EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1014 final COMMISSION STAFF WORKING DOCUMENT Country Report Lithuania 2019 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2019) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Reform priorities 3.1.Public finances and taxation 3.2.Financial sector 3.3.Labour market, health, education, and social policies 3.4. Competitiveness reforms and investment 1.Macroeconomic perspective 2.Assessment of barriers to investment and ongoing reforms Annex A: Overview table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Cohesion Policy Funding 2021-2027 for Lithuania References LIST OF Tables Table 1.1:Key economic indicators

Table 2.1:Assessment of 2018 CSR implementation Table 3.2.1:Financial soundness indicators Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth Table D.1:Policy Objectives LIST OF Graphs Graph 1.1: Breakdown of GDP growth Graph 1.2: Contribution to HICP inflation change Graph 1.3: Key labour market indicators Graph 1.4: Financing of the international investment position Graph 1.5: At-risk-of-poverty or social exclusion rate and its components Graph 1.6: General government balance and gross debt Graph 2.1: Overall multiannual implementation of 2011-2018 CSRs to date Graph 3.1.1: Gini coefficient development in the Baltic countries Graph 3.2.1: Credit growth

Graph 3.2.2: Annual change in real house prices Graph 3.2.2.1: Reform effect on equivalised household disposable income Graph 3.4.1: Labour productivity, whole economy (2000=100) Graph 3.4.2: Total investment Graph 3.4.3: FDI inflows Graph 3.4.4: Breakdown of ULC growth Graph 3.4.5: Real effective exchange rate, index (ULC and HICP based) Graph 3.4.6: Export market share development Graph 3.4.7: GDP per head (PPS) in 2016, EU28 = 100 Graph 3.4.8: Total population change in %, 2010-2016 LIST OF Boxes Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Lithuania Box 3.3.1: Monitoring performance in light of the European Pillar of Social Rights in Lithuania Box 3.3.2: EUROMOD simulations of adopted tax changes Box 3.4.1: Investment challenges and reforms in Lithuania Executive summary The Lithuanian economy continues to catch up with the rest of the European Union rapidly but needs to adjust to the challenge of a shrinking population. Thanks to a business-friendly environment, a resilient financial system and stable government finances, the country has rebounded swiftly since the economic crisis and enjoyed relatively high growth in recent years. However, the fruits of its rapid economic development have not been equally shared among its social groups and regions. The declining population, including the labour force, is putting pressure on the labour market and social security systems. Persistent weaknesses in the education and health sectors are limiting potential growth. Stronger investment in human capital, innovation, resource efficiency and transport are key to raising productivity and long-term growth potential ( ).

Domestic factors are driving growth. Growth reached 3.6 % in 2018. It was underpinned by robust consumer spending as wages rose and inflation slowed. Investment also grew steadily following a strong rebound in 2017. However, imports exceeded exports as the latter slowed down due to weakening foreign demand. Consumer spending and investment are expected to remain the main drivers of growth in the coming period. In addition to continued rises in wages, disposable income should get a boost from the income tax and social security reforms that will be implemented in 2019. At the same time, investment growth is expected to remain strong, boosted by Lithuania's faster absorption of EU funds. The strong economic performance is helping public finances. Rapid wage growth and, consequently, strong consumer spending boosted tax revenue over the last 3 years. Together with cautious government spending, this has enabled Lithuania to keep its budget in surplus. Nonetheless, the surplus is expected to shrink in the coming years due to legislated cuts in income taxes. Public debt remains below 40 % of GDP. However, despite pension reforms adopted in recent years, long-term risks to fiscal sustainability are still present due to negative demographic trends and inconsistencies in the system’s design that could undermine pension adequacy over time. The shrinking population, notably of people of working age, remains a major bottleneck to growth. Lithuania’s population has fallen by nearly 25 % since the early 1990s. The main reasons are high emigration and adverse demographic trends. Net emigration continues even though its pace has slowed recently. The shrinking working-age population is one of the reasons for the increasing shortages of skilled labour and is also pushing up wages. Employment stands at over 77 %, above the EU average, while unemployment fell to 6.3 %. Youth unemployment and long-term unemployment are below the EU average. However, the rates of people with disabilities and low-skilled people in work are worse than the EU average. The labour cost growth is among the fastest in the EU. After a sharp contraction during the financial crisis, wages started to recover rapidly, albeit from a low level. Wage growth was driven by the growing shortage of workers and a range of labour market policies, including consecutive minimum wage increases. By contrast, productivity growth was sluggish between 2012 and 2016, which led to increasing unit labour costs. The higher costs have not had a significant impact on Lithuania’s export performance so far as companies have absorbed them in their profit margins. However, a continued fast increase in labour costs could weaken Lithuania’s competitiveness in the longer run. The strong rebound in productivity growth seen in 2017, which was helped by the pick-up in investment, therefore needs to be maintained. Focusing investments on human capital, innovation, using resources more efficiently and improving transport connections would boost productivity and growth potential. Skills shortages are hindering private investment, especially with the labour force shrinking, and together with poor health status of the population are limiting productivity gains. Increasing social inclusion could help reduce high levels of income inequality and poverty, and uneven access to employment. Strengthening innovation in the private sector and increasing its capacity to absorb technology could support the shift toward activities that are more knowledge-based and add higher value to the economy. Using resources more efficiently would reduce the costs for businesses and households. Better transport connections would allow Lithuanian companies to export more. Focusing on efficiency of investment would help Lithuania reach its strategic goals. Annex D identifies key priorities for support by the European Regional Development Fund, the European Social Fund Plus and the Cohesion Fund over 2021-2027 in Lithuania, building on the analysis of investment needs and challenges outlined in this report. Lithuania has made limited ( ) progress in addressing the 2018 country-specific recommendations. There has been some progress in the following areas: ·Tax authorities continue to promote voluntary tax paying culture and the use of smart tax administration system. These measures are starting to give positive results although the overall tax compliance remains low. ·The introduction of the pension indexation from 2018 aims to increase the fiscal sustainability of the pension system, but might decrease the adequacy of pensions in the long run. Additional reforms passed in summer 2018 aim to strengthen the second pension pillar but their effect will largely depend on the willingness of people to participate in it. There has been limited progress in the following areas: ·The outcomes and efficiency of the general education system, as well as adult learning, remain relatively low. The implementation of reforms in the education sector, including the merger of universities, is slow. ·The legal frameworks for further consolidation of hospitals and strengthening disease prevention at the local level have yet to be adopted. Measures taken to improve the quality of health care were partial, targeting only primary care entities. Despite some measures taken to reduce the price of pharmaceuticals, out-of-pocket payments remain high, especially for the most vulnerable groups. ·The design of the tax and benefit system has slightly improved, but its impact on income inequality and poverty reduction remains limited. The guaranteed minimum income was increased (and started to be indexed) and so was the universal child benefit. Recent tax reform introduced some progressivity in the personal income taxation, but the effects on reducing income inequality are expected to be small. Public spending on social protection remains low. ·Some interim measures were taken to improve the efficiency of public investment, but integration of the investment and strategic planning is not foreseen before the 2021-2023 budget. ·Despite some slight improvements in the coordination of the research and innovation policy, the new coherent policy still needs to be developed. Some measures were introduced to increase the cooperation between science and industry, which, however, remains limited. There has been no progress in the following areas: ·The tax base was not broadened to sources less detrimental to growth. Environmental and property taxes remain low. Regarding progress towards its national targets under the Europe 2020 strategy, Lithuania has achieved its overall renewable energy target as well as the targets regarding the employment rate of the working-age population, greenhouse gas emissions, the share of early school leavers and the share of the population that has attained tertiary education. However, more effort is needed to reach the energy efficiency target, increase the share of renewable energy in the transport sector, reduce the number of people at risk of poverty or social exclusion, and increase expenditure on research and development, particularly in the private sector. Lithuania’s performance on the indicators of the Social Scoreboard supporting the European Pillar of Social Rights is mixed. The improved conditions on the labour market are well reflected in the indicators of the Social Scoreboard supporting the European Pillar of Social Rights: the employment rate is high for both men and women, unemployment is decreasing and there are fewer young people not in employment, education or training. However, income inequality and poverty remain high, even though the impact of social transfers on reducing poverty has slightly improved. Key structural issues analysed in this report, which point to particular challenges for Lithuania’s economy, are the following.

