Results of the 2020 International Tax Competitiveness Index
Lithuania’s tax system is ranked the sixth most competitive and neutral in the OECD according to the Tax Foundation’s International Tax Competitiveness Index 2020 which was released on October 15th. Looking at the different areas of taxation, Lithuania ranks particularly well on corporate income taxes, individual income taxes, and property taxes, while consumption taxes and international tax rules receive average scores. However, it falls behind its Baltic neighbours – Estonia and Latvia, the top two countries in the ranking.
A tax code that is competitive and neutral promotes sustainable economic growth and investment while raising sufficient revenue for government priorities. While some see tax policy as a tool for directing investment decisions and managing incentives in an economy, the best approach is to let tax policy get out of the way of business and individual decision-making.
Current Economic and Budget Situation Due to Covid-19
Lithuania is among the countries least affected by COVID-19. GDP dropped by 3.7 percent in the second quarter of 2020, while the Eurozone suffered a 15 percent decline. European Union (EU) tourist destinations such as Spain, France, Italy, and Portugal were hit most (a 22.1 percent decline in Spain and a 16.3 percent decline in Portugal, for example). Compared to other EU Member States, Lithuania has an economic structure that is more resilient to the pandemic. The sectors that are the most sensitive to the coronavirus, such as tourism, accommodation services, culture & entertainment, healthcare, restaurants & food services, account for a lower share of Lithuania’s GDP than the countries that were most impacted by COVID-19. Instead, Lithuania’s economy relies more heavily on industry, construction, and transportation services; these sectors have been relatively more resilient in the short term.
Good management of COVID-19 on the health front helped Lithuania end up with lower economic losses. However, the country’s economic recovery remains atypical, with private consumption pulling the economy out of the pit, while industrial production is showing a slower comeback.
According to the latest forecasts, real GDP is expected to decrease by about 7,1 percent in 2020 and then bounce back by around 6.7 percent in 2021 (European Commission, EC). However, the Bank of Lithuania (LB) forecasts a 9.7 percent GDP decline in 2020 followed by growth of 8.3 percent in 2021. According to the EC, annual inflation is expected to stand at 0.8 percent in 2020 and reach 1.5 percent in 2021 (LB forecast is 0.6 percent and 0.9 percent respectively). In comparison, the EC expects the overall Euro area to contract by about 8.7 percent in 2020 before recovering 6.1 percent in 2021. Inflation in the Euro area is forecast at 0.3 percent for this year and 1.1 percent in 2021.
Budget revenue – pessimistic data:
In January through July 2020, revenues of state and municipal budgets fell by 6.4 percent (€400.1 million) compared to the same period in 2019, according to preliminary data from the Ministry of Finance. Revenues are down 12.7 percent (€851.7 million) compared to the fiscal plan for 2020.
National debt – hitting record high:
The Lithuanian government plans to spend €6.3 billion in the economy and on unemployment and social benefits within until the end of 2021. Borrowing will be the primary source of funding for this spending. National debt is expected to reach 50.2 percent of GDP (€22.5 billion) by the end of the 2020, an increase by one-third (about €5 billion) from 2019. In 2022, public debt is projected to rise by a further €2.6 billion, reaching €25.1 billion in total (52 percent of GDP). However, National Audit Office notes that if the crisis bounces back and the general government deficit is not reduced fast enough, public debt could approach the 60 percent threshold in the next couple of years.
Labor market – mismatches, caused by incautious policy:
In spring 2020 the EC had forecasted an 8.2 percent decline in wages for Lithuania, the largest in the EU, but wages grew by 8.5 percent in the second quarter of 2020 compared to the second quarter of 2019. Yet, not all labor market statistics allow the same level of optimism. Registered unemployment hit a record high of 13.7 percent, compared to 8 percent in September 2019. At the same time, over 40,000 job vacancies were registered in August, a record high in the past decade.
The Need for Long-term Pro-growth Tax Policy
Tax policy can be a significant contributor to a policy mix that promotes long-term growth. While some see tax policy as a tool for directing investment decisions and managing incentives in an economy, the best approach is to let tax policy get out of the way of business and individual decision-making.
Pro-growth tax policy is about raising revenue for government purposes in ways that cause the least amount of economic damage. This can be done by designing personal income tax systems so that high marginal tax rates do not push individuals away from working. It can also be done by ensuring that business’s hiring and investment decisions are not deterred by tax costs.
