According to the survey of market participants conducted by the Lithuanian Free Market Institute (LFMI) in July and August 2006, the growth of Lithuania’s economy will not slow down in 2006 and 2007. The study also shows that the rapid growth, long reflected in statistical indicators, have now reached the pockets of the Lithuanian people: their living conditions are noticeably increasing. Despite growing prices, rapidly increasing salaries enable people to not only satisfy their basic needs, but also to save and invest more every year. The profitability of enterprises also increases continuously, though not quite as rapidly as salaries. On a less optimistic note, there are indicators of a growing shadow economy, an unreceptive national investment climate which is not improving, a rate of emigration which does not decrease, and a vacuum of constructive policy in the government’s attempts to resolve these problems – that explains more moderate expectations in some cases.  

 

 

Market participants polled by LFMI raised their spring forecasts by 0.5 percentage points and think that Lithuania’s gross domestic product (GDP) will grow by 6.8 percent in 2006. The economy is expected to grow by another 6.5 percent in the coming year. 

An uninterrupted and brisk economic growth is stimulated by growing consumption, activities in the ever-expanding domestic market as well as a fast export growth. A continued strong economic development and a declining supply of labour keep augmenting personal earnings and household income. As household income grows, people have increasingly more extra money – household savings and investments are growing at a much faster rate than earnings.

 

Market participants’ expectations are also boosted by the benefits derived from the European Union (EU) membership. The positive impact is particularly evident regarding the positive changes in the division of labour, increased specialisation and changes in foreign trade. On the other hand, in terms of per capita GDP in the European Union, Lithuania (together with Poland and Latvia) is still at the bottom of the list – the country's GDP per capita equals only 52 percent of the European Union average. The poor starting conditions and the necessity to “catch up” with other countries acting on the same market reinforce expectations regarding fast economic development.

 

However, market participants have not just positive views regarding the situation in the domestic market. As many as 44 percent of them agree that the investment climate in Lithuania has not improved in the past several years. Market participants believe that the following measures would be helpful in attracting investments (measures are listed according to how frequently they were mentioned): an overhaul of the tax system, especially lowering labour taxation and introducing an upper ceiling for Sodra contributions, simplification of the tax rules, a reduction of bureaucracy, resolving the problems of emigration and qualification of the labour force, and reforming the land market. Only 5 percent of respondents said that the introduction of the euro would serve as an essential tool – meanwhile, most market participants gave priority to eliminating domestic problems in the tax, regulatory and bureaucratic systems.

 

Overall, the euro is not viewed as a crucial stimulus to economic growth. Fifty-six percent of those polled reported that the country would sustain economic losses if it failed to launch the euro, but at the same time, a large proportion – 44 percent – thought the economy would not be markedly affected.

 

The continued economic growth ensures the most favourable conditions ever to carry out structural reforms in the energy, healthcare, education, transport, social security and government spending systems. However, political attention and energies are instead primarily being focused on one company privatisation issues, while financial resources have been squandered on short-term political pet projects and ineffective measures that are insufficient to solve basic and essential problems. These priorities are also evident in the 2007 budget.

 

Despite the first steps of the tax reform – namely the reduction of income tax from 33 to 27 percent - market players do not expect the shadow economy to decrease substantially - this and the next year it should be decreasing by approximately one percentage point a year – from 21 percent of GDP in 2005 down to 19 percent in 2007. According to market participants, the shadow economy will be one percentage point smaller than in 2005 and will account for 20 percent of GDP in 2006. Market participants expect that the shadow economy will slightly decrease in 2007 and will account for approximately 19 percent of the entire economy.

It is obvious that market participants do not see the current income tax decrease as sufficient to substantially reduce incentives to operate in the shadow economy. Seeking to diminish the shadow economy more significantly, it is necessary to implement a more radical reduction of the personal income tax, as compared to the minor tax cuts of a few percentage points currently implemented. In terms of taxation, the income tax should be reduced to at least 20 percent, as now discussed, an upper ceiling for Sodra contributions should be introduced, and the temporary social tax for companies should be scratched.

 

In the current survey market participants were asked to evaluate how considerably income tax should be reduced for the shadow economy (including unreported remuneration for work) to diminish markedly. Survey participants were asked to indicate a tax rate. The average of the answers provided was 16.8 percent, lower than the Government’s timid plans of tax cuts up to 20 percent. The most frequent response was 15 percent and the majority of respondents were of the opinion that the tax rate must be lowered to 15 percent in order to decrease the size of the informal sector. A number of those polled said that a reduction of the personal income tax alone is not enough and that other exigent measures, an upper ceiling on contributions to Sodra and lowering the rate of the social insurance contribution, also must be introduced.