·The tax and benefits system is having little impact on reducing income inequality. Despite recent changes to personal income tax, the tax system is still not very progressive. Combined with low expenditure on social policies, this makes the power of the tax and benefits system to reduce income inequalities among the least developed in the EU. There was no progress in broadening of the tax base to sources less detrimental to economic growth, like environmental taxes, including car taxes, and property taxes. ·Levels of poverty and inequality remain among the highest in the EU. Poverty and income inequality remain major challenges despite Lithuania's fast economic growth. Income inequality is largely driven by comparatively strong growth in the income of top earners. Social dialogue between employers and trade unions in the private sector is limited, which weakens the position of low wage earners. Poverty affects mostly older people, people with disabilities and single-parent households. The risk of poverty or social exclusion in rural areas is nearly double that of urban areas. ·Recent pension reforms have made the system more financially sustainable but the adequacy of pensions remains a concern. The introduction of the pension indexation formula in 2018 linked pension rises to increases in the wage bill. This will balance the pension contributions received and spending on public pensions, thereby making the system more financially sustainable. However, since the overall wage bill is expected to increase more slowly than individual wages due to the shrinking workforce, pensions might not keep pace with wage growth over time. As a result, the adequacy of pension benefits, which is already among the lowest in the EU, is expected to drop further in the medium term. ·The shrinking labour force and the lack of necessary skills are limiting Lithuania's growth potential. With the growing shortage of workers, the employment rate and the proportion of working-age people in employment are reaching record highs. However, relatively high unemployment among vulnerable groups suggests weaknesses in government measures to improve the level of skills and to help the jobless find work. Many low-skilled or people with disabilities are not in work or training. Participation in adult learning is stagnant at well below the EU average. The labour force's low level of digital skills is limiting the use of digital technologies by businesses and the potential for innovation. ·Ensuring efficiency and quality in the education and training system represents a major challenge. Student numbers continue to decline across all education levels but the education system is not adjusting at the same pace. Urban-rural disparities in access to quality education and in student performance are large. This calls for organising the school and university networks more efficiently, to improve their quality and make them more inclusive of disadvantaged groups. New measures have been adopted to upgrade the vocational education and training system but concerns about their implementation remain. Policies to increase participation in adult learning are being implemented but their effect is limited. ·The poor quality of research and limited business-science cooperation are hindering productivity growth. The research and innovation system is fragmented and private R&D investment is among the lowest in the EU. This is yielding innovation results that are mediocre overall and is limiting the growth potential of the Lithuanian economy. Progress with the reform of innovation policy has been slow. The higher education reform envisages consolidating universities' fragmented research capacities, but these measures have yet to be implemented. Developing coherent policy measures to support science-business cooperation and introduce a simplified and consolidated research and innovation support system remains a challenge. ·The health status of the population remains poor. Life expectancy is among the lowest in the EU and mortality rates are above the EU average. Progress with the reforms in the health sector is slow. Spending in healthcare is too low to address the multiple challenges the sector faces. The proposals to further shift from hospital-based care towards a model based on stronger primary care remain at a draft stage. Public health policies do not sufficiently involve local offices in dealing with risk factors related to lifestyle. The overall quality of health services remains a concern and measures to improve the quality of health care remain scarce. High out-of-pocket payments (on-the-spot payments to healthcare providers) and wide regional disparities hurt the most vulnerable groups. ·The benefits of Lithuania's speedy economic convergence are heavily concentrated in the two metropolitan areas. Regional disparities in Lithuania are larger than the EU average and have been widening over the past two decades. Predominantly rural regions, which cover most of the territory and host nearly 55 % of the population, are experiencing strong population declines compounded by decreasing access to quality public services. Significant socio-economic disparities within the country show that certain regions have distinct investment needs. Increasing links between adjacent territories within Lithuania, including transport and digital connections, also remains a challenge. 1. Economic situation and outlook GDP growth The economy is maintaining a robust growth momentum. Real GDP growth is expected to have reached 3.6 % in 2018 after peaking at 4.1 % in 2017. Private consumption remained the main engine of growth, supported by rising wages and easing inflation, while for the second year in a row investments were spurred by high capacity utilisation in the context of increasing labour shortages. After an impressive export performance in 2017 (when export growth reached 13.6 % and was the highest in the EU), exports slowed down due to weakening external demand and the strong base effect. Consequently, the contribution of net exports to growth turned slightly negative. According to the Commission’s Winter Forecast, growth in Lithuania is expected to slow to 2.7 % in 2019 and 2.4 % in 2020. The main reason is expected to be the less dynamic external environment, which will further limit export growth. At the same time, domestic factors — consumption and investment — are expected to remain the main drivers of growth (see Graph 1.1). Graph 1.1:Breakdown of GDP growth Source: European Commission Consumption Strong wage growth continues to support consumption. Private consumption benefited from a boost in disposable income sustained by falling unemployment, continuous real wage increases and favourable credit conditions. It is estimated to have grown by 4.2 % in 2018, up from 3.3 % in 2017. In the coming period, disposable income should get an additional boost from income tax and social security reforms adopted in summer 2018. Investment Investment has started to recover. The share of investment in GDP dropped sharply after the crisis and has since remained below the EU average. However, after being almost flat in 2016, investment growth accelerated to an average of 7 % in 2017-2018. The major contribution came from private investment, while public investment, heavily reliant on EU funds, remained subdued despite a recent pick-up in their usage. In recent years, the structure of investment has become more favourable to growth, geared towards machinery and intellectual property and away from housing. Investment growth is expected to remain buoyant, boosted by continued favourable financing conditions, the need for modernisation and automation, and improved use of EU funds. Inflation Inflation slowed down markedly as the effects of 2017 increases in excise duties disappeared. After reaching 3.7 % in 2017, HICP inflation dropped to 2.5 % in 2018. Prices are, however, being permanently driven upwards by rising prices of services, mainly due to the rising wages. In 2018, these pressures were reinforced by rising oil and gas prices, while the contribution of changes in excise duties, albeit much smaller than in 2017, was still positive (see Graph 1.2). Strong wage growth is expected to continue to support disposable income and service price increases in the future, but overall inflation is expected to moderate further in the coming period as the effects of higher oil prices fade away. Graph 1.2:Contribution to HICP inflation change Source: European Commission Demographic developments

Demographic developments pose a challenge for future economic growth. Lithuania's demography is adversely affected by ageing and an overall population decline. The main drivers of the latter are the negative natural population growth rate and persistent net emigration. Over 2006-2018 Lithuania experienced one of the largest relative depopulations in the EU (from 3.3 million in 2006 to 2.8 million in 2018). To address the challenge of emigration, the government adopted in 2018 a 2018-2030 strategy on demography, migration and integration. The aim of the strategy is to ensure population growth and improve its age structure. The strategy focuses on family support policy, management of migration flows and comprehensive ageing policy. Labour market The labour market continued to perform well, but strong regional differences persist. Since 2010, employment and unemployment indicators have continuously been improving (see Graph 1.3). Employment reached a record high of 77.5 % in the third quarter of 2018 while unemployment was 6.3 % in the fourth quarter, a rate last observed in 2008. Nevertheless, this has to be seen in the context of a shrinking working age population. The activity rate reached 82 % in 2017. Vilnius and Kaunas counties offer better labour market opportunities than other counties, and this drives the internal interregional migration. However, in other regions employment opportunities remain scarce. Unemployment rates remained persistently high in the least developed regions (14.9 % in Utena County as compared to 4.8 % in Vilnius County). Other key labour market indicators have improved, returning to pre-crisis levels. Long-term unemployment fell to 2.1 % in the third quarter of 2018 (EU average: 2.9 %). Youth unemployment (13.3 %) and the rate of young people not in employment, education or training (NEET, at 9.1 %) were below the EU average in 2017. Graph 1.3:Key labour market indicators Source: European Commission Cost-competitiveness Wage growth remains among the highest in the EU. The average monthly gross wage in the third quarter of 2018 was up by 10 % from the same period in 2017, representing the fastest growth rate of the last 9 years. Rapid wage growth reflects the tightening labour market with increasing labour shortages, especially in the country’s largest cities, as well as successive minimum wage increases since 2015. In addition, over the course of 2018, the government decided to raise wages for workers in healthcare and higher education. The dynamism of wages has led to strong unit labour cost increases. Over 2012-2016 productivity growth was heavily outpaced by wage growth. This led to rapidly increasing unit labour costs, whose three-year cummulative increase reached 16 % in 2017, the highest in the EU. However, the impact of rising labour cost on external cost-competitiveness and the export performance has been limited so far, cushioned in part by reduced profit margins. This, however, may not be sustainable in the longer term. While productivity growth picked up strongly in 2017, maintaining cost competitiveness would require that wage growth is matched by productivity growth in the longer run. External position The current account has been broadly balanced in recent years, reaching a small surplus in 2017. This was driven by an exceptional performance in exports which benefited from improved external demand and increased capacity, especially in the manufacturing and transportation sector, due to higher investment. In the coming period, robust private consumption and investment demand for capital goods are expected to result in a deficit in the goods trade balance. This should be partially offset by the strong performance of trade in services, especially in the transport sector and travel, together with the positive secondary income balance. Lithuania’s external position improved over the decade. The net international investment position (NIIP) improved from almost -60 % of GDP in 2009 to -36 % of GDP in 2017. This was mainly linked to the decreased dependency of the financial sector, mainly commercial banks, on parent banks abroad. The NIIP is currently mainly made up of foreign direct investment and long-term government debt (see Graph 1.4). This implies a relatively low risk from Lithuania’s external position to the broader macroeconomic stability. Graph 1.4:Financing of the international investment position Source: European Commission Poverty and inequality Despite recent progress, poverty remains a major challenge. Overall, the share of the population at risk of poverty or social exclusion (AROPE) has decreased since Lithuania joined the EU in 2004. However, it remains among the highest in the EU (29.6 % in 2017, compared to 22.4 % in the EU, see Graph 1.5). The risk of poverty or social exclusion in rural areas is nearly double that of urban areas, which corresponds to the gap in the unemployment rate between cities and rural areas (4.5 % v 11 % in 2017). In particular the metropolitan areas of Vilnius and Kaunas, where significant economic activity is centred, drive a significant gap between AROPE rates in urban and rural areas ( ). Lithuania’s expenditure on social protection is among the lowest in the EU and the impact of social transfers on poverty reduction is limited, but the recent reforms of social benefits are the first steps in the right direction. Income inequality is still among the widest in the EU. In 2017, the income of the richest 20 % of households was 7.3 times greater than of the poorest 20 %. This reflects both the low level of benefit adequacy and the very limited progressivity of the tax system. In 2017, the median incomes of rural households were only 67 % of those of urban households, one of the lowest shares in the EU. In light of the low redistribution through taxes and social transfers (European Commission, 2018a), the inequality of disposable income slightly increased in 2017. The recent reform of personal income tax is not expected to have any significant effect on the progressivity (see Box 3.3.2). The indicators of the Social Scoreboard, supporting the European Pillar of Social Rights, show the level of income inequality in Lithuania as critical (see Box 3.3.1). Graph 1.5:At-risk-of-poverty or social exclusion rate and its components Source: European Commission Regional disparities Over the past 15 years, Lithuania has experienced the fastest convergence in the EU, but the benefits of economic growth are uneven across regions. Disparities among Lithuania's regions have steadily grown in this period. While GDP per capita reached nearly 110 % of the EU average in the capital region of Vilnius, it is only between 42 % and 77 % in other regions. The country’s rapid convergence is mainly fuelled by two regions — the capital region of Vilnius and Kaunas County — producing 42 % and 20 % of the national GDP, respectively. In 2014-2016 these regions grew on average by 4.6 % (Vilnius) and 3.3 % (Kaunas), while the other regions, which have a higher share of rural areas, stagnated or were in recession. Financial sector Lithuania’s banking system is well capitalised, liquid and profitable. The level of non-performing loans is below the EU average and the level of capital is high, ensuring the banking sector’s resilience to adverse shocks. Amid a financial upturn, the profit of the banking sector remained historically high. Banks' net interest income continued to grow, mainly due to cheap funding and rapidly expanding credit, the latter accompanied by rising housing prices. The main systemic risks to financial stability relate to these cyclical developments in credit and real estate markets, as well as to banks' structural interconnectedness with Nordic financial groups amidst high real estate valuations and household indebtedness in some Nordic countries. This warrants proactive use of macro-prudential policy tools by the Bank of Lithuania and close collaboration among financial supervisors.

