EUROPEAN COMMISSION Brussels, 26.2.2020 SWD(2020) 514 final COMMISSION STAFF WORKING DOCUMENT Country Report Lithuania 2020 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2020 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(2020) 150}



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, education and social policies 3.4. Competitiveness, reforms and investment 3.5.Environmental sustainability Annex A: OVERVIEW TABLE Annex B: Commission debt sustainability analysis and fiscal risks Annex C: Standard tables Annex D: Investment Guidance on Just Transition Fund 2021-2027 for Lithuania Annex E: Assessment of Lithuania's progress towards the SDGs References LIST OF Tables Table : 1.1 Key economic and financial indicators

Table 2.1:Assessment of 2019 CSR implementation Table 3.2.1:Financial soundness indicators Table A.1:CSR assessment 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 Performance LIST OF Graphs Graph 1.1: Breakdown of GDP growth Graph 1.2: Key labour market indicators Graph 1.3: Net international investment position Graph 1.4: At-risk-of-poverty or social exclusion rate and components Graph 1.5: Regional income per head Graph 1.6: Real house price and mortgage growth Graph 1.7: General government balance and gross debt Productivity in Lithuania and EU Member States Note: GDP in current PPS per hour worked and in percentage of the EU-15. The red line is Lithuania; grey lines are the other Member States.

Source: AMECO, Commission services Graph 2.1: Overall multiannual implementation of 2011-2019 CSRs to date Graph 3.1.1: Breakdown of tax revenues, 2018 Graph 3.1.2: Tax burden on labour, 2018 Graph 3.1.3: VAT gap as % of the VAT total tax liability, 2016-2017 Graph 3.2.1: Loans to households and non-financial corporations, percentage change Graph 3.2.2: Access to finance reported as the most important issue for SMEs, 2018 Graph 3.3.1: Changes in the effectiveness of tax and benefit policies reducing inequality, 2008-2018 Graph 3.4.1: Hourly productivity relative to the EU Graph 3.4.2: Export market shares (EMS) Graph 3.4.3: Net foreign direct investment inflows Graph 3.4.4: Insolvency regimes in the Baltic, 2016 Graph 3.4.5: Efficiency of public investment Graph 3.4.6: Worldwide Governance Indicators, 2018 Graph 3.4.7: Regional labour productivity Graph 3.4.8: European Regional Competitiveness Index Graph 3.5.1: Greenhouse gas emissions by sector Graph 3.5.2: Circular material use LIST OF Boxes

Box 1.1: Avoiding the risk of a middle-income trap Box 2.2: EU funds and programmes to address structural challenges and to foster growth and competitiveness in Lithuania Box 3.3.3: Monitoring performance in light of the European Pillar of Social Rights Box 3.3.4: EUROMOD simulations of announced tax and benefit changes Box 3.4.5: Investment challenges and reforms in Lithuania Executive summary Robust growth in Lithuania provides favourable conditions for social and economic reforms to ensure that growth benefits all of society. Growth is driven by sustained private consumption and high exports despite the slowdown in Lithuania’s main trading partners. Employment has risen, while the labour force has contracted, mostly due to emigration. The shortage of workers has been growing in recent years while labour costs have increased considerably. Nevertheless, risks to competitiveness remain limited so far: there are signs that the shortage of workers is now declining with unemployment slightly rising and the job vacancy rate slightly decreasing. In the longer term, the main challenges for Lithuania remain a declining population and persistent weaknesses in its education and health systems. This comes against a backdrop of high income inequality and poverty, weak support for innovation, and low resource efficiency, notably in transport, the residential sector, and industry( ). In 2019, Lithuania’s fiscal policy was expansionary. The reductions in labour taxation enacted in 2018 resulted in substantial revenue losses that were not fully compensated for by other tax measures, including improvements in tax administration, whose yields did not meet expectations. Spending on social benefits and wages in 2019 exceeded planned levels. Consequently, after 3 years in surplus, public finances are close to being balanced in the short term. At the same time, labour taxation and pension reforms have helped to improve soundness of the finances of the State Social Insurance Fund. General government debt is set to remain below 40% of GDP. The banking sector remains well capitalised but small and medium-sized enterprises face challenges accessing finance. Banks operating in Lithuania remain profitable. The concentration of the banking sector, already high, increased further in 2019. This has increased the systemic importance of individual banks, reduced competition, and made it more difficult for smaller firms to access finance. The financial sector is dominated by banks from Nordic countries; potential imbalances in those countries pose a risk to the stability of Lithuania’s financial system. Employment has recovered steadily since the crisis and unemployment is forecast to remain low. Lithuania’s labour market faces a work force that is shrinking, mainly due to emigration, ageing, and poor health outcomes. Although net migration turned positive in 2019, the outflow of skilled labour continued, limiting the potential for growth. Immigration from non-EU countries increased in 2019, with migrant workers, mainly from Ukraine and Belarus, filling low- and medium-skilled vacancies in construction, industry, transport, and services. However, the challenges Lithuania’s labour market is facing are exacerbated by the country’s poor performance in education and, low participation in adult learning and in upskilling. At the same time, education reform is proceeding slowly. Lithuania is taking positive steps to reduce poverty and inequality but the effectiveness of the tax and benefit system is limited. Pensions have increased more than initially envisaged and measures to improve assistance to the most vulnerable are under way. However, benefits are still not sufficient to reduce poverty, particularly among the elderly, or on inequality. Significant funding cuts for policies to get people into employment will result in fewer vulnerable people being in work. The overall scale and design of the tax and benefit system is not managing to align resources with objectives in social protection. Productivity is increasing but more slowly than in the pre-crisis period, and the level is still well below the EU average. Investment and productivity have recovered steadily since the financial crisis (apart from 2014-2016 when Russian sanctions generated uncertainty). Hence, productivity is continuing to catch up with the EU average, but this is mostly because of capital accumulation rather than upgrades in technology. In the short term, there has been some pressure on labour costs but with no obvious impact on cost-competitiveness: Lithuania’s exports have performed well, (again with the exception of 2014-2016), despite the weaker environment in its main trading partners. This international context is also reflected in low foreign direct investment. In fact, investment is still below historical levels, despite the partial recovery. This is reflected in the fact that Lithuanian exports are not gaining in sophistication. In the longer term, Lithuania could boost its competitiveness by improving the planning and delivery of public investment, notably in innovation and skills. Removing barriers to innovation and to doing business will speed up the technological upgrading of the economy. Institutional constraints are limiting the growth of companies and inhibiting innovation. The predominant type of businesses in Lithuania are microenterprises, which in general are less innovative and productive than other firms. At the same time R&D intensity is relatively low and spending remains inefficient and overly reliant on European funds. Likewise, public research and innovation are held back by a cumbersome institutional network, and a shortage of talent. Businesses face difficulties accessing finance and international markets. In some sectors, notably energy, regulatory barriers hamper firm entry and competition. Another persistent obstacle to doing business is the insolvency framework, although the new insolvency law may improve the situation. Public administration in Lithuania is good overall but progress fighting the shadow economy and corruption has been slow. The public administration is mostly efficient and stable, but municipalities have limited policymaking capacity despite their significant responsibilities. The shadow economy is large (and growing) and weighs on businesses and public finances. Lithuania has stepped up its fight against corruption but many of the planned anticorruption measures are delayed and some key legislation is still pending. In public procurement, it is all too common for tenders to have a single bidder. Corruption in healthcare also remains a problem, even though the authorities