WP/11/270

Assessing the Variability of Tax

Elasticities in Lithuania
Tigran Poghosyan

 2011 International Monetary Fund

WP/11/270

IMF Working Paper

Fiscal Affairs Department
Assessing the Variability of Tax Elasticities in Lithuania
Prepared by Tigran Poghosyan1
Authorized for distribution by James Morsink and Abdelhak Senhadji
November 2011
Abstract
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily
represent those of the IMF or IMF policy. Working Papers describe research in progress by the
author(s) and are published to elicit comments and to further debate.
This paper quantifies the variability of tax elasticities in Lithuania using two alternative methods:
rolling regressions and pooled mean group estimator. The analysis is motivated by the systematic
variation of tax revenues observed over the economic cycle in the recent past. Both methods
confirm that tax elasticities moved with the cycle, which can be attributed to the procyclical tax
compliance tendencies and structural composition effects across tax bases. Comparison of VAT
revenue gaps across Baltic countries during the recent recovery suggests that tax revenues
rebounded fastest in Estonia, followed by Lithuania and Latvia. Overall, the results of the study
emphasize the importance of accounting for cyclical variation in tax elasticities when making
short-term tax revenue projections.
JEL Classification Numbers:
Keywords:

tax elasticity, economic cycles, Lithuania.

Authors E-Mail Address:

C32, C23, E32.

[email protected].

I would like to thank Emanuele Baldacci, Thomas Baunsgaard, Dora Benedek, John Brondolo, Martin Grote,
Jacques Miniane, James Morsink, Abdelhak Senhadji, and seminar participants at the European Department and
the Ministry of Finance of Lithuania for helpful suggestions and comments, as well as Zhaogang Qiao and
Gillian Adu for excellent research assistance. Audrone Mikneviciene from the Ministry of Finance of Lithuania
has kindly provided the data. The usual disclaimer applies.

2
Contents

Page

I.

Introduction ....................................................................................................................3

II.

Related Literature on Estimating Tax Elasticities .........................................................4

III.

Brief Overview of the Lithuanian Tax System ..............................................................5

IV.

Stylized Facts .................................................................................................................6

V.

Data and Estimation Results ..........................................................................................8

VI.

Conclusion ...................................................................................................................15

References ................................................................................................................................16
Tables
1.
PMG Estimation Results ..............................................................................................12
Figures
1.
Trends in Tax Revenue Collections over the Last Decade ............................................5
2.
Taxes and Respective Bases ..........................................................................................7
3.
VAT C-Efficiency Across new EU Member Countries ................................................8
4.
Time-Varying Elasticities from Rolling Regressions ..................................................10
5.
Deviation of VAT Revenues from their Long-Run Equilibrium .................................14

3
I. INTRODUCTION
Tax elasticities tend to vary systematically over economic cycles. Evidence suggests that
tax revenues (including neutral and regressive taxes) tend to fall more sharply than their
respective tax bases during recessions, and recover more strongly than bases during booms.
Hence, using long-run tax elasticities for short-term revenue projections can lead to
overestimation of revenues during contractions and to underestimation of revenues during
booms.
The purpose of this paper is to quantify the variability of tax elasticities in Lithuania
and assess where they stand at present. Tax revenues in Lithuania are prone to volatility
due to: (i) the structure of the tax system, which relies highly on taxing flows (direct and
indirect taxes) rather than stocks (wealth and immovable property), and (ii) macroeconomic
flows, such as GDP, private consumption, and the wage bill, which are more volatile than the
EU average. This paper analyzes the variability of elasticities for a range of taxes (value
added taxVAT, personal income taxPIT, corporate income taxCIT, and excise duties EX) over time, with a particular emphasis on the dynamics during the recent recession. We
also analyze the cyclicality of standardized VAT revenue collections (defined as the ratio of
VAT revenues to the country-specific statutory rates) in Lithuania relative to other new EU
member countries, focusing on the deviations from the long-run equilibrium over the cycle.
We find strong evidence of cyclicality in the elasticity of VAT revenues in Lithuania.
While the long-run VAT elasticity is close to one, revenue collections deviated from their
long-run equilibrium up to 15 percent over the business cycle. Similar to other Baltic
countries, deviation of VAT revenues from their long-run equilibrium in Lithuania was
positive in the pre-recession boom period (2006-2008), but turned negative during the bust.
The procyclical behavior of the revenue gap could be attributed to the procyclical tax
compliance tendencies and structural composition effects across tax bases. At present, VAT
revenues are rebounding to their long-run equilibrium, but remain about 5 percent short of it
as of end-2010.
The PIT, CIT, and EX elasticities also vary with time, but their dynamics is not fully
synchronized. As expected, the PIT and CIT elasticities exceed unity in most part of the
sample given their progressivity. The CIT elasticity exhibits the widest range of variation
(mainly due to uneven schedule of CIT payments within the year), followed by the EX
elasticity. All elasticities have exhibited some increase during the recent recovery, but with
different intensity.
The rest of the paper is structured as follows. Section II provides a selective literature
overview. Section III presents a brief overview of the Lithuanian tax system. Section IV
discusses stylized facts. Sections V present estimation results for rolling regression and panel
data methods, respectively. The last section concludes.

