Cutting Deficits: Lessons from Lithuanian Austerity Kaetana Leontjeva Senior Policy Analyst Lithuanian Free Market Institute INESS Cutting Deficits Conference, Bratislava October 9, 2012

Presentation menu What austerity measures did we pursue in ? 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 spending Horizontal 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 spending Vertical 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 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!