have taken action to try to remedy this. Lithuania’s overall convergence with the EU average masks significant social and economic disparities across its regions. Disparities in income are driven mainly by labour productivity differences between the Vilnius capital region and western-central Lithuania. The key challenge, emigration, also has a marked regional component: rapid depopulation, ageing, and social exclusion predominantly affect territories outside the major cities. Lithuania is on track to meet its climate change objectives for 2020 but is at risk of missing its 2030 targets. In its national energy and climate plan Lithuania has pledged not to increase emissions by more than 15% by 2020 and to reduce them by 9% by 2030 compared to 2005 emission levels from sectors not covered by the EU’s emission trading system (ETS)( ). By 2018, non-ETS greenhouse gas emissions had increased by 7% compared to 2005. This means that, while the target for 2020 will be achieved, the 2030 climate change targets risks being missed. As the share of renewable energy has increased significantly, the country has already surpassed its 2020 target level. To reach the 2030 target of 45%, Lithuania will need to do more efforts, including making use of a recently introduced renewable energy prosumer scheme, covering users who both produce and consume energy. Manufacturing’s prominent role in the economy poses a threat to environmental sustainability. Environmental sustainability in Lithuania is low overall, the main contributing factors being low resource efficiency, high pollution levels from fossil fuel consumption in transport, and little progress on the circular economy. This situation is exacerbated by a low landfill tax, weak controls on waste management companies and polluting producers, and little progress on green procurement and green taxation. Increasing environmental sustainability requires a clearer commitment and targeted and smart public investment in green technologies. In addition to manufacturing, Lithuania could benefit from better incorporating environmental considerations into other sectors, notably transport and agriculture. Even though the transport sector contributes 40% of all of Lithuania’s greenhouse gas (GHG) emissions, taxes on transport do not sufficiently reflect vehicles’ environmental performance. Clear incentives to improve energy efficiency and increase the share of renewable energy sources are vital if Lithuania is to achieve climate neutrality by 2050. To deliver on the climate and energy objectives and shape a new growth model, identify investment needs in green technologies and sustainable solutions, and secure adequate funding is crucial: Lithuania’s National Energy and Climate Plan is an important step in this context. Mobilising investment in the private sector will be crucial if Lithuania is to achieve climate neutrality and circular economy models and to carry out its energy transition. Lithuania has made limited progress in addressing the 2019 country-specific recommendations. There has been some progress in the following areas:

·Legislation and technical measures to improve tax compliance were introduced in 2019. However, the VAT gap remains one of the highest in the EU. The introduction of a passenger vehicle registration tax based on CO2 emissions and other changes to the real estate tax and excise duties are small steps towards broadening the tax base to sources less detrimental to growth. ·To reduce poverty and social exclusion, action taken by Lithuania includes an increase in universal child benefit, the indexation of pensions and an additional increase in pensions. No effective measures were adopted to address income inequality. In addition, the changes to the design of the tax and benefit system will not have a tangible effect on Lithuania’s tax revenue relative to its GDP, which is one of the lowest ratios in the EU, and therefore will not increase the system’s power to reduce income inequalities. ·Lithuania improved the affordability of healthcare by taking action to reduce out-of-pocket payments and exempting the most vulnerable groups from co-payments on medicines. Lithuania also slightly increased the budget for public health, continued to improve its e-health system, and took action to enhance primary care and make its healthcare system more efficient. ·As part of the Baltic region that enjoys 23% interconnection capacity, Lithuania has already reached interconnection targets for electricity and is now developing a new electricity interconnector with Poland. Natural gas interconnector pipeline capacity development is also advancing, but there have been some delays. Overall implementation of energy infrastructure projects is proceeding according to the schedule outlined in the 2021-2030 National Energy and Climate Plan as well as the priorities agreed in the context of the Baltic Energy Market Interconnection Plan (BEMIP) High-level Group including the Projects of Common Interest. There has been limited progress in the following areas: ·Lithuania made slow progress on implementing educational reforms to improve the quality of educational outcomes and to better allocate of resources across education levels and between urban and rural areas. ·Participation in adult learning remains well below the EU average and policies for getting people into work are little used in order to improve the level of skills. ·Progress on increasing the quality of the health care system remains limited. ·More action is required to stimulate productivity growth by improving the efficiency of public investment. Further action is also needed to improve the coherence of the policies in place to support science-business cooperation, and to consolidate research and innovation implementing agencies. Public investment is still needed to boost the energy transition, increase resource efficiency and make transport more sustainable. Lithuania has achieved its national targets under the Europe 2020 strategy concerning the employment rate of the working-age population, the share of early school leavers and the share of the population that has attained tertiary education. However, while the number of people at risk of poverty or social exclusion is decreasing, the national target has been achieved only partially. Lithuania’s performance remains mixed on the indicators of the Social Scoreboard, which supports the European Pillar of Social Rights. Lithuania’s relatively good labour market is reflected in the indicators of the Social Scoreboard: the employment rate is high for both men and women, unemployment is relatively low and there are few young people not in employment, education or training. However, income inequality and poverty remain high, while the impact of social benefits on reducing poverty is critically low. These indicators are also reflected in Lithuania's performance on the United Nations' Sustainable Development Goals (SDG) indicators. The analysis in this report indicates that Lithuania has advanced in SDG 5 ‘Gender equality’ while significant challenges remain in SDG 1 ‘No poverty’, SDG 3 ‘Good health and well-being’, and SDG 10 ‘Reduced inequalities’ ( ). Other key structural issues analysed in this report, which point to particular challenges for Lithuania’s economy, are the following: ·Deficiencies in how the government plans spending are contributing to the weakening of public finances. Lithuania’s budgetary process lacks impartial spending reviews. In the context of increasing needs for funding, this forces the authorities to reduce some expenditure items proportionally while preparing the budget. Such an approach tends to backfire during the budget execution as actual spending exceeds planned limits. Consequently, this practice jeopardises the country’s fiscal targets. There are delays in the implementation of the budget framework reform, which is set to enhance expenditure planning. ·The number of pupils and students is decreasing, the teaching workforce is ageing, and education outcomes are poor, particularly in rural areas. Low participation in adult learning limits the workforce’s ability to adapt to changes in the labour market. Structural reforms in education are being held back by the lack of a comprehensive long-term strategy to improve quality and efficiency, difficulties in managing several changes at the same time, weak central steering and insufficient involvement of relevant stakeholders. ·Recent pension reforms have made the system more sustainable but pension adequacy remains a concern. The introduction of pension indexation in 2018 linked pension increases to the total wage bill, making the system more financially sustainable. However, linking pensions to the total wage bill when the labour force is shrinking risks making pensions less able to cover living costs, in a context where pensions in Lithuania are already among the lowest in the EU. ·Lithuania has the one of the highest treatable and preventable mortality rate in the EU. Low funding and inefficient allocation of resources in the healthcare system are long-standing issues. As