Public finance Lithuania is maintaining its public finances in surplus. In 2017, the general government budget surplus stood at 0.5 % of GDP (see Graph 1.6). It was the second year in a row that Lithuania sustained a strong fiscal position thanks to robust tax revenue collection and contained government spending. The general government balance is expected to remain around ½% of GDP in 2018 and 2019. The general government debt is expected to decrease further from 39.4 % of GDP in 2017 to 37.9 % in 2019. Nonetheless, fiscal challenges are likely to remain relevant in the medium term, as the declining population and ageing are expected to put upward pressure on spending on pensions, healthcare and long-term care. Graph 1.6:General government balance and gross debt Source: European Commission Table 1.1:Key economic indicators Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise) 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 83 % of all country-specific recommendations addressed to Lithuania have recorded at least 'some progress' ( ). 17 % of these CSRs recorded 'limited' or 'no progress' (see Graph 2.1). Lithuania has achieved substantial progress and full implementation in the areas of fiscal policy and governance, including governance of state-owned enterprises, and improving the security of energy supply. Graph 2.1:Overall multiannual implementation of 2011-2018 CSRs to date Source: European Commission Lithuania has maintained its public finances in surplus and continued adjusting the pension system to address its fiscal sustainability and adequacy. For the third year in a row, Lithuania achieved a general government surplus, which was well supported by tax-rich economic growth. In structural terms, Lithuania’s budget position has improved significantly, as the structural budget deficit shrunk from 3.5 % of GDP in 2011 to an estimated 0.6 % in 2018. It also made efforts to strengthen its fiscal framework. The government implemented measures to reduce the tax burden on low income earners and increase tax compliance. However, during the recent overhaul of the income tax system, Lithuania once again did not use the opportunity to broaden the tax base to sources that are less detrimental to growth, and thus to compensate, at least partly, for the costs of the reforms. From 2018, the fiscal sustainability of the pensions system has been strengthened by introducing a pension indexation formula. These reforms also address to some extent the low adequacy of pensions. However, in the longer term the overall low level of spending on pensions might limit further improvements. Lithuania has made limited progress in improving the quality, efficiency and labour market relevance of education and training. The reforms in general education are still ongoing, with the efficiency of the school network and the quality of outcomes remaining the main challenges. The reform of the higher education system is progressing slowly. The measures taken to improve vocational education and training (VET) seem promising, but consistent progress is still needed to ensure effective governance of VET institutions and improve the learning experience. Lithuania continues to strengthen its network of adult learning coordinators in municipalities, but the results are limited so far and participation in adult learning remains low. Progress with improving the performance of the health sector has been limited. Measures to further consolidate the hospital network are yet to be adopted. Adopting legislation on the use of alcohol and tobacco in recent years has helped somewhat to contain health risk factors. However, public health interventions at local level remain limited due to low investments and the lack of a framework ensuring that municipalities implement evidence-based interventions. In recent years, an increasing number of measures have also sought to improve the quality of healthcare services. However, their scope remains limited, addressed only to primary care and introduced on a voluntary basis. Despite some measures taken in the last 2 years to reduce the overall costs of pharmaceuticals, including the reduction of user charges and VAT and incentivising the sale of cheaper products, measures to address affordability for specific groups have not been adopted yet. Lithuania is continuing its efforts to reduce poverty and income inequality, but the results are limited so far. In recent years, some important measures have been taken to address poverty. These include the revision of unemployment benefits, the increase of the state supported income, and improving legislation on cash social assistance. From 2019, Lithuania has further increased the universal child benefit, which should have a positive impact on poverty reduction. However, important challenges remain. The risk of poverty for elderly people and people with disabilities remains high, and despite the recent progress, the adequacy of benefits remains relatively low. Income inequality remains among the highest in the EU, and the recent tax reforms do not seem to be sufficiently effective in reducing it. Tailoring taxes and benefits in a way that reduces poverty and income inequality, and increasing incentives to enter the labour market, remain major challenges.

Overall, Lithuania has made limited progress in addressing the 2018 CSRs ( ). Some progress was achieved in addressing the CSRs on tax compliance and strengthening the sustainability and adequacy of the pension system. However, progress in addressing the issues in the labour market, education and health sector, improving the design of the tax and benefit system, as well as in increasing productivity by making public investment and research and innovation policy more efficient, was limited. There was no progress in broadening the tax base to sources less detrimental to growth.

Table 2.1:Assessment of 2018 CSR implementation Source: European Commission

Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Lithuania Lithuania is a major beneficiary of the European Structural and Investment (ESI) Funds and can receive up to EUR 8.4 billion over 2014-2020. This potentially represents around 3 % of GDP annually. By the end of 2018, an estimated EUR 5.6 billion (66 % of the total) had been allocated to projects on the ground. Over the same period, Lithuania signed 13 agreements for EUR 390 million for strategic transport projects under the Connecting Europe Facility. A total of 313 participants received funding of EUR 40 million under Horizon 2020 (including 69 SMEs which received about EUR 13 million). EU funding has helped to address policy challenges identified in the 2018 CSRs. Actions financed through European Regional and Development Fund (ERDF) and European Social Fund (ESF) cover, among other things: support for ongoing reforms in the health and education sectors, notably by investing to improve access to quality healthcare across the country; support for consolidating education infrastructure and raising the quality of education at all levels; promoting R&I in the private sector and cooperation between science and business. By the end of 2018, ERDF and Cohesion Fund (CF) investment had reached more than 4 800 businesses and attracted over EUR 450 million in private funds matching public support. Around 22 000 pupils are studying in renovated schools. A total of 76 upgraded health care institutions provide improved services for over 220 000 patients. Among other achievements, ERDF and CF investments led to the reconstruction of 480 km of roads and 60 km of railways and improved wastewater treatment services for 995 000 people. The ESF invested in people and in social inclusion — more than 71 000 unemployed persons (including about 20 000 young people aged under 29) improved their employability. More than 110 000 pupils could improve their skills in formal and non-formal education and about 10 000 people participated in lifelong learning activities. Social services were provided for more than 11 000 people, and 16 000 people with disabilities were given support to enable them to work in adapted workplaces. Each year about 200 000 people received food packages from FEAD, together with measures to support their social inclusion. In addition, the Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help Member States implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. Lithuania, for example, received support to enhance the public sector efficiency through the optimisation of the institutional framework of public-sector organisations, enable industry transformation through digitalisation and address corporate insolvency. In 2018, technical support is being provided to the Office of the Government of the Republic of Lithuania for its efforts to reduce shadow economy via measures that raise awareness and create positive incentives in the public. Support measures are also underway to enhance the capacity of local authorities to evaluate the long-run sustainability of their financial structure and develop structural analysis of the revenue and expenditure of municipalities. In addition, support is also being provided to the authorities to help reform the network of teacher education institutions and to help develop alternative access to finance for SMEs. EU actions strengthen national, regional and local authorities and civil society. EUR 123 million of ESI Funds has been allocated for strengthening the capacity of public administrations at different levels by prompting close cooperation with stakeholders. Lithuania is also benefiting from support under the pilot action for regions in industrial transition, which provides advisory services for the development of a comprehensive strategy for national economic transformation. EU funding is helping to mobilise private investment. ESI Funds, especially via ERDF and CF, are mobilising additional private capital by allocating about EUR 700 million in the form of loans, guarantees and equity. This is expected to leverage additional private investment of EUR 1.3 billion. Altogether, EUR 650 million of the ESI Funds have been paid in the form of financial instruments. In addition, the European Fund for Strategic Investments (EFSI) has allocated EUR 399 million to 13 infrastructure and innovation projects and 6 SMEs projects in Lithuania. This is set to trigger EUR 1.5 billion in additional investments. Lithuania ranks 11th in the overall volume of approved EFSI operations as a share of GDP. More information on: https://cohesiondata.ec.europa.eu/countries/LT 3. Reform priorities 3.1.Public finances and taxation 3.1.1.fiscal policy Lithuania plans to maintain the budget surplus. In 2018, according to preliminary data, the general government balance remained in surplus for the third consecutive year, amounting to 0.6 % of GDP. However, due to costs of the reforms legislated in the middle of 2018, the general government surplus is set to decrease slightly to 0.4 % of GDP in 2019. Revenue losses stemming from adjustments to personal income tax and social security contributions are expected to be partially offset by additional revenues thanks to improvements in tax administration and the termination of transfers from the State Social Insurance Fund to private pension funds. Overall, taking into account increases in public wages, social benefits and other types of social support, the current fiscal stance is considered to be slightly expansionary. 3.1.2.Tax POLICY Lithuania has one of the lowest tax-to-GDP ratios in the EU. Total tax revenues were 29.5 % of GDP in 2017 compared with the EU average of 39.0 %. Lithuania relies mostly on indirect taxes (11.9 % of GDP) and social security contributions (12.3 % of GDP). Direct taxes account for only 5.4 % of GDP, among the lowest proportions in the EU (data for 2017). However, the tax burden on low-income labour is relatively high. The tax-benefit system has one of the weakest powers to correct income inequality in the EU. As measured by the Gini coefficient ( ), Lithuania has relatively high inequality in pre-tax market income. Combined with a weak redistribution through taxes and social transfers, this leads to one of the highest levels of disposable income inequality in the EU. Moreover, inequality is on the rise with the Gini index climbing to 37.6 in 2017 from 37.0 in 2016 (see Graph 3.1.1). This compares to levels in neighbouring Estonia and Latvia of 31.6 and 34.5, respectively. The EU average stands at 30.3. Graph 3.1.1:Gini coefficient development in the Baltic countries Source: European Commission Despite the reduction in the tax burden for low income earners, overall tax progressivity remains low. The tax wedge ( ) on low-income earners in 2017 (34.0 % for singles without children earning 50 % of the average wage) fell compared to 2016 (-2.5 pps). However, it remains above the EU average of 32.4 %, even though income tax in Lithuania is well below the EU average. Lithuania continued to raise the non-taxable income threshold in personal income tax, from EUR 310 in 2017 to EUR 380 in 2018, and increased the allowance for people with disabilities, while the minimum wage was set at EUR 400. Personal income tax will become more progressive in 2019. The new personal income tax reform further increases the non-taxable income threshold. This is expected to reduce the tax payable by low income earners and help cut poverty by focusing on the most disadvantaged people in the workforce (see Box 3.3.2). In addition, Lithuania is introducing a new progressive tax structure for personal income tax with a 20 % and 27 % ( ) tax rate replacing the existing 15 % flat tax rate. However, the income of self-employed people and certain social security benefits like maternity benefits, sickness benefits, etc. will continue to be taxed at 15 %. This implies that the effective labour taxation rate on the same job is not neutral in respect to which legal form of activity is chosen (individual activity certificate, self-employed or regular employment contract).