Tax policy should be set for the long-term and be predictable and transparent. A policy approach that utilizes temporary or targeted policies to spur investment in the near term can undermine longer-term growth by creating complexity and uncertainty.
In the current economy when there is significant uncertainty, a stable tax system that has low compliance costs is advantageous.
As businesses make investment and hiring decisions, they consider many factors including tax costs. Tax systems can create barriers to those decisions through high tax costs of employment or corporate taxes that significantly eat into returns on investment.
Lithuania has an opportunity to ensure long-term policy is geared toward growth rather than disrupting decisions by workers and employers. To understand what that opportunity could look like it is worth comparing Lithuania’s tax system to that of its neighbors and other countries around the world.
Results of the 2020 International Tax Competitiveness Index
According to the Tax Foundation’s International Tax Competitiveness Index, Lithuania’s tax system is the sixth most competitive and neutral in the OECD. The Index evaluates the tax systems of 36 countries in the Organisation for Economic Co-operation and Development (OECD) along more than 40 different measurements.
Looking at the different areas of taxation, Lithuania ranks particularly well on corporate income taxes, individual income taxes, and property taxes, while consumption taxes and international tax rules receive average scores.
Individual Income Taxes
Lithuania’s major labor tax reform has shifted almost all employer-side social security contributions to employees by reducing employer-side contributions and increasing both employee-side contributions and personal income taxes. To avoid reductions in employees’ net wages, employers were required to recalculate gross wages by increasing them by 28.9 percent.
The Baltic country has been relying heavily on tax revenue from social security contributions. In 2018, 42.1 percent of all tax revenue came from social security contributions and only 13.5 percent from personal income taxes, compared to OECD averages of 26.2 percent and 23.9 percent, respectively. In an effort to move labor taxation from social security contributions to personal income taxes, Lithuania has decreased its total social security taxes and switched from a 15 percent flat-tax to a two-bracket progressive personal income tax.
In 2019, the standard personal income tax rate increased from 15 percent to 20 percent. In 2020, the top rate was increased from 27 to 32 percent, applying to income exceeding 84 average monthly wages. The top income tax threshold is expected to be reduced to 60 times the average wage in 2021, further flattening the tax structure.
Business investments in machinery, buildings, and intangibles in Lithuania receive on average the third best tax treatment of all OECD countries, only after Estonia and Latvia. Lithuania’s short depreciation schedules allow businesses to quickly recover investment costs for tax purposes, making investments overall less costly. Lithuania currently levies a 15 percent corporate tax on profits exceeding €2 million, compared to an OECD average of 23.59 percent. For comparison, the other two Baltic countries, Estonia and Latvia, both operate a more competitive and neutral cash-flow tax on business profits, taxing profits only when they are distributed to shareholders.
Lithuania’s value-added tax (VAT) is structured as a standard 21 percent VAT rate levied on only approximately half of final consumption due to multiple exemptions and reduced rates, leaving room for base-broadening measures. A VAT with a lower rate and broader base limits economic distortions while raising significant revenue. Lithuania’s standard VAT rate is higher than the OECD average of 19.3 percent in 2019. Of the EU member states, Lithuania has the third-largest VAT gap of 25.9 percent.
Lithuania introduced a pollution tax ranging up to €540 for every car that is registered or re-registered. The tax is based on a vehicle’s carbon emissions and was implemented in 2020.
Lithuania currently ranks 23rd in the ITCI for consumption tax competitiveness.
The threshold for nontaxable noncommercial real estate was reduced for 2021 from €220,000 to €150,000, with a higher €200,000 threshold for families with three or more children. Property tax rates range from 0.5 percent to 2 percent.
Banks pay an additional 5 percent in addition to the standard corporate income tax.
Lithuania’s tax system is among the most competitive and neutral in the OECD, which contributes to making it an attractive place for both domestic and foreign investment. A tax code that is competitive and neutral promotes sustainable economic growth and investment while raising sufficient revenue for government priorities. However, this year Lithuania dropped from the fourth to the sixth position from 2019 and falls behind its Baltic neighbours – Estonia and Latvia, the top two countries in the ranking.