a consequence, primary healthcare, public health measures and, to a lesser extent, long-term care remain underfunded and services are of insufficient quality. Regional disparities in access to healthcare and in health outcomes are exacerbated by the shortage of nurses, the uneven distribution of healthcare professionals, the ageing of doctors, and the uneven use of telecommunication technology to diagnose, treat patients at a distance, and provide more integrated care. ·Despite overall progress, more efforts are needed to achieve the 2030 targets. Lithuania has surpassed its 2020 target on renewables, although primary and final energy consumption increased. To provide a significant contribution to the EU’s 2030 energy and climate targets, Lithuania will need to implement new policies and take further measures. ·Identifying investment needs in green technologies and mobilising funding will be crucial for Lithuania’s climate neutrality and energy transition, and for shaping a new growth model and improving the circular economy. Meeting 2030 climate change and recycling targets may require additional measures (such as environmental taxation). The Commission’s proposal for a Just Transition Mechanism under the next multi-annual financial framework for the period 2021-2027 includes a Just Transition Fund, a dedicated just transition scheme under InvestEU, and a new public sector loan facility with the EIB. It is designed to ensure that the transition towards EU climate neutrality is fair by helping the most affected regions in Lithuania to address the social and economic consequences. Key priorities for support by the Just Transition Fund, set up as part of the Just Transition Mechanism, are identified in Annex D building on the analysis of the transition challenges outlined in this report. 1. Economic situation and outlook GDP growth

The Lithuanian economy keeps growing fast amid weakening growth in the EU as a whole. Real GDP increased by 3.8% in 2019 despite a slowdown in the EU. Domestic demand was largely due to private consumption and, to a lesser extent, public expenditure: both public investment and public sector wages increased. Exports remained resilient despite the weak performance of major trading partners. Double-digit growth for trade in services kept net exports positive despite a deceleration in the exports of goods in the second quarter of 2019. The weak environment — particularly the near stalling of international trade forecast by next year — is expected to dent growth in the years to come, with real GDP expected to slow down to 2.4% per year. Graph 1.1:Breakdown of GDP growth Source: European Commission Consumption In the short term private consumption will remain the backbone of domestic demand. Real private consumption growth increased by 3.2% in 2019 and is expected to remain the most resilient component of domestic demand in the near future. Consumption has been supported by a high employment rate and rising wages, an increase in the tax free allowance, the new indexation of pensions, and rising minimum wages. Private consumption was complemented by a 1.3% real increase in public consumption. Investment Investment is growing steadily but its level remains below historical rates. Real investment has been growing at around 8% for 3 consecutive years, more than double the EU average. Capital formation is recovering steadily after the 2014-2016 slowdown caused by international instability and trade sanctions from Russia. About one third of the increase in total investment in 2019 can be attributed to public investment and accelerated use of EU funds. The propensity to invest, however, currently stands around the EU average since the financial crisis and investment in general is expected to slow down in the near future. For a catching-up economy this is too low: if the level of income and capital is well below the EU, investment should be higher than that of the EU. Inflation Inflation is moderating towards the euro area objective. Harmonised index of consumer prices (HICP) inflation is continuing to moderate and stood at 2.4% in 2019. The effect of lower fuel prices were balanced by higher prices in some food products, coupled with increases in service prices. In the coming years wage growth, though slowing, is expected to sustain inflation in services. Further increases will stem from scheduled increases in excise duties on alcohol and tobacco products. However, these effects will be counteracted by a projected fall in oil prices so overall HICP inflation is expected to decrease to slightly above 2% in 2020 and 2021. Labour market The labour market has recovered steadily from the 2009 contraction. Since 2010, employment and unemployment rates have improved continuously (Graph 1.2): in 2019 unemployment was 6.4% while the activity rate was 82.9% in the third quarter. Long-term unemployment remained below 2% in the third quarter of 2019 (2.4% in the EU). Also below the EU average in this quarter were youth unemployment (at 11.7%) and the rate of young people not in employment, education or training (at 7.8%). Going forward, there are signs that the labour market is loosening. The cooling down of the labour market can already be seen in the stabilisation of unemployment in 2019 and a drop in the vacancy rate. Both hint at a moderation of activity and a slowdown in real wage growth. Graph 1.2:Key labour market indicators Source: European Commission Demographic developments Net migration turned positive in 2019 but demographic challenges remain. Positive net migration resulted from three trends: reduced emigration of Lithuanian nationals, a rise in immigration from non-EU countries, and nationals increasingly returning home. However, the labour force continues to shrink and the working-age population has contracted by 350 000 people (16%) since 2010. Should these migration trends persist, it will impose a further strain on a social security system already burdened by population ageing. This can be mitigated by upskilling and reskilling the low and medium skilled, as well as by improving the overall health of the labour force (Krasnopjorovs, 2019). Furthermore, the ageing of the working-age population calls for adapting the adult learning system. Cost-competitiveness Wages have grown fast in Lithuania but are expected to stabilise in the near term. Wage growth slowed down from 7.7% to a still high rate of 7% in 2019. This rate was higher than what domestic developments in labour productivity, prices, and unemployment would have warranted, and higher than the rate that would have kept the real effective exchange rate unchanged. However, the Commission forecasts a further deceleration over the next 2 years down to 4%. Real wage growth (adjusted for inflation) stood at 4.9% in 2019 down from 5.8% in 2017. The deceleration of wages and the productivity growth reduced unit labour costs inflation in 2019. Together with the signs of labour market loosening, these developments indicate a significant moderation of labour costs over the coming years. Graph 1.3:Net international investment position Source: European Commission External position The current account has been in balance in recent years. The saving rate is relatively low, amounting to 18% of GDP, five percentage points below the EU average. However, the propensity to invest has also been subdued since the financial crisis. As a consequence, the current account balance (excess savings) has been close to zero since 2016. Including EU funds, the economy as a whole registered a modest positive net lending rate of around 1.4% of GDP in 2019. These surpluses have reduced the negative international investment position (NIIP) from -60% of GDP in 2010 to -28% in 2019. At the same time, the share of the NIIP corresponding to foreign direct investment (FDI) has remained constant; indicating that the reduction is due to other types of liabilities (see Graph 1.3). Graph 1.4:At-risk-of-poverty or social exclusion rate and components Source: European Commission

