Reasons and Consequences of Suboptimal State of Public Finances in

Lithuania

Dr Raimondas KuodisBank of Lithuania, Vilnius University

www.ekonomika.org

Presentation at the Conference

“Catalysts and Impediments of Economic Development in Central and Eastern Europe”

Vilnius, October 14-15, 2004

Outline

1. Long-term trends in Lithuania’s public finances2. On the optimal size of a public sector3. Is Lithuania’s level of public revenues optimal4. What led to the suboptimal equilibrium5. Major exemptions, loopholes and administration

weaknesses of the tax system6. Procyclicality of the tax system7. Regressivity of the tax system8. Conclusions

Introduction

One can analyze a tax burden from various perspectives (Atkinson and Stiglitz, 1980): how a tax burden is “shared” by labor and capital, by producers and consumers, how a tax system affects wealth of various regions, generations etc. The objective of this presentation is to analyze (in a comparative fashion) the aggregate tax burden in Lithuania, which in my opinion is a much more important problem for our country.

Introduction (2)

This dimension of analysis is related to the principal question of the weight of Lithuanian state in the economic system. The public choice of this weight shapes the main features of the long-term development in economic, social (and even political) spheres.

Aggregate tax burden and its dynamics in Lithuania

The rates of major taxes in Lithuania are moderate, as compared to developed countries and new member states of the EU, but certainly they are not the lowest (see tables 1, 2 and 3).

Table 1. Income Tax Rates in EU candidate countries (2001-2002 fiscal year).

Table 1. Income Tax Rates in EU candidate countries (2001-2002 fiscal year). Country Number of

Brackets Maximum

rate First positive rate “Average”

rate Bulgaria 4 38 20 29 Cyprus 3 40 20 30 Czech Republic 4 32 15 23.5 Estonia 1 26 26 26 Hungary 3 40 20 30 Latvia 1 25 25 25 Lithuania 1 33 33 33 Malta 3 35 15 25 Poland 3 40 19 29.5 Romania 5 40 18 29 Slovakia 5 38 10 24 Slovenia 6 50 17 33.5 Turkey 6 40 15 27.5 Source: Martinez-Serrano and Patterson (2003); author’s calculations.

Table 1a. Social Security Tax Rates in Accession Countries.Country Employers

rate Employees’

rate Total

Cyprus 8 6 14 Czech Republic 35 12 47 Estonia 33 0 33 Hungary 33.5 13 46.5 Latvia 26.1 9 25.1 Lithuania 31 3 34 Malta 10 10 20 Poland 17.6 18.5 36.1 Slovakia 38 13 51 Slovenia 16.1 22.1 38.2 Source: KPMG, “Ernst & Young”.

Table 2. Profit Tax Rates in Accession Countries (2001-2002 fiscal year).

Country Rate (%) Bulgaria 15+10 Cyprus 25 Czech Republic 31 Estonia 0 Hungary 18 Latvia 22 Lithuania 15 Malta 35 Poland 28 Romania 25 Slovakia 25 Slovenia 25 Turkey 30 Source: Martinez-Serrano and Patterson (2003).

Table 3. VAT Rates in Accession countries (2002).Country Standard rate (%)

Bulgaria 20 Cyprus 10 Czech Republic 22 Estonia 18 Hungary 25 Latvia 18 Lithuania 18 Malta 15 Poland 22 Romania 19 Slovakia 23 Slovenia 20 Turkey 18 Source: Martinez-Serrano and Patterson (2003).

Aggregate tax burden and its dynamics in Lithuania (2)

However, the main statutory rate on personal income in Lithuania is relatively large (33%), there are no brackets as in most of countries in the region. Nevertheless, the aggregate tax burden, as measured by the ratio of consolidated public income to GDP, is much lower in Lithuania, as compared to the new EU countries (see Fig. 1). Despite such a large gap this ratio has been on the downward trend (see Fig. 2).

Fig. 1. Public Income in Various Countries, Average 1995-2002 (% GDP)

0.0

5.010.0

15.0

20.025.0

30.0

35.0

40.045.0

50.0

Croatia

Czech R

ep.