The overall progressivity of labour taxation remains relatively low due to changes to the social security contribution (SSC). The combined SSC rate (employer and employee) will be reduced by around 19 pps. Employers’ SSC rate will be set at 1.47 % instead of current 30.5 %, and employees’ contribution rate will be raised to 19.5 % from 9 % currently. To compensate for the statutory tax increase for employees, employers are legally obliged to increase gross salaries by 28.9 %. Additionally, Lithuania introduced a SSC cap with the aim of attracting investors. The cap will be applied to yearly incomes exceeding 120 average monthly wages and will be gradually reduced to 84 average monthly wages in 2020 and to 60 in 2021. In practice, this measure counterbalances the labour taxation progressivity introduced by the personal income tax reform for the highest earners and is not expected to reduce income inequality (see Box 3.3.2). The current reform does not involve any broadening of the tax base to more growth-friendly sources, despite entailing budgetary costs (see Box 3.3.2). Environmental taxes, which account for 1.9 % of GDP, are mostly taxes on energy (1.7 % of GDP). Environmental taxes are significantly below the EU average of 2.4 % of GDP (data for 2017). Taxes on transport are the lowest in the EU and do not take into account vehicles’ environmental performance. CO2-based motor vehicle taxes are not in place in Lithuania. Incentives to favour cars with lower CO2 emissions are very limited and new vehicles purchased in Lithuania are among the least environmentally friendly in the EU. No changes to car taxation or the road-use tax for private passenger vehicles are envisaged. Lithuania has one of the lowest excise duties on petrol, diesel and other motor fuels in the EU. The overall implicit tax rate on energy is among the EU’s lowest. However, excise duties on tobacco products will further increase and a tax on electronic cigarette liquid will be introduced in 2019. Property taxation remains low and no further changes are planned. In 2017, Lithuania collected only 0.3 % of GDP from recurrent property taxes, which is significantly below the EU average of 1.6 %. Lithuania’s R&D incentives are generous but appear ineffective in motivating private sector R&D investment. In 2017, private R&D expenditure amounted to 0.3 % of GDP, compared to an EU average of 1.4 %. The fiscal instruments in place to support R&D include a deduction of 300 % of R&D expenditures from taxable income if certain innovation criteria are met and a scheme allowing faster depreciation of some R&D capital assets. A reduction in compliance costs and relieving the administrative burden on small businesses could widen the use of R&D tax incentives. 3.1.3.tAX COMPLIaNCE Tax compliance remains relatively low. Although the VAT gap ( ) decreased slightly from 25.6 % in 2015 to 24.5 % in 2016, Lithuania still has one of the largest gaps in the EU (CASE, 2018). The country has introduced several measures to combat the shadow economy and improve tax compliance. The State Tax Inspectorate is continuing taxpayer awareness campaigns and promoting a voluntary taxpaying culture. The cash registry receipt lottery game organised by the Inspectorate showed good results, with more than two thirds of VAT payers in the catering sector registered in the lottery. Several public relations campaigns aimed at increasing public awareness and engagement were undertaken. 'Smart tax administration system' (i.MAS) measures introduced in recent years have almost halved the time businesses need to comply with tax rules, from 171 hours in 2015 to 99 hours in 2017 (World Bank, 2018a). Lithuania will introduce taxpayer risk profiles and other compliance measures from 2019. The government will provide a one-time opportunity for taxpayers to benefit from the tax amnesty in 2019. Private individuals will have the opportunity to recover some of their personal income tax if they use services with certified tax accounting. Other compliance measures are planned, such as a free accounting system services for small businesses in 2019 and a 'virtual cash register' project in 2020. 3.1.4.Fiscal framework Application of the fiscal rules has been broadened. According to the Constitutional Law on the Implementation of the Fiscal Treaty, from 1 January 2018, all large budgets in the central and local government sector have to be balanced or in surplus in structural terms. This requirement, intended to further strengthen fiscal discipline, was applied in 2018 for the first time to the budgets of the three biggest municipalities and the National Health Insurance Fund. According to the Law, the balanced budget rule does not apply to the state budget and the State Social Insurance Fund. In July 2018, the Law on the Budget Structure was amended to improve the transposition of Council Directive 2011/85/EU on requirements for Member States’ budgetary frameworks. The amendments are aimed at increasing the transparency of the macroeconomic and budgetary forecasts produced by the Ministry of Finance and improving the monitoring of national fiscal rules (Office of the Seimas of the Republic of Lithuania, 2018). Lithuania seeks to further improve its medium-term budgetary planning system. Under the first stage of this reform, budgetary procedures were revised in 2018. Deliverables and key performance indicators were set for appropriation managers, who are expected to achieve them over a three-year period. During preparation of the draft budgetary plan for 2019 the Lithuanian authorities also made efforts to perform expenditure reviews. Though such reviews had been implemented in the past, they lack a more structured approach, including adopted methodologies and tools. Taking into account the small size of the government sector, Lithuania would also benefit from a fundamental review of state functions in the context of limited public funding. In 2019, during the second stage of the reform, the Ministry of Finance plans to draft the necessary legal documents and procedures on budget structure, implementation, monitoring and evaluation. 3.1.5.Debt sustainability analysis and fiscal risks Lithuania faces low sustainability risks in the short, medium and long term. The early-detection indicator of fiscal stress, S0 ( ), is below its critical threshold, both for the fiscal and the financial competitiveness sub-indices (see Annex B). Similarly, fiscal sustainability risks appear low over the medium term, both according to the sustainability gap indicator S1 ( ) and the debt sustainability analysis, given the moderate current debt-to-GDP ratio and the limited sensitivity to possible macro-fiscal shocks (European Commission, 2019). Lastly, over the long term Lithuania is considered at low fiscal sustainability risk. The sustainability gap indicator S2 ( ) shows that only a small fiscal adjustment would be required to stabilise debt in the long run. Total ageing costs are projected to remain relatively flat in the long term. They are projected to increase from 16.0 % of GDP in 2016 to 16.7 % in 2030 and peak at 17.1 % in 2040 before decreasing again to below 16 % in 2070 (European Commission, 2018b). The introduction of the new pension indexation formula in 2018 increased fiscal sustainability. Following the 2016 reform, pension benefits and accumulated pension points are now indexed on the basis of changes in the total wage sum. The introduction of a link between public pension expenditure and the contributions received provides for an automatic balancing of the system. The indexation mechanism, together with the increase in eligibility requirements for full pension benefits, should reduce pension expenditure between 2016 and 2060 by 3.7 % of GDP (European Commission, 2018b) compared to projections based on the previous rules. Since pensions account for over 40 % of all age-related costs, this has reduced the overall risk demographic ageing poses to Lithuania’s public finances. However, baseline pension projections for Lithuania are subject to important risks as the current legislation expects authorities to put forward corrective measures in case the benefit ratio decreases (European Commission, 2018c). Increasing fiscal sustainability, however, comes at the cost of declining pension adequacy. Since the total wage bill is expected to increase at a slower pace than wages due to the rapidly shrinking working-age population, the benefit ratio is projected to fall in the future. This is particularly worrisome since Lithuania has one of the lowest benefit ratios in the EU (see Section 3.3.3). With a relatively weak corrective power of the tax and benefit system (see Section 3.1.2), pensions are the main redistributive mechanism in Lithuania. Declining adequacy would therefore significantly increase poverty rates. To address the issue of a low replacement ratio, the government passed an additional pension reform in summer 2018 to move the basic pension from the State Social Insurance Fund to the state budget. According to the Lithuanian authorities, this aims to reinforce the link between benefits and contributions and strengthen the second pension pillar (see Section 3.3.3). The results of the reform will largely depend on the participation rate, i.e. on the willingness of participants to stay enrolled in the second pillar and pay higher pension contributions ( ). Despite rapid population ageing, expenditure on healthcare and long-term care is expected to remain relatively contained. It is projected to increase from, respectively, 4.1 and 1.0 % of GDP in 2016 to 4.6 and 1.7 % by 2040. Both increases are below EU average expenditure growth over this period.