Poverty and inequality Poverty and inequality are a concern even though steps are being taken to improve the situation. Expenditure on social protection in Lithuania remains among the lowest in the EU and the at-risk-of-poverty or social exclusion rate at 28.3% remains among the highest in the EU (21.7% in the EU). Income inequality even after pensions and social transfers is one of the highest in the EU, with the impact of social transfers on poverty reduction marked as critical on the Social Scoreboard. In 2019, the income of the richest 20% of households was around 7 times greater than that of the poorest 20%, one of the highest ratios in the EU. The rapid ageing of the population risks putting additional stress on the system. Gender In general gender inequalities are relatively low in Lithuania. In most indicators under the SDG 5 "Gender equality" Lithuania compares favourably to the EU average. There is very low or low incidence of physical and sexual violence to women and a relatively small gender employment gap. There are very low or low gender differences in the levels of early school leaving, the employment rates of recent graduates, and the numbers of people inactive due to caring responsibilities. Many more women than men have tertiary education. In business and politics, the picture is more nuanced. Gender balance is increasing in the government and is at present around the EU average of 30%. However, the share of female members of parliament has stagnated around 22% while in the EU displays an increasing trend and has a current figure of 31%. In business, there are few female board members (half the EU average) but many executives (double the EU average). Graph 1.5:Regional income per head Source: Eurostat Regional disparities Regional disparities in Lithuania are persistently high despite convergence of the country as a whole with the EU. Regional disparities increased during the economic boom of 2004-2007, shrank during the crisis because of the downturn in Vilnius, and have been stable since 2013. The country has three distinct regions in terms of income per capita. First, the Vilnius region, which generates 40% of Lithuania's GDP, has the highest level of income and has registered the biggest increases since 2010. Second come the regions of Kaunas and Klaipėda, which are both important business and industrial centres, with the latter having the country's largest seaport. Kaunas generates 19% of the country GDP and in recent years has grown faster than Klaipėda; in 2017 both regions had the same GDP per capita. Third and last come the remaining regions of Lithuania; these all have GDP per capita below 60% of the EU average. Demographic challenges are particularly severe in regions outside the capital region. While the population of Vilnius remained constant over the period 2014-2017, the population in Klaipėda and Kaunas declined by -2.7% and -3.1% respectively. For the other regions the reduction was even larger: from -5.4% in Šiauliai to -7% in Utena. Graph 1.6:Real house price and mortgage growth Source: Eurostat, ECB, Commission services. Financial sector Banks operating in Lithuania have been profitable and remain resilient to external shocks. High market concentration in the banking sector increases the systemic importance of individual banks. Lending to households for house purchase is at peak levels. By contrast, the overall growth in the corporate loan portfolio has dropped significantly as banks took a more prudent approach to business financing and companies turned to non-bank funding (see section 3.2 for details). The housing market has recovered from the 2009 downturn but no signs of overheating. After the boom and bust around the financial crisis, the housing market is back to normal, with investment in dwellings relative to income even below the EU average. House prices are growing moderately as reflected in the stability of the house price-to-income ratio, but are still well below historical levels. Loans for house purchases have recovered but the volume is still growing less than 10% per year (Graph 1.6) and residential building permits remain stable. Graph 1.7:General government balance and gross debt Source: European Commission Public finance Lithuania plans lower budget surplus targets for the general government. After a record-high surplus in public finances of 0.6% of GDP in 2018 (see Graph 1.7), the budgetary outcome for 2019 is set to be in balance. The labour taxation reform, implemented in 2019, had a negative impact on government revenues. At the same time, according to the preliminary data, expenditure on wages and social benefits exceeded planned levels. In 2020, the government aims to achieve a surplus of 0.2% of GDP by adjusting the tax system, improving tax administration, and by keeping expenditure growth below the pace of revenue increases (Ministry of Finance, 2019). Low interest rates and good macroeconomic and fiscal indicators are facilitating state debt management. From 2020 to 2022, Lithuania is scheduled to redeem large amounts of dollar-denominated bonds issued a decade ago. For this reason, the country started accumulating pre-financing under very favourable conditions in advance, which considerably influences the debt-to-GDP ratio. Overall, the general government debt is expected to have grown from 34% of GDP in 2018 to 36% in 2019, before declining to approximately 35% of GDP in 2020. Interest expenditure is expected to drop from 0.9% of GDP in 2018 to 0.5% in 2020. UN Sustainable Development Goals Within the broad framework of the United Nations’ Sustainable Development Goals (SDGs) Lithuania performs well on gender equality but less well on poverty and health. In gender equality (SDG5), and relative to other EU countries, Lithuania has one of the highest rates of tertiary education for women and one of the lowest gender employment gaps. But it has one of the highest incidences of poverty (SDG1), one of the highest levels of inequalities (SDG10), the lowest share of people with good or very good perceived health and among the lowest life expectancies at birth (SDG3). In other chapters the picture is mixed. For example, in sustainable cities (SDG11) indicators on crime and vandalism and municipal waste recycling are positive, but on access to public transportation and air pollution the performance is rather poor.

Box 1.1: Avoiding the risk of a middle-income trap The Lithuanian economy has grown steadily since the mid-90s. National income per head was barely 30% of the western European average in 1995. With low income but a relatively good education system and institutions, the transition to a market economy and later to EU membership, led to a remarkable take-off. Today national income per head is 72% of that of the EU-15. Over this period productivity increased to three times the level of the 1990s as a result of massive investments. However, there is still a long way to go: while Lithuania performs well among the new Member States, it remains behind the leading group of countries. Productivity in Lithuania and EU Member States Note: GDP in current PPS per hour worked and in percentage of the EU-15. The red line is Lithuania; grey lines are the other Member States. Source: AMECO, Commission services Lithuania is at a turning point in seeking to move beyond manufacturing to become a more diversified economy. Turning to an open market-based economy brought early and brought rapid gains. The challenge now is to sustain this process and develop from a middle- to a high-income country. Importing more sophisticated machines and intermediate goods contributes to the technological upgrading of the economy but will not be enough on its own to achieve this. Meanwhile, wages have grown too high for Lithuania to remain a low-cost economy. Without the right reforms, the economy is at risk of falling into a middle-income trap 'squeezed between the low-wage competitors that dominate in mature industries and the rich-country innovators that dominate in industries undergoing rapid technological change ( I )'. The protracted recovery and low productivity growth that followed the financial crisis demonstrated the credibility of this risk. The current stagnation of the economic complexity of exports suggests that the economy may be getting stuck in the low-value added segment of the international value chain: estimates of relative functional specialisation point towards Lithuania specialising in production (e.g. manufacturing) rather than in pre- or post-production (e.g. the development of new products or marketing) ( II ). Escaping the middle-income trap and making a successful transition to a knowledge-based economy requires deeper structural reforms. The Lithuanian innovation eco-system remains fragmented, while funds are poorly targeted and not available at all development stages of a company. Public funding still relies excessively on EU funds, although the planned Innovation Support Fund may ensure more stability in the future. Private funding for competitive firms is hampered by the increasing concentration in the banking sector. This sector is currently dominated by three banks, although current efforts to introduce new financial institutions and alternative ways of funding have the potential to increase competitive pressures on traditional banks. The attainment of tertiary education is among the highest in the EU but the system is oversized and university graduates tend to emigrate. This contributes to the brain drain which has been identified as an obstacle to research and innovation in the country. Retaining talent will require product market reforms to create demand for skilled labour and improved socioeconomic conditions: poor social security (the absence of an effective safety net) is cited as a one of the main reasons for emigrating, second only to low pay. Institutional constraints limit the growth of companies and inhibit innovation: preferential tax treatment of microenterprises prevents them from growing and encourages the shadow economy. For example, there is evidence that microenterprises try to avoid the revenue threshold under which they enjoy a preferential tax treatment. There is also some evidence of a similar effect being caused by the threshold for preferential VAT treatment for the self-employed, although the evidence there is less conclusive (see Section 3.4.1). The accumulation of such of distortions may discourage firms from achieving their optimal size and discourage the self-employed from becoming an incorporated business and growing to become more productive. Tax systems with too many exceptions can hamper the efficient allocation of resources. Table : 1.1 Key economic and financial indicators Source: 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 70% of all country-specific recommendations addressed to Lithuania have recorded at least “some progress” ( ). 