Lithuania’s Economic Policy and Affairs in 1998

The Macroeconomic Environment
According to the Department of Statistics, the country’s GDP rose by 4.4 percent in 1998, reaching 10,685 million US dollars and 2,900 US dollars per capita. The share of GDP contributed by the private sector remained at the level of 70 percent. The annual rate of inflation, measured as the consumer price index, was 2.4 according to the Department of Statistics.
LFMI’s survey of macroeconomic variables showed that economic agents (experts) were more realistic in estimating GDP growth prior to the economic collapse in Russia. In early 1998, official statistics predicted a 7-percent growth, while LFMI’s survey forecasted 5.8 percent. The prognoses for inflation were 6 and 9.9 percent respectively.
According to the Economic Ministry, capital investments totalled 1.622 million US dollars in 1998, or 18.2 percent more than in 1997. This was 15.2 percent of GDP, as compared to 14.3 percent in 1997.
As the Bank of Lithuania indicated, direct foreign investments rose by 56.2 percent in 1998, reaching 1,625.3 million US dollars, or 439 US dollars per capita.
In 1998, the foreign trade balance ran a deficit of 2,084 million US dollars, or 19.5 percent of GDP as compared to 10.6 percent in 1997. As compared with 1997, Lithuania’s exports dropped by 3.8 percent and imports rose by 2.7 percent. Before 1998 the pace of growth of foreign trade averaged 17.3 percent for exports and 26.9 percent for imports.
The current account deficit reached 12.1 percent of GDP during 1998 as compared to 10.3 percent in late 1997. At the same time, Lithuania’s official foreign reserves rose by more than one third, reaching 1,460 million US dollars at the end of 1998. Foreign currency reserves, which account for the biggest part of backing (almost 96 percent), rose by 37 percent over 1998 despite a 16-percent slump from August through December.
In 1998, the average monthly salary after tax rose by 26 percent and was 252 US dollars. The rate of unemployment was 6.4 percent.
Formation of the National Budget
A budget reform aimed at creating a transparent and effective system of public finance got off the ground in 1998. The parliament adopted new principles of budget formation, providing for (i) the formation of a balanced budget as of 1999 and adoption of a requisite constitutional law; (ii) programme budgeting; (iii) combining of state and municipal budgets plus extrabudgetary funds into a single budget; and (iv) planning of the state budget for a three-year period and approval of a one-year budget.
The adoption of a balanced budget for the year 1999, with revenues and expenditures each equalling 1,800.5 million US dollars, was the biggest innovation. However, it should be viewed with certain reservations. For one thing, budget revenues were projected on the assumption that GDP would grow by 5.5 percent and inflation by 5 percent. It is unclear at the moment what the government will do in case economic indicators prove to be more modest: raise taxes, reduce public spending or forego part of government expenditures altogether.
The government plans to borrow through 1999 up to 168 million US dollars more than to earmark for loan repayment. This suggests a fiscal deficit and living at the expense of tomorrow. The costs of servicing state debt are expected to rise from 8.4 percent in 1998 to 10.7 percent of the total state budget in 1999. In late 1998 state debt reached 2.401 million US dollars, or 22.5 percent of GDP. Foreign loans accounted for seven tenth of the total debt.
The state budget is not consolidated: It fails to reflect government expenditures allocated through a total of 22 extra-budgetary funds. If it did, the 1999 budget would be in deficit.
Other innovations include budget planning for a three-year period and programme budgeting. The latter means that money is not allotted to public funds’ administrators but earmarked for specific programmes. The principle of programme budgeting will prove hard to implement as it is still unclear what functions should be performed and financed by the state. The budget structure legislation defines public outlays in such a broad and implicit manner that even narrow group interests and personal needs may slip through the net. Under such conditions, programme budgeting will fail to enhance transparency and efficiency of government spending. To meet these objectives, it is essential to spell out all government functions and responsibilities.
The share of GDP redistributed through the state and municipal budgets has been increasing. The level of redistribution rose from 25.8 percent in 1994 to 36 percent in 1998.
The Tax System
The government of Lithuania adopted a programme for revising tax legislation, defining six principles to be used in redesigning the existing tax system. The principles include proportional income taxation, uniform tax rules for all economic agents, a revenue-generating, as opposed to regulatory, role of taxes, clear and consistent tax rules, minimum effects of taxes on economic processes, a declining tax burden, transparency, and effective and inexpensive tax compliance and administration.
The main clause of the programme is to abolish corporate income tax and to offset the ensuing shortfall in revenues by broadening the tax base of non-residents’ income received from Lithuanian firms, taxing dividends, and widening the tax base of income and property taxes. Tax rates, except for excise duties, are not supposed to increase.
In 1998 changes were made to corporate and personal income taxation. A 15-percent withholding tax was introduced on foreign loan interest payable by Lithuanian legal persons and permanent offices. A 29-percent was imposed on dividends received from Lithuanian companies. Dividends received by Lithuanian companies were taxed at the rates of 24 and 29 percent. The regular corporate income tax rate of 29 percent was imposed on permanent offices, or dependent branches or subdivisions, of foreign entities.