 

The environment for a decrease of the shadow economy is not expected to be more favourable next year either due to the excise duty increase by 30 percent planned for March 2007. Record-high smuggling activities and low living standards in Lithuania are the main factors why excise duties should be raised at the latest date possible. First, an increase in excise duties after several years, accompanied by rising living standards, would not be as painful as in 2007. Second, there is a potential danger that sizeably increased excised duties from 2007 will boost the informal tobacco market even more drastically: those who might have been reluctant to engage in clandestine activities so far, may now be lured to embrace the opportunity to reap increased profits. Thus, smuggling activity will possibly boom further, but if excise duties were raised at a later stage, more time would be saved for ensuring border security.

 

Market participants think that the growth of both exports and imports remains rapid. They believe that exports and imports will grow at a similar rate in 2005 and 2006, although imports will grow more rapidly than exports. As the survey indicates, in 2006 exports will grow by 14.9 percent and imports will rise by 15.3 percent. Survey participants predict that the growth of foreign trade will remain similar to this year’s, albeit somewhat slower in 2007: exports are expected to grow by 14.6 percent and imports will increase by 15 percent. Market participants’ expectations regarding export growth are primarily bolstered by economically attractive or finally recovering (euro-zone) export markets (unceasing demand from the CIS countries, especially Russia). Import growth expectations, on the other hand, are bolstered by increasing household income, growing purchasing power and consumption, also hopes that investment processes will start to revive after a stagnation that lasted for several years.       

 

Inflation has been the most intensively observed economic indicator this year, increasingly attentively monitored every month to assess Lithuania’s chances to launch the euro in 2007. However, this year’s level of inflation appeared to be too high to meet the Maastricht criterion and the EU earlier this year closed the door to Lithuania’s euro zone membership. Market participants do not think that the level of inflation will drop in this and the coming year. On the contrary, they raised the forecasts for the 2006 consumer price growth by one-fourth. The ex ante forecast of prices of producer goods and services was also increased and is higher than that for consumer goods and services.

 

According to market participants, consumer prices will rise by 4.6 percent and producer prices will increase by 5.5 percent in 2006, compared to 3.9 and 4.3 percent respectively in 2005. The LFMI survey shows that consumer prices will go up by 5 percent in 2007 and producer prices will climb by 5.6 percent in 2007. Mounting energy prices, increases in transport fees, lavish government expenditure, surging oil prices and a growing domestic demand reinforced by a continuous consumption boom encouraged by growing personal earnings were the main factors behind the increased prices.

 

Prices rise as additional money is thrown into the market, which is an outcome of increasing government borrowing, EU funds and private crediting sources. A continuing upsurge in heating and fuel prices will be the most important drive of prices in the short run. However, these prices barely depend on the Lithuanian Government’s decisions and its anti-inflation measures. Increases in taxes (e.g. excise duties), restricted competition (e.g. in the energy sector) and government-stimulated consumption (e.g. tax favours for housing loans and compensations for heating) have also been augmenting prices in Lithuania.

 

It is important to understand that price growth is a natural process at this stage of economic development in Lithuania. That is why no synthetic measures must be adopted, even when focusing on such major goals as the introduction of the euro.

 

The survey shows that unemployment in Lithuania continues to fall rapidly. According to market participants, the rate of unemployment will be 5.8 percent at the end of 2006, compared to 7.34 percent at the end of 2005. It is expected that unemployment will continue to fall steadily and will stand at 5.4 percent at the end of 2007. The unemployment figures will not be discussed in more detail here because the indicator cannot be seen as representative in the current economic situation – it no longer reflects the actual situation in the market. There is no unemployment in the country at the moment; instead there is a real lack of qualified labour. Therefore, any unemployment figures have lost their actuality and practical value.

 

Emigration remains one of the most important economic issues this year. It also plays a significant role in rising labour price in the country – not only because of the decreasing number of workers in the country, but also because of the increased mobility in the domestic market. With competition rising, workers choose jobs more carefully, are more inclined to change place of work.

 

Emigration creates tension in the market and has serious economic consequences. However, no constructive measures to solve the problem are taken. Various working groups discussing institutional set-up up emigration problem solving are being created, but the essential causes of emigration, let alone the ways of resolving them, are not even being identified.