30% of these CSRs recorded “limited” or “no progress” (see Graph 2.1). Graph 2.1:Overall multiannual implementation of 2011-2019 CSRs to date Source: European Commission Lithuania has made a small step towards broadening the tax base towards sources less detrimental to growth. From July 2020, a new vehicle registration tax, linked to CO2 emissions, will be introduced. In addition, a few adjustments to real estate taxation and excise duties on alcohol and tobacco came into force from 1 January 2020. The overall budgetary effect of those changes is small (0.15% of GDP). Lithuania also introduced a few legal and technical measures to improve tax compliance. However, tax compliance remains an issue. Lithuania has made some progress in addressing poverty and social exclusion. This includes measures to address poverty and social exclusion. The increase in universal child benefit is expected to have a positive impact on reducing the risk of poverty and social exclusion for households with children. The indexation and additional increase of pensions is also a step forward in addressing the risk of poverty among older people. Other measures, such as an increase in the minimum monthly wage, and amendments in the area of cash social assistance, and social housing are also steps in the right direction, but their effect on poverty and social exclusion is yet to be seen. More remains to be done in reducing income inequality and improving the design of the tax and benefit system. Progress with improving quality and efficiency at all levels of education and training, including adult learning, is limited. More remains to be done to increase the low efficiency of the education and training system and to improve the allocation of resources across education levels and between urban and rural areas. Implementation of reforms in the education system is slow. Participation in adult learning remains well below the EU average. There has been some progress in health reforms, especially in reducing co-payments and improving primary care. More remains to be done to improve the overall quality of healthcare services and the efficiency of allocation of resources given underinvestment in public health measures and long- term care and overcapacity in the hospital sector. More targeted investment from sources other than EU funds is needed to focus investment-related economic policy on key areas. In particular, more investment is needed to boost the energy transition, increase resource efficiency, and sustainable transport, including for increasing system adequacy after the synchronisation with the European continental grid. Overall implementation of energy infrastructure projects is proceeding according to the schedule outlined in the National Energy and Climate Plan (NECP) as well as the priorities agreed in the Baltic Energy Market Interconnection Plan (BEMIP) High – level Group including the Projects of Common Interest. A final NECP () for 2021 to 2030 has been presented including investment needs estimates for the energy transition going forward. The assessment of the investment CSR 3 does not take into account the contribution of the EU 2021-2027 cohesion policy funds. Overall, Lithuania has made limited progress in addressing the 2019 CSRs ( ). Some progress was achieved in addressing the CSRs on tax compliance and broadening the tax base. Overall progress remains limited in addressing education and training related issues and with regards to its health system. Lithuania has made limited progress on stimulating investment and productivity growth. Incremental growth of business investment in research and innovation has been slow, and progress on consolidating research and innovation implementing agencies remains limited. Table 2.1:Assessment of 2019 CSR implementation Source: European Commission Upon request from a Member State, the Commission can provide tailor-made expertise via the Structural Reform Support Programme to help design and implement growth-enhancing reforms. Since 2017, such support has been provided to Lithuania for over 30 projects. In 2019 for example, the Commission: (i) provided the authorities with an in-depth assessment of the state pension schemes; (ii) supported the authorities in the reorganisation of the institutional network for teacher training; and (iii) provided assistance to government interventions in the field of science, technology and innovation. This included providing advice on the simplification of the institutional structure and supporting the design of a more effective and harmonised approach to evaluating research projects for public financing. In 2019, work started under the Structural Reform Support Programme to enhance the governance and capacity building of local government, to help the national authorities improve school leadership, and to develop a sustainable finance strategy and action plan. Box 2.2: EU funds and programmes to address structural challenges and to foster growth and competitiveness in Lithuania Lithuania is one of the countries which benefits most from EU support. The financial allocation from the EU Cohesion policy funds ( III ) for Lithuania amounts to €7.89 billion in the current Multiannual Financial Framework, around 2.6% of the GDP every year. By the end of 2019 some €7.14 billion (91% of the total amount planned) was allocated to specific projects while €3.58 billion was reported as having been spent by the selected projects ( IV ) showing a level of implementation above the EU average. While promoting more harmonious development by reducing economic, social and territorial disparities, EU Cohesion policy funding also contributes significantly to addressing structural challenges in Lithuania. The Cohesion Policy programmes for Lithuania have allocated EU funding of €1.4 billion for smart growth, €3 billion for sustainable growth and sustainable transport, and €2.1 billion for inclusive growth. EU Cohesion policy funding contributes to a major transformation of the economy, promoting growth and employment by investing in, for example, research, technological development and innovation, the competitiveness of enterprises, sustainable transport, employment, and labour mobility. By 2019, investments driven by EU Funds have already led to building or modernisation of 493 km of roads, both regionally and in connection with the Trans-European Transport Network (TEN-T); over 111 supported research projects have been commercialised; support was already provided to 4,891 enterprises including 1,017 start-ups, generating 1,640 new jobs. ESI Funds contributed to a reduction of 447,559 tonnes of greenhouse gases. The European Social Fund (ESF) is being used to upskill and reskill the labour force, and to promote employment and social inclusion. The ESF supported 461 311 participants, including 35,604 long-term unemployed; 30,328 participants with disabilities took part in activities to promote employment or inclusion; 44,878 people gained a qualification; and the Youth Employment Initiative supported 61,321 young people. The ESF also supports the shift towards community-based services, having helped to reduce the number of children in institutional care from 4,086 in 2014 to 2,667 in 2018. Agricultural and fisheries funds and other EU programmes help address investment needs. The European Agricultural Fund for Rural Development (EARDF) makes €2.03 billion available, and the European Maritime and Fisheries Fund (EMFF) €82.2 million (including national co-financing). Lithuania also benefits from other EU programmes such as the Connecting Europe Facility, which allocates EU funding of €389.1 million to projects on strategic transport networks or Horizon 2020 providing EU funding of €64.5 million, including around €20.2 million to 56 SMEs. EU funding contributes to the mobilisation of significant private investment. By the end of 2018 programmes supported by the European Structural and Investment funds ( V ) mobilised additional capital by committing around €642.9 million in the form of loans, guarantees and equity ( VI ), which is 8.4% of all the confirmed allocations of the European Structural and Investment funds (ESIF). EU funds already invest in line with the Sustainable Development Goals (SDG). In Lithuania, up to 94% of the expenditure of the European Structural and Investment Funds supports work towards achieving 13 out of the 17 SDGs.