Estonia

Hungary

Latvia

Lithuania

Poland

Slovakia

Slovenia

C. E

urope (+Latvia and Estonia)

CIS

Germ

any

Greece

Japan

Portugal

US

A

Source: EBRD Transition Report 2002

Fig. 2. Public Income in Lithuania, 1995-2002 (% GDP)

28

28.5

29

29.5

30

30.5

31

31.5

32

32.5

33

1995 1996 1997 1998 1999 2000 2001 2002 Average

Source: EBRD Transition Report 2002; IMF

The gap in aggregate tax burdens is so huge, that…

These comparisons allow to make a conclusion, that Lithuania’s public income level is so much lower as compared to the levels of countries in the same stage of transition, that (a) either Lithuania’s public finances are in crisis, or (b) other countries “are not right”. What should this ratio, which roughly reflects the weight of a government in an economy, be is a matter of “taste”. That is why in Lithuania there are (on the surface) two conflicting views on the issue of the tax burden.

Two views

The Confederation of Industrialists of Lithuania (2003) stresses the large and increasing number of taxes and their relatively high statutory rates (the nominal burden). But, as was demonstrated earlier, the effective burden is not large (PM A. Brazauskas, 2003-2004).

Two views (2)

In my view, the main reason of the low effective burden is a vast number of exemptions, loopholes in our tax “system”, and weak tax administration. Therefore, both views are right, but one stresses the nominal and the other – the effective dimension! However, when nominal and effective tax burdens differ so much, the tax system is inefficient and, consequently, the socio-economic system is stuck in a suboptimal state.

On the optimal size of the public sector in the economy

Via democratic processes (elections) societies periodically make a social choice as to the desired place of a public sector in an economy. In other words, democratic societies may choose the desired mix of public and publicly provided public goods vs. private goods.

On the optimal size of the public sector in the economy (2)

Formally, the optimal choice is at the point where the marginal rate of substitution of private goods for public goods is equal to the tax price of the latter (see also Samuelson, 1954). In addition, in the long run this public choice has to respect the dynamic constraint on public finances: a public debt, which is a sum of public deficits, should be stationary.

Is Lithuanian level of public revenues optimal?

Let me switch to the normative mode. In my view, there are a number of reasons why Lithuania’s public revenue level is suboptimal (too low): there is a need to accomplish large-scale structural reforms, which themselves are public goods (they cannot be provided by the private sector): the land reform, the health care reform, the education reform, the pension system reform, the energy sector reform etc.;

Is Lithuania’s level of public revenues optimal? (2)

These reforms are slow due to the lack of public funds (especially for land and property restitution). One of the byproducts is corruption (most notably in the land restitution process); The authorities have to finance the projects related to the integration into the EU (co-financing) and NATO (2% of GDP). Another EU accession related project which will require public money is the closure of the Ignalina nuclear power plant;

Is Lithuania’s level of public revenues optimal? (3)

The authorities made a commitment to finance a number programs, which restore the historic justice: the restitution of savings lost during the hyperinflation of 1991-1992, land and real estate restitution etc.; The level of public investment in Lithuania has been relatively low and insufficient, and investment projects, which last for years, are more costly (according to the World Bank); The failure to pay for for the provision of goods by the private sector in a timely fashion has been (and still is) the uncivilized way to finance deficits;

Is Lithuania’s level of public revenues optimal? (4)

Insufficient financing of the health care (see Tables 5 and 6) and education sectors led to the “quasi-privatization” of these sectors (people have to “co-pay” for the provision of these services). It is not a transparent state of affairs; The failure to pay “efficiency wages” (see Yellen, 1984) for public employees of certain systems (customs office, police etc.), which face the largest temptations to take bribes, is a necessary (but not sufficient) reason of corruption;

Is Lithuania’s level of public revenues optimal? (5)

A large turnover of specialists in some public institutions implies that the government in effect subsidizes the training of specialists for the private sector (after leaving the public sector they “fight” with it on the side of the private sector using “inside” information); Poor social system (the average old-age pension amounts to only 1/3 of the average wage, while in developed countries this ratio is usually 60-70%) is responsible for the poverty of a large share of the population, which in turn is the reason behind the “pendulum” type of voting and the rise of populism;

Is Lithuania’s level of public revenues optimal? (6)

Due to the low level of public revenues and the tax structure in which consumption taxes dominate automatic stabilizers are weak and the tax system is rather regressive (see below). Finally, the lack of funds is partly responsible for the large budget deficits (Fig. 3 and 4), which hinders macroeconomic stability and long-term growth.