The aforesaid programme states that lower corporate and personal income tax rates should be levied on small and medium-sized enterprises until corporation tax is removed. For this reason tax benefits and exemptions were not eliminated.
The income tax base was broadened by imposing taxes on dividends and capital gains. As of January 1999, dividends received by individuals are taxed at the rate of 29 percent. A 15-percent tax is levied on capital gains, or an increase in the money value of securities, unless they are reinvested or exceed twelve tax-exempt minimums in one year. The latter decision was adopted in response to the criticism from capital market participants that taxation of investment funds with a corporation tax without taxing other investors impedes the rise of investment funds in Lithuania. Under the new rules, investment income generated by investment funds is not taxed. The programme for revising the tax code provides that all types of income will be subject to a uniform tax rate of 29 percent after the income tax base has been expanded.
The new rules of income taxation defines an optional method of the computation of investment, by which both a company’s own money and borrowed capital used for investment purposes are made tax-deductible. Prior to that, a zero tax rate was applied only to reinvested income. The laws do not allow companies to replace a chosen method of investment computation.
In addition, it is planned to widen the property tax base by introducing a tax on real estate of individuals (land owners ineligible for tax relief pay land tax under a separate legislation). Presently, real estate tax is levied on buildings and paid by legal entities and companies without the status of legal persons.
Resorting to inadequate measures to bolster tax collection has become a tradition of late. 1997 saw the launch of a “fierce action” against free riders. The action failed to bring desired results. Instead, it multiplied the instances of forced bankruptcies and litigation. Misguided notions of wilful violations of the tax code remain in use. At this point it should be noted that under the existing convoluted and muddled tax legislation, violations of rules are natural and inevitable.
Under the new amendments, a commission for settling tax disputes was set up. Tax disputes are now investigated by local tax administrators. Their decisions may be appealed to the central tax administrator. The latter’s verdict may be appealed to the said commission, and the commission’s decisions may be appealed to a court. The establishment of this new institution lengthens a taxpayer’s route to court. Thus, its purpose of safeguarding taxpayers’ interests looks of a rather questionable kind.
Late in 1998 the government forfeited the right to set excise duties. This right is now vested in parliament. The beginning of 1999 saw an increase in excise duties on fuel, alcohol, tobacco, and other goods. Excise duties on fuel are scheduled to be increased in three phases. As of January 1999, excise duties rose by 22 percent. They will grow by another 18 percent as of 2000 and by yet another 15 percent as of 2001. Excise duties on fuel were raised by 22 percent in the spring of 1998. An increase in excise duties is motivated by Lithuania’s aspirations to join the European Union. Indeed, the level of excise duties in Lithuania is lower than in the EU, but the European Commission does not indicate this as an obstacle for negotiation talks.
Changes were made to the rules governing value added tax payers. Persons whose annual income is not in excess of 2,500 US dollars are not VAT payers. If income ranges between 2,500 and 25,000 US dollars, a person may choose whether to become or not a VAT payer. If income exceeds 25,000 US dollars, to become a VAT payer is obligatory. According to the programme for revising tax legislation, VAT will not be raised in the future. Currently, VAT is applied at a zero-rate (on exports) and at the rate of 18 percent.
In 1998 Lithuania signed agreements on double taxation avoidance with Ireland, Iceland and Moldova. Such treaties are in effect with fifteen other countries, including Norway, Finland, Sweden, Poland, the Czech Republic, Latvia, Estonia, Belarus, China, Italy, Canada, Kazakhstan, France, the Ukraine, and Germany.
Money and capital markets
Over 1998 litas remained a stable, strong currency. The Bank of Lithuania’s interventions in the money market were minimal, while shaky neighbouring markets urged Lithuanian authorities to continue to adhere to currency board principles. According to the Bank of Lithuania, litas will be unpegged from US dollar and linked to a basket of US dollar and euro not earlier than in the year 2000. The Bank of Lithuania has repeatedly reiterated that litas will not be devalued in the process.
The crisis in Russia did not have much effect on the banking system in Lithuania. At the outset of Russia’s economic downfall (August 1998) the Bank of Lithuania’s investments in Russia accounted for a mere 1.5 percent of total banking assets. The indicators of Lithuanian banks kept improving throughout 1998. The assets rose by more than one third, while the capital doubled.
In 1998 loans granted by Lithuanian banks to the private sector increased by one tenth to constitute 1,013.9 million US dollars. Time deposits in banks rose by 27 percent, to 660.5 million US dollars. Time deposits in foreign currency increased by 29 percent, and in litas by 22 percent. More than seven in every ten litas were time deposits in foreign currency. Lithuanian commercial banks’ liabilities to non-resident banks had more than doubled. The total amount of liabilities to foreigners had reached 410 million US dollars.
The average annual interest rates on loans ranged between 10.7 and 13.7 percent in litas and between 9.8 and 11.2 percent in foreign currency. The average annual interest rate on time deposits ranged between 5.5 and 6.7 percent in litas, and between 4 and 4.5 percent in foreign currency. After the crisis in Russia interests rates on both loans and time deposits somewhat increased.
Interest rates on treasury bills rose after the crisis in Russia by an average of 3.2 percentage points and were about 13 percent at the end of December. The largest investors into treasury bills are Lithuanian banks, whose share was close to 70 in late October. The share of foreign buyers was less than 4 percent.
The shares of the blue-chips, which are most actively traded on the National Stock Exchange, fell by 40 percent over 1998. Market participants believe that low prices are likely to attract more investors shortly. Still, a rise of the market is rather unlikely. Non-resident investments in shares fell by nearly one third. Resident investments increased by less than 2 percent.
The Bank of Lithuania prepared a package of measures designed to reduce the current account deficit. The main focus is on promoting exports and saving as well as restricting the use of imported goods and services by state and municipal institutions. The imposition of a 15-percent tax on interest payable abroad, a measure intended to restrict the inflow of borrowed capital, received a barrage of criticism. It is expected that this position will be either softened by exempting interest payable to banks or abandoned altogether. Analysis of the current account deficit shows that this situation is largely due to extensive state borrowing. Therefore, proposals have been voiced to do away with the state’s fiscal deficit rather than restrict the inflow of private capital.
State economic activity and regulation
Last year 344 objects were privatised for 582.2 million US dollars. This was by 73 objects more than in 1997. The largest share, four fifth, of income from privatisation was received from the sale of a 60-percent stake in the Lithuanian Telecom.
According to the functioning laws, two thirds of proceeds from privatisation will go towards repaying residents’ savings lost to rouble depreciation. This project will require 851.3 million dollars. In order to prevent a sudden increase in consumption, the government defined stages by which different groups of population would be allowed to freely dispose of repaid savings. The government offered a savings programme under which depositors who opt to keep the money in their accounts are paid interest 1.5 to 3 percentage points above the regular rate.
In late 1998 the first group of people freely disposed of repaid savings in the amount of 101.7 million US dollars. According to the Ministry of Finance, only half of the savings were withdrawn.
Privatisation of the only oil transportation and refinery complex, Mažeikių Nafta, provoked much public debate. This was the second case after the sale of the Lithuanian Telecom when exclusive conditions had been afforded to investors (the Lithuanian Telecom was given monopoly rights for five years). In the oil case, a US-based Williams International company was recognised by the parliament as a strategic investor and was granted the right to obtain a 33-percent stake. The parliament decree states that if the value of the company is at a certain time lower than the projected amount (300 million US dollars), the Mažeikių Nafta will be obliged to repay the investor up to half of the total investment amount. The terms of the agreement were not limited to this privilege.
The remaining two state-owned banks failed to be privatised last year. After futile attempts to sell the troubled Lithuanian State Commercial Bank, the bank was merged in early 1998 with the state Lithuanian Savings Bank. The government is going to privatise the Lithuania Savings Bank only after the sale of the Lithuanian Agricultural Bank. The sale is scheduled for the first half of 1999.
The government adopted a range of new regulatory levers. Last year new business and agricultural aid programmes were launched. In late June the government passed a programme for regulating and promoting export of agricultural and food products, which provides for new interventions of buying up grain, meat, and dairy products. A special agency was set up to organise the buying up of surplus products, storage, and realisation. This indicates that instead of curtailing its involvement in economic affairs, the state is expanding it.
As of January 1999 a law on SME development came into force. The main objective of the law is to create favourable conditions for starting and running a business activity. From now on any firm qualifying as a small or medium-sized business may seek from state or municipal authorities financial support, tax favours, and other privileges. This means that people’s energy and resources will be focused by and large on soliciting government largesse rather than on doing business.
The adoption of the law prompted a barrage of criticism and intense debates on business deregulation. A deregulation process was initiated, aiming to remove barriers on market entry and regulatory constraints on business activity.
In late October the government approved a strategy for export development for the years 1999 through 2001. The strategy defines a number of measures for export promotion, including training of exporters, creation of an information basis about foreign markets, financial support, non-tariff restrictions on import and a policy of developing infant industry.
The European Integration
During the Luxembourg Summit in late 1997 Lithuania was not invited to start accession negotiations with the EU. However, a decision was made that on the European Commission’s recommendation Lithuania would be able to start negotiations without approval of the European Council. In late October the European Commission released a report, concluding that Lithuania was not ready for accession and not recommending to begin negotiations.
The report mentions that in the near future Lithuania will not be able to withstand the pressure of competition and market forces within the EU. Also, “[…] significant efforts are still needed to fully address priorities in the areas of energy (establishment of a comprehensive long term energy strategy including the question of Ignalina); economic reform (establishment of a medium term economic programme); administrative capacity (especially public administration reform); internal market (public procurement, competition, state aids) and JHA (improvement of border management).”
Yet, the European Commission acknowledged Lithuania’s stable macroeconomic environment and the progress made in making its legal system compatible with EU standards, as well as the improved banking supervision.