3. Reform priorities 3.1.Public finances and taxation 3.1.1.Fiscal policy In 2019, the Lithuanian fiscal policy stance was expansionary. According to preliminary data for 2019, general government finances were close to balance after posting a record surplus of 0.6% of GDP in 2018. The labour taxation reform entailed overall revenue losses of 1% of GDP, linked to adjustments in personal income tax and social insurance contributions in 2019. The measures to compensate the resulting losses were limited, and Lithuania did not use this opportunity to broaden the tax base to sources less detrimental to growth. On the other hand, the tax reform, together with the pension reform enacted at the same time, reduced budget pressures on the State Social Insurance Fund. The Draft Budgetary Plan for 2020 expects general government expenses to have increased by 8.4% in 2019, with wage and social benefits accounting for large relative changes. Overall, without any major revenue or expenditure related reforms in 2020, the general government balance is expected to remain close to zero. As before, the government relies on additional revenues stemming from improvements in tax administration. The effectiveness of these measures is difficult to assess and has been criticised by the National Audit Office, which also serves as the Independent Fiscal Institution (Lietuvos Respublikos valstybės kontrolė, 2019 and 2019a). 3.1.2.Medium and long term fiscal challenges Analysis points to low sustainability risks for Lithuania. The S0 indicator that evaluates short-term fiscal stress related to an economy’s fiscal and macro-financial situation and its competitiveness suggests low risks (see Annex B). Fiscal sustainability risks appear low over the medium term, according to both the S1 sustainability gap indicator and the debt sustainability analysis, given Lithuania’s relatively low debt-to-GDP ratio. In the long term, Lithuania is expected to face a low fiscal sustainability risk as well. The S2 sustainability gap indicator shows that only a small fiscal adjustment would be required to stabilise debt in the long run. The sustainability of Lithuania’s public finances improved after multiple adjustments to the pension system. The pension reform that took effect from 1 January 2019 eliminated transfers from the State Social Insurance Fund (the first pillar of the pension system) to private pension funds (the second pillar). The second pillar is now funded directly by participants, and there is also a supplementary payment from the state budget to encourage private pension accumulation. However, the absence of rules and procedures on annuity payments mean that pension reform has not yet been completed. This policy gap and the frequent adjustments of the pension system create uncertainty and reduce trust in the second pillar. The build-up of complementary personal pension savings is essential considering the low pension adequacy in Lithuania (see Section 3.3.2). 3.1.3.Fiscal framework Lithuania’s fiscal framework is established and functioning, but still faces some issues. In 2019, the International Monetary Fund conducted a fiscal transparency evaluation, which contained a few recommendations, notably on fiscal risk analysis and management (IMF, 2019). Lithuania’s Independent Fiscal Institution, established within the National Audit Office, also identified a methodological gap related to financial reporting at municipal level (Lietuvos Respublikos valstybės kontrolė, 2019b). Furthermore, during the annual review of the state’s financial statements for 2018, the National Audit Office identified inefficiencies in a number of programmes whose funding is fixed as a share of certain public revenues. In some cases, there was no proper target setting or monitoring of the programme results. Expenditure planning is a pressing issue. In Lithuania, general government expenditure forecasts rely to a large extent on incremental planning. Though ministries are encouraged to review their expenses during the budgetary procedure, this does not ensure impartiality, and there are no incentives to reduce spending. In addition, at the final stages of budget preparations, there are cases where certain expenditure items are proportionally reduced without proper examination in order to meet desired budgetary targets. This might result in higher than planned actual spending during budget execution and jeopardise the achievement of fiscal targets. This is exactly what happened in 2019, when actual spending on the universal child benefit exceeded the planned limit, which had been mechanically reduced during the budget preparation. The ongoing budget framework reform is expected to partly address the expenditure planning issue. Three pilot expenditure reviews were conducted in very narrow areas linked to healthcare, social security and education. These pilots yielded positive results and fed into a draft methodology on expenditure reviews, which should already be broader when the 2021-2023 budgets are prepared. Overall, the government aims to: (i) adopt a revised law on the budget structure, which contains provisions on the medium-term budget; and (ii) establish a relevant management methodology so that the new budgeting approach can already be used in 2020. For this reason, the timely implementation of the reform is of the utmost importance. However, endorsement of the aforementioned documents is already delayed. In addition, in its latest report, the National Audit Office (Lietuvos Respublikos valstybės kontrolė, 2019c) indicated that due to some delays there is a risk that the 2021-2023 budget will not be prepared according to the new principles as planned. The Independent Fiscal Institution faces difficulties in recruiting staff. From 2019, recruitment of the civil servants was centralised for all government bodies and entrusted to an agency under the Ministry of the Interior. This affects the National Audit Office and its Budget Policy Monitoring Department, which is Lithuania’s Independent Fiscal Institution. The National Audit Office considers that this reform puts its independence at risk. This issue was also raised by the OECD in a recent review of Lithuania’s Independent Fiscal Institution. In its review, the OECD recommended that the institution should have the autonomy to make its own hiring decisions (OECD, 2019b). Lithuania’s budgetary system and public finances contain environment- and climate-oriented elements. One of the approaches used in state budget planning is the allocation of funds to specific programmes, including those dedicated to environmental and climate issues. Information on central government spending in these areas (2.2% of total expenditure in 2020) is provided to the public in a clear way (Lietuvos Respublikos Finansų ministerija, 2019). The national authorities also prepare a three-year plan containing the measures and funding needed to implement the Strategy for National Climate Change Management Policy for 2013-2050. In 2018, Lithuania started issuing green bonds in order to raise funding for the renovation of multi-apartment buildings with low energy efficiency. Moody’s assessed this at the highest possible rating (GB1 Excellent). In 2019, Lithuania started a project ‘The Lithuanian Strategy and Action Plan for Sustainable/Green Finance (Green Capital Markets)’. This project is funded by the European Union under the umbrella of Structural Reform Support Programme. 3.1.4.Tax system and compliance Tax policy and compliance challenges keep Lithuania’s tax-to-GDP ratio one of the lowest in the EU. In 2018, the total tax revenues amounted to 30.2% of GDP, while the EU average stood at 39.2%. As regards revenue structure, Lithuania relies mostly on indirect taxes (11.8% of GDP) and social security contributions (12.7% of GDP). Direct taxes account for only 5.7% of GDP, one of the lowest proportions in the EU (data for 2018). Low taxation of corporate income, capital gains and property contributes to rather modest tax revenues and limits the country’s possibility to finance public goods and services and to increase the corrective power of the tax-benefit system (see also Section 3.3.2). The latest labour taxation reform reduced the tax wedge. This was achieved by increasing the tax-free allowance, adjusting rates of personal income tax and social insurance contributions, and by introducing a second income bracket for which a higher personal income tax rate is applied and social insurance contributions are capped. The overall effect of the reform has been a tax cut for the entire working population (ESTEP, 2018). Therefore, for 2019, the tax wedge for a single person earning the average wage is expected to have gone below the 2018 level of 40.6%. Graph 3.1.1:Breakdown of tax revenues, 2018 Source: European Commission The progressivity of the personal income tax system is low. For 2020, the upper personal income tax rate is set to increase from 27% to 32%. This will affect only a very small amount of taxpayers as the threshold is set at yearly income exceeding 84 times the average monthly wage. In addition, this tax rate does not apply to other types of income, such as capital gains and dividends, which are taxed at 15%, i.e. below the current tax rate on labour income (20%). Furthermore, the self-employed have different personal income tax regimes, which in some cases are more generous. For example, the fixed personal income tax amount paid for an individual activity certificate can be as low as €1 per year. This implies that the effective labour taxation rate on the same job is not neutral depending on the legal form of employment chosen (i.e. an individual activity certificate, self-employed status or a regular employment contract) and may encourage arbitrage to minimise tax liabilities. Lithuania is failing to tap the taxation potential of sources less detrimental to growth. Revenues from environmental taxes, accounting for 2.0% of GDP, are mostly collected from taxes on energy (1.8% of GDP). This is significantly below the EU average of 2.4% of GDP (data for 2018). The nominal excise duties on petrol, diesel and other motor fuels are relatively low and there is an absence of tax on private passenger vehicles based on their CO2 emissions. The Law on Motor Vehicle Registration Tax, adopted at the end of 2019, comes into force in the middle of 2020 and sets the rates linked to CO2 emissions at low levels. Revenues from recurrent property taxes stand at only 0.3% of GDP (2018 data), significantly below the EU average of 1.5%. Increases in real estate taxes in 2020 are set to have a negligible effect on the tax-to-GDP ratio. Graph 3.1.2:Tax burden on labour, 2018 Source: OECD and European Commission

