Weekly Briefing, Vol. 25. No. 3 (LT) January 2020
The collection of value-added tax remains the main challenge for Lithuania’s efforts to build a welfare state
Lithuanian society has entered the New Year with increased concerns about the further development of the economy and society at the time when the country has reached its peak so far. Over the previous two years, the salary growth has accelerated, reaching the annual increase of 13,5% of net income in the last quarter of 2019 as compared the same period a year ago. The latest data released by the State Social Insurance Fund Board under the Ministry of Social Security and Labour, which collects state social insurance and mandatory public health insurance taxes, has shown that the wage increases impacted the people on low income mostly. The number of the inhabitants earning less than a government-mandated minimal wage (555 euros monthly), has been steadily decreasingly; the figure dropped from 148 thousand people in 2017 to 105 thousand people in 2019. The salaries have increased above the average for the number of professions in the public sector, including primary and secondary school teachers, social workers, health care professionals and medical staff.
However, despite the positive developments for the increased personal incomes of several professions in the public sector, the overall public sentiment has been somewhat cautious. According to the latest 2020 Eurobarometer survey (which is conducted across the EU to gauge the public opinion of the European populations), 52% of the respondents in Lithuania indicated inflation as their biggest problem and 25% mentioned taxes and their second-largest perceived problem. These concerns contrast with the majority of the EU citizens; only 18% of the EU citizens perceive inflation as a significant problem, and even less (8%) consider taxes a problem.
Below is an overview of these and related socio-economic issues which Lithuanian society has been struggling with, trying to identify the main drivers which has caused the society to be that somewhat cautious as concerning the prospects of social wellbeing in the country in the years to come, despite the overall positive developments in the economy to-date.
Though Lithuania’s population is ethnically and culturally remarkably homogeneous (84,1% of the country’s population are Lithuanians, and 71,2% indicate their belonging to the Catholic Church), the society is far from being cohesive on other accounts. The latest annual European Commission’s country report on Lithuania, assessing the progress on structural reforms, prevention and correction of macroeconomic imbalances for the year 2020, maintains that “poverty and inequality are a concern even though steps are being taken to improve the situation”. The income inequality, which in turn is gradually translating into social inequality, is what creates the new division lines within the society.
According to the above report, expenditure on social protection in Lithuania remains among the lowest in the EU, while the at-risk-of-poverty or social exclusion rate at 28.3% remains among the highest in the EU (21.7% in the EU). Income inequality, even after pensions and social transfers, is one of the highest in the EU, with the impact of social transfers on poverty reduction marked as critical on the Social Scoreboard. It is also reflected in Lithuania’s performance on the respective United Nations’ Sustainable Development Goals (SDG) indicators where significant challenges for the country remain under the overall goals SDG 1 (‘No poverty’), SDG 3 (‘Good health and well-being’) and SDG 10 (‘Reduced inequalities’).
In 2019, the income of the wealthiest 20% of households in Lithuania was around seven times greater than that of the most deficient 20%, one of the highest ratios in the EU. The rapid ageing of the population increases risks of putting additional stress on the system of social welfare with the prospects of the reduced availability of public funds for the welfare even further. Thus, the European Commission states, the income inequality and poverty remain high, while the impact of social benefits on reducing poverty is critically low.
Over the last few years the government took on board some of the recommendations by the European Commission in addressing the risk of poverty among the most vulnerable groups of society by increasing universal child benefits, indexing and increasing pensions, increasing a minimum monthly wage and certain social benefits. However, as pointed out by the report, the effects of these incremental measures have yet to be seen.
The main focus of those efforts has been to address the before-taxes income inequality indirectly. The measures for addressing the after-taxes income inequality which is more relevant to a broader population (for example, through the introduction of the progressive elements in the taxation system) has not gained full acceptance in society. The need for increased taxation has not been perceived as linked to the immediate benefits for the broader good. Hence, in Lithuania, progressive taxation has never been fully introduced.
Much of the literature on flat tax reforms have emphasized the benefits of introducing flat personal income tax systems in transition economies, including Lithuania. The advocates of the benefits of flat tax systems mentioned simplicity, higher compliance and lower distortionary effects on growth and employment. These arguments have often been used to support policy recommendations favouring to introduce and maintain the flat tax systems in Central and Eastern European (CEE) countries during the transitory period.
In 2018 European Commission’s Joint Research Centre prepared a study which modelled the progressive tax reform scenarios in the CEE countries using the microsimulation model EUROMOD and EU-SILC data. The model used include a static tax and benefit calculator using representative microdata from the EU Statistics on Income and Living Conditions (EU-SILC) survey to simulate individual tax liabilities and social benefits under different scenarios.
The study reached the conclusions that enhancing progressive elements in the personal income tax system under alternative and plausible tax reform scenarios would have significant positive effects on redistribution and equity and would yield additional tax revenues. Budget neutral reforms combining progressive personal income tax systems with a working tax credit or complementing a higher flat tax rate with tax allowances would lead to somewhat similar results or, in some observed cases, would lead to a further reduction in income inequality. However, the study acknowledged that there are substantial variations of results across countries, depending on the existence of tax expenditures. In the medium-term, the macroeconomic impact of the budget-neutral reforms appears to be positive, yet not significant. In other words, as the empirical study suggests, the progressive elements in taxation might not help to achieve the decrease of the after-tax income inequality if the overall amount of the collected taxes remain the same (in a budget-neutral scenario).