 

The role of the government in trying to keep the labour force in Lithuania is very specific – to build a needed environment and create conditions that would motivate workers to stay in the country. To attain this, it is crucial to cut labour income taxation, to liberalise employment regulations, to reduce the administrative burden for business (and to restrict the role of regulatory institutions in particular) and to reform the education, health care and pension systems so that the could be trusted by those working in the country.

 

The tax burden fluctuates, but does not decrease.  Market participants think that the tax burden will be 34.6 percent of GDP in 2006, compared to 34.1 percent in 2005. The LFMI survey participants believe the tax burden will decrease by one percentage point and constitute 33.7 percent of GDP in 2007.

 

Changes in the Lithuanian tax regime this and the last year – namely, a reduction of the personal income tax, an imposition of the social tax, and expectations regarding further decisions in the tax system - can be primarily related to the estimates and forecasts reported by market participants.

 

It is evident that the first steps of the tax reform have not bolstered significantly market participants’ optimistic expectations, although the figure of the tax burden was reduced slightly. The cuts of the personal income tax in July this year have been “outweighed” by a social tax and uncertainty of future plans (increases in excise duties and the real estate tax and expansion of the tax base). A more considerable decline in the tax burden may be expected only when the guidelines of the further tax reform are declared. Gradual reduction of taxes has been insufficient to give a push to the Lithuanian economy so far – such policy is futile in encouraging the business community to create new jobs, decreasing the shadow economy, reducing emigration, and attracting foreign investments.

 

A draft law on the 2007 budget submitted by the Government in the autumn of 2006 does not envisage any significant changes in the tax regime this or next year. The rate of the personal income tax will not be lowered and the social tax will not be abolished although its necessity is highly questionable, while it keeps on undermining business’ confidence and expectations. Tax conditions will not be improved either as excise duties will undergo a planned 30-percent increase. Although Government officials talked about an improvement of the tax climate during the present year, recently, however, they have been arguing that it will be financially impossible to lower the personal income tax from 2007. If a 24-percent personal income tax came into effect from the 4th quarter of 2007, the national budget would receive about 200 million litas less in revenues, which would compel the Government to trim funding of certain other envisaged programmes. In the light of that, the Government now plans to cut the personal income tax rate to 24 percent starting only from 1 January 2008. It is also welcome that the government recently has started to think about a more radical variant of the tax reform – a reduction the personal income tax rate to 20 percent, skipping the intermediate step of a 24-percent rate. The official plan at the moment is to institute this reduction from October 2008, right before the parliamentary elections. It is essential that this process is not delayed and that decisions to boost the country’s competitiveness are adopted in a bold manner, while drawing on the current favourable situation in the economy and the state finances.

 

Market participants polled by LFMI think that after a period of stagnation until 2004 wages have been rising quite rapidly for several years in a row. Market participants believe that average net earnings will increase by about 11 percent, or 127 litas, in 2006 and will amount to 1,295 litas per month.  LFMI survey participants estimate the average monthly reported or unreported monetary remuneration for work after tax.

 

The LFMI survey shows that while the situation regarding labour market regulation and education system reform remains unchanged, wage growth is being affected by a decreased supply of surplus labour, a result of large-scale emigration and the endemic weaknesses of the education system. Increasing productivity, bolstered by new technologies and modernisation, is another factor which is instrumental in creating the conditions for wage growth. Net earnings may increase this year as a result of a reduction of the personal income tax from 33 to 27 percent. However, it is likely that some workers will not observe this rise in their earnings as employers and employees often negotiate salaries to be received “in hand” (after tax).

 

Along with the rapid wage growth, household earnings have also been rising significantly. According to market participants, the average monthly household income will rise by 9.5 percent in 2006, as compared to the previous year, and will amount to 2,307 litas. The updated forecast is 2.8 percent higher than the figure reported six months ago. Monthly household income per household member will average 905 litas. The financial situation of households will continue to improve in the coming year too. Market participants project that average household income will grow at a higher rate in 2007 than in 2006 – by approximately 12.5 percent, and will amount to 2,594 litas per month. Income per household member will for the first time exceed 1,000 litas, amounting to 1,017 litas per month. Apart from rising wages, income will increase due to constantly growing social benefits, as well as possibilities to earn money outside the borders of Lithuania. Money earned by the Lithuanians abroad and sent to Lithuania adds to the finances of Lithuanian households.

