Lithuania: Staff Concluding Statement of the 2018 Article IV Mission

May 21, 2018

The Lithuanian economy is performing well, with high growth, unemployment that is close to pre-crisis levels, fiscal surpluses and a strong financial system. However, medium-term challenges are significant, including high social disparities — magnified by the crisis and a recovery that has left some groups behind — and severe demographic pressures. To address these challenges, Lithuania needs ambitious reforms to transition from a low-wage economy to a high-productivity one and reaccelerate convergence toward Western European living standards. In this connection, the recent reform package proposed by the government is a step in the right direction although it could be more ambitious.

Economic developments and outlook: The recent strong economic performance is expected to continue over the near-term without pre-crisis imbalances reemerging.

The economic recovery picked up steam in 2017 with unemployment reaching its lowest rate since the crisis . Growth reached 3.9 percent, driven mainly by higher investment, which benefited from healthy credit growth and high capacity utilization. Exports also bounced back due to strong external demand, including from new markets, and past investments in export capacity contributing to a strong external position and a current account surplus. Despite tightening labor markets, private consumption slowed because strong nominal wage growth was partially offset by higher inflation.

Positive economic performance is expected to continue in 2018, albeit at a slower pace because of weakening external demand. Growth is projected at 3.2 percent with a widening output gap. Inflation is expected to decelerate to around 2.4 percent following the 2017 excise hikes. Regarding domestic demand, while consumption growth should slow in 2018, investment and the absorption of EU funds are expected to improve significantly.

In the absence of ambitious reforms, growth is expected to gradually decline in the coming years 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 will require ambitious reforms to boost productivity.

Policy mix: With external and internal imbalances addressed, macroeconomic policies should aim at preserving stability while preventing the reemergence of pre-crisis imbalances.

Fiscal policy

Lithuania needs a strong fiscal position to tackle external shocks and medium-term fiscal pressures. As a small open economy without an independent monetary policy, fiscal policy plays an important role guarding against external shocks and creating a buffer against age-related spending pressures. In this regard, fiscal policy has been appropriately counter-cyclical over the last few years, especially given the strength of the recovery and ECB’s accommodative monetary policy stance. This has resulted in general government surpluses for the first time in Lithuania’s history. The fiscal rule has helped support the recent strong budgetary stance but the rule would benefit from a simpler design to enhance transparency and provide a stronger anchor for fiscal policy. The authorities’ intention to maintain a broadly neutral fiscal stance going forward strikes the right balance between rebuilding fiscal buffers and addressing pressing social needs.

Financial sector and Macroprudential policies

The banking system is well capitalized, liquid, and profitable and is well placed to support credit growth over the near term . The main risks to the banking system could come from the acceleration in housing prices and credit, and spillovers from developments in Nordic countries through parent banks. Although the growth of housing prices and credit has moderated in recent months, the authorities should remain vigilant and continue to use macroprudential policy proactively to address systemic risks. Still, with the stock of credit and housing prices well below pre-crisis levels, the reemergence of sizable imbalances in the near term is unlikely. Moreover, the increasing reliance of Nordic subsidiaries on domestic funding is a positive development, limiting funding risks from adverse developments in Nordic countries. The Bank of Lithuania should maintain close cooperation with regional regulators in the context of the Nordic-Baltic Stability Group. Finally, the ongoing reform of credit unions should gradually strengthen the sector.

Structural policies: Lithuania’s attention should turn to addressing medium-term challenges by implementing reforms that boost productivity and address social disparities and poverty.

The pension reform proposals under consideration are a step in the right direction. While the pension system is fiscally sound, pensions are too low to prevent old-age poverty. The proposed increase in minimum pensions could help alleviate old-age poverty. At the same time, 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 of the pension system seek to increase the replacement rate by increasing the number of participants and their contributions, helping to diversify risks, and reducing fees.

There are significant risks that need to be addressed for pension reform to be successful in delivering higher pensions while preserving fiscal sustainability. To ensure fiscal soundness while improving the redistributive aspect of the system, the government could consider linking the retirement age to life expectancy, raising overall pensions while subjecting them to income taxation and strengthening the redistributive component of basic pensions. The envisaged contribution from the state budget of two percent of average wages to the funded pillar of the pension system should weigh the benefits of increasing incentives to achieve high participation against a more targeted use of those resources to reduce old-age poverty . High participation, crucial for the success of the reform, could also be achieved through compulsory enrollment. Importantly, to be successful, pension reform should seek broad political and social consensus to ensure long-term stability and predictability, and maximize participation.

Tax reform proposals would lower reliance on labor taxes but will not generate additional revenue or enhance the government’s ability to redistribute income. Notwithstanding some reforms introduced last year, the tax system in Lithuania has a small degree of progressivity and the proposed reform of property taxes is unlikely to have a meaningful impact on revenue and redistribution. The introduction of a ceiling on social security contributions, while having a positive effect on compliance and reflecting the already existing ceiling on pension benefits, will reduce redistribution further. Finally, with a large informal economy, tax administration reforms should continue to fight informality and help mobilize additional revenues. However, there is a risk that expected gains in this area will not fully materialize. International experience suggests that the proposed tax amnesty, despite focusing on fees and late interest and leaving tax liabilities unchanged, may unintentionally weaken compliance.

With one of the lowest tax revenue ratios in the European Union, additional resources will be needed to reduce social disparities and make a dent on 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). Other measures such as the introduction of environmental taxes linked to vehicle pollution emissions could also be considered. These more ambitious reforms would generate additional revenues, increase tax progressivity and help fund additional capital spending and targeted social assistance.

Education and healthcare reforms have the right focus but are subject to significant implementation risks. In education, inefficiencies in an excessively large system result in poor outcomes and large skill mismatches. Similarly, while many hospitals have low occupancy rates, health outcomes are among the lowest in the euro area. As a consequence of over-sized networks, both medical and education staff face low wages. Improving efficiency in education will require reducing the number of teachers, consolidating school infrastructure, and linking decision making and funding to performance. Reform proposals in education, including greater emphasis on vocational training rather than on tertiary education, lack sufficient specificity to fully assess their potential impact. Healthcare reform proposals would expand primary and long-term care and optimize the current system. These are steps in the right direction.

Wage increases for education and healthcare personnel should be considered only in the context of a broader, and long-overdue, reform of these sectors . Upfront wage increases, while popular given current low wages, will put at risk the implementation of other politically sensitive but critical reform elements such as the rationalization and consolidation of the hospital, school and university networks. Only a comprehensive reform of these sectors will allow Lithuania to produce a competitive workforce necessary to tackle the strong demographic headwinds and avoid missing a historic opportunity.

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. This trend should continue towards the level that prevailed in Lithuania before 2013, around 40 percent of average wages. A high national minimum wage hampers employment prospects, especially for low-skilled and young workers in rural areas whose productivity is typically lower than that of the everage worker. Rather than relying on the minimum wage to reduce income inequality, the authorities should use targeted social spending to help those in need.

Plans to overhaul innovation promotion by streamlining the number of agencies and instruments will increase the effectiveness of innovation policy. These efforts should seek to exploit synergies under a more centralized structure rather than create a network of loosely coordinated agencies that run the risk of perpetuating existing inefficiencies.

The IMF team is grateful for the generous hospitality of the Lithuanian authorities and would like to thank all its interlocutors in government, the Bank of Lithuania, the European Central Bank, the private sector, and NGOs for constructive and fruitful discussions.