The alternative view, which is dominant in Lithuania, is that instead of increasing taxation (either by making it more progressive or by increasing direct taxes on capital), there is a more straightforward way of increasing the public finances to make the economy much more redistributive, that is, by tackling more vigorously tax avoidance. According to the public statements of Lithuania’s Minister of Finance, at least a quarter of the national budget is not collected and remains in the “shadow economy”. The total loss of the budget might account for 2 billion EUR, as estimated. Thus, the main challenge for the government for the year to come is to significantly decrease the size of the shadow economy by recovering the unpaid taxes.
According to the definition provided in the literature, the shadow economy includes any market-based legal production of goods and services that are deliberately concealed from public authorities to avoid tax payment or social security contributions. Four types of activities fall under the category of the shadow economy, namely, economic activities of individual household (household consumer goods), unofficial economic activities (the goods and services which are kept off the accounting books), irregular economic activities (comprising illegal production of legal goods) and illegal economic activities, which include the production and distribution of illegal goods. Illegal and irregular activities have been extensively tackled by the government over recent years, especially as concerning illegally smuggled items. However, the main concern for the government remains the extraction of unpaid taxes from the unpaid value-added tax. According to the report by the European Commission, Lithuanian has one of the most substantial VAT gaps (25,3% of the VAT total tax liability). The highest VAT gap in the EU is in Romania (35.5%) and Greece (33.6%). VAT gap in Lithuania has remained nearly unchanged since 2015 (though the decrease of the VAT gap was registered in most of the EU countries during that period), which indicates that there are structural issues in the fiscal governance which keep the VAT uncollected at such a high level. The econometrical analysis has shown that the dispersion of value-added tax rates within a country and the overall unemployment rate (the higher the unemployment rate, the higher level of VAT gap) have had a positive impact on the VAT gap.
According to the EU regulations, EU Member States are required to levy a standard VAT rate of at least 15% and a reduced rate of at least 5%. Lithuania’s VAT system does not allow much dispersion. The VAT tax is fixed at 21%, which is the average VAT rate of the EU countries. The reduced VAT tariffs in Lithuania are set at 9% (applicable for the consumption of heating energy, solid fuel for domestic consumption, books and non-periodical publications, regular public transportation, tourism accommodation) and 5% (applicable for pharmaceuticals, periodical publications, equipment for the disabled). Apart from these, no further VAT tax reductions are foreseen for the consumption of goods and services in Lithuania. Being a small market, Lithuania’s small and medium enterprises in general but the sole-proprietor enterprises (which make up the majority of service providers in a number of the low added value service sectors) in particular are susceptible to the cost structure where VAT plays a significant part. The limited turnover, the high labour costs and the low rate on return on capital of micro businesses make VAT a high cost for these individual economic actors.
The 2019 International Tax Competitiveness Index has ranked Lithuania as fourth (Latvia takes up the 3rd place, while Estonia tops the list with New Zealand ranked one place below) in the world in terms of tax competitiveness. The ranking is based on the composite index assessing the level of different types of taxation (corporate tax, personal income tax, consumption taxes, property taxes) and the overall compliance with international rules. Lithuania is ranked 3rd for corporate and personal income taxes which are rather low. For property taxes, the country is ranked as seventh. However, in terms of the consumption taxes (VAT is the form of consumption taxation), Lithuania is ranked only as 26th.
Such an imbalance within a taxation system (where on the one hand the country has one of the lowest tax tariffs on capital and labour, while on the other maintains an inflexible flat rate VAT) creates the rigidity which impacts both the consumer spending and the consumer sentiment (as evident from the latest Eurobarometer survey, as referred to above) and the difficulty in collecting VAT to boost the public spending on social needs.
References:
- SODRA, Kristina Zitikytė, „Gyventojų darbo pajamų apžvalga: 2019 m. 4 ketvirtis” (The overview of the salaried income of the working population: the 4th quarter of 2019), 20 Feb., 2020; https://www.sodra.lt/uploads/documents/files/20200220_Sodra_2019%204%20ketvircio%20darbo%20pajam%C5%B3%20ap%C5%BEvalga_PREZENTACIJA.pdf
- Salvador Barrios, Viginta Ivaškaitė-Tamošiūnė, Anamaria Maftei, Edlira Narazani and Janos Varga, “Progressive tax reforms in flat tax countries”, JRC Working Papers on Taxation and Structural Reforms No 02/2018, European Commission, Joint Research Centre, Seville, JRC115044, 2018; https://ec.europa.eu/jrc/sites/jrcsh/files/jrc115044.pdf
- Vicent Almenar, José Luis Sánchez and Juan Sapena, “Measuring the shadow economy and its drivers: the case of peripheral EMU countries”, Economic Research – Ekonomska Istraživanja, DOI: 10.1080/1331677X.2019.1706601
- Institute for Advanced Studies, “Study and Reports on the VAT Gap in the EU-28 Member States: 2019 Final Report”, TAXUD/2015/CC/131; https://ec.europa.eu/taxation_customs/sites/taxation/files/vat-gap-full-report-2019_en.pdf
- Tax Foundation, Daniel Bunn, Elke Asen, “International Tax Competitiveness Index 2019”, Oct. 2, 2019; https://taxfoundation.org/publications/international-tax-competitiveness-index/