IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
In recent years, the Baltic States have been showcased as an austerity success story. While the whole world has seen countries such as Greece, Spain and Portugal struggling to reduce their public spending, Lithuania has been hailed as an austerity example. Lithuanian success in public spending cuts has been widely acknowledged; yet simultaneous tax increases and their harmful effects have received less attention. Since the end of 2011, however, the country once again found itself embroiled in a budget crisis and is now moving down the dangerous road of tax hikes.
This suggests that something was not done properly. What can be learned from the Lithuanian experience that can be useful to countries going for austerity measures? Let us find out.
Lithuania began pursuing austerity measures in late 2008, when a new right-wing coalition government came to power to find a gaping hole in state finances. Lithuania being one of the few countries that operate under a Currency Board arrangement, the Lithuanian Central Bank cannot finance government spending through inflationary measures. In the absence of a monetary solution (if there is one) to an economic crisis, the government is really forced to focus exclusively on budgetary policy. It comes therefore as no surprise that the parliament passed numerous tax laws that raised the corporate income tax from 15% to 20%, VAT from 18% to 19% (soon followed by a further increase to 21%), excise duties, abolished “reduced VAT rates” and increased the tax burden on individual business owners and artists. On the spending side, the parliament cut some of the planned expenditure but the actual spending for 2009 was about LTL 370 million (€ 106 million) or 1.4% higher than in 2008.
Within months it became apparent that the projected tax revenues were too optimistic and the parliament had to amend the budget on the basis of those lower revenue expectations. The enormous “budget cuts” the politicians talked about turned out to be cuts in expected revenues: by July, expected revenues from corporate income tax were reduced to 59% of their original level, revenues from VAT – to 73%, and revenues from excise duties – to 82%. The main reason for lower tax revenues were a sharp GDP contraction of 15% and an expanding shadow economy, a direct result of lower demand and higher tax rates. According to the Lithuanian Free Market Institute’s survey, the shadow economy grew from 18% GDP in 2008 to 23% in 2009 and 27% in 2010. This outcome is in line with Laffer’s curve, suggesting that Lithuania was on the right-hand side of the curve whereby higher tax rates result in lower tax revenues.
Falling tax revenues were not accompanied by appropriate expenditure cuts, leading to a steep growth of sovereign debt. In the span of just one year, total sovereign debt in absolute terms grew by 56% - from 16% GDP in 2008 to 29% GDP in 2009. Modest spending cuts came in mid-2009, with some further cuts in 2010.
Cutting spending can be done in a number of ways – cutting planned increases in expenditure, horizontal spending cuts (decreasing spending all across the board by, say, 5-10%) and vertical spending cuts. Cutting spending all across the board is easier to implement than vertical spending cuts, but there is a limit up to which horizontal spending cuts can be done (for example, cutting all spending by 50%, including salaries, would be very difficult to do). Horizontal spending cuts lower the quality of services provided by the public sector (for example, if teachers, policemen or firemen are being forced to go on unpaid leave or if courts can no longer use phones) resulting in consumers’ dissatisfaction. The Lithuanian government implemented the first two ways of cutting spending, while the third instrument of vertical spending cuts has not been undertaken. Vertical spending cuts would have required urgently needed reforms in healthcare and social security sectors and elimination of unnecessary budget programs. Due to an absence of budget programs’ efficiency indicators, the government was unable to identify unnecessary budget programs.
Forgoing on planned expenditure increases and introducing horizontal spending cuts meant that none of the public sector’s functions were relinquished, but that the same functions had to be performed with less funding. Bureaucrats’ salaries were cut by 8-36%, with overall spending on bureaucrats’ salaries decreasing by 19.1% in 2010 compared to 2008. However, since salaries of civil servants constitute only around a tenth of state budget spending, salary cuts meant only modest spending cuts of the overall budget.
The government did introduce one improvement to the state budget – as of 2011, the law on state budget contains a clause stipulating that a mandatory amendment will be automatically triggered whenever budget revenues fall below their expected level. Such “conditionality” of the budget has been proposed by the Lithuanian Free Market Institute for over a decade and it partially found its way into law during those fiscally challenging times. This “conditionality” of the budget has not been entirely implemented, however, since a true implementation would require assigning priorities to different budget programs (such as “very important”, “important” and “less relevant”) and in case of a budget revenue shortfall, budget allocations to the “less relevant” programs would be automatically suspended.
In 2011, the economic hardship and budgetary woes seemed to be over as the economic growth picked up to 5.9%. Prepared in mid-October, the draft of 2012 state budget envisioned a 9% growth in revenues and 1% growth in expenditure. But, by late November, renewed growth forecasts for 2012 appeared bleaker and the country once again found itself in the epicenter of a budget crisis. The newly-formed budget gap amounted to 1 billion Litas (€ 290 million) or 3.8% of projected budget revenues.
Because no proper “conditionality” requirement exists, the government proposed initially to plug the budget gap by increasing the VAT from 21% to 23%. Yet, facing widespread public and political opposition, it soon backed down and instead agreed to a LTL 1 billion spending cut. The budget gap problem appeared, once again, to be solved, but numerous politicians exploited the situation as a publicity campaign and began proposing myriad new taxes. The social democrats pulled out their traditional idea of progressive income taxation, which surprisingly found some admirers among the right-wing conservatives-Christian democrats. Most politicians began exploiting the “greed card”, calling for taxation of luxuries such as villas, expensive cars, diamonds, etc.
Eventually, the parliament introduced a residential property tax of 1% property market value (with a significantly high tax-exempt value); a new copyright levy on devices such as cell phones and hard drives; also increased were taxes on land, natural resources, buses and cargo vehicles. In the spring of 2012, politicians plan to return to the issues of progressive income taxation, automobile taxes and taxing interest income. Among possible plans is the lowering or elimination of the tax-exempt value of a family’s residential property, meaning that residential property tax, an idea originally “sold” to sympathetic public as a luxury tax, would become universal.
The Lithuanian example indicates that the spending cuts introduced in mid-2009 were much needed, but were undertaken on a much smaller scale than required to prevent the country from falling into another budget crisis at the end of 2011. The lack of efficiency indicators of budget programs and the absence of prioritization within spending has contributed to the government’s inability to undertake vertical spending cuts that would have allowed the country to get rid of wasteful spending and abolish unnecessary budget programs. In contrast to the private sector, which in an economic crisis has no other choice but to contract, in the public domain there is a vicious inclination to raise taxes rather than cut spending. The Lithuanian case also reaffirms Laffer’s curve, whereby tax hikes resulted in lower tax revenues. However, this lesson has not yet been learned by the Lithuanian politicians who have once again endeavored down the path of higher taxes, holding ungrounded hopes this will result in a different outcome.
To conclude, countries should prepare themselves for possible contractions before they come, identifying wasteful programs, stipulating priorities in government spending and being ready to cut the less relevant spending. Government spending should not be rigid and disregarding economic realities, instead it should adjust itself according to budget revenues. This is the only way to avoid painful tax increases, which do not always bring in more revenues and only deepen the recessions.