The generous corporate income tax system and reduced compliance costs for taxpayers have contributed to making Lithuania’s business environment more attractive. The time for medium-sized business to meet tax-related obligations decreased from 171 hours per year in 2015 to 95 hours in 2018 (World Bank, 2019). At the same time, the tax rates for small companies and agricultural companies are set at 5% and 10% respectively, while the standard rate of 15% is already one of the lowest in the EU. Although Lithuania’s R&D-related tax incentives are generous, private-sector R&D investment remains low. In 2017, R&D expenditure in the business enterprise sector amounted to 0.3% of GDP, compared to an EU average of 1.4%. This calls for an efficiency analysis of these tax incentives. Challenges with tax compliance remain. The VAT gap in Lithuania amounts to 25% and is still one of the largest in the EU (Centre for Social and Economic Research, 2019). This estimate has remained stable for the last 3 years. In order to tackle the shadow economy, reduce the compliance burden and encourage the voluntary payment of taxes, Lithuania continues to introduce new legal and technical measures and to improve existing ones. For example, in 2019 taxpayers were offered a one-time tax amnesty. However, the effectiveness of this measure is not entirely clear, given that the additional amount collected is relatively low and no target was set at the beginning of the exercise. Moreover, the State Tax Inspectorate still needs to catch up with tax audits after the amnesty period. The tax administration has developed a smart accounting system for small businesses as a part of the ‘Smart Tax Administration System’ (i.MAS), which is expected to reduce administrative burden and ensure effective control. However, according to the latest report by the National Audit office of Lithuania, the maturity of the electronic services is still low and their effect on tax compliance is limited (Lietuvos Respublikos valstybės kontrolė, 2019). Other i.MAS components (i.KON and i.EKA) are being developed and should also support tax compliance. The i.KON system will partially automate monitoring, analysis and assessment of tax payers’ risks. i.EKA is a virtual cash register project which could significantly reduce the shadow economy. However, its implementation has been delayed until 2021. Overall, as i.MAS is still not fully operational, electronic services cannot yet have a substantial positive impact on tax compliance and do not compensate for the reduction in traditional tax control measures. Graph 3.1.3:VAT gap as % of the VAT total tax liability, 2016-2017 Source: European Commission 3.2. Financial sector 3.2.1.Financial stability Banks operating in Lithuania remain profitable due to the strong financial position of the Lithuanian banking sector. The main contributors to high bank profitability are a rapid decline in funding costs and the high level of efficiency (with a cost-to-income ratio of about 45%). The return on equity stands at 16.3%. The non-performing loan ratio decreased from 3.1% in 2018 to 2.2% in 2019, reflecting both the decreasing volume of such loans and an expanding loan portfolio. The capital adequacy ratio of banks stood at 19.6% at the end of 2019, well above the minimum capital adequacy requirements and the capital buffers currently put in place. The capital consists almost entirely of common equity tier 1, which is the highest quality capital (CET 1 ratio of 19.4%). Meanwhile, the financial leverage ratio (equity-to-asset ratio) increased to 14.5% by at the end of the second quarter of 2019 (which equals the euro area average), thus contributing to the good capacity of banks to resist negative shocks. The average liquidity coverage ratio was 254% by the end of 2018. Funding of credit institutions largely rests on domestic deposits, contributing to a loan-to-deposit ratio of 90% in September 2019, down from more than 150% before the crisis. The latter indicates sustainable bank funding despite low interest rates and amid active lending. Table 3.2.1:Financial soundness indicators Source: European Central Bank CBD2 The concentration of the banking sector remains high, increasing systemic risks from individual banks. At the beginning of 2019, SEB, Swedbank, and Luminor, all subsidiaries of foreign-owned parent banks in Sweden and Estonia, accounted for a combined 83% of assets. In 2019, market concentration increased because Luminor reduced its market share. Consequently, there are fewer suppliers in the loan market and each has high relative market shares. To increase competition the Bank of Lithuania has attempted to attract Fintech companies to Lithuania and, as of 1 January 2017, facilitates "specialised" bank licences. The local interbank market is not active. The level of interconnectedness between domestic banks remains low. A risk to the financial stability system stems from potential imbalances in Nordic countries. Although Lithuanian banks’ direct links with international financial markets are marginal, financial institutions remain dependent on their parent banks from other Nordic countries. The latter attract a significant portion of their own funding primarily through financial markets and are therefore more vulnerable to market turbulences. Possible imbalances also stem from a deteriorating external environment, an increase in risk premiums in global financial markets and concerns over alleged money-laundering transactions through Nordic banks in Estonia and Latvia. Nonetheless, positive stress tests of banks operating in Lithuania and proactive macro-prudential policies mitigate potential risks to the Lithuanian banking. Financial market supervisory authorities from the Nordic and Baltic countries are aware of the potential spillovers and continue to cooperate closely to: (i) maximising the effectiveness of national macro-prudential policy; (ii) ensuring a level playing field for all credit institutions; and (iii) reducing the risk of regulatory arbitrage, i.e. financial firms shopping around for the most favourable regulatory system. 3.2.2.Credit growth and access to finance The overall growth in the corporate loan portfolio dropped in 2019 as companies turned to non-bank funding. The annual growth rate of loans to non-financial corporations decreased by 3.2%. At the same time, banks took a more prudent approach to business financing, especially to real estate developers/construction companies and to small businesses, by reducing the volume of micro-loans. Surveys of enterprises reveal constraints in credit availability and an increasing number of rejected loan applications, rising from 22% in 2018 to 27% in 2019, indicating that banks have become more selective choosing their customers (see also Graph 3.2.1). This further increases overall market dependency on the limited number of loan suppliers in the concentrated market. As a result, the average cost of borrowing rose with market concentration to 2.7% compared to 1.6% in the euro area (ECB, September 2019). Mortgage loan uptake increased in 2019 but activity in the housing market is moderate. The housing market has recovered from the 2009 collapse after some years of depression. Activity as measured by mortgage loans, price-to-income ratios and construction permits is within normal ranges. The housing market is therefore not seen as posing a risk for the banking sector. Graph 3.2.1:Loans to households and non-financial corporations, percentage change Source: ECB Difficulties in accessing finance continue to affect SMEs’ ability to innovate and grow. In 2018, Lithuania had one of the highest percentages of SMEs in the EU for which access to finance represents the most significant concern (13%, compared to 7% at EU level) ( ). This high percentage is mostly due to high rejection rates of loan applications by commercial banks rather than the cost of the loan or other factors. The loan application rejection rate stood at 61% for small enterprises during the second half or 2018, up from 40% in the same period in 2017 ( ), in a setting where loans, together with leasing and credit lines, are one of the main funding sources for SMEs. Firms in Lithuania are also dissatisfied with the collateral requirements, and the cost and amount of funding (EIBIS, 2019). Graph 3.2.2:Access to finance reported as the most important issue for SMEs, 2018 Source: ECB Authorities are taking measures to improve access to finance. The government increasingly focuses on measures to support alternative ways of financing SMEs, such as business angel and venture capital investment and crowdfunding. It has introduced clearer and more flexible legislation in this context and injected public funds into venture capital funds, thus facilitating equity funding. In August 2019, the continuation of the Baltic Innovation Fund initiative has been ensured through the signature of the Baltic Innovation Fund 2 Agreement, agreed by the European Investment Fund (EIF) and the three Baltic States. Lithuania is also one of the first countries to launch, together with the EBRD and the European Commission, an EU-funded project in the field of sustainable finance which will create attractive conditions for new international investors and offer Lithuanian companies more opportunities to attract funding for sustainable projects. 3.3. Labour market, education and social policies 3.3.1.Labour market Employment has recovered steadily since the crisis and unemployment is low. Total employment in absolute terms has continued its upward trend but has not reached its pre-crisis level. The employment rate declined in the third quarter of 2019 for the first time in a decade. Unemployment has been declining steadily (see Graph 1.2 in Chapter 1). From 2010 to 2018, the number of unemployed falls to a third. However, unemployment of older people (50-59), although on a downward trend, is higher than in the EU (6.7% vs. 5.2% in 2018). The steady decline in unemployment was also reflected in the decreasing number of long-term unemployed people and the improved labour market situation of young people not in education, employment or training (NEET).

