers, consolidate school infrastructure, and link decision making and funding to performance.
- Reform proposals include greater emphasis on vocational training rather than tertiary education but lack sufficient specificity to fully assess potential impact.
- Healthcare:
- Many hospitals have low occupancy rates; health outcomes are among the lowest in the euro area.
- Over-sized networks depress wages for medical and education staff.
- Reform proposals would expand primary and long-term care and optimize the current system.
- Wage policy for education and healthcare personnel:
- Wage increases should be considered only in the context of a broader reform of these sectors.
- Upfront wage increases risk endangering politically sensitive but critical reforms such as rationalization and consolidation of hospital, school, and university networks.
- Only comprehensive reform will allow Lithuania to produce a competitive workforce to tackle demographic headwinds.
Minimum wage
- Assessment:
- Minimum wages remain high and are an inefficient income policy tool.
- Recent moderate increases in minimum wages will reduce the ratio of the minimum to average wage from a peak of 50 percent in 2016 to around 45 percent in 2018.
- Recommendation: continue the trend toward the level that prevailed before 2013, around 40 percent of average wages.
- Rationale: high national minimum wage hampers employment prospects, especially for low-skilled and young workers in rural areas.
- Policy alternative: use targeted social spending rather than minimum wage increases to reduce income inequality.
Innovation policy
- Plans to streamline the number of agencies and instruments to overhaul innovation promotion will increase the effectiveness of innovation policy.
- Advice: seek to exploit synergies under a more centralized structure rather than create a network of loosely coordinated agencies that risk perpetuating existing inefficiencies.
Closing acknowledgments
- The IMF team thanks the Lithuanian authorities and interlocutors in government, the Bank of Lithuania, the European Central Bank, the private sector, and NGOs for constructive and fruitful discussions.
IMF Staff Concluding Statement, May 21, 2018