Information about Europe Europa
Chapter

V Medium-Term Fiscal Frameworks

Author(s):
International Monetary Fund
Published Date:
April 2002
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The previous sections identified the need for the Baltic countries and other EU accession countries to pursue prudent fiscal policies. This will be crucial to maintaining high and sustainable growth in a low-inflation environment and protecting their external positions. At the same time, EU and NATO accession will require shifts in the composition of spending and changes in taxation within a relatively short period of time. This may be complemented by steps to lower the tax burden, in particular on labor income and corporate profits. Moreover, transfers from the EU, although potentially sizable, will need to be complemented by national cofinancing and, upon EU accession, national payments to the EU.

General Principles and Objectives

This section illustrates the potential tensions and trade-offs in the budgets of the Baltic countries over the next few years, as well as the financial flows with the EU. Such predictions, however, are subject to a considerable margin of error. The terrorist attacks of September 11 have amplified the usual uncertainty surrounding macroeconomic projections. In addition, uncertainty is added by the timing of accession; the length of transition periods accorded by the EU to each country under the various acquis chapters; each country’s progress in building appropriate structures and institutions; possible changes to existing pre- and postaccession financial instruments; and the speed and specifics of the envisaged tax reforms.

These fiscal challenges are assessed in the context of medium-term frameworks (Tables 6 through Tables 8). Three such frameworks are derived for each country, built on differing assumptions regarding the date of EU accession and growth. The baseline, Scenario I, assumes that EU accession will take place at the earliest possible date—that is, on January 1, 2004. The two alternative scenarios respectively assume EU accession at the same date but in a low-growth environment (Scenario II); and EU accession in the more distant future—that is, after 2006 (Scenario III), which would also be associated with moderately lower growth than in the baseline scenario.

Table 6.Estonia: Summary Medium-Term Fiscal Scenarios(Percent of GDP, unless indicated otherwise
Projections
2000200120022003200420052006
Baseline Scenario I (EU accession in 2004)
Average CPI inflation (percentage change)4.05.73.03.53.53.53.5
Current account balance-6.4-6.8-6.8-6.5-6.5-6.5-6.5
Primary fiscal balance0.00.6-0.3-0.10.00.20.3
Overall fiscal balance1-0.30.3-0.7-0.4-0.3-0.10.0
Real GDP growth (percentage change)6.94.54.15.55.55.55.5
Revenue and grants38.938.339.439.040.740.840.8
Grants (EU)0.60.71.11.02.72.72.7
Tax revenue35.434.735.735.535.635.835.9
Nontax revenue2.92.92.62.52.42.32.2
Expenditure39.738.140.039.441.040.940.8
EU-related0.80.92.32.25.15.15.1
Spending of EU grants and cofinancing0.80.92.32.24.04.04.0
Payments to the EU0.00.00.00.01.11.11.1
VAT payments0.00.00.00.00.20.20.2
GNP payments0.00.00.00.00.80.80.8
Own resources0.00.00.00.00.10.10.1
Other38.937.237.837.335.935.835.7
Of which: discretionary spending 229.427.828.027.125.926.026.1
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants4.45.96.211.617.3
Assuming half of EU grants and cofinancing finance existing programs6.98.312.518.224.2
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants-0.20.71.81.81.6
Assuming half of EU grants and cofinancing finance existing programs-0.80.10.30.20.1
Scenario II (EU accession in 2004 and a reduction in growth)
Real GDP growth (percentage change)6.9452.13.53.53.53.5
Revenue and grants38.938.339.439.140.840.840.9
Grants (EU)0.60.71.11.02.72.72.7
Tax revenue35.434.735.735.535.635.835.9
Nontax revenue2.92.92.62.52.42.42.3
Expenditure39.738.140.039.541.040.940.9
EU-related0.80.92.32.35.25.25.2
Other38.937.237.737.235.935.835.7
Of which: discretionary spending 229.427.827.826.825.625.725.7
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants1.91.0-0.82.15.1
Assuming half of EU grants and cofinancing finance existing programs4.33.55.38.311.6
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants0.01.02.22.12 1
Assuming half of EU grants and cofinancing finance existing programs-0.70.30.60.50.5
Scenario III (EU accession after 2006)
Real GDP growth (percentage change)6.94.54.15.04.94.84.7
Revenue and grants38.938.339.439.039.039.039.0
Grants (EU)0.60.71.11.01.00.90.9
Tax revenue35.434.735.735.535.635.835.9
Nontax revenue2.92.92.62.52.42.32.2
Expenditure39.738.140.039.439.339.139.0
EU-related0.80.92.32.22.12.12.0
Other38.937.237.837.337.237.037.0
Of which; discretionary spending 229.427.828.027.027.127.227.3
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants4.45.310.014.719.7
Assuming half of EU grants and cofinancing finance existing programs6.97.712.417.122.0
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants-0.20.70.60.60.5
Assuming half of EU grants and cofinancing finance existing programs-0.80.10.00.00.0
Sources: National authorities; and IMF staff estimates and projections.