3.2. Financial sector 3.2.1.FINANCIAL STABILITY The financial position of the Lithuanian banking sector is strong. Lithuanian banks operate with high levels of capital (Table 3.2.1). As of June 2018, the total capital ratio was 19.0 %, well above the minimum capital adequacy requirements and the capital buffers currently in place. As regards its composition, the capital consists almost entirely of Common Equity Tier 1 (CET 1), which is the highest-quality capital (CET 1 ratio of 18.7 %). The rapid decline in funding costs was the main contributor to high bank profitability, with a return on equity of 13.5 %. The non-performing loan ratio continued its decreasing trend to below the European average, falling to 3.1 % from 3.7 % the year before. Banks in Lithuania have minor exposure to non-bank non-residents (only 2.3 % of the total amount of outstanding loans as of Q1-2018), as the loan portfolio is largely domestically oriented. The loan-to-deposit ratio remains safely below 100 %, at 93 % at the end of November 2018, indicating sustainable bank funding amid active lending. Table 3.2.1:Financial soundness indicators Source: European Central Bank One of the main systemic risks to financial stability relates to cyclical developments in credit and real estate markets. Credit to Lithuanian residents continues to grow robustly, albeit at a slower pace than to corporations (Graph 3.2.1). The housing loan portfolio posted the highest growth, with an annual growth of around 8 % in 2018. Given the sustained upswing in the credit and housing market (see Section 3.2.3), the Bank of Lithuania decided to apply a countercyclical buffer of 0.5 % at the end of 2017 (with effect from January 2019). In June 2018, the Bank further increased it to 1 % (with effect from June 2019), as credit growth continued and banks’ profitability was high. The primary objective of this macro-prudential tool is to make the banking system more resilient and less pro-cyclical. Measures aimed at the borrower’s side date back to 2011, when the Bank approved the Regulation for Responsible Lending, which was amended in 2015. It includes a loan-to-value ratio of maximum 85 %, a debt-service-to-income ratio of maximum 40 % (50 % with a 5% interest rate; 60% in exceptional circumstances) and a loan maturity of maximum 30 years. Graph 3.2.1:Credit growth Source: European Central Bank Lithuania’s banking sector has become one of the most concentrated in the EU, thereby also increasing systemic risk. As of September 2018, the three largest banks (Swedbank, SEB and Luminor) hold a market share of 82 %. This is partly attributable to the relatively small market size and the high competitiveness of the big players which crowd out smaller institutions. The Bank of Lithuania actively encourages the entry of new participants into the market and, together with the government, in 2016 submitted a set of proposals and amendments of legal acts covering diverse alternative financing sources for small and medium sized enterprises (SMEs). A highly integrated and concentrated Nordic-Baltic banking system warrants close collaboration among financial supervisors. Risks mainly relate to the Scandinavian housing markets and the high indebtedness of their households. They may materialise in the form of constrained lending activity, short-term deposit volatility, and higher financing costs for Lithuanian banks, given the relatively heavy dependence on wholesale funding from some Nordic countries. Supervisors from the Nordic and Baltic countries are aware of potential spillovers and of the existing differences in legal frameworks. They are cooperating closely to maximise the effectiveness of national macro-prudential policy instruments, ensure a level playing field for all credit institutions and reduce the risk of regulatory arbitrage. In this respect, the Bank of Lithuania has decided to automatically reciprocate other EU countries’ macro-prudential policy measures, ( ) e.g. the lower limit for risk weights on residential mortgage loans in Finland ( ) as well as a 1 % systemic risk buffer rate to banks’ Estonian exposures ( ). Ensuring cyber security remains an important challenge to Lithuania’s financial system. FinTech developments are increasing the risk of cyber attacks, which may have a large impact on financial stability. Virtual currencies and unregulated digital money that may be used as a payment pose additional risks to financial stability — notably money laundering, hacking and market risk in terms of the exchange rate of the virtual currency. 3.2.2.Access to finance