Net migration trends have turned slightly positive in 2019, but the outflow of skilled labour continues. While emigration of Lithuanian nationals continues, immigration from non EU-countries has increased. Migrant workers mainly from Ukraine and Belarus tend to fill low- and medium-skilled vacancies in the construction, industry, transport and service sectors. Unfavourable demographic trends due to a shrinking labour force, the emigration of skilled Lithuanian nationals, ageing and poor health outcomes continue to pose challenges (see Box 1.1, Chapter 1, on avoiding the risk of a middle-income trap). Access to the labour market remains limited for low- and medium-skilled workers. In 2018, the employment rate for the low-skilled improved but still remains well below the EU average (48% vs 57% in the EU). The unemployment rate of the low- and medium-skilled decreased but remains above the EU average and has not yet bounced back to its pre-crisis level. Spending and coverage of active labour market policies decreased in 2019. This puts further pressure on the labour market integration of the long term unemployed and of vulnerable groups. The coverage of labour market policy measures dropped from 17% in 2018 to less than 10% in 2019, while the cost per participant increased significantly in 2019 compared to 2018, and the total budget for the measures decreased. Lithuania increased the amount of training in the total share of activation measure, but the number of apprenticeships remains low. The effectiveness of the measures is impaired by the number of trilateral training and employment agreements and bottlenecks in the provision of training relevant to the job market, which lead to results with low levels of sustainability. More positively, Lithuania’s public employment service is providing more tailored services to improve to help get the long-term unemployed back into work, whilst a pilot project of an integrated service model targeting the most vulnerable long-term unemployed is continuing, with some positive results in participating municipalities. Social dialogue is improving but weaknesses remain. In 2019, new collective agreements at national, sectoral and company levels were signed. The coverage of employees by collective agreements increased to 15% in 2019. Most collective agreements are signed in the public sector. However, a lack of capacity and resources is a barrier to social partners engaging in effective social dialogue at sectoral or company level (Müller et al., 2019). The role of social partners is still insufficiently recognised by some relevant public institutions and at regional level. There is also scope to involve social partners more constructively in the European Semester process. Box 3.3.3: Monitoring performance in light of the European Pillar of Social Rights The European Pillar of Social Rights is a compass for a renewed process of upward convergence towards better working and living conditions in the European Union. 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. The Social Scoreboard supporting the European Pillar of Social Rights points to a number of employment and social challenges in Lithuania. The economic and labour market perfo rmance has been solid in recent years. The strong economic growth contributed to a drop in the overall and long-term unemployment rates, while the share of the economically active population and employment levels have reached historic heights. Nevertheless , disparities persist in employment across regions and in skill levels. Despite an increase in 2018, the gender employment gap remains one of the lowest in the EU. Despite strong economic growth, inequality and poverty remain high. The ratio between the incomes of the richest 20% and those poorest 20% is one of the highest in the EU, and the share of income earned by the bottom 40% of the population remains low. Despite some progress, the limited redistributive capacity of the tax and benefit system leads to high levels of income inequality and a high at-risk-of-poverty or social exclusion, especially for vulnerable groups. In addition, the impact of social transfers in reducing poverty is among the lowest in the EU. Early school-leaving remains among the lowest in the EU but other challenges in education remain. The very good performance on early school-leaving helps to keep the share of young people neither in employment, nor in education or training (NEET) close to the EU average. However, the latest results of the 2018 OECD Programme for International Student Assessment (PISA) nonetheless show that, in all tested subjects, Lithuania’s mean performance is below the EU average. The proportion of underachieving pupils in science, reading, and mathematics remains practically unchanged since 2015. Unmet medical needs are low but some services, like dental care, are less covered. Nearly the entire population (98%) has health insurance. The only uninsured people are those with irregular employment status, who failed to make statutory contributions or are registered as resident, but are living abroad. The share of the population with unmet medical needs is low, but the level of unmet needs is higher for services with lower coverage, e.g. dental care. 3.3.2.Social policies Income inequality and the poverty rate in Lithuania remain among the highest in the EU. While slightly lower than in 2017, 28.3% of the population was at risk of poverty or social exclusion in 2018, well above the EU average of 21.9%. More than one in five were at risk of income poverty (22.9%, vs. 17.1% in the EU). Severe material deprivation is on a declining trend, but remains twice as high as the EU average (11.1% vs. 5.9% in the EU in 2018). Income inequality remains among the highest in the EU (European Commission, 2019b). The income of the richest 20% was 7.1 times higher than the income of the poorest 20% in 2018, compared to 5.2 times for the EU as a whole. The income share of the poorest 40% of the population was 17.5%, one of the lowest in the EU (EU average: 21%). Lithuania has recently undertaken some steps to reduce poverty and income inequality through changes in its tax and benefit system. Some of the changes are expected to improve the situation (see the Euromod simulations in Box 3.3.2). The ability of the tax-benefit system to tackle poverty and income inequality remains limited. Social transfers reduced the at-risk-of-poverty rate by less than a quarter in 2018 (22.9% in Lithuania vs. 33.2% in the EU). Overall, in the past thirteen years, Lithuania has moved away from reaching Sustainable Development Goal 10 (reducing inequalities). There is no comprehensive strategy on how to reduce poverty and income inequality through benefits and taxation. At the same time, Lithuania’s spending on social protection and the tax-to-GDP ratio remain among the lowest in the EU. While in most EU Member States the tax-benefit system achieves a greater reduction in income inequality than in 2008 (Graph 3.3.1), in Lithuania the change is negligible. Improving the ability of social benefits to reduce inequality would facilitate progress on SDG 1 "No Poverty". Lithuania’s universal child benefit system is helping to reduce poverty in households with children. Child poverty in Lithuania is above the EU average but on a declining trend. The universal child benefit system put in place in 2018 has already had a significant positive effect on households with children (see Box 3.3.2). Graph 3.3.1:Changes in the effectiveness of tax and benefit policies reducing inequality, 2008-2018 Source: European Commission (2019) Pensions remain too low to protect the elderly against poverty and social exclusion, despite automatic pension indexation since 2018. In 2018, 38% of the people aged 65 or older were at risk of poverty, much higher than the EU average (16 %). The difference across genders remain significant with 44% of women at risk of poverty compared to 26% of men, reflecting a gender pay gap of 15% (although this is still below the EU average). Part of the reason is the low adequacy of pensions. