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Cutting Deficits: Lessons from Lithuanian Austerity Kaetana Leontjeva Senior Policy Analyst Lithuanian Free Market Institute INESS Cutting Deficits Conference, Bratislava October 9, 2012 Presentation menu • What austerity measures did we pursue in 2008-2012? • How successful were they in cutting our budget deficit? • What useful lessons can we learn from the Lithuanian example? Situation in 2008 • • • • • Soft landing or hard landing? New center-right wing coalition Gaping hole in state finances Currency Board Focus on budgetary policy “Overnight” Tax Reform of 2008 • A relatively stable and predictable tax system changed overnight – 106 law articles amended • Tax increases: → Corporate income tax – from 15% to 20%; → VAT “temporarily” from 18% to 19%; → Excise duties on alcohol and energy products; → For individual business owners; → 5% VAT rates on food, etc. abolished After the Tax Reform • Tax increases did not bring about the expected results: → Projections of corporate income tax revenues cut to 59% of their original level → VAT revenues – to 73% → Excise duties’ revenues – to 82% • Deepened recession: GDP contraction of 15% • Surge in the shadow economy from 18% of GDP in 2008 to 27% in 2010, according to the Lithuanian Free Market Institute’s survey • Outcome in line with Laffer’s curve Laffer’s curve Further Tax Changes • The government rolled back some of the tax increases: → corporate income tax and excide duty on diesel reduced back to 2008 level → healthcare insurance contributions no longer levied on dividends • But, VAT was raised from 19% to 21% Ways of cutting spending Cutting planned increases in spending • Spend 100 EUR this year • Plan to spend 120 EUR next year • Cut spending to 110 EUR next year • Is this a spending cut? Ways of cutting spending Horizontal spending cuts: → easier to implement, but can be done up to a limit → lower the quality of service, result in customers’ dissatisfaction → doing the same with less money, so functions of the public sector do not change Ways of cutting spending Vertical spending cuts: → most needed, but difficult to implement: require muchneed reforms in healthcare and social security areas and elimination of unnecessary budget programs → reduce functions of the public sector Conditional budget • Spending should be made conditional on revenues • Proposed by the Lithuanian Free Market Institute over a decade ago • Partially introduced in 2010 • True implementation would mean priority line assigned to each budget program, for example: → Program A - Pensions: Spending not reduced → Program B – Roads: Spending cut by 20% → Program C – Social advertisements: Spending abolished Spending cuts in Lithuania • 2012 compared to 2008: → overall nominal state budget spending cut of 12%; → number of bureaucrats reduced by 10% ; → spending on bureaucrats’ salaries lowered by 17% (progressive wage cuts of 8-36% on bureaucrats’ salaries). • But spending on bureaucrats salaries’ is only 1/10 of the state budget Lithuania’s State Budget (excluding EU funds, mln. Litas) 25000 20000 15000 Revenues Expenditure 10000 5000 0 2008 2009 2010 2011 2012 State Social Insurance Fund (mln. Litas) 16000 14000 12000 10000 Revenues 8000 Expenditure 6000 4000 2000 0 2008 2009 2010 2011 2012 Record-breaking deficits and no reform in sight. Transfers into II pension pillar cut from 5.5% to 1.5% as a “savings cut” Lithuania’s Total State Debt (mln. Litas) 50000 45000 40000 35000 30000 25000 20000 15000 10000 5000 0 2007 2008 2009 2010 2011 From 17% of GDP in 2007 to 41% in 2012 2012 Another Budget Crisis in 2011 • • • • Economic growth of 5.9% Bleak renewed growth forecasts New budget gap of 3.8% of projected budget revenues How should it be filled? Dividends from State-Owned Enterprises Budget Hole Stocks Owned by the State Long-Term Material Assets Owned by the State Financial Assets Owned by the State Total Assets Owned by the State Filling 2012 Budget Hole • No privatization pursued • Spending cut fully filled the budget hole • Politicians’ competition led to introduction of: → Residential property tax of 1% property market value (with a significantly high tax-exempt value) → Copyright levy on devices → Land tax potentially raised from 1.5% to 4% → Raised taxes on natural resources, buses and cargo vehicles • Plans for more new and higher taxes Lessons from the Lithuanian case • Horizontal spending cuts of 2009-2010 were needed, but were not enough • State social insurance systems are very vulnerable to negative economic changes and need reforms • Lack of efficiency indicators means inability to prioritize spending and pursue vertical spending cuts Lessons from the Lithuanian case • Inclination to raise taxes – something the private sector cannot do! • Reaffirmation of Laffer’s curve: tax hikes result in lower revenues • Prepare for contractions before they come: identify wasteful spending, make priorities and be ready to cut the less relevant spending • Spending should not be rigid – it should be adjusted to revenues Thank you!