4
II. RELATED LITERATURE ON ESTIMATING TAX ELASTICITIES
Most methodological approaches focus on estimating long-run tax elasticities, which are
supposed to be constant assuming no changes in the tax system. These approaches are
motivated by the observed cyclical adjustment of government revenues and fiscal balance,
for which tax elasticities serve as key input. A widely cited reference is Girouard and Andre
(1995), which follows the disaggregated approach for the cyclical adjustment of
government revenues. The authors calibrate elasticities of individual tax categories with
respect to their respective bases for 20 OECD countries using tax codes and legislation.
These elasticities are then multiplied by the elasticities of tax bases with respect to the output
gap to obtain overall tax elasticities that enter the calculations of cyclically adjusted balances.
In line with the intuition, the study finds that personal and corporate income taxes are
progressive (elasticity is above one), social security contributions are regressive (elasticity is
below one), while indirect taxes are neutral (elasticity close to one).2 In contrast to Girouard
and Andre, Fedelino et al. (2009) and Congressional Budget Office (2009) follow an
aggregated approach, in which elasticities with respect to the output gap are calculated for
aggregate government revenues.
Despite the long-run constancy assumption, several studies have found that tax
elasticities may temporarily deviate from their long-run estimates. One important set of
factors contributing to the time variation of elasticities are beyond the cycle effects. While
business cycle is the most prominent source of government revenue fluctuations, these
revenues can also be affected by shocks related to the boom-and-bust cycles of assets,
property prices, and commodity prices, which are not always correlated with the business
cycle. For example, Aydin (2010) argues that beyond the cycle effects played a prominent
role in explaining highly volatile tax elasticities in South Africa. Another set of factors is
related to changes in the output composition (Bornhorst et al., 2011). For example, an
economic expansion driven by private consumption will have a much larger impact on tax
collection than an export-driven expansion. Cyclical adjustment does not account for the
composition effect, as it only considers the output gap, which could be the same under both
scenarios. Finally, tax elasticities can be affected by changes in tax compliance, since firms
and households are more likely to evade taxes when they are credit constrained or financially
depressed. For example, Brondolo (2009) suggests that during the financial crisis tax
compliance declines as taxpayers began to delay tax payments. According to basic models of
tax compliance, taxpayers facing economic stress or bankruptcy may perceive the downside
risk of tax evasion (penalties) to be smaller compared to the potential upside gains (avoiding
bankruptcy). In addition, shift in economic activity from formal to the informal sector may
increase during the downturns, contributing to the cyclicality. Similarly, Sancak et al. (2010)
show that the efficiency of VAT collections tends to be lower in bad times (when the
output gap is negative and informal economy is expanding), and vice versa. In a cross2

In case of the VAT, the elasticity is set to unity without conducting any estimations.