Difficulties in accessing finance affect SMEs’ innovation and growth. More than one of eight SMEs considered access to finance its most important concern. This is among the highest and almost double the EU average. Despite the improved availability of funding, SMEs access to finance score remained close to the EU average. (European Commission, 2018d). SMEs continued to experience some challenges in obtaining loans. This is evidenced by one of the highest loan rejection rates in the EU, the perceived deterioration of banks’ willingness to provide a loan, and higher relative borrowing cost for small loans to large loans (European Commission, 2018e). The market gap for business financing was estimated at EUR 660 million in 2018 and growing. Funding gaps were high and growing for risk capital and start-ups in particular (Ministry of Finance, 2019). These bottlenecks affect the entrepreneurial ecosystem and the innovation capacity (see Section 3.4.1), hindering SMEs’ growth. 3.2.3.Housing market House prices are slowing. After averaging 5 % since 2014, growth in house prices has slowed recently as housing supply catches up with demand growth (see Graph 3.2.2). The supply of new housing in Vilnius and its suburbs, the country’s biggest real estate market, has reached post-crisis highs and the stock of unsold apartments in the three largest cities has started to increase since the beginning of 2017. The demand for housing is still strong, fuelled by rapidly rising wages (see Section 3.4.2), benign financial conditions and positive expectations. In the first half of 2018, the number of monthly transactions was the highest since the 2007-2008 peak (State Enterprise Centre of Registers, 2018). Since 2010 housing market activity has been concentrated in more densely populated areas and the largest cities, but in 2018 less populated areas started to get very active as well. Graph 3.2.2:Annual change in real house prices Source: State Enterprise Centre of Registers, Statistic Lithuania, UAB OberHaus, Commission calculations The key drivers in the housing market seem to be in balance. The overall valuation gap calculated by the European Commission ( ) signals that house prices in Lithuania are not overvalued. This indicator, however, does not catch large regional differences, which are prominent in Lithuania (Vilnius and other cities v rural areas). While credit growth, supported by low interest rates, improving financial health of households and positive expectations, has been noticeable in recent years, households are also financing a large share of housing purchases with their own resources ( ). The household debt at 26 % of GDP in 2017 is among the lowest in the EU, aligned with fundamentals, and not leading to prudential concerns ( ). These factors point to an overall balanced situation in the housing market and suggest limited risks of market correction at the present juncture. 3.3. Labour market, health, education, and social policies 3.3.1.Labour market The labour market continues to perform well but a shrinking labour force, skills shortages and territorial disparities remain challenges. The working-age population decreased from 1.8 million to 1.7 million between 2014 and 2017, reducing the potential supply of labour at a time of economic growth. Work-related immigration has increased and a majority of third-country nationals fill the jobs requiring medium skills, mainly in the transport, construction and service sectors. To a certain extent, this indicates the inability of the Lithuanian education and training system to anticipate and provide the required skills. Employment opportunities are also very unequal in Lithuania: in 2017 the employment rate gap between people living in cities and those living in rural areas was one of the highest in the EU (13.7 pps). Employment opportunities for low-skilled workers are fewer than in other EU Member States. Tertiary graduates in Lithuania perform better on the labour market than the EU average. Their unemployment rate in 2017 was lower than the EU average (3.0 % v 4.6 % in the EU). The employment rate difference for people with different skills levels is significant. The employment rate for the low, medium and high-skilled is 44 % (55 % in the EU), 70 % (73 % in the EU) and 90 % (84 % in the EU) respectively. Due to the tightening labour market, the unemployment rate of the medium and low-skilled is decreasing, but remains well above the EU average and has not yet reached pre-crisis levels. The government has recently started developing national skills/human resource monitoring processes, but there is no structured regulatory framework for anticipating the skills that will be needed in the medium term. Ensuring the supply of skills is one of the main areas where demand for investment remains significant. Spending on and coverage by active labour market policy measures remains limited compared to other EU countries. The proportion of registered unemployed people in Lithuania covered by these policies is relatively low (around 20 %). The low-skilled unemployed are underrepresented as, for example, they count for only 16 % (October 2018) of total participants in vocational training programmes. Participation by people with disabilities in active labour market policy (ALMP) measures is also low. The measures are overwhelmingly financed by external sources like the European Social Fund (around 60 % of the total cost). In 2018 the cost of providing these measures increased due to the configuration of vocational training provision and increased costs for other measures, but the resources allocated remain limited. The extent of the ALMP measures' coverage is linked to funding, and the demand for investment will remain significant. Cooperation between the Public Employment Service and other stakeholders on labour market activation is lacking. This reduces the relevance and effectiveness of ALMP measures. To ensure better effectiveness and relevance of labour market activation measures, and their integration with social and health services, Lithuania is developing a special integrated services model. It envisages cooperation between different stakeholders, including social partners, municipalities and civil society organisations. In 2019, a pilot project of the model targeting the long-term unemployed will be launched in several municipalities. The level of digital skills in the labour force is limiting the use of digital technologies by businesses. While the use of digital technologies by businesses is above the EU average, the number of ICT specialists is among the lowest in the EU with 2.7 % ICT specialists as a percentage of employed individuals, against 3.7 % on average in the EU. This, and the decreasing number of graduates in STEM subjects (science, technology, engineering and mathematics), are factors limiting the further uptake of digital technologies. Among businesses that have recruited or tried to recruit ICT specialists, 40 % reported hard-to-fill vacancies. Lithuanian businesses are also underinvesting in enhancing digital skills: only 9 % of companies provide training to their personnel to develop and upgrade their ICT skills, significantly below the EU average of 23 % (European Commission 2018f). The Lithuanian Digital Agenda strategy and the National Industry Digitalisation Platform ‘Pramonė 4.0’, launched in 2017, have helped the digital transformation of the economy but further efforts are needed. Box 3.3.1: Monitoring performance in light of the European Pillar of Social Rights in Lithuania The European Pillar of Social Rights is designed as a compass for a renewed process of upward convergence towards better working and living conditions in the European Union ( I ). It sets out 20 essential principles and rights in the areas of equal opportunities and access to the labour market; fair working conditions; and social protection and inclusion. Lithuanian’s performance on the indicators of the Social Scoreboard supporting the European Pillar of Social Rights is mixed. Continuous economic growth is driving the good performance of the labour market and the employment rate of both women and men has risen. However, skills shortages are becoming evident. Lithuania continues to have one of the smallest gender employment gaps in the EU. The economic growth has not yet translated into greater social inclusion, though. Income inequality (measured by the income quintile ratio), which is largely driven by disproportionate growth in the income of top earners, is the main challenge. The impact of social transfers on poverty reduction, while improving slowly, remains weak. The level of poverty and social exclusion remains among the highest in the EU and there is much more to be done to achieve convergence. Poor health outcomes call for persisting challenges in the healthcare system and public health policies to be addressed. Unmet medical needs are around the EU average but out-of-pocket payments are still high and have an impoverishing effect on certain groups. Lifestyle risk factors need to be addressed more consistently and the role of local entities in public health policies needs to be strengthened. The recent increase in social benefits has improved the impact of social transfers on poverty reduction. The situation is not assessed as critical, in contrast to the 2018 Country Report. The universal child benefit system, introduced in 2018, has been instrumental in reducing the risk of poverty for households with children, including for single-parent families (see Box 3.3.2). Social dialogue in Lithuania is slowly improving. The institutional setup for involving the social partners at national level is in place. Bipartite social dialogue is rather weak, with some progress being made in signing sectoral agreements, but only in the public sector. There is scope for further improvement, in particular focusing on the know-how and training of the social partners, developing models of cooperation between the trade unions and work councils, and incentivising engagement in negotiations at sectoral and company level. In this context, investment in building up the social partners’ capacity and engagement is important to ensure the effectiveness of social dialogue, in line with the social dialogue principle of the European Pillar of Social Rights. 3.3.2.Social policies Income inequality remains one of the highest in the EU and is largely driven by income growth among top earners. According to the indicators of the Social Scoreboard, supporting the European Pillar of social rights, Lithuania faces a critical challenge on income inequality. In 2017, the income of the richest 20 % of the population was 7.3 times higher than the poorest 20 %, up from 7.1 times from the previous year. The top 20 % also earned 2.7 times that of the middle 20 %, one of the highest ratios in the EU. The effect of benefits on reducing market income inequality is below the EU average and the tax system is not conducive to reducing inequality ( ). The tax reform passed in 2018 seems to be having little to no effect on disposable income inequality (see Section 3.1.2 and Box 3.3.2). Old-age poverty remains a serious challenge, with levels well above the EU average. In 2017, over 16 % of people over 65-years-old were severely materially deprived. This is lower than in 2016 (17 %), but still three times higher than the EU average (5 %). Also in 2017, 33 % of over-65-year-olds were at risk of poverty, after significant year-on-year increases since 2012 due to pensions not keeping up with the increase in salaries. There is also concern at the levels of older women at risk of-poverty or social exclusion (AROPE) ( ), with a 20 % pps gender gap. These data do not take account of the recent policy changes and the indexation of pensions in 2018, which could have had some positive impact. (see Section 3.3.3). The risk of poverty for people with disabilities is also one of the highest in the EU, and is increasing. About 44 % are at risk of poverty or social exclusion compared to 30 % in the EU. The AROPE rate gap between people with and without disabilities is one of the highest in the EU (twice the EU average). At the same time, access to jobs for people with disabilities who are able and willing to work is improving, but remains limited. The employment rate gap between people with and without disabilities is 31 pps compared with the EU average of 26 pps. The lack of skills and of the effectiveness of vocational rehabilitation are two of the main obstacles to integrating people with disabilities into the labour market (ANED, 2018). Public and private investment is needed to facilitate the integration of the people with disabilities into the labour market and put in place an effective scheme of social economy. Despite recent progress, the adequacy of benefits remains low. Social protection spending in Lithuania is among the lowest in the EU, amounting to about 15 % of GDP in 2016 ( ). This is also reflected in the poor adequacy of the guaranteed minimum income, which in 2016 was around 36 % of the poverty threshold ( ) compared to the EU average of 58 % (European Commission 2018g). In January 2018, the minimum monthly guaranteed income was raised for the first time since 2008 (by almost 20 % or EUR 20 in absolute terms).

