Cutting Deficits: Lessons from Lithuanian Austerity

Kaetana LeontjevaSenior Policy Analyst

Lithuanian Free Market Institute

INESS Cutting Deficits Conference, BratislavaOctober 9, 2012

Presentation menu

• What austerity measures did we pursue in 2008-2012?

• How successful were they in cutting our budget deficit?

• What useful lessons can we learn from the Lithuanian example?

Situation in 2008

• Soft landing or hard landing?

• New center-right wing coalition

• Gaping hole in state finances

• Currency Board

• Focus on budgetary policy

“Overnight” Tax Reform of 2008

• A relatively stable and predictable tax system changed overnight – 106 law articles amended

• Tax increases:

→ Corporate income tax – from 15% to 20%;

→ VAT “temporarily” from 18% to 19%;

→ Excise duties on alcohol and energy products;

→ For individual business owners;

→ 5% VAT rates on food, etc. abolished

After the Tax Reform

• Tax increases did not bring about the expected results:→ Projections of corporate income tax revenues cut to 59%

of their original level→ VAT revenues – to 73%→ Excise duties’ revenues – to 82%• Deepened recession: GDP contraction of 15%• Surge in the shadow economy from 18% of GDP in 2008

to 27% in 2010, according to the Lithuanian Free Market Institute’s survey

• Outcome in line with Laffer’s curve

Laffer’s curve

Further Tax Changes

• The government rolled back some of the tax increases:

→ corporate income tax and excide duty on diesel reduced back to 2008 level

→ healthcare insurance contributions no longer levied on dividends

• But, VAT was raised from 19% to 21%

Ways of cutting spending

Cutting planned increases in spending

•Spend 100 EUR this year

•Plan to spend 120 EUR next year

•Cut spending to 110 EUR next year

•Is this a spending cut?

Ways of cutting spendingHorizontal spending cuts:

→ easier to implement, but can be done up to a limit

→ lower the quality of service, result in customers’ dissatisfaction

→ doing the same with less money, so functions of the public sector do not change

Ways of cutting spendingVertical spending cuts:

→ most needed, but difficult to implement: require much-need reforms in healthcare and social security areas and elimination of unnecessary budget programs

→ reduce functions of the public sector

Conditional budget

• Spending should be made conditional on revenues

• Proposed by the Lithuanian Free Market Institute over a decade ago

• Partially introduced in 2010

• True implementation would mean priority line assigned to each budget program, for example:

→ Program A - Pensions: Spending not reduced

→ Program B – Roads: Spending cut by 20%

→ Program C – Social advertisements: Spending abolished

Spending cuts in Lithuania

• 2012 compared to 2008:

→ overall nominal state budget spending cut of 12%;

→ number of bureaucrats reduced by 10% ;

→ spending on bureaucrats’ salaries lowered by 17% (progressive wage cuts of 8-36% on bureaucrats’ salaries).

• But spending on bureaucrats salaries’ is only 1/10 of the state budget

Lithuania’s State Budget (excluding EU funds, mln. Litas)

State Social Insurance Fund(mln. Litas)

Record-breaking deficits and no reform in sight. Transfers into II pension pillar cut from 5.5% to 1.5% as a “savings cut”

Lithuania’s Total State Debt (mln. Litas)

From 17% of GDP in 2007 to 41% in 2012

Another Budget Crisis in 2011

• Economic growth of 5.9%

• Bleak renewed growth forecasts

• New budget gap of 3.8% of projected budget revenues

• How should it be filled?

Dividends from State-Owned Enterprises

Budget Hole

Stocks Owned by the State

Long-Term Material Assets Owned by the State

Financial Assets Owned by the State

Total Assets Owned by the State

Filling 2012 Budget Hole• No privatization pursued

• Spending cut fully filled the budget hole

• Politicians’ competition led to introduction of:

→ Residential property tax of 1% property market value (with a significantly high tax-exempt value)

→ Copyright levy on devices

→ Land tax potentially raised from 1.5% to 4%

→ Raised taxes on natural resources, buses and cargo vehicles

• Plans for more new and higher taxes

Lessons from the Lithuanian case

• Horizontal spending cuts of 2009-2010 were needed, but were not enough

• State social insurance systems are very vulnerable to negative economic changes and need reforms

• Lack of efficiency indicators means inability to prioritize spending and pursue vertical spending cuts

Lessons from the Lithuanian case

• Inclination to raise taxes – something the private sector cannot do!

• Reaffirmation of Laffer’s curve: tax hikes result in lower revenues

• Prepare for contractions before they come: identify wasteful spending, make priorities and be ready to cut the less relevant spending

• Spending should not be rigid – it should be adjusted to revenues

Thank you!