The Lithuanian Economy

Monthly newsletter from Swedbanks Economic Research Department by Vaiva ekut and Laura Galdikien No. 1 8 February 2013

Public finances are sound, but shadow economy remains a problem

National budget revenue last year increased by 7.9% compared with 2011 and was 0.6% higher than planned. Revenues from personal income and profit taxes were significantly above plans; however, revenues from value added taxes (VAT) and excise duties were lower. There are indications that the efficiency of VAT and excise duties collection deteriorated last year. Interest rate developments have been favourable lately; however, the borrowing need for 2013 is estimated at LTL 7.3 billion, and the current ample liquidity situation in the financial markets will not be permanent. To strengthen the revenue base and reduce borrowing needs, it is important to continue to fight the shadow economy.
Higher-than-planned budget revenues
Budget collection in 2012 reflected the strong performance of the Lithuanian economy. Annual national budget revenue increased by 7.9% and was 0.6% higher than planned. The forecast of the Ministry of Finance was rather conservative, and employment and profits increased more than expected. The more rapid job creation was the main reason why unemployment last year decreased more than the ministry forecast. Personal income tax revenues were 5.9% higher than planned, and profit tax revenues exceeded the target by 21.8%. Strong employment growth and increasing profitability explain these developments.
State budget revenues in 2012, m LTL
24000 20000 16000 12000 8000 4000 0 -4000 Budget (EU supp.excl) VAT PIT Excise duties Prof it tax 99.3 97.6 105.5 98.7 121.8 124 120 116 112 108 104 100 96

Also, revenues from social security funds exceeded expectations, and expenditures grew by less than planned. Revenues were 3.8% higher than planned and 5.1% higher than a year ago. The number of insured has increased more than the number of employed by 31,900 and 21,400 respectively, indicating a somewhat smaller unofficial remuneration.

Shadow economy still larger than expected

The tax collection plans for VAT and excise duties were too ambitious revenues were, respectively, 2.4% and 1.3% lower than planned. During 2012, the efficiency of VAT collection must have deteriorated. According to our estimation, the cefficiency ratio1 decreased from 46.2% in 2011 to 45.0% in 2012. The ratio of excise tax revenue to household consumption fell marginally from 4.7% to 4.6%. If the efficiency ratios had not decreased, VAT and excise revenue would have been slightly above the plan. However, there were some increase in excise duties and the income level from which VAT is applied was lifted in 2012. This means that excise duties collection efficiency probably decreased more and VAT somewhat less. One reason for the unfulfilled expectations was the failure to introduce cash registers in all covered market places. Too many exceptions were

2012 actual 2011 actual

2012 plan Plan execution, % (rs) Source: Ministry of Finance.

1

The ratio of VAT revenue to consumption, divided by the standard tax rate.

Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000 E-mail: ek.sekr@swedbank.com www.swedbank.com Legally responsible publisher: Magnus Alvesson, +46-8-5859 3341. Nerijus Maiulis, +370 5 2582237. Vaiva ekut, +370 5 258 2156, Laura Galdikien, +370 5 258 2275

The Lithuanian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 8 February 2013

introduced, and the majority of nonfood products continued to be sold unofficially and not taxed. Even though these ratios are only approximate, as the exact tax base is not calculated, there are other signs that the shadow economy might not be decreasing in some areas. Overall tax revenue as a percent of GDP and as a share of domestic demand decreased in the third quarter last year.
General government balance and tax revenues
25 24 18 20 12 6 15 0 -6 10 2007 -12 2008 2009 2010 2011 2012 General gov ernment balance, % of GDP (rs) Tax rev enue, % of domestic demand Tax rev enue, % of GDP Sources: Ministry of Finance and Swedbank.

prices of necessities and the probability that the savings rate will not decrease much further. We expect Lithuania will maintain fiscal discipline this year. The budget deficit will decrease to 2.5%, and public debt is estimated to fall from its peak of 40.9% of GDP in 2012 to 38.4% of GDP in 2013. Still, borrowing needs for 2013 are estimated at LTL 7.3 billion. It is planned that the main part (75-80%) will be raised in the domestic market. Interest rate developments have been favourable. At the end of January, Lithuania borrowed EUR 400 million for five years at 2.63% annual interest--one of the lowest rates in its history.
Lithuanias credit default swaps (CDS), basis points
450 400 350 300 250 200 150 100 50

Moreover, according to the Nielsen empty-pack survey, the share of smuggled cigarettes in Lithuania increased significantly in the last quarter of 2012 after decreasing for one-and-a-half years.
A share of smuggled cigarettes in Lithuania, %
45 40 34.6 35 30 25 20 15 10 2009Q2 2010Q2 2011Q2 2012Q2 Source: Nielsen empty pack surv ey . 12.6 21.3 30.8 29.3 41.5 43.0

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CDS (USD, 5 y ear)

CDS (USD, 10 y ear) Source: Bloomberg.

Reducing the size of the shadow economy should be a priority

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The current excess liquidity in financial markets will not be permanent, nor will the low interest rates. One way to alleviate the borrowing needs of the government would be to reduce the size of the shadow economy. In 2012, the shadow economy in Lithuania was measured to account for about 26% of the GDP.2 More efficient tax collection would strengthen public balances and ease the pressure arising from decreasing support from EU structural funds. Therefore, one of the main priorities of the government should be to increase its efforts to make the shadow economy official and, thereby, reduce tax evasion. The size of the shadow economy not only affects public finances through lost tax income but also increases the tax burden for those who operate legally. Therefore, in order to compensate for the lost tax revenues from decreased labour taxation,

Public finances will continue to improve

This year, income tax revenue will be supported by further increases in employment and faster growth of wages. Revenues from VAT and excise duties are to a large extent dependent on household sentiment and consumption growth, the latter of which is forecast to fall from a growth of 4% last year to 3% this year. This is mainly due to rising

Lithuanian Free Market Institute, Lithuanian Shadow Economy,,2012.

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The Lithuanian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 8 February 2013

tax reform should also involve measures to fight the shadow economy. The smuggling of cigarettes, alcohol, fuel, and other goods accounts for about one-third of the shadow economy. Illegal work and unofficial remuneration, unaccounted sales of goods and services, and sales of illegal goods and services also account for a significant part of lost revenues. The main reasons for illegal work and unofficial remuneration are the inefficient enforcement of tax collection rules and high labour taxation. In 2012, the tax wedge3 on labour in Lithuania was almost 40%. In addition, rigid labour market regulation, as well as the complicated tax system, has a negative effect on employers willingness to engage in legal employment relations. One important way to deal with illegal work and tax evasion would be to continue easing the tax burden on labour (such as, e.g., in countries like Ireland, Cyprus, and Malta, where labour tax rates are half those of Lithuania's). In a country with a weak tax morale, shifting the tax burden from labour to unproductive assets (e.g., personal cars) could be more efficient in lowering tax evasion. Easing the regulations of employment relations and simplifying the tax system could also help to reduce the levels of illegal work. In addition, the fines should be sufficiently high, so that the expected costs of fraudulent behaviour exceed the benefits. Also, tax law compliance could be improved by making the manager of the company, instead of the owner, responsible for illegal employment. Moreover, limiting the time period in which the unemployment and social benefits can be received might be a helpful measure against unemployment benefit fraud; it would also stimulate a faster return of the unemployed to the labour market. Most important, however, is in our view is the lack of strong negative consequences for an employee receiving an unofficial wage. Therefore, it would be useful to tie the services and benefits the person receives from the state to taxes paid by creating virtual accounts or a points system, whereby a person could track his taxes paid and the public services earned. In order to reduce the volumes of unaccounted sales of goods and services, it is necessary to eliminate legal possibilities for this kind of behaviour, not only by narrowing the range of business activities that can be carried out using business certificates, but also by expanding the
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mandatory use of cash registers. Since unaccounted sales are especially widespread in the restaurant sector, one of the ways to lower them would be to forgo the use of nonfiscal receipts4. Another measure to deal with unaccounted sales and tax evasion is to restrict the use of cash for payments; this approach is becoming increasingly popular in some EU countries, such as Italy, Spain, Greece, and Romania. This could entail setting a certain money limit above which all payments must go through the banking system, and restricting cash payments of wages in business and public sectors, as well as of all transfers by the government. In order to fight smuggling, it is necessary to use regular administrative measures effectively, including strengthening border protection, and increasing fines for violating customs formalities and bribing officials. The risks of being caught and of being punished still remain relatively low, and this encourages criminal activities. Furthermore, lowering the scale of smuggling and the sales of those goods requires spreading the responsibility for such crimes to all levels, i.e., punishing not just the direct smuggler, but also the people involved in the distribution and retail sale of those goods, as well as the final consumers. Another priority should be to reduce the widespread corruption amongst customs officers and politicians, and thereby limit their cooperation with smugglers and the tolerance for smuggled goods. One of the most important reasons for the large shadow economy in Lithuania is the weak tax morality. The inefficiency of the public sector, corruption, and low quality of public services reduce peoples willingness to pay taxes and induces them to engage in illegal activities. In order to deal with this problem, the government should strive to improve the quality of services (e.g., health care and higher education), enhance the efficiency of public institutions, and lower the level of corruption. Implementing such difficult reforms will require a strong political will. Tangible results will take time but reforms will pay off in the long term. Vaiva ekut Laura Galdikien

The tax wedge is defined as the difference between the cost of the employer and the take-home pay of the employee.

Only fiscal receipt ensures that the sum the customer pays will be properly accounted and all taxes will be paid.

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The Lithuanian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 8 February 2013

Swedbank Economic Research Department

SE-105 34 Stockholm Phone +46-8-5859 1028 ek.sekr@swedbank.com www.swedbank.com Legally responsible publisher Magnus Alvesson, +46-8-5859 3341. Nerijus Maiulis, +370 5 258 2237. Vaiva ekut, +370 5 258 2156. Laura Galdikien, +370 5 258 2275

Swedbanks monthly newsletter The Lithuanian Economy is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbanks monthly newsletter The Lithuanian Economy.

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