Current reforms have allowed for an increase in the state-supported income as well as family-related benefits. The government is taking further action to increase the adequacy of support by introducing the ‘amount of minimum consumption needs’ and a system of automatic indexation based on this amount. The new system is effective from 1 January 2019 but has not led to any significant change in monetary terms compared to 2018, and does not compensate for the 10-year freeze in the state-supported income. A universal child benefit system was put in place in 2018, and from January 2019 the amount has increased from EUR 30 to EUR 50 per child per month. This measure will reduce the at-risk-of-poverty rate for households with children (see Box 3.3.2), but there is still a lot of scope for further social convergence with the rest of the EU. High levels of homelessness persist. The most recent data on homelessness for Lithuania (FEANTSA, 2015), estimate that over 4 000 people are homeless or living in shelters. Lithuania has one of the highest rates in the EU of households unable to keep the home adequately warm in winter, and of tenants overburdened by housing costs. The housing cost overburden for tenants is 48 %, among the highest in the EU. Lithuania also faces a shortage of social housing (OECD, 2016). The poor quality of housing remains a concern in rural areas. At almost 10 %, the rate of severe housing deprivation for the rural population, though falling, remained above the EU average in 2017, and significantly higher than for urban dwellers (6 %). To address the issue of homelessness and poor quality of housing, investment needs to be ensured, in particular at municipal level. 3.3.3.Pensions The Lithuanian pension system is not effective at protecting the elderly against poverty and social exclusion. Public pension expenditure on pensions as a share of GDP is among the lowest ( ) in the EU (European Commission, 2018b). As a result, old-age benefits are low, unable to keep pace with the increase of salaries, and the old-age poverty rate is one of the highest in the EU (see Section 3.3.2). Recent reforms put more emphasis on financial sustainability but were less successful in ensuring adequacy (see Section 3.1.5). The theoretical net replacement rate is low and estimated to drop by 7 pp. from 56 % in 2016 to 49 % in 2056, placing Lithuania among the countries with the lowest such rates in the EU (European Commission, 2018h). The changes to the pension system in January 2018 led to a gradual increase in the number of working years required to qualify for a full pension, from 30 to 35 years by 2027, and introduced annual indexation. The indexation will increase old-age pensions by 6.9 % and 7.6 % in 2018 and 2019, respectively. This increase should help to reduce the old-age poverty rate in the short and medium term. In the long term, the increase in the adequacy of pensions might remain limited due to the decrease in the working-age population and low public expenditure on pensions. As of January 2019, the pension system has been further adjusted to mitigate the risks caused by demographic trends. A points system is introduced for calculating the earnings-related part (individual pension component), which is expected to lead to a more transparent accrual of entitlements in the future. The government shifted the ‘general’ (basic) components of social insurance pensions to the state budget, and the statutory funded pension scheme (second-pillar pension scheme) was strengthened by introducing automatic enrolment for those aged under 40, which should increase coverage. From 2020, the annuities will be paid by a single institution, the State Social Insurance Fund Board. To cope with future economic shocks, Lithuania established a social insurance reserve fund in 2018. This will strengthen the fiscal sustainability of the pension system. However, some concerns remain over pension adequacy in the long term. Box 3.3.2: EUROMOD simulations of adopted tax changes This box presents the results of a simulation conducted by the Joint Research Centre of the European Commission using EUROMOD( II ) based on the reforms adopted by the government in mid-2018. From January 2019, notable changes to social insurance contributions (namely their consolidation and the shift to employees) and personal income tax came into force. In addition, the universal child benefit was increased from EUR 30 to EUR 50 per month while the minimum monthly wage was set at EUR 555. According to the simulation outcome, the adjustments to personal income tax and social insurance contributions are set to result in revenue losses of around EUR 560 million (or 1.2 % of GDP). Though changes in personal income tax are expected to generate additional tax receipts of EUR 1.3 billion (or 2.7 % of GDP), revenues from social insurance contributions are set to shrink by EUR 1.8 billion (or 3.9 % of GDP). The overall simulated tax cuts are around EUR 120 million higher than the estimates provided by the Lithuanian Ministry of Finance. The discrepancies can be explained by the differences in data used for the calculations, such as the fact that EU-SILC does not capture high-income earners well, and assumptions about wage dynamics. The cost of the increase in child benefit is expected to amount to EUR 140 million or 0.3 % of GDP, which is in line with the estimates of the national authorities. Overall, the simulated reforms have a positive impact on individuals from all income deciles, with the smallest relative gains for the top decile (see Graph 1). Equivalised household income is expected to rise by an average of 4.7 %. The implicit tax rate is expected to fall on average from 8.1 pps in the first decile of equivalised income to 2.4 pps in the tenth. This assessment does not take account of voluntary additional transfers to private pension funds that could eliminate the positive effect of the tax cuts on disposable income. Graph 1: Reform effect on equivalised household disposable income Effects on disposable income inequality are expected to be neutral overall. The simulation shows the Gini coefficient only slightly decreasing from 34.52 to 34.25. However, the at-risk-of-poverty rate drops significantly for households with children. For example, the rate for single-parent families falls by 8.8 pps. This highlights the positive impact of increasing the universal child benefit. Source: European Commission, Joint Research Centre Shifting the social insurance contribution burden from employers to employees would provide positive (albeit mild) work incentives. According to the results from the labour supply model, simulated reforms slightly increase both the average participation rate and the number of hours worked. In the former case, the reform marginally raises the probability of the unemployed entering the labour market. In the latter case, the policy changes create an incentive to work additional hours, by shifting from part-time jobs to full-time employment and overtime. 3.3.4.Health Health outcomes remain among the worst in the EU. Life expectancy at birth is 6 years below the EU average and characterised by a large gender gap. Excess mortality due to cardiovascular diseases and suicides, mainly among men, is more than double the EU average; in 2016 it was on average 30 % higher in rural areas than in urban areas. Preventable and amenable mortality was respectively 2 and 2.5 times higher than the EU average. Spending on healthcare is low and major challenges to the efficiency of spending and the quality of health services remain. Health expenditure amounted to 6.3 % of GDP in 2017, and was among the lowest in the OECD (OECD, 2018a). Overall, the focus on quality is insufficient and quality-assurance policies and measures remain underdeveloped. Hospitalisations for ambulatory care-sensitive conditions remain significant and hospital mortality for acute conditions is high. A system-wide support for continuous healthcare quality improvement at the clinical level is not developed and compliance with clinical guidelines and quality indicators in hospitals, even if sometimes monitored, does not inform decisions. Progress in the accreditation programme launched in 2016 is insignificant. Strengthening policy impact evaluation and the application of Healthcare Systems Performance Assessment methods is an important enabling condition for results-driven investments. Public health policy measures are relatively weak. Public health initiatives, which are the responsibility of local public health offices, are of small scale and the resources to scale up activities are too low. Strengthened co-operation of public health bureaus with primary care centres is a good step in the right direction. However, the effectiveness of measures on the ground is not evaluated and monitoring is limited to the assessment in terms of process indicators. Measures addressing the key drivers of poor health with a focus on specific risk groups are underdeveloped. Despite legislation put in place to reduce the use of alcohol and smoking, alcohol and tobacco consumption remains high. Absolute levels of hospitalisation remain high and bed occupancy ratios and variation are low. The shift from hospital to primary care improved the capacities of primary care to manage patient care, but was put on hold at the end of 2017. Some measures which have been taken have the potential to further consolidate the hospital network. These include limiting contracting for surgery and maternity to hospitals exceeding a minimum volume of services, and standardising pathways for stroke and some myocardial infractions. However, more decisive steps at higher administrative level to plan the delivery of hospital services across municipalities is key to a quicker transition. Primary care is well organised, with modernised general practitioner and nursing services, but there is room to strengthen its role in managing patients’ health. Some guidelines continue to unnecessarily limit the responsibilities of general practitioners, and the share of responsibilities between general practitioners and specialists is not fully delineated. Recent measures to expand the functions of primary care practitioners are a step in the good direction. Furthermore, the role of primary care teams in coordinating patient care, including mental healthcare, is not being fully exploited. Recent measures to reorganise services for patients with mental health problems have the potential to increase access to mental health at primary care level. Long-term care is predominantly provided by residential care institutions, but not all needs are met. In 2014, 47 % of elderly people in need of long-term care were on the waiting list. As elderly people report having particularly low health status, the needs for integrated social and health services for the elderly will continue to grow. Considering that Lithuania is one of the fastest-ageing Member States, well-functioning and effective long-term care and deinstitutionalisation will remain a significant challenge in the medium term. The deinstitutionalisation programme, launched in 2014, aims at moving people with disabilities and children from institutional care to home- and community-based care services. Its implementation is going well in reducing the number of children under institutional care, but for persons with mental disabilities the programme is less advanced. Long-term care and deinstitutionalisation will remain a challenge in the medium term and will require adequate investment. The affordability of healthcare remains a challenge. Out-of-pocket payments represent a third of health spending in Lithuania (32 % in 2016) and are heavily concentrated among older people (aged 60+) and households without children. 80 % of out-of-pocket payments are due to medicines and this proportion is even higher among households belonging to the lowest income quintile (WHO, 2018). Several measures intended to reduce user charges on prescription medicines were implemented in 2017 and 2018, and measures to increase financial protection of the most vulnerable groups have been presented, but not adopted yet. Though declining, informal payments remain high with one in four patients still declaring them in 2016 (Transparency International, 2016). Unmet medical needs due to waiting time exceeded the EU average in 2016. This, together with low affordability, reduces access to quality healthcare, in particular for more vulnerable groups. Imbalances in the health workforce, including territorial ones, are becoming evident. These imbalances are not addressed through a fully-fledged strategy involving forecasting of professions and skills. Recent measures taken to modernise the system of doctors' training are a step in the good direction. Training of nurses is not adapted to current needs and remains a particular challenge. The territorial distribution of healthcare personnel exacerbates these challenges, with specialists particularly unevenly distributed across the country. Considering the overall ageing of the working age population, increased investment will be needed to address the current and potential imbalances in the supply of the health workforce. The government focuses on creating incentives to attract medical staff to public services by increasing salaries at 20% annual rate in 2018, 2019 and 2020.