Including the projected cost of the pension reform. The overall balance is identical in all three scenarios.

Defined as expenditure less EU-related spending, pensions, military expenditure, and interest payments.

Sources: National authorities; and IMF staff estimates and projections.

Including the projected cost of the pension reform. The overall balance is identical in all three scenarios.

Defined as expenditure less EU-related spending, pensions, military expenditure, and interest payments.

Table 7.Latvia: Summary Medium-Term Fiscal Scenarios(Percent of GDP, unless otherwise indicated otherwise)
Projections
2000200120022003200420052006
Baseline Scenario I (EU accession in 2004)
Average CP1 inflation (percentage change)2.62.53.03.03.03.03.0
Current account balance-6.9-7.1-7.0-6.4-6.1-5.8-5.2
Primary fiscal balance-2.2-0.8-0.50.10.20.71.2
Overall fiscal balance1-3.3-1.7-1.5-0.9-0.9-0.30.0
Real GDP growth (percentage change)6.67.04.56.06.06.06.0
Revenue and grants37.436.336.436.938.338.638.8
Grants (EU)0.50.61.01.22.32.52.7
Tax revenue31.431.030.830.831.131.131.0
Nontax revenue5.54.74.74.84.95.05.1
Expenditure40.737.838.037.739.038.738.6
EU-related0.60.71.32.15.15.45.7
Spending of EU grants and cofinancing0.60.71.21.53.53.84.1
Payments to the EU1.11.11.1
VAT payments0.20.20.2
GNP payments0.80.80.8
Own resources0.10.10.1
Other40.137.136.635.633.933.332.9
Of which; discretionary spending 227.726.325.725.123.823.823.9
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants2.55.86.213.019.9
Assuming half of EU grants and cofinancing finance existing programs3.47.512.520.328.3
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants0.51.22.52 42.4
Assuming half of EU grants and cofinancing finance existing programs0.30.81.10.90.7
Scenario II (EU accession in 2004 and a reduction in growth)
Real GDP growth (percentage change)6.67.02.54.04.04.04.0
Revenue and grants37.436.336.436.938.338.638.8
Grants (EU)0.50.61.01.22.32.52.7
Tax revenue31.431.030.830.831.131.131.0
Nontax revenue5.54.74.74.84.95.05.1
Expenditure40.737.838.037.739.038.738.6
EU-related0.60.71.32.15.25.55.8
Other40.137.136.635.633.833.332.8
Of which; discretionary spending227.726.325.624.723.223.223.1
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants-0.20.3-1.91.95.5
Assuming half of EU grants and cofinancing finance existing programs0.72.14.18.713.3
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants0.71.53.03.13.2
Assuming half of EU grants and cofinancing finance existing programs0.51.11.61.51.5
Scenario III (EU accession after 2006)
Real GDP growth (percentage change)6.67.04.55.55.45.35.2
Revenue and grants37.436.336.436.937.337.437.5
Grants (EU)0.50.61.01.21.31.31.4
Tax revenue31.431.030.830.331.131.131.0
Nontax revenue5.54.74.74.84.95.05.1
Expenditure40.737.838.037.738.037.537.3
EU-related0.60.71.32.12.22.22.3
Other40.137.136.635.635.835.435.0
Of which, discretionary spending227.726.325.725.025.625.725.8
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants2.55.113.419.926.4
Assuming half of EU grants and cofinancing finance existing programs3.46.915.422.129.0
Necessary expenditure cuts (discretionary expenditures)relative to 2001
Assuming existing programs do not qualify for EU grants0.51.20.60.50.5
Assuming half of EU grants and cofinancing finance existing programs0.30.80.20.10.0
Sources: National authorities; and IMF staff estimates and projections.

Including the projected cost of the pension reform. The overall balance is identical in all three scenarios.

Defined as expenditure less EU-related spending, pensions, military expenditure, and interest payments.

Sources: National authorities; and IMF staff estimates and projections.

Including the projected cost of the pension reform. The overall balance is identical in all three scenarios.

Defined as expenditure less EU-related spending, pensions, military expenditure, and interest payments.

Table 8.Lithuania: Summary Medium-Term Fiscal Scenarios(Percent of GDP, unless indicated otherwise)
Projections
2000200120022003200420052006
Baseline Scenario I (EU accession in 2004)
Average CPI inflation (percentage change)1.01.42.83.03.03.03.0
Current account balance-6.0-5.8-5.8-5.5-5.3-5.7-4.8
Primary fiscal balance-1.0-0.10.11.01.11.11.1
Overall fiscal balance1-2.7-1.7-1.5-0.8-0.6-0.5-0.5
Real GDP growth (percentage change)3.94.54.04.85.36.06.0
Revenue and grants230.329.430.130.131.631.631.6
Grants (EU)31.11.12.82.72.7
Tax revenue28.427.027.026.926.827.027.0
Nontax revenue1.92.32.02.12.02.02.0
Expenditure232.431.031.230.832.232.132.1
EU-related30.20.21.41.44.94.74.7
Spending of EU grants and cofinancing0.20.21.41.43.83.63.6
Payments to the EU0.00.00.00.01.11.11.1
VAT payments0.00.00.00.00.20.20.2
GNP payments0.00.00.00.00.80.80.8
Own resources0.00.00.00.00.10.10.1
Other32.230.829.929.527.327.327.3
Of which; discretionary spending 419.117.717.217.015.015.515.5
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants1.23 5-3.55.211.5
Assuming half of EU grants and cofinancing finance existing programs5.27.78717.424.5
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants0.50.82.72.22.2
Assuming half of EU grants and cofinancing finance existing programs-0.20.10.80.40.4
scenario II (EU accession in 2004 and a temporary reduction in growth)
Real GDP growth (percentage change)3.94.52.02.83.34.04.0
Revenue and grants230.329.429.829.831.331.331.3
Grants (EU)31.11.12.82.72.7
Tax revenue28.427.026.726.626.526.726.7
Nontax revenue1.9132.02.02.01.91.9
Expenditure232.431.031.330.631.931.831.8
EU-related30.20.21.41.44.94.84.8
Other32.230.830.029.227.027.127.1
Of which; discretionary spending 419.117.717.316.714.715.215.2
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants-0.2-1.9-10.5-4.3-0.5
Assuming half of EU grants and cofinancing finance existing programs3.72.11.07 111.4
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants0.41.03.02.52.5
Assuming half of EU grants and cofinancing finance existing programs-0.30.31.10.70.7
scenario III (EU accession after 2006)
Real GDP growth (percentage change)3.94.54.04.34.54.84.8
Revenue and grants230.329.430.129.829.729.729.7
Grants (EU)31.11.11.11.01.0
Tax revenue28.427.027.026.626.626.726.7
Nontax revenue1.92.32.02.02.02.02.0
Expenditure232.431.031.230.630.330.230.2
EU-related30.20.21.41.41.41.31.3
Other32.230.829.929.228.928.928.9
Of which: discretionary spending 419.117.717.216.716.617.117.1
Real growth of discretionary expenditure relative to 2001 (percentage change)
Assuming existing programs do not qualify for EU grants1.21.46.214.720.2
Assuming half of EU grants and cofinancing finance existing programs5.25.610.618.924.6
Necessary expenditure cuts (discretionary expenditures) relative to 2001
Assuming existing programs do not qualify for EU grants0.51.01.10.60.6
Assuming half of EU grants and cofinancing finance existing programs-0.20.30.40.00.0
Sources: National authorities: and IMF staff estimates and projections.