Fig. 3. Budget Deficits in Lithuania, 1995-2002 (% GDP)

-9

-8

-7

-6

-5

-4

-3

-2

-1

0 19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

Ave

rag

eSource: EBRD Transition Report 2002

Fig. 4. Budget Deficits in CEE and CIS, Average 1995-2002 (% GDP)

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0 Cro

atia

Cze

ch R

ep

.

Esto

nia

Hu

ng

ary

Latvia

Lith

ua

nia

Po

lan

d

Slo

vakia

Slo

ven

ia

C. E

urop

ea

nd B

altics

CIS

Source: EBRD Transition Report 2002

Fig. 5. Public Expenditure in Lithuania, 1995-2002 (% GDP)

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

199

5

199

6

199

7

199

8

199

9

200

0

200

1

200

2

Ave

rag

eSource: EBRD Transition Report 2002

Fig. 6. Public Expenditure in CEE and CIS, Average 1995-2002 (% GDP)

0.0

10.0

20.0

30.0

40.0

50.0

60.0

Cro

atia

Cze

ch R

ep

.

Esto

nia

Hu

ng

ary

La

tvia

Lith

ua

nia

Po

lan

d

Slo

vakia

Slo

ven

ia

C. E

uro

pe

(+L

atvia

an

d E

ston

ia)

CIS

Source: EBRD Transition Report 2002

Table 5. Health Care Expenditures in Various Countries (% GDP)

USA 12EU-15 8.5Slovenia 7.9Czech Rep. 7.8Hungary 6.1Poland 6.1Bulgaria 4.2Romania 4Lithuania 3.4Source: "Veidas" weekly, 2004.01.22

Table 6. Decrease of Spending on Health Care in Lithuania (% GDP) 1998 4.281999 4.122000 4.022001 3.932002 3.672003 3.512004 3.42

Source: "Veidas" weekly, 2004.01.22

What are the ways out of this bad equilibrium?

In principle there are two ways. First is to cut public expenditures – privatize the provision of some publicly provided private goods (primary candidates are the higher and university education, the health care system). This would increase transparency and efficiency. On the other hand, it would be a risky decision: a continuous provision of these services is critical; consumption of these products by poor people is likely to fall, and this may lower the social cohesion and (via the reduction of the human capital) long-term economic growth.

What are the ways out of this bad equilibrium (2)

The other alternative is the tax reform, which would remove major loopholes and exemptions in our tax system, and would increase the public revenue level to some 35-36% of GDP. The broadening of the tax base would also allow to lower marginal tax rates on income and consequently the excess tax burden (distortions caused by a tax system and measured by using Harberger triangles).

What are the ways out of this bad equilibrium (3)

However, such a reform is politically difficult to implement. The choice will also depend on the past trajectory (a hysteresis): for example, “to put the genie back into the bottle” in, say, the health care system would be extremely difficult.

What led to the suboptimal equilibrium in the first place?

The usual suspects: Shorter than needed from the long-term growth perspective horizon of optimization by politicians...; ... and lobbyists exploited that; The making of social policy mostly using relative-prices-distorting tax changes, rather than explicit transfers (the 2nd Fundamental Theorem of Welfare Economics);

What led to the suboptimal equilibrium in the first place? (2)

The lack of resources for tax administration purposes (a vicious circle)...; ... and the lack of brains: the authorities tend to use repressive methods, rather than market mechanisms in the fight against tax evasion (an example is the problem of underpriced imports); The lack of motivation for the tax authorities; A cost-benefit analysis is not institutionally required in the public decision making in the field of taxation.