5
sectional dimension, it was shown that emerging countries with institutions that are less
conducive to tax compliance practices tend to have higher efficiency in VAT collections
(Agha and Haughton, 1996, De Melo, 2009, and Aizenman and Jinjarak, 2008).
III. BRIEF OVERVIEW OF THE LITHUANIAN TAX SYSTEM
The overall tax burden in Lithuania at about 30 percent of GDP is lower than the EU
average. The proportion of tax revenues received by the central government is slightly below
50 percent, local governments receive about 12 percent of total tax revenues, and the rest is
being received by the social security and extra budgetary funds. Between 2001-2010, indirect
taxes comprised 60 percent of total tax revenues and 35 percent of total government revenues
(Figure 1). VAT and EX are the main indirect taxes, comprising 38 and 16 percent of total
tax revenues, respectively, while PIT and CIT are the main direct taxes, comprising 32 and
10 percent of total tax revenues, respectively. Other taxes constitute the remaining 4 percent
of the total.3
Figure 1. Trends in Tax Revenue Collections over the Last Decade
Share in Total Government Revenues

Share in Total Tax Revenues

(Percent)

(Percent)

40

50

CIT

45

PIT

VAT

Excise duties

Direct taxes

35

40

Indirect taxes

Social contributions

30

35

25

30
25

20

20

15

15

10

10

2010

2009

2008

2007

2006

2005

2004

2003

2002

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

Sources: Statistics of Lithuania, ESA-95 Data.

2001

Sources: Statistics of Lithuania, ESA-95 Data.

The tax structure relies on taxing income and consumption (flows), while taxes on
wealth and capital (stocks) are among the lowest in the EU making tax revenues
vulnerable to economic fluctuations. The main taxes in Lithuania are PIT, CIT, VAT, and
EX. The main characteristics of these taxes broadly correspond to the ones elsewhere in the
EU4, although it is important to note that CIT and PIT rate changes are easier to implement
unilaterally in comparison to VAT and excise duties which face tougher harmonization
constraints at the EU level. The tax structure relies on taxing income and consumption
3

IMF (2010) reviews the structure of the Lithuanian tax system.

Comparison tables are provided in the most recent periodical on taxation trends in the European Union (see
European Commission, 2011).

6
(flows), while taxes on wealth and capital (stocks) are among the lowest in the EU making
tax revenues vulnerable to economic fluctuations.
Social security contributions in Lithuania are comparable to the regional average.
Social contributions are counted separately from tax revenues and their importance has
increased from 2009, when compulsory health insurance contributions have become part of
social contributions. The contribution rates were on an upward trend in Lithuania during the
last decade, growing from 9.2 percent in 1999 to 11.6 percent in 2009. The 2009 contribution
rate of 11.6 percent of GDP corresponds to the average collection in the new EU member
countries for the 1999-2009 period.
Revenues from property and land taxes are relatively modest. Lithuania collected only
0.37 percent of GDP in property and land taxes in 2010. At present, only commercial
property is taxed in Lithuania, with the annual tax being set by the municipalities in the 0.3-1
percent range. Unimproved land is taxed at 1.5 percent, but numerous exemptions and base
reductions apply narrowing the taxable base substantially. There is no net wealth tax.

IV. STYLIZED FACTS

Prima facie evidence hints at time-varying tax elasticities in Lithuania. On the whole, tax
revenues contracted more sharply than their respective bases during the recession (Figure 2)
and tax revenues are rebounding at a faster pace than their bases since the beginning of the
recovery in 2010. For example, between 2008-2009 VAT collections declined by 25 percent,
compared to a 14 percent drop in nominal private consumption during the same period. In
contrast, during 2009-2010 VAT collections grew by 12 percent, compared to a 3 percent
decline in private consumption. The VAT revenue growth outpaced that of private
consumption also during the pre-recession boom period. This divergence of tax growth rates
and their bases over the cycle is also driven by changes in tax policies, which we account for
in our econometric analysis.5 Nevertheless, the comparison of growth rates provides some
indication of a time-varying nature of tax elasticities that we would like to quantify.

European Commission (2011) contains detailed description of major tax system changes in Lithuania before
and during the crisis (see pages 215-217). Specifically, in 2009 VAT statutory rate was raised from 18 to 21
percent, PIT statutory rate was reduced from 24 to 21 percent, CIT statutory rate was temporarily raised from
15 to 20 percent and then reversed back to 15 percent, and EX rates on fuel, alcohol, and tobacco have changed
to comply with the EU regulation.