Assuming the implementation of the pension reform from 2004 onward with a loss of 0.5 percent of GDP of the payroll tax revenue, excluding contributions by the general government and an increase of 0.1 percent of GDP in expenditure representing contributions by the general government to the mandatory second pillar. The overall balance is identical In all three scenarios.

Excluding payroll tax contributions by the general government to the Social Insurance Fund (SoDra)

Data on grants and their spending for 2000–01 are not available. Only cofinancing Is reflected.

Other expenditure excluding benefits paid by SoDra. defense spending, and interest.

Sources: National authorities: and IMF staff estimates and projections.

Assuming the implementation of the pension reform from 2004 onward with a loss of 0.5 percent of GDP of the payroll tax revenue, excluding contributions by the general government and an increase of 0.1 percent of GDP in expenditure representing contributions by the general government to the mandatory second pillar. The overall balance is identical In all three scenarios.

Excluding payroll tax contributions by the general government to the Social Insurance Fund (SoDra)

Data on grants and their spending for 2000–01 are not available. Only cofinancing Is reflected.

Other expenditure excluding benefits paid by SoDra. defense spending, and interest.

The fiscal implications of NATO accession are reflected in the frameworks as well. The NATO Membership Action Plan requires that aspirant countries devote “sufficient resources” to military spending but leaves it open to individual agreements with such countries to specify the magnitude of such spending.30 In fact, NATO has made it clear that it does not expect new members to strain fragile budgets to purchase new equipment; instead, the focus should be on improving the existing military infrastructure. Nevertheless, as a general guideline, military spending at about 2 percent of GDP at the time of accession is seen as meeting the criterion of “sufficient resources,”31 and the three Baltic countries have repeatedly reiterated their intention to meet, or come close to, this standard by 2003.32

The frameworks illustrate that expenditure would need to be reprioritized to make room for new spending related to EU and NATO accession, as well as for possible tax reform and harmonization efforts. In other words, the new priorities would partially crowd out some discretionary spending if the authorities are to adhere to their balanced-budget objective. However, the EU will support the accession candidates in this endeavor with net financial assistance. The frameworks provide some preliminary estimates of the pre- and postaccession financial flows between the EU and the Baltic countries, which are projected to rise substantially in the years following accession (Box 6).

The mandated reorientation of spending will lead to an increase in capital outlays, essentially related to the EU pre- and postaccession financial instruments, although restraint will be necessary with respect to current expenditure. On the basis of the analysis in Section II, such restraint could be effected on account of (1) the wage bill, since wage increases are projected to be moderate, and the impact of civil service reforms will be felt; (2) improved targeting of social benefits; and (3) effective cuts in purchases of goods and services. Public sector reforms, as well as the move toward medium-term budget planning, should help in this process. In addition, sustained economic growth, a further liberalization of the labor markets, and the projected reduction in labor taxation are expected to reduce unemployment and help to curtail transfer payments from the government to households. Similar beneficial effects are expected from the impact of the recently adopted pension reforms, which are projected to reduce pension transfers over the medium term. Finally, a decline in interest payments in Latvia and Lithuania should help the authorities’ efforts because the move toward a balanced budget will lower financing costs.

This reprioritization notwithstanding, discretionary spending would still rise in real terms, on average, during the next five years (Figures 8 and Figures 9). Under the baseline scenario (Scenario I), the annual real increase in such spending could average about 3 percent in all three countries, but it would be more generous in the postaccession years. This points to the need for comparatively tighter budgets in the preaccession years, which could be relaxed somewhat upon accession when more support from the EU will become available.

Figure 8.The Baltic Countries: Real Growth in Discretionary Spending Relative to 2001 Under Various Scenarios 1

(Percent change)

Source: IMF staff calculations and projections.

1 Scenario I: EU accession in 2004; Scenario II: EU accession in 2004 and lower growth; Scenario III: EU accession after 2006.

Figure 9.The Baltic Countries: Reduction in Discretionary Spending relative to 2001 Under Various Scenarios 1

(Percent of GDP)

Source: IMF staff calculations and projections.

1 Scenario I: EU accession in 2004; Scenario II: EU accession in 2004 and lower growth; Scenario III: EU accession after 2006.

As a consequence, relative to 2001, discretionary spending would decrease by 1 ½ to 2 ½ percentage points of GDP by 2006. However, the need for such curtailment would be reduced to the extent that the authorities’ current investment program and some other spending categories (for example, related to agriculture) qualify for EU assistance.33 On the other hand, the scenarios anticipate that limits on their absorptive capacity will prevent the Baltics from coming close to the 4 percent of GDP cap on transfers from the EU budget during the early postaccession years. If this assumption is relaxed, the necessary reduction in discretionary spending may be underestimated because of the larger cofinancing needs.

In a low-growth environment (Scenario II), discretionary spending would be flat in real terms, leading to a larger reduction in the expenditure-to-GDP ratio than under the baseline scenario to maintain the balanced-budget objective at all times. If EU accession took place in the more distant future (Scenario III), discretionary spending would grow faster in real terms than under the baseline scenario, and cuts would likely be smaller in terms of GDP. However, growth prospects would be less promising and real convergence with EU income levels slower, and external vulnerabilities would increase.

The frameworks underline the importance of a medium-term setting of budgetary planning and decision making. Such a need for a medium-term planning horizon was also the underlying motivation for the European Commission to subject accession candidates to the Pre-Accession Fiscal Surveillance (PFS) procedures, which include, among other things, the regular submission of Pre-Accession Economic Programs (PEPs) (Box 7). This medium-term orientation of budgeting and planning is intended to provide the national authorities with sufficient room to maneuver in conducting effective stabilization policies in the face of unexpected shocks. The Baltics have begun to move toward medium-term budget planning; in Lithuania, for example, the organic budget law passed in 2000 requires that a three-year budget projection should accompany the annual budget document.

Scenario I: EU Accession in 2004

Under Scenario I, the baseline case, EU accession is assumed to take place in early 2004. The Baltic countries will aim to gradually achieve a broadly balanced budget over the medium term. This will ensure a continuation of the current successful policy mix and thus foster robust growth and safeguard the external current account position. It is expected that all three economies will continue to grow strongly and sustainably, at about 4 to 6 percent annually, over the next five years, driven by exports and investment by both the private and the public sectors and fostered by the prospect of early EU accession. On the supply side, continued efficiency and competitiveness gains are expected in line with progress made on the structural front. Inflation would remain moderate, at 3 to 3½percent, reflecting faster productivity growth than that of trading partners and leading to renewed real appreciation of the exchange rates (the Balassa-Samuelson effect).

The future large investment needs, coupled with a catch-up in private consumption, will make a further reduction in the current account deficits less likely. Private saving is projected to be fostered by rising incomes, the further development and sophistication of financial markets, the reduction in payroll taxes, and pension reform in general. However, it can be assumed that households will have a relatively stable or only moderately rising marginal propensity to save outside the pension system, leading to a broad stabilization of private saving over the medium term (it will actually decline somewhat in Lithuania). At the same time, private investment is expected to remain buoyant.

The current account deficits are expected to improve somewhat in Latvia and Lithuania over the next few years, mirroring the expected strengthening of government saving-investment balances. The external current account deficits will be largely or fully financed by FDI, thus keeping the Baltic countries’ already low external debt indicators in check. Although privatization of large-scale public enterprises could bolster FDI inflows in Latvia and Lithuania in the early years—this process is already completed in Estonia—more sustained FDI inflows are expected for all three countries owing to an improved business environment, sustained economic growth, and, most important, integration with the EU. Nevertheless, FDI inflows underlying the projected medium-term macroeconomic framework are lower relative to GDP than during the past four years.

Box 6.EU Pre- and Postaccession Financial Instruments

Preaccession

There are three distinct programs under which financial support can be secured: PHARE, ISPA, and SAPARD.1

The PHARE program aims to support acquis related institution building and investments in social and economic cohesion that eventually will result in overall compliance with EU norms. Key requirements of the program are: (1) a 30/70 percent split between institution building and investments; (2) investments need to be at least €2 million; and (3) projects require at least 25 percent cofinancing from the national budget.

The ISPA program aims to contribute to the preaccession preparation in the areas of economic and social cohesion. Assistance is granted for the improvement of the environment and for transport and infrastructure projects. Key requirements of the program are: (1) project cost should be at least €5 million: (2) projects usually require at least 25 percent cofinancing, in some cases 0 or 15 percent; (3) technical assistance can be supported; and (4) the combined assistance under ISPA and other community aid shall not exceed 90 percent.

The SAPARD program targets the implementation of the acquis with regard to the EU’s Common Agricultural Policy (CAP) and related policies. It focuses its support on 15 eligible measures in the context of rural development programs. Key requirements are: (1) no minimum cost per measure; (2) technical assistance, as well as preliminary studies and evaluations initiated by the European Commission (EC), can be supported: and (3) the cofinancing share is usually at least 25 percent, but zero for technical assistance projects. For revenue-generating investments, public aid may amount up to 50 percent of the total eligible cost, of which the EU contribution may amount up to 75 percent.

The Baltic countries have begun to attract funds from all three programs. Allocation estimates from the EC indicate that, on average, the Baltics could attract about I to 1 ¼ percent of GDP in preaccession support each year.

Postaccession

To manage die interaction between national budgets and the EU financial system and to track the budgetary impact of EU membership, the Baltic countries need to develop a sophisticated budgeting and monitoring system. Although membership in the EU will certainly be beneficial, it will also lead to significant additional financing needs. As is the case during the preaccession phase. EU-funded projects require national cofinancing. In addition, other acquis-related expenditure may be covered only in part through EU transfers—most notably in the area of environmental policies, transport and infrastructure, and the CAP. The composition of budget flows between the EU and the Baltic countries can best be described as follows.

In terms of transfers from the EU budget to the national budgets, the following items are the most relevant:

  • Agriculture: This item comprises direct support, issues related to the CAP, as well as rural development and accompanying measures.
  • Structural and cohesion funds: The Cohesion Fund comprises transport and environment (aiming at the promotion of economic and social cohesion and solidarity between members of the Union); structural funds include regional development programs (ERDF), labor market and human resources (ESF), agricultural industry in rural areas (EAGGF), and fisheries (FIFG).
  • Internal policies.
  • Collection costs: 25 percent of the traditional own resources (see below) to reimburse for their collection.

In terms of transfers from national budgets to the EU, the following items are relevant:

  • Traditional own resources: This item comprises custom duties, agricultural levies, and levies on sugar.
  • VAT payment: Fraction of national VAT base to be paid to the EU budget.
  • GNP payment: Fraction of national GNP to be paid to the EU budget.
  • E1B payment: Onetime payment to the European Investment Bank to become a shareholder.
  • EDF Payment: Payments into the European Development Fund.

Total payment appropriations in the EU budget are limited to 1.27 percent of community GNP, the EU’s own resources. At the Berlin summit, it was decided that this ceiling will be maintained until 2006.

1 PHARE is Operation PHARE. the Poland and Hungary Assistance for Economic Restructuring program, extended in 1990 to other eastern European states. ISPA is die Investment for Structural Policies for Pre-Accession program. SAPARD is the Special Accession Program for Agriculture and Rural Development.

It is expected that the national governments will succeed in striking a balance between the need to (1) adhere to the balanced-budget objective over the medium term; (2) consolidate and reorient expenditure to meet EU and NATO accession requirements, with a noticeable rise in government investment; and (3) implement tax harmonization requirements and some tax reform proposals.

Box 7Preaccession Fiscal Surveillance

With EU accession and EMU participation in sight, the Baltic countries need to prepare for participating in the procedures for multilateral surveillance and economic policy coordination. The Pre-Accession Fiscal Surveillance (PFS) procedure aims to prepare candidate countries for postaccession policy-coordinating structures. PFS closely resembles the EU’s permanent fiscal surveillance procedure for members and comprises the following two components.

