During the COVID-19 pandemic, the National Audit Office (NAO) of Lithuania has continued to effectively perform the three functions delegated to it: external audit, fiscal institution, and EU investment audit. One of NAO’s critical tasks was to assess the 2022 draft budget.
NAO’s aim in doing so was not only to project the general government balance and debt trends, but also to analyze risk factors affecting the pension system and the impact of climate change on fiscal sustainability. NAO’s assessment revealed challenges that the country’s public finances could face in the long term.
No Sustainable Revenue for Long-Term Expenditure
The pandemic has necessitated significant unplanned, short-term public sector expenditures. In response, the European Union temporarily narrowed the application of fiscal discipline rules between 2020 and 2022 and activated the general escape clause of the Stability and Growth Pact, allowing member states to deviate from budgetary requirements. This clause also sets the condition that, for permanent non-COVID-19 expenditure measures, member states must provide permanent revenue that ensures a neutral impact on public finances in the medium term.
Upon review of Lithuania’s financial indicators for 2022, NAO found that temporary government expenditures related to COVID-19 appear to have been replaced by growing long-term expenditures for which there are no sustainable sources of revenue. These long-term expenditures averaged 1 percent of the gross domestic product (GDP) annually over the period of 2017 to 2021. Prior to the pandemic, these expenditures were covered by unsustainable cyclical revenues, due to Lithuania’s economy growing more quickly than its potential GDP.
Some actual macroeconomic indicators—such as increased labor shortages in industry, trade, services, and construction; record-high use of industrial production capacity; and acceleration of core inflation—show the economy is exceeding its potential and likely to continue to do so.
In its function as a fiscal institution, NAO has observed that due to COVID-19 measures, the country’s economy has experienced the largest positive fiscal impulse since 2007. However, if one excludes the impact of these measures, then Lithuania’s fiscal policy tends toward pro-cyclicality. This poses the risks of even higher inflationary pressures and overheating of the economy.
Demographic Risks Affecting the Pension System
As part of its assessment of the draft budget, NAO analyzed risks to the sustainability of pensions. NAO found that in the long term, the country’s aging population—with a projected decrease in employed persons and increase in people of retirement age—will pose challenges to its public finances.
NAO used EUROPOP2019 (baseline scenario) for this analysis. According to projections, raising the retirement age by 2026 reduces risks. But in the long term, the large segment of the population aged 50-64 means that challenges will grow proportionally with increasing social security liabilities for pension benefits.
Conversely, the working-age population has been declining over the last two decades, but its employment has slightly evolved due to the increase in the labor force activity rate. Under the favorable EUROPOP2019 scenario, which assumes zero net migration, the number of employed persons is projected to decrease. Moreover, as society ages, its productivity decreases, which affects budgetary indicators.
Another relevant trend is that working-age men in Lithuania have suffered the greatest total loss of life expectancy. This could also negatively impact potential funding of the pension system and pose challenges to the general government’s financial indicators.
All of these socio-demographic factors point to the need for sustainable long-term sources of revenue. When adopting changes that may affect the sustainability of the pension system, it is important to take into account demographic challenges and the long-term forecasts of general government revenue and expenditures.
Managing Climate Change Risks
In the near future, public finances will be exposed not only to the pressures of an aging population, but also to the effects of climate change, which can include significant social and economic damages. Both adapting to and combating climate change will require public resources.
While the Organization for Economic Cooperation and Development (OECD) states that the consequences of climate change are not clear enough to be reflected in fiscal sustainability assessments, the most pressing risks can be identified. These include increased public expenditures due to extreme weather, which can damage infrastructure and impact economic activity. Costs can also increase due to the need to adapt more user-friendly infrastructure. The successful transition to a zero-emission economy would reduce fiscal risks in the long term.
Cover graphic: dim4ik69/AdobeStock
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