 

The good news is that rapid wage growth makes it possible for households to save and invest more every year. Both in 2006 and 2007, an increasing part of incomes will be allocated to savings and investments – the growth of money saved and invested during this period outpaces the rise in wages. Market participants think that in 2006 Lithuanian residents save 10 percent larger amounts as compared to 2005. Average household savings will soar and total more than 354 litas per month this year, compared to 322 litas per month in the year before. Household investments will go up by as much as one-fifth and amount to 406 litas per month in 2006. Household savings will account for 15 percent of household income and investments for significantly more, 18 percent. Market participants predict that household savings will rise by 19 percent in 2007 and amount to 482 litas per month, accounting for 19 percent of household budgets. Household investments are expected to edge up by 16 percent in 2007 and will total 411 litas per month, accounting for 16 percent of household budgets.

 

It is important to note that market participants believe that the share of income that households save and invest is becoming rather tangible and is constantly growing. This indicates that Lithuanians no longer spend all or even the biggest parts of their income on food only. This is one of the primary factors demonstrating that the living standard in the country is rising.

 

On the other hand, in making decisions on what to do with the money left after all of the most necessary expenditures have been made, Lithuanians turn out to be very conservative – they invest money in conservative funds, do not make use of the services of investment mediators, and, on the whole, feel safer depositing their money with banks or keeping it at home.

 

The LFMI survey indicates that the indicators of profit margin and return on equity should remain relatively unchanged in the year of 2006, as compared to the year before. Market participants predict that in 2006 the profit margin will on average be 6.6 percent, while the return on equity will stay at approximately 12 percent. They further suggest that the average profit margin will remain at 6.6 percent, while the return on equity will increase by a half of a percentage point to 12.5 percent in 2007. Unchanging, although modestly optimistic, expectations, are very likely related to the continued growth of the Lithuanian economy, rising domestic demand and the benefits of the membership of the EU. A growing demand for, and costs of, skilled labour and a shortage of qualified workers may have had an adverse impact on corporate indicators.

 

The LFMI surveys show that the share of reinvested profits increased steadily from 1997 until 2001, but also that this trend was reversed in 2002 and since then remains largely unchanged. According to market participants, the proportion of reinvested profits will stand at only 43 percent on average in 2006, down from 46 percent a year before, and as much as 20 percentage points lower than in 2001 (66 percent).  No important changes are projected for 2007 either. Market participants think that reinvested profits will remain similar to this year’s low levels – they will make up 44 percent and will be the lowest in all the years preceding 2006.

The tendency of prolonged indicator stagnation can be directly linked to the changes in taxation in 2002, more specifically the decision to apply profit tax to all investments. During the years when the best indicators of reinvested profits were recorded (1997-2001), investments were not being taxed. As soon as the taxation laws had been changed and the new tax started to be applied, the companies’ reinvested profits, according to the market participants, plummeted, and have not recovered since. A more noticeable drop of reinvestments to 43-44 percent in 2006-2007 could also be related to debates about changes in taxation. The solidarity tax, in particular, could have had a strong negative impact, since it was introduced after the companies had already planned their finances for the year ahead. It is possible, that aiming to keep a fiscal balance, companies chose to lower their share of reinvestments.

 

According to the LFMI survey participants, innovation processes are shrinking along with the reinvested profits. Market participants‘ estimate is that at the end of 2006 expenses on research and development (R&D) will account for 5.4 percent of companies’ total expenses, which is more than one percentage point less than in 2005 (6.5 percent) and much less than in 2001 (7.2 percent). In 2007 the share of expenses on research and development are expected to reach 6,2 percent.

 

The LFMI survey shows that the cost of borrowing from commercial banks at the end of 2006 will be slightly higher as compared to the end of 2005. According to market participants, at the end of 2006 loans up to one year in litas will cost 5.54 percent, as compared to 5,26 percent a year ago. Interest on loans for more than one year will not have changed significantly – at the end of the year it should average at 5,2 percent, as compared to 5,17 percent a year ago. The next year the interest on loans is expected to increase – to 5,78 percent (loans up to one year) and 5,49 percent (loans over one year).  

 

In addition to bank loans, lease and factoring are getting increasingly popular. The lease and factoring portfolios account for an increasingly bigger proportion of bank loans (including bank loans extended to other banks and financial institutions) and their rate of growth is as high as that of bank loans.

 

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The next survey will be conducted in the winter of 2007. It will provide market participants’ ex poste estimates of 2006 and will show changes in their expectations for the year 2007.