3.3.5.Education AND SKILLS The quality and efficiency of the education and training systems remain major challenges. Education and training systems and adult learning remain relatively ineffective in addressing skills shortages and mismatches. Government expenditure on education was 5.2 % of GDP in 2016, above the EU average of 4.7 %. The share of total public government expenditure that goes to education and training has remained broadly stable since 2010, at around 15 % (v around 10.5 % in the EU). However, the funds are mostly used to maintain the buildings and not to improve the quality of education (National Audit Office, 2017). Even though certain constraints are imposed by specifying a minimum amount of expenditure for non-salary expenses such as textbooks, continuing professional development of teachers, ICT and student career guidance, the spending tends to gravitate towards the required minimum level. Demographic decline has put the school network under pressure. The number of pupils and students across the education system has declined by 19 % since 2010. This has led to one of the lowest student-to-teacher ratios in the EU (on average there are 8 students for every teacher in primary and secondary school v 13 in the EU in 2016). In addition, strong differences exist across education levels and regions. The number of general school pupils declined by 22 % over the period, whereas that of primary pupils alone rose by 1 %. In geographic terms, while Vilnius County lost 6 % of pupils in general education between 2010 and 2017, the rest of the country saw enrolment decline by 25 %. As a consequence, schools, mainly those in rural areas, merge classes by bringing together pupils from grades 1 to 4 into a single class, which risks compromising the quality of education. This demographic shift calls for strategies to preserve access to high-quality education for all while ensuring the efficiency of the school network and supporting teachers affected by school consolidation. The new ‘class basket’ model might prevent an efficient organisation of the school network. In September 2018, the government moved from the 'student basket' funding model for schools to the ‘class basket’ and ‘quality basket' models. The ‘quality basket’ model aims to link funding with quality indicators while the ‘class basket’ model bases funding on the number of classes in a school. In the new system, funds for teacher salaries cannot be used to cover administrative costs and municipalities must add extra funding for extremely small classes. However, the model does not prevent funding for schools with a small number of pupils, weakening the incentives to optimise the oversized school network and to make it more efficient. First results of the implementation of the new funding system are expected by March 2019. Reforms to teachers’ salaries and initial training have been launched but the public debate on wage increases is ongoing. A new collective agreement with teacher unions was signed in November 2017 and launched a move from salaries based on teaching hours to a fixed salary model. The model, introduced in September 2018, aims to provide a smoother salary progression. In the new system, school heads are more responsible for managing teachers' working hours. The final step in the teacher system reform relates to initial teacher education. The new Teacher Training Regulation adopted in May 2018, sets quality requirements for study programmes and teacher placements, as well as quality criteria for national teacher training centres, but will require investment to become operational. Participation in early childhood education and care (ECEC) is increasing, but challenges in access and quality remain. Participation in ECEC by children older than 4 years is increasing but remains below the EU average (91 % vs 95 % in 2016). For children under 3, it has increased only marginally and is half the EU average (15 % in 2016 vs 33 %). The increase in overall enrolment in ECEC is tempered by regional differences in participation and quality. The enrolment of 3-6 year-olds in rural areas is approximately half the rate in urban areas. These disparities arise from the limited availability of public ECEC, transport difficulties in rural areas and differences in demand. The increasing number of private centres is making ECEC services more widely accessible, mainly in urban areas. However, the proportion of the costs of privately-provided ECEC reimbursed through public subsidies varies by municipality, and not all families receive a subsidy. Investment is needed to increase access to public ECEC. Lithuania’s education and training system is successful in preventing early leaving. Lithuania continues to perform well in preventing early leaving from education and training. With the rate at 5.4 % in 2017, Lithuania reached its Europe 2020 target and is among the EU’s top performers (EU average 10.6 %). However, the early school leaving rate for people with disabilities is much higher than the EU average (36 % v 24 %). Lithuania has launched the Action Plan on the Inclusion of Children in Education and Multidimensional Education for 2017-2022, which aims to reduce the number of children in special schools, but it is too early to assess progress. School outcomes are below the EU average, with a wide performance gap between rural and urban areas. There is a significant gap between students from urban and rural areas, which have smaller schools and merged classes. This gap is wider than observed among Lithuania’s regional peers (OECD, 2017) and is mostly explained by the socio-economic status of rural families and schools. A small share of audited schools implement some form of monitoring of students’ progress, and in only 18 % do leaders indicate the improvement of learning outcomes and school performance indicators as a goal (National Audit Office, 2017). Additional efforts are needed to improve school monitoring and better identify individual educational needs in order to improve school outcomes. The number of students in higher education continues to decrease. In 2017 Lithuania remained the EU leader in tertiary educational attainment, at 58 % of people aged 30-34. In 2017, the employment rate of recent tertiary graduates was 7 pps higher than the EU average (92 % vs 85 %). Due to demographic trends, the number of students fell by 37 % between 2010 and 2017 and is expected to further decrease, partly because the minimum admission requirements have been raised to improve the quality of new entrants. However, higher education in Lithuania is not inclusive: the tertiary education attainment gap between people with and without disabilities is twice the EU average (28 pps v 13 pps). Implementation of the reform of the higher education system is progressing at a slow pace. A number of institutions and programmes have not adjusted to the declining number of students, thus lowering the quality and efficiency of higher education. The government launched a series of reforms, most notably to consolidate the network of universities and strengthen the accreditation system. However, their implementation is lagging. Three mergers are currently ongoing but significant steps are still required to consolidate the higher education network comprising more than 40 state-owned and private universities and colleges. In 2017, Lithuania took additional steps to upgrade its vocational education and training (VET) system. The initial steps seem promising, but significant and consistent progress is still needed to implement the changes in governance and the curriculum if the upgrade is to transform learning experience in schools. In 2019, 24 updated or new professional standards, as well as the guidelines for continued renewal of professional standards, need to be adopted. All modular VET programmes should be updated in line with new professional standards by July 2020. Extending access to new (modular) programmes is envisaged as at present only 24 % of VET qualifications can be attained through such programmes, even if 43 % of all VET students were already enrolled in modernised programmes in 2018. Reform of the governance of VET institutions was completed in 2018 but it has yet to be seen whether the involvement of municipalities and the social partners will result in VET making a stronger contribution to local needs for skills, improved work organisation practices and technology adoption. Investment is needed to increase the uptake of updated modular VET programmes and broaden work-based learning opportunities. Adult participation in learning remains low. At 5.9 % in 2017, it remained below the EU average of 10.9 %. Some measures to encourage adult learning have been rolled out at municipal level but adult learning features low on the political agenda and in the education reform (Ministry of Education and Science, 2018). The resources deployed have very limited impact on the ground. There is a lack of coordination of the validation of programmes across education, the labour market and the voluntary sector. Coverage by existing instruments, such as financial incentives to companies or guidance to individuals, is low or not well balanced or targeted. Less than 10 % of adults in Lithuania report having received any guidance on learning opportunities in 2016, compared to an EU average of 24 % (European Commission, 2018i). Public financial incentives or grants are mostly focused on medium-sized and large businesses. Investment is needed to boost adult learning and to put in place a sustainable adult learning system, in particular targeting low- or medium-qualified adults and smaller companies. 3.3.6.Investment needs A rapidly shrinking working age population and persistently high levels of poverty and inequality call for increased investment in education, training and social inclusion to foster long-term inclusive growth. Skills shortages and mismatches are among the main obstacles to business investment, pointing to the need to invest more in flexible upskilling and reskilling opportunities and better anticipate new skills requirements. Better aligning education curricula to labour market needs and expanding adult participation in learning are needed to reduce skills shortages. Making use of the full labour potential also requires investment in social inclusion and a reduction in material deprivation; an affordable and effective healthcare system; and the availability of child and long-term care services, including deinstitutionalisation. 3.4. Competitiveness reforms and investment 3.4.1.Productivity Following a period of rapid catching-up with the EU, productivity growth has slowed since the crisis. At the same time, labour productivity growth rate is still among the highest in the in the EU. This reflects the fast catching-up process and the effects of the structural transformation of the economy towards modern technologies, mainly in agriculture and manufacturing. In 2017, labour productivity stood at over 75 % of the EU average, almost 35 pps higher than in 2000. However, productivity growth has been more or less stagnant in 2012-2016. This is mainly linked to subdued total factor productivity growth, indicating a lack of technology uptake by companies. Accompanied by a rebound in investment growth (see Section 3.4.2), productivity growth recovered in 2017. Increasing the share of knowledge-based activities in the economy, based on skills and technology upgrade, would help sustaining these positive developments and resume the fast catch-up process. Graph 3.4.1:Labour productivity, whole economy (2000=100) Source: European Commission Productivity growth is concentrated in low value added sectors. A breakdown of real productivity growth for 2016 shows that it has been highest in low value added sectors, such as agriculture and manufacturing. These are also sectors that are strongly oriented towards exports and which experience pressure to innovate in order to maintain their cost competitiveness. This is confirmed by firm-level data. At firm level, labour productivity growth appears to have been higher among exporting firms (compared to non-exporters) and — contrary to most EU countries — among low-productivity firms (CompNet, 2018). Population decline impacts productivity. Lithuania's rapidly declining population (see Section 1) impacts productivity growth in several ways. Net emigration is leading to increasing skills shortages, which are already very prominent (see Section 3.3.1). Furthermore, it is making the provision of a number of activities less productive because of diminished usage, such as schools, hospitals, roads and energy infrastructure. On the other hand, a tightening labour supply and resulting high wage growth is putting pressure on firms to invest in productivity - enhancing technologies, such as automatisation and robotisation. This is becoming increasingly important in the context of increasing unit labour cost and its impact on cost-competitiveness (see Section 3.4.3)

3.4.2.Investment Investment needs The economy needs additional investment in innovation, resource efficiency and connectivity to ensure a smoother integration into the single market and raise productivity growth. The level of innovation and technology absorption capacity of businesses in Lithuania is low. Higher investment levels are needed, especially in the private sector, to increase productivity growth. The economy remains relatively resource-intensive, with high dependency on energy and material imports. Resource productivity is low while energy consumption is high, especially in the residential and transport sectors. More investment in energy efficiency and domestic energy generation from renewable sources would help to 'green' the economy and put it on a more sustainable growth path, while also reducing dependency on energy imports. Better connectivity of air, rail, maritime and road transport would increase the economy's productivity and allow it to take full advantage of the single market (see Section 3.4.4).

Investment Despite recent increases, investment remains at a relatively low level, notably in the corporate sector. Total investment stood at 19.7 % of GDP in the third quarter of 2018. During the crisis, corporate sector investment dropped by almost 40 % between 2007 and 2009. It has slightly recovered since, but has remained significantly below the other Baltic countries and the EU average throughout the period (see Graph 3.4.2). However, from 2017, investment started to grow robustly (see Section 1) and has been accompanied by increasing productivity growth. This momentum needs to be sustained in order to improve long-term growth prospects and speed up the convergence process. In the last decade, household and government investment, which is highly dependent on EU funds, stayed rather stable. However, at 3.3 % of GDP, public investment in Lithuania, although above the EU average of 2.8 %, remains 30-40 % below the level of other Baltic countries. In view of possible changes in the allocation of EU Cohesion Funds and the national co-financing rate, Lithuania would need to plan sufficient public investment to ensure funding for key policy areas. Graph 3.4.2:Total investment Source: European Commission The lack of investment is aggravated by low levels of inward foreign direct investment (FDI). FDI inflows have been consistently below those of peer countries in recent years (see Graph 3.4.3). They remain depressed at 1.2 % of GDP, compared to levels around 5 % before the crisis. The lower inflows have resulted partly from poor international market conditions holding back investment and FDI, but also from transforming the Lithuanian economy to a market economy – the level of inflows seen before the crisis will probably not be reached again because they were related mostly to large privatisations and acquisitions. However, Lithuania is still far from the productivity frontier and attracting FDI, with the transfer of capital and knowledge it implies, remains an important policy goal. Graph 3.4.3:FDI inflows Source: United Nations Conference on Trade and Developme