For the seventh year in a row, Estonia has the best tax code in the OECD. The country’s top score is due to four key elements: a 20 percent tax rate on corporate income, a flat 20 percent tax on individual income, a property tax only applying to land value and its territorial tax system exempting 100 percent of foreign profits earned by domestic corporations from taxation. The second place goes to Latvia for adopting the Estonian corporate tax system and enhancing its labour income tax.
Due to planned government recovery spending and reduced revenues as a result of COVID-19, Lithuania will need to raise additional revenue if it wants to avoid excessive deficits. Policymakers should be eyeing base-broadening measures such as levying the VAT on a larger share of final consumption and moving all goods to the standard rate, minimizing economic distortions.
Opportunities for pro-growth tax reforms
A zero-tax rate on reinvested profit as a key to regional competitiveness
Lithuania ranks the sixth in the International Tax Competitiveness Index 2020 and eleventh in the World Bank’s 2020 Doing Business report, partially due to a low corporate income tax rate of 15% and a relatively neutral treatment of capital investment cost. In recent years, Lithuania has enjoyed record high FDI flows, a rise of the fin-tech and the startup ecosystem, and industry and export development. Yet, Lithuania’s tax system is not as attractive as those in neighboring Latvia and Estonia. Lithuania is the only of the Baltic States that taxes reinvested business profit. Lithuania’s effective corporate and personal income tax burden is about 28 percent, while Latvia and Estonia apply a 20 percent tax rate. Ongoing talks in Lithuania about raising the personal tax on dividends from the current 15 percent to 20 percent can further drive capital to nearby jurisdictions. A zero-tax rate on reinvested profits would help Lithuania keep up with the neighboring countries in terms of attracting FDI and fostering an environment for domestic businesses to grow. This reform would be very timely in the light of COVID-19, when investment capital is hard to secure.
Lower consumption and income taxes as an antidote to the shadow economy
The current economic downturn may incentivize illicit consumption or undeclared work. As many as one in two people in Lithuania say they would consider buying cheaper goods from unofficial sources or from legitimate traders who do not declare their revenues if their financial circumstances worsened. Although labor taxes have decreased during the recent years due to the increase in the non-taxable minimum income and social security contribution cap, Lithuania’s relatively low household income reduces the affordability of legal goods and services. A further reduction in labor taxes in the form of increasing non-taxable income, equating it to the minimum monthly wage and/or returning to a flat 15 percent personal income tax rate and a return to the 18 percent VAT rate, which was temporarily raised to 21 percent during the recession of 2008, could help reverse this trend. Without reducing the standard VAT rate, adding more exemptions would only complicate the system and make it less efficient. Lithuania is particularly prone to undeclared excise goods due to its geographic location. Therefore, it is advisable to keep excise duties at a level comparable or lower than those in the neighboring countries.
Stability in the times of change
Lithuania ranks among the top countries in the International Tax Competitiveness Index, but it is plagued by notoriously frequent changes to tax laws. Research from the Lithuanian Free Market Institute shows that in the period from 2015 through 2019, Lithuanian tax laws were amended nearly every two weeks on average. Experiments with the tax system are expensive and every potential economic policy mistake can be critical in the long run. Adjustment costs, which fall on both companies and public administrators, are particularly painful for small and medium-sized companies. Frequent changes also damage the country’s reputation, as investors tend to be very sensitive to the stability of economic policy. The Lithuanian tax system is further destabilized by a provision that allows tax laws to be changed without a 6-month notice period if changes are proposed during annual budget negotiations. Eliminating this provision would contribute to stability in the Lithuanian tax system.
Proposals on sector-specific taxes threaten Lithuania’s reputation
Unfortunately, in Lithuania, it is still common practice to design tax initiatives in an incoherent way, based not on an assessment of need or an assessment of existing regulation, but on ad hoc rules. Proposals have been put forward to introduce sector-specific taxes, such as on banks, insurance companies and retail. Despite the political rhetoric surrounding those proposals, such taxes would fall on consumers and customers of financial institutions in the form of higher prices of goods and services, bank loans, and insurance. These taxes would undermine the predictability of the tax system, create additional barriers to market entry, and discredit the country in the eyes of foreign investors and international organizations. Sectoral taxes are also a discriminatory practice, criticized by the European Central Bank and the EU.