7
Figure 2. Taxes and Respective Bases
PIT and Wage Bill

Excise Tax and GDP

(nominal growth, in percent)

(nominal growth, in percent)

30

30
Wage bill

20

20

PIT

10

10

-10

-10

-20

-20

-30

-30

Sources: Ministry of Finance; and IMF Staff Calculations.

Sources: Ministry of Finance; and IMF Staff Calculations.

VAT and Private Consumption

CIT and Operating Surplus

(nominal growth, in percent)

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

Excise tax

2000

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

GDP

(nominal growth, in percent)

30

200
Private consumption

20

Operating surplus

VAT

CIT

150

10

100

0
50

-10

-20

Sources: Ministry of Finance; and IMF Staff Calculations.

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

-50

2000

-30

Sources: Ministry of Finance; and IMF Staff Calculations.

For a panel of new EU member countries, analysis of the VAT C-efficiency scores
further highlights fluctuations over the cycle as well as across countries. The VAT Cefficiency scores are obtained by dividing the VAT revenue to personal consumption ratio
over the VAT statutory rates obtained from the European Commission.6 The efficiency
scores vary widely across the countries in our sample (Figure 3), with Poland falling in the
lower end of the distribution (median score is 55 percent), while Estonia in the upper end
(median score is 85 percent, which is very high by international standards). More relevant for
our analysis, the efficiency scores also moved widely over time (Figure 3): starting from a
median of 57 percent in 1999 they reached a peak of 72 percent in 2007 (pre-recession), and
then returned back to 62 percent in 2010 (recovery). The dispersion of scores across
countries has also varied across time, recording the lowest range during the pre-recession
peak in 2007.

Higher score reflects more efficiency, and vice versa. Median scores are reported instead of averages to
alleviate the impact of outliers and extreme observations.

8
Figure 3. VAT C-Efficiency Across new EU Member Countries
Medians of VAT C-efficiency in New EU Member Countries
Over Time (in percent)

Medians of VAT C-efficiency across New EU Member

Countries (over 1999-2010) (in percent)

1999

Estonia

2000

Slovenia

2001

Bulgaria

2002

Czech Republic

2003

Hungary

2004

Lithuania

2005
2006

Latvia

2007

Slovakia

2008

Romania

2009

Poland

2010

20

40

60

80

Sources: Eurostat; European Commission; and IMF Staff Calculations.

100

20

40

60

80

Sources: Eurostat; European Commission; and IMF Staff Calculations.

V. DATA AND ESTIMATION RESULTS

We use quarterly data on taxes and their bases for the 1999-2010 period. Data on VAT,
PIT, CIT, and EX for Lithuania, as well as changes in tax systems (based on which control
dummies are generated), are obtained from the Ministry of Finance. Information on tax
bases, including GDP, personal consumption, wage bill, operating surplus, is taken from the
Statistics of Lithuania. We also use a panel data on VAT revenues and personal consumption
for 10 new EU member countries from the Eurostat. The new EU member countries used in
the analysis are: Bulgaria, Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland,
Romania, Slovenia, and Slovakia.
We use two methodologies to assess the variability of tax elasticities. First, we apply
rolling regression methods to individual taxes in Lihuania. The advantage of this method is
that it allows comparing tax elasticities estimated for different subsamples. The drawback is
the limited precision of obtained estimates due to the absence of sufficiently long time series.
Second, we apply panel data methods to VAT collections in new EU member countries. This
methodology overcomes the above mentioned limitation by expanding the number of
observations across countries. It also allows comparing revenue collection performance
across countries and accounts for substantial part of tax revenues given that new EU member
countries largely rely on VAT. However, it cannot be applied to PIT, CIT, and EX, since it is
more difficult to measure efficiency for these taxes relative to VAT given considerable
differences in tax systems across countries (income distributions, multiple tax brackets, etc.).
Unfortunately, the analysis of tax elasticities for social contributions was not possible to
conduct given the absence of the pre-2004 quarterly data.