  • Notification is related to the provision of detailed information on government debt, fiscal deficits, GDP, and other key macroeconomic and financial variables. A meaningful multilateral surveillance approach to fiscal operations requires not only a sophisticated information system for budgetary operations and commonly defined accounting standards (ESA 95),1 but also sufficient administrative and analytical capacity. Member states are required to submit the relevant data every six months; candidate countries made their first submission in April 2001. Each notification is evaluated by the European Commission (EC) and comprises a data summary, an assessment whether the quality of the notification data are of sufficiently high standard to allow for fiscal analysis, an assessment of compliance with ESA 95, and monitoring of current fiscal developments based on the submitted notification.
  • The Pre-Accession Economic Program (PEP) is to be prepared by the accession countries and submitted to the EC for the first time in 2001, to be followed by annual updates. The PEP is intended to provide an overview of the economic reforms being undertaken or still needed to accede to the EU and to help assess the development of institutional and analytical capacity that is necessary to participate in EMU, most notably in areas of economic analysis and medium-term policy planning. Key areas to be covered in the PEP are:
  • A review of recent economic developments comprising recent macroeconomic performance, institutional developments, and possibly any political and economic events that may have prevented the authorities from realizing their objectives.
  • A detailed macroeconomic framework comprising the main policy objectives, with intermediate goals, and quantitative scenarios and projections of key macro variables with a five-year time horizon.
  • A detailed presentation of the medium-term fiscal objectives, including the general government deficit, primary balance, and public indebtedness. Objectives need to be clearly defined and explained, as well as assessed in terms of feasibility. In the preaccession phase, die EU’s main concern is medium-term fiscal sustainability rather than achieving specific fiscal targets as laid out under the Maastricht criteria. Thus, deficits may well be different in different accession countries, possibly depending on economic growth, external vulnerabilities, or the extent of structural reforms still needed.
  • A structural reform agenda, including in areas such as those related to privatization, corporate governance, the financial sector, the labor market, the public sector, and agriculture. As such, the PEP will contain two policy matrices: one to summarize the policy commitments contained in the latest PEP and a second one comparing past commitments with actual outcomes.
  • Once the PEP is submitted, it is evaluated by the EC, summarizing program objectives, assessing policies, and evaluating institutional and analytical preparations for future EMU participation. Estonia and Latvia submitted PEPs in May 2001 and Lithuania, as requested, in October 2001.
1 European System of Accounts: ESA 95 (Eurostat, 1996).

The baseline scenarios for the three countries have some common assumptions and basic features, but also reveal some striking differences.

  • A moderate primary surplus will be achieved over the medium term, which is consistent with a broadly balanced budget of the general government. This illustrates the positive public debt dynamics of all three countries.34
  • On the revenue side, the Baltics are expected to benefit fully, by 2002, from the allocations for which they are eligible under the three preaccession instruments, which are equivalent to about 1 percent of GDP. The countries are projected to benefit from the postaccession financial instruments starting in 2004. Such transfers from the EU related to agricultural, structural, and internal policies, and to cover collection costs, are conservatively estimated to range between 2 and 3 percent of GDP in 2004–06,35 but could, in theory, amount up to 4 percent of GDP if the Baltics significantly increased their absorptive capacity (see Box 6).
  • Tax revenues relative to GDP are projected to remain broadly stable. In Estonia and Latvia, this partially reflects reductions in tax rates—especially regarding the social tax and, in the case of Latvia, the corporate income tax—which are compensated by a broadening of the tax base and improved tax administration.36 In addition, the EU-mandated tax harmonization is expected to have a beneficial impact on collections of VAT and excises. All of these developments tend to increase somewhat the share of indirect taxes in total tax revenue, mirroring similar past efforts in advanced economies. In Lithuania, the authorities are planning to reduce the personal income tax by compensating it with higher revenue from the corporate income tax, especially by broadening the tax base. Indirect taxes are expected to decline relative to GDP over the medium term, as the sales tax is abolished and long transition periods for raising excise tax rates are being negotiated.
  • Upon accession, total spending relative to GDP is assumed to rise moderately as a result of higher spending financed by the increase in EU transfers. Nevertheless, in all three countries, a significant reallocation of appropriations becomes necessary, leading to a decline in “other” (non-EU-related) expenditure relative to GDP. In real terms, however, such spending would still rise.
  • EU-related spending will more than double between 2003 and 2004. This reflects three broad spending categories: (1) transfers to the EU budget, comprising in particular the so-called GNP and VAT payments (such transfers to the EU budget are equivalent to about 1 percent of GDP and represent less than half of the transfers received from the EU budget, thereby ensuring a sizable positive net position with the EU budget); (2) the required cofinancing of EU-supported projects, which could amount to approximately 1 percent of GDP; and (3) other acquis-related spending, which varies from country to country. In the case of Latvia, implementation of the environmental chapter is expected to cost about LVL 700 million over a 14-year period, implying clean-up costs of about 0.5 percent of GDP annually after 2002. Costs of similar magnitude are estimated for Estonia to implement the environmental and transport chapters, while—based on incomplete information—in Lithuania the public sector costs of implementing key chapters would not exceed 0.4 percent of GDP annually.

Overall, discretionary expenditure could still grow annually by between 2 ¼ and 3 ¾ percent in real terms on average during the next five years.37 The preaccession years will involve relatively smaller real increases in such spending in all three countries, where as the postaccession years will allow all three countries more room to expand such spending again. Compared with 2001, the shift in expenditure toward EU-related spending at the expense of discretionary spending is about 1 ½ to 2 ½ percent of GDP by 2006.

Scenario II: EU Accession in 2004 in a Low-Growth Environment

This scenario represents the impact of a permanent external shock affecting the Baltics in 2002, and EU accession is assumed to take place in 2004. Such circumstances would be the most pessimistic of the three scenarios and thus would require very difficult policy choices from the national authorities if they were to adhere to the balanced-budget objective.

Simplifying assumptions were used to illustrate the impact of such an external shock. With growth assumed to be lower by 2 percentage points during 2002–06 relative to Scenario I, it is assumed that all revenue categories, including the flows with the EU budget, are kept constant in terms of GDP; thus, their nominal values are reduced accordingly. On the expenditure side, interest payments, pension payments, and acquis-related expenditures evolve according to commitment estimates, and their ratio in percent of GDP increases, with all other spending categories experiencing a reduction in nominal terms.

As a consequence, discretionary spending would, on average, need to remain broadly flat in real terms to maintain the projected fiscal balance. Relative to GDP, such spending would fall by about 2 to 3 percentage points in all three countries, a somewhat larger decline than in the baseline scenario. Overall, the significantly reduced room for real growth of discretionary spending in a low-growth environment would make the pursuit of a strictly balanced-budget strategy demanding.

Scenario III: EU Accession in the More Distant Future

This scenario assumes that EU accession will not take place before 2006. Although based on the Laeken decision and the Baltic countries’ progress in closing the acquis chapters, it appears unlikely that this scenario will actually materialize—but it is interesting in that it provides a “pure” preaccession framework. Under this scenario, financial flows coming from the EU are limited to the expected magnitudes of the three preaccession financial instruments and to clearly distinguishable spending, including the national cofinancing shares related to such support.

As a result, the fiscal situation, as well as preaccession financial flows and fiscal implications between 2001 and 2003, is similar to that in Scenario I. However, the preaccession flows are projected to continue until 2006. In addition, the macroeconomic framework would be somewhat less favorable, since the growth impetus associated with EU accession is weaker.

The need to reorient discretionary spending would be the least demanding in this scenario. This mainly reflects the lower national cofinancing shares for EU-related projects that would need to be made available. Overall, discretionary spending would fall in terms of GDP by about ½ of 1 percentage point relative to 2001, compared with 1½to 2½ percentage points in the baseline scenario. In addition, the real growth rates for discretionary spending would be the highest under this scenario, at 4 to 5 percent annually.

This scenario illustrates the relatively lower pressure on the accession candidates to reorient their spending toward high-priority categories, since more time would be available to tackle the difficult choices to be made. This “advantage” would need to be weighed against the lower growth path under this scenario: FDI inflows would be less buoyant, thereby delaying the real convergence process.

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