The weakest points in our tax system (treat as reform proposals...)

The biggest problem is the personal income and social security taxes, not the consumption taxes: “Business license holders”, who pay a fixed lump-sum tax, not linked to profits – an average license holder pays about an 8 times smaller income tax than an average employee working under the usual labor contract. They also pay the minimum social contribution, which will entitle them only to the basic pension;

The weakest points in our tax system (2)

The “Authors fees” is a way to circumvent the usual labor contract and to pay only a 15% rate of personal income tax and nothing to the Social Security Fund (“Sodra”); Private consumption of shareholders and employees (as a part of their compensation) via firms – the owners claim back the VAT, depreciate “the investment”, deduct maintanence and repair costs of these “investment goods” from the profit tax bill;

The weakest points in our tax system (3)

These practices are treated as illegal, but the tax authorities lack resources to combat them (another bad equilibrium): it takes a number of years to accomplish a full round of checking financial reports, no time left to check expenditures of the firms; There is an imbalance of excise tax rates for gasoline, diesel and LPG. This causes the growing substitution away from gasoline and diesel; A failure to deal with the “economic tourism” to/from Kaliningrad and Byelorussia, and smuggling.

The weakest points in our tax system (4)

A VAT is a good tax (from the perspective of economic efficiency, not equity) if its rate is applied uniformly to all goods, since that does not distort relative prices. However, in Lithuania this is not the case. For example, in 2003 lobbyists managed to introduce a 5% VAT rate on raw meet. This distorts competition with the producers of close substitutes and with the rest of producers in general. This is also detrimental to long-term growth due to the shift of resources to the less productive agricultural sector.

A macro deficiency: the procyclicality of our tax system

A consumption smoothing motive makes consumption–tax based systems more procyclical, contrary to income-tax based systems. In Lithuania consumption taxes (VAT and excises) comprise more than 40% of tax revenues (see Fig. 7). The automatic stabilizer on the expenditure side – unemployment benefits - has also been week so far. The replacement ratio (of the lost wage) has been low, the benefits are linked to the lost wage. The weakness of automatic stabilizers may backfire when Lithuania joins the eurozone.

Fig. 7. Structure of Tax Revenues in Lithuania.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1995 1996 1997 1998 1999 2000 2001 2002

Income Taxes

Social Security Taxes

Consumption Taxes

The tax system is regressive

Our tax system is de facto regressive due to the domination of consumption taxes. The same VAT and excise rates are faced by rich and poor people alike, because they cannot be differentiated due to administration considerations. However, 18 cents of the VAT paid out of 1 litas worth of purchase of, say, bread is much more painful for a pensioner (in terms of relative welfare losses) than for a rich person.

Conclusions

Lithuania badly needs a tax reform (despite the claim by the former government that they made one). The authorities are at the crossroads now: either we have to privatize some sectors which provide private goods (health care, higher education…) and thus ensure proper financing of the rest of the public sector, or to broaden the tax base and increase the public revenue to GDP ratio. In the latter case the public revenues should be raised to the level which would ensure that (a) budget deficits finally disappear (over the cycle); (b) pensions increase closer to the replacement level of developed countries; (c) there is no shortage of funds to finance reforms.

References

Samuelson, P. A. (1954) "The pure theory of public expenditure", Review of Economics and Statistics, 36, 387-389. Atkinson A. B. and Stiglitz, J. (1980) “Lectures on Public Economics”, McGraw-Hill. Stiglitz, J. (2000) “Economics of Public Sector”, W.W.Norton. Shome, P., ed. (1995) “Tax Policy Handbook”, International Monetary Fund, Washington, D.C. Martinez-Serrano, Alicia and Patterson, Ben (2003) "Taxation in Europe: Recent Developments", European Parliament, DG for Research, Working Paper 2003-01 (Economic Affairs Series). Ernst &Young (2003) "Company Taxation in the New EU Member States". Yellen, Janet (1984) “Efficiency Wage Models of Unemployment”, American Economic Review, May 1984.