9
Rolling regressions
Tax elasticities can be derived from the relationship between cyclical fluctuations in tax
revenues and their bases. The following relationship has been commonly used as
benchmark in the literature (e.g., Bornhorst et al., 2011):

B
T T* *
B

(1)

where T is the tax revenue, T* is the structural tax revenue, B is the tax base, B* is the
potential tax base, and is the tax elasticity ( > 0). Depending on the magnitude of , the tax
system can be progressive ( > 1), regressive ( < 1), or neutral ( = 1). The empirical
assessment of tax elasticities is based on equation (1):

T
B
ln t* 0 1 *ln t* 2 * CONTROLSt vt
Tt
Bt

(2)

where 1 is the estimate of the tax elasticity (), T* and B* are estimated using the HodrickPrescott (HP) filter for each tax (VAT, CIT, PIT, and SC), and CONTROLS is a vector of
dummy variables to control for changes in the corresponding tax systems (including changes
in statutory rates, exemptions, etc.).
One drawback of equation (2) is its reliance on the potential tax and tax base estimates
obtained through the HP filter. The limitations of HP filter as a tool for disentangling the
trend and cyclical fluctuations in emerging markets featuring short time series and frequent
structural changes have been documented widely (e.g., De Masi, 1997). Therefore, one could
estimate equation (2) using differences of T and B, instead of their deviations from potential,
to avoid relying on HP filter results:7
ln Tt 0 1 * ln Bt 2 * CONTROLSt t

(3)

Rolling window regression methods are used to capture the time variation in tax
elasticities from equation (3). A fixed moving window of 28 quarters (7 years) is used in
each estimation.8 Given the seasonal volatility of the series, year-on-year percentage changes
are used for both Tt and Bt. The obtained elasticity estimates together with their upper and
lower bounds (computed as 2 s.d. around coefficient estimates) are plotted to assess both
the dynamics and significance of elasticities.
Equation (3) can be derived from equation (2) by assuming constant growth rates in Bt* and Tt*. For the
estimation purposes, we take y-o-y differences to account for the seasonality effects.

Robustness checks using moving windows of different sizes produce qualitatively similar results.

10
Figure 4. Time-Varying Elasticities from Rolling Regressions
Time-Varying VAT Elasticity from Rolling Regressions

Time-Varying CIT Elasticity from Rolling Regressions

2.5

10

1.5

0.5

2
0

Coeff_VAT
Upper_VAT

-2

Time-Varying EX Elasticity from Rolling Regressions

2.5

Coeff_PIT

Coeff_EX
Upper_EX

1.5

Upper_PIT

Lower_PIT

Lower_EX

1.5

2010Q4

Time-Varying PIT Elasticity from Rolling Regressions

2010Q3

Sources: Statistics of Lithuania; and IMF Staff Calculations.

2010Q4

2010Q2

Sources: Statistics of Lithuania; and IMF Staff Calculations.

2010Q3

2010Q1

2009Q4

2009Q3

2009Q2

2009Q1

2008Q4

2008Q3

2008Q2

2008Q1

2007Q4

2007Q3

2007Q2

-4

2010Q4

2010Q3

2010Q2

2009Q4

2009Q3

2009Q2

2009Q1

2008Q4

2008Q3

2008Q2

2008Q1

2007Q4

2007Q3

2007Q2

2007Q1

2006Q4

2010Q1

Lower_VAT

-1

2007Q1

-0.5

2006Q4

Coeff_CIT
Upper_CIT
Lower_CIT

0.5
1

0.5

-0.5

2010Q2

2010Q1

2009Q4

2009Q3

2009Q2

2009Q1

2008Q4

2008Q3

2008Q2

2008Q1

2007Q4

2007Q3

2007Q2

2007Q1

2010Q4

2010Q3

2010Q2

2010Q1

2009Q4

2009Q3

2009Q2

2009Q1

2008Q4

2008Q3

2008Q2

2008Q1

2007Q4

2007Q3

2007Q2

2007Q1

2006Q4

Sources: Statistics of Lithuania; and IMF Staff Calculations.

2006Q4

-1

Sources: Statistics of Lithuania; and IMF Staff Calculations.

Note: Reported are time-varying elasticities from equation (3) using a moving window of 28 quarters
(7 years). The following tax bases are used: wage bill (PIT), (lagged) operating surplus (CIT),
personal consumption (VAT), and GDP (excise duty).

Rolling window regressions confirm the time varying nature of tax elasticities, but the
extent of variation differs across taxes (Figure 4):

The VAT elasticity has ranged between 0.5 and 1.5. In line with the prima facie
evidence, the elasticity increased at the onset of the downturn, which was not a
positive development given that the bases were contracting sharply. In the recovery
phase, the elasticity is returning to its pre-recession level but remains above 1 fueling
the recent recovery in tax collections.

The PIT elasticity ranges between 0.9 and 1.4. It was on an upward trend between
2006-2008, then slightly declined during the recession, and is currently rebounding to
its pre-recession level. The elasticity has stayed above unity in most part of the
sample, in line with the progressivity of this tax.

11

The CIT elasticity ranges between 1 and 4 (the widest variation among taxes). It was
on a declining path during the recession, but stabilized with the recent recovery. The
wider variation of CIT elasticity compared to the one for other taxes can be explained
by the relatively more uneven schedule of CIT payments within the year.

The excise duty elasticity ranges between 0 and 1. Similar to PIT, it is currently
rebounding. This may indicate the progress made by the authorities to counteract
cross-border smuggling of fuel and cigarettes, which became particularly prominent
in the wake of the recession.

Panel data regressions

We apply the pooled mean group (PMG) estimator of Pesaran et al. (1999) to analyze
the VAT tax elasticities in a panel of ten new EU member countries.9 The advantage of
the PMG is that it provides an estimate of long-run tax elasticities and allows assessing the
deviation of tax revenues from their long-run equilibrium implied by these elasticities. The
empirical specification takes the following form:
ln Tit i ln(T )it 1 0 1 ln( Bit 1 ) i ln( Bit ) i it

(4)

where 1 is the (pooled) long-run tax elasticity coefficient, i is the (country-specific) speed
of adjustment to the long-run equilibrium, i is the (country-specific) short-run adjustment
coefficient, i is the country fixed effect capturing unobserved heterogeneity in tax systems
across countries, and it is the i.i.d. error term. We estimate specification (4) using VAT
revenues adjusted for the impact of changes in statutory rates (T) and personal consumption
(B). The dynamics of the deviations from long-run equilibrium (the term in square brackets)
during the recent recession would help to shed light on the cyclicality of tax revenues in
Lithuania. In addition, the difference between current tax revenues and their long-run
equilibrium at the end of the sample (if negative) would help to assess the potential for
further VAT revenue improvements in Lithuania.
The PMG estimator is a panel data version of the error-correction model. It imposes a
homogeneity restriction on the long-run relationship between VAT and its base, while
allowing for the short-run effects to vary across countries. The PMG takes a middle ground
between the two alternative estimation extremes:

the fixed effects (FE) estimator, which imposes the homogeneity restriction on both
long-run and short-run slope coefficients;

The 10 new EU members were chosen as a comparator sample to Lithuania. Unfortunately, the panel data
analysis cannot be extended to PIT, CIT, and EX due to considerable differences in respective tax systems
across countries.

12

the mean-group (MG) estimator, which assumes that both long-run and short-run
coefficients vary across countries.

The PMG specification can be tested against the MG and FE models using the
Hausman test. The Hausman test does not reject the hypothesis of poolability of the longrun coefficients in both quarterly and annual regressions, favoring the PMG specification
against the alternative MG specification. The evidence in favor of the PMG specification is
even stronger when FE specification is considered as an alternative. Taken together, these
results suggest that the long-run elasticity of unity for VAT holds for all new EU member
countries. However, the VAT revenue collections can deviate from their long-run
equilibrium at any particular time period and economic cycles can exacerbate these
deviations.
The PMG estimations produce strongly significant coefficients that are consistent with
the economic rationale (Table 1). The long-run tax elasticity coefficient is close to one in
line with the neutral nature of the VAT explicitly assumed in previous work (see, e.g.,
Girouard and Andre, 1995). The speed of adjustment to the LR equilibrium is negative and
significant, suggesting that about 10 percent of the deviation from the long-run equilibrium is
adjusted within a quarter (column 1). Both results hold when real VAT and personal
consumption are used in the estimations (column 2). The elasticity is slightly higher, but
insignificantly different from one, when using annual data (columns 3 and 4). The speed of
adjustment in the annual regressions suggests that about 60 percent of the deviation from the
long-run equilibrium is adjusted within a year.
Table 1. PMG Estimation Results
Model

Long-run relationship
Constant
Private consumption (LR elasticity)
Dynamics coefficients
Speed of adjustment
Changes in private consumption

Quarterly data
Nominal
Real
(1)
(2)

Annual data
Nominal
Real
(3)
(4)

-0.0296***
[-3.91]
0.9809***
[27.94]

-0.0274***
[-2.82]
0.9976***
[12.17]

-0.4264***
[-7.21]
1.0273***
[39.95]

-0.6626***
[-6.97]
1.0746***
[20.90]

-0.1067***
[-6.42]
1.2120***
[8.96]

-0.0850***
[-4.07]
0.8372*
[1.94]

-0.6264***
[-6.09]
1.2865***
[10.87]

-0.6022***
[-5.68]
1.1882***
[6.09]

Number of obs.
470
470
110
110
Hausman test, p-value (PMG versus MG)
0.5783
0.3628
0.2076
0.3941
Hausman test, p-value (PMG versus FE)
0.9598
0.9746
0.9504
0.9645
Source: Statistics of Lithuania; and IMF Staff Calculations.
Note: t-statistics in parentheses. *, **, and *** denote significance at 1, 5, and 10 percent confidence
levels. The reported speed of adjustment coefficients represent simple averages of country-specific
coefficients.

13
Deviations of VAT revenues from their long-run equilibrium in Lithuania are closely
related to the economic cycle (Figure 5). The deviations were positive during the prerecession boom period (2006-2008), but turned negative during the recession (2009-2010). In
more recent quarters, tax collections have exhibited a tendency of rebounding to the long-run
equilibrium on the back of the ongoing recovery, but still remain about five percent below
the equilibrium. The relationship between the economic cycle and the revenue gap was
different in the pre-2006 period. In particular, the revenue gap was positive in end-1999
2000 when the economy was still suffering from the Russian crisis spillovers. This result can
be explained by the composition effect: the positive contribution of the private consumption
to the GDP growth in 1999-2000 (3.2 ppt on average), which has consistently exceeded the
real GDP growth (2.1 ppt on average). In fact, private consumption was the only component
positively contributing to GDP growth in 1999, which has fueled VAT collections. This is in
contrast to 2003-2004, when VAT revenue gap was negative. During this period, the
contribution of private consumption (7 ppt on average) to growth was lower than the output
growth itself (8.8 ppt on average).
Comparison of VAT revenue gaps in Lithuania relative to other two Baltic countries
reveals some similarities (Figure 5). First, the revenue gap was positive in all Baltic
countries during the 200608 period, when all three countries were benefitting from the
tailwinds and the booming economic environment. Next, the revenue gap turned negative in
all three countries following the bust. However, while in Estonia the revenue gap has
returned back to positive at the beginning of 2009, the gap has stayed negative in both Latvia
and Lithuania. The relatively better performance of revenues in Estonia can be largely
explained by tighter revenue administration efforts as evidenced by outstanding C-efficiency
scores (see Figure 3). Among three Baltics countries, Latvia has experienced the largest
revenue drop during the recession, resulting in a negative revenue gap of about 20 percent at
end-2010, which is four times larger than the 5 percent negative gap obtained for Lithuania.

14
Figure 5. Deviation of VAT Revenues from their Long-Run Equilibrium
Lithuania: Cyclical VAT Gap
(Percent)
12
8
4
0
-4
-8
-12

Mar-08

Mar-09

Mar-10

Mar-08

Mar-09

Mar-10

Mar-08

Mar-09

Mar-10

Mar-07

Mar-06

Mar-05

Mar-04

Mar-03

Mar-02

Mar-01

Mar-00

Mar-99

-16

Sources: Ministry of Finance; and IMF Staff Calculations.

Latvia: Cyclical VAT Gap

(Percent)
20
15
10
5
0
-5
-10
-15
-20
-25

Mar-07

Mar-06

Mar-05

Mar-04

Mar-03

Mar-02

Mar-01

Mar-00

Mar-99

-30

Sources: Ministry of Finance; and IMF Staff Calculations.

Estonia: Cyclical VAT Gap

(Percent)
12
8
4
0
-4
-8
-12

Mar-07

Mar-06

Mar-05

Mar-04

Mar-03

Mar-02

Mar-01

Mar-00

Mar-99

-16

Sources: Ministry of Finance; and IMF Staff Calculations.

15
VI. CONCLUSION
The above analysis provides empirical evidence on the variability of tax elasticities in
Lithuania. The deviation of short-run tax elasticities from their long-run counterparts can be
driven by the composition effects in tax bases and cyclical movements in tax compliance.
These effects are in-line with the basic models of tax compliance, according to which during
times of economic stress taxpayers tend to downplay risks of tax evasion (penalties) and put
larger weight on potential upside gains from tax evasion (Brondolo, 2009). The direction of
the variation differs across taxes, with most elasticities being flat during the recession and
rebounding with the recent economic recovery. The panel regressions suggest that the most
recent VAT collections in Lithuania are below their long-run equilibrium level by about
5 percent, implying that there is room for further improvement in VAT revenues in coming
months.
The variability of tax elasticities has important policy implications. Deviations of tax
elasticities from their long-run level should be taken into account when making short-term
tax revenue projections. The deviation of short-term tax elasticities from their long-run level
can be especially pronounced in new EU member countries with tax systems heavily relying
on taxing flows (rather than stocks), which are more volatile compared to the EU average.
For instance, long-run VAT elasticities should be adjusted above unity during the periods of
rapid economic expansions and contractions. The extent of adjustment should vary across
taxes, in line with the extent of their responsiveness to the business cycle.

16
REFERENCES
Agha, A, and Haughton, J., 1996, Designing VAT Systems: Some Efficiency
Considerations, Review of Economics and Statistics, 78(3), pp. 303-08.
Aizenman, J., and Jinjarak, Y., 2008, The Collection Efficiency of the Value Added Tax:
Theory and International Evidence, The Journal of International Trade & Economic
Development, 17(3) pp. 391-410.
Aydin, B., 2010, Cyclicality of Revenue and Structural Balances in South Africa, IMF
Working Paper 10/216 (Washington: International Monetary Fund).
Bornhorst, and others, 2011, When and How to Adjust Beyond the Business Cycle? A
Guide to Structural Fiscal Balances, Technical Guidance Note, Fiscal Affairs
Department (Washington: International Monetary Fund).
Bouthevillain, and others, 2001, Cyclically Adjusted Budget Balances: An Alternative
Approach, ECB Working Paper No. 77.
Brondolo, J., 2009, Collecting Taxes During an Economic Crisis: Challenges and Policy
Options, IMF Staff Position Note 09/17 (Washington: International Monetary Fund).
Congressional Budget Office, 2009, Measuring the Effects of the Business Cycle on the
Federal Budget, (Washington: Congressional Budget Office).
De Masi, P., 2007, IMF Estimates of Potential Output: Theory and Practice, IMF Working
Paper 97/177 (Washington: International Monetary Fund).
De Mello, L., 2009, Avoiding the Value-added Tax: Theory and Cross-Country Evidence,
Public Finance Review, 37(1): pp. 27-46.
European Commission, 2011, Taxation Trends in the European Union, 2011 Edition
(Luxembourg: Publications Office of the European Union).
Fedelino, A., Ivanova, A., and Horton, M., 2009, Cyclically-Adjusted Balances and
Automatic Fiscal Stabilizers: Some Computational and Interpretational Issues, IMF
Technical Notes and Manuals 09/05 (Washington: International Monetary Fund).
Girouard, N., and Andr, C., 2005, Measuring Cyclically-adjusted Budget Balances for
OECD Countries, OECD Economics Department Working Paper No. 434.
IMF, 2010, Lithuania: Options for Revenue-Supported Fiscal Adjustment, IMF Selected
Issues Paper No. 10/202 (Washington: International Monetary Fund).
Sancak, C., Velloso, R., and Xing, J., 2010, Tax Revenue Response to the Business Cycle,
IMF Working Paper 10/71 (Washington: International Monetary Fund).
Pesaran, H., Shin, Y., and Smith, R., 1999, Pooled Mean Group Estimation of Dynamic
Heterogeneous Panels, Journal of the American Statistical Association, 94: pp. 621-34.