Publication: Monitor Volume: 6 Issue: 13

In contrast to the CIS economies, with the exception of Kazakhstan, the Baltics have done well in attracting foreign investment. In 1998 Estonia attracted more foreign investment per capita (US$407) than any other state in Central Europe (United Nations 1999 World Investment Report). Foreign investment has helped modernize the Baltic economies’ industrial sectors and provided the inflows necessary to finance growth in domestic spending. Many of these investments were attracted by the Baltic economies’ privatization programs, which have also been more ambitious than privatization efforts in the CIS. However, as the privatization process is wrapped up over the next year or two, the Baltics risk a slowdown in foreign capital inflows. This could risk the investment and growth needed to modernize their economies and prepare for membership in the European Union.

All three Baltic countries are therefore cutting taxes in order to boost investment in 2000. On January 1, Estonia eliminated the 26 percent corporate profit tax on undistributed profits. Latvia has abolished its 1.5-4.0 percent property tax which had been the object of much investor ire. Although Latvia’s real estate tax will now be applied to buildings as well as land, its rate will be reduced from the current 1.5 percent to 1.0 percent in 2002. In Lithuania, the government’s tax-reform program calls for eliminating the 29 percent corporate profit tax (as in Estonia). In light of Lithuania’s fiscal tensions, however, that government has decided to implement this pledge only gradually, dropping the rate to 24 percent in 2000.

Estonia and Latvia are now pulling out of the recession which followed Russia’s August 1998 financial collapse, and can look forward to healthy growth in 2000. After three quarters of decline, in the third quarter of 1999 Estonia’s GDP grew 0.2 percent compared to the third quarter of 1999, and Latvia’s managed to stay even. Under these circumstances, lower tax rates are less likely to have sharp budgetary consequences.

Lithuania, on the other hand, is not expected to begin recovering from its recession until mid-2000. Third-quarter GDP was down 5.0 percent year-on-year. Vilnius struggled to get its 2000 budget deficit down to 2 percent of GDP in order to meet IMF conditions (see the Monitor, January 7). Tax cuts under these circumstances could have an unfortunate impact on budget revenues. And because Lithuania’s depressed business climate at present is likely to deter investors, lower corporate taxes may not have much of a pay-off. In fact, tax cuts which accentuate Lithuania’s fiscal imbalance and lead to more borrowing and higher debt could deter foreign investors, who are already concerned about Lithuania’s domestic and external imbalances.

Because Lithuania is farther behind in the privatization process than Estonia and Latvia, a better option might be to attract more foreign investment through faster privatization. Vilnius has in fact pledged to do this: the government’s economic program for 2000 envisions extensive privatization and restructuring in the telecommunications, energy, and transport sectors (See the Monitor, January 11). But in light of the parliamentary elections scheduled for later this year, this program is unlikely to be implemented in full. Its unwillingness to move faster on economic reform could cost Lithuania the chance to cut taxes and spur growth, as Estonia and Latvia are now doing.