Project “Reform Round Table”

In 1998 LFMI participated in a Reform Round Table project organised by the International Centre for Economic Growth (ICEG). The goal of the project was to facilitate the transformation of the economies of Central and Eastern Europe and the former Soviet Union from the centrally planned to the market-driven model by making available information on the changes in the health care and pension system in the context of public redistribution.

As a result of this project, LFMI developed and disseminated two analytical studies. The first study looked at changes in the health care and pension system in the context of public redistribution. It laid out analysis of the 1995 pension reform (with special focus on the new model, modification of the pension formula, and an increase in the retirement age) and a compulsory health insurance system introduced under the 1997 reform. Finally, the paper presented alternative models for social security reform.

The other study investigated tax policy developments and the prospects for reform. The experience of Western nations in building and replacing tax systems was explored, identifying potential pitfalls for the nations in transit contemplating similar tax models. The aims of tax reform are defined along free market lines. LFMI gives a detailed account of the three forms of a tax burden – direct, indirect and hidden, and elucidates ways to lower them. LFMI presents principles of a pro-liberal tax system and a formula for building a tax system consistent with the said principles. Individual taxes are investigated in terms of their compliance with the principles in question as well as the goals of a pro-liberal tax reform.

The studies were translated into Russian and about one hundred copies were disseminated to policy research institutes and other NGOs around the world.

Changes in the Health Care and Pension System in the Context of Public Redistribution


An important task facing countries undergoing a transition from a planned to market economy is to consistently and consciously cut down on government functions, entrusting them to the private sector. Health care and retirement provision are, as a rule, the first areas to undergo changes. It is obvious that the choice of reform models determine not only the success and efficiency in supplying these services, but also the soundness of the whole economy and the extent to which the public sector (redistribution) exerts pressure on the private one.

Over the last years Lithuania has instituted some changes to the social safety net. Of these, the most important are the 1995 pension reform and the 1997 health care reform. Yet, the aforesaid policy shifts failed to reduce the ever-increasing redistribution, as will the changes scheduled for the near future. According to LFMI’s data, in 1993 taxes accounted for 28.2 percent of GDP, and in 1996 this indicator peaked at 34.2 percent. This paper is aimed at providing some insight into why recent changes are unacceptable and contradictory to Lithuania’s general direction of reforms. It will also delineate principles that should guide the creation of a viable and efficient health care and pension system. Although based on Lithuanian data and reform experience, this material is targeted at any country in transition.

Health care reform has long been on Lithuania’s reform agenda. 1996 saw the adoption of a new law on health insurance, a law whose preparation was initiated three years ago. The law in question introduced a centralized, inflexible system disregarding private medical service suppliers and private insurance companies. The health care system is now financed from mandatory contributions payable to the health insurance fund. The state budget contributes to the system on behalf of children, pensioners, unemployed, and some other groups of residents, who constitute the majority of the insured. Thus, the formation of a health insurance fund builds on some obscure mixture of budgetary and insurance-type financing.

Insurance principles fail to be consistently applied in paying for medical services. There is a whole range of free services. Certain services are rendered and compensations (e.g. for medicines) are available to the insured and those not covered by insurance alike. Medical services are provided at fixed prices.

The aforesaid reforms are very unlikely to create an efficient system of financing health care insurance. Given that medical establishments will be interested in swelling their expenses, sickness funds will constantly lack money and the state budget will be forced to subsidize them. Mandatory public health insurance will operate on purely administrative principles. There will be no room for competition, therefore the system will fail to achieve the desired objective of high quality of services.

What principles of health insurance would help create a financially sustainable and efficient health care? First and foremost, health insurance should be based on real but not “pseudo” principles. No medical services should be free of charge, save some basic services provided for socially assisted groups. Their prices should be established by market forces, and health insurance should help patients pay these prices. Patients should have a right to choose among service suppliers and insurers. Public establishments and private health care entities and insurance companies should operate under equal rules and with equal rights. Unrestricted competition and patients’ right to choose on the market would eventually force out-moded and inefficient structures out of the market, allowing customers’ to receive the best value for their money. The Lithuanian Free Market Institute formulated and widely disseminated the aforesaid principles, gaining a broad-based support of specialists and the general public. The Lithuanian health insurance is to undergo certain changes. Yet, the path of compromise-making and repairing partly operating mechanisms would make it hard to create an appropriate system, much harder than installing an entirely new one.

The year 1995 saw changes to the pension system. Until 1995, Lithuania had been operating virtually a flat pension system, a system that would prove to difficult to be adjusted to new needs. On the adoption of a new pension law, Lithuania switched to an earnings-related pension scheme. The reform was launched with the hope that it would give people an incentive to return to the legal labour market. Yet, that did not happen. The number of the insured continues to fall, showing that people lack confidence in the public pension system.

Lithuania’s problems in the area of pension insurance are similar to those in other Central and Eastern European countries. Social insurance expenditures have been steadily increasing, reaching the present level of 9 percent of GDP. The social insurance budget is continuously suffering a deficit, even though the size of pensions is on the edge of poverty and insufficient to live on (the average pension is about USD 55). The pension replacement rate has declined from 50 percent in 1992 to below 40 percent today. Further, the pension insurance system is already under strain because of the aging population. The number of people under the retirement age has been increasing and constitutes today about 20 percent of the country’s population. Regrettably, many social benefits are irrational and badly targeted. Social outlays, which continue to increase, are inefficient and place a cumbersome burden on the society.

The recent pension reform failed to live up to the desired objectives of facilitating pension financing and providing safe retirement. There is an evident need for a more massive reform of retirement provision. Lithuania should switch from the earnings-related pension model to flat, subsistence-level, pensions financed from the state budget. Under a two-pillar pension system, state pensions would provide only minimal retirement benefits. The second-tier would provide fully-funded optional pensions administered by private managers. A draft law on private pension funds has been prepared, laying the legal foundations for the accumulation and disbursement of fully funded pensions. The bill is scheduled for government approval and submission to parliament shortly. The proposed system will operate on a defined-contributions scheme. Pension fund members will pay pension contributions to personal accounts, which will be administered separately. These contributions will be invested, and investment returns will be accrued on personal accounts in proportion to accumulated amounts.

With private pension insurance in effect, it will be essential to redesign the financing of the public pension scheme. At first, it will be essential to exempt payments to private pension funds and gradually reduce the rate of social security contribution payable by pension fund members. Later, after revising the principles of budget formation, the separate social insurance budget will have to be eliminated, and public pensions will be financed from the state budget. A reform like this would significantly contribute to improving the business climate and promoting competition. The current system of financing the social insurance budget by means of a painful and extraordinary taxation of labour force hampers economic transformation, stimulates shadow labour relationships, and stifles economic competitiveness.

Pension funds as major saving and investment institutions will contribute significantly to the development of the capital market. The institutionalisation of retirement savings become, as a rule, a major force behind financial innovations. An increased supply of capital accumulated by pension funds will makes it grow cheaper, facilitating considerably enterprise financing.

The implementation of the aforesaid principles in redesigning the pension and medicare systems would create prerequisites for (i) the development of a competitive economy and (ii) revision of other functions that are currently under state control. Reductions in redistribution would not be an end in itself. The underlying idea of the proposed transformations would be a consistent and conscious denationalisation of economic and social life as well as renunciation of the paternalist government vision, giving way to private initiative and responsibility.

Tax Reform and Tax Policy Development


In redesigning their tax systems, post-socialist countries can either install indigenous tax systems or rely on world-wide experience. In most cases the countries in transition copy Western tax systems, systems that developed over many years and under the influence of various interests and factors. These systems contain a host of weaknesses, such as multiple taxation, progressive tax rates, widespread relief and exemptions, ambiguous and complex tax rules, costly administration, and a heavy tax burden. Taxes are used as a regulating tool, distorting the workings of the market and providing an open invitation to corruption, tax evasion, and arbitrary disbursement of the tax burden. The paper expands on the defects of such systems, identifying potential pitfalls involved in their adoption.

The purpose of tax reform should be to reduce the tax burden so as to create the most favourable conditions for the pursuit of well-being and achieve the most efficient allocation of resources. Tax reforms should be aimed at minimising destructive and distortionary effects of taxes on economic processes and market agents, cutting down the cost of tax administration, as well as easing and levelling the tax burden.

The tax burden is determined by the attitude to the role and functions of the state. The tax burden is threefold: direct, or paid in taxes, indirect, or the costs of tax compliance and administration, and hidden, or the impact of taxes on the economy and allocation of resources. To lift the direct tax burden, a budget reform should be adopted, aiming at privatisation of government functions, expedient financing, and a balanced and transparent budget. For the indirect tax burden to be reduced, tax systems should be replaced, enacting simple and accurate procedures for tax computation and payment as well as automatic tax administration that would occur regardless of the administrator’s will. To minimise the hidden tax burden, an economically neutral tax system must be installed, a system that would do the least possible damage to economic activity and perform, not a regulating, but revenue-generating role.

The identification of fundamental principles of a new system is vital for a consistent enactment of the reform and prevention of eclectic, incoherent decision. The principles that would allow to construct an economically neutral, simple, automatic and pro-growth tax system are the following principles: the revenue-generating, not regulating, role of taxes; the least effect on economic activity; fairness; a declining tax burden; single taxation; transparency; universality and automaticity; and inexpensiveness of tax administration. These principles were used as the basis in constructing the whole tax code.

The paper explores all prevailing taxes in terms of their defects and compatibility with the aforesaid principles. The taxes analysed include corporate and personal income taxes, social security contributions, value-added tax, excise and customs duties, property taxes, etc. The analysis is supplemented with a comprehensive vision of reform and recommendations for the restructuring of individual taxes. VAT is identified as a tax most compatible with the principles attached to a simple, automatic and pro-growth tax system, therefore a shift from direct to indirect taxation-that is, the abolition of income taxes in favour of general VAT and earmarked taxes-is viewed as a means to achieve such a system. VAT, if applied without breaks and exemptions, operates automatically, can hardly be used as a regulating tool, and prevents voluntary decisions. As a result of the proposed reform, VAT would become the principal source of budget revenues.

There are two alternatives of eliminating direct income taxes. One of them consists of removing corporate income tax with a subsequent abolition of personal income tax. The other option involves concurrent reductions in both tax rates until their complete abolition. The former alternative is more acceptable politically but its adoption will not reduce the cumbersome burden imposed by personal income tax and social security contributions on labour force. Nor will it ease complex tax accounting and compliance procedures for companies. The second option is more acceptable from an economic point of view but given its longer implementation, it will require a strong commitment to reform on the part of the government.

To multiply the effect of the reform, tax revenues should become the only source of financing government functions. The remaining two sources-government borrowing and the dilution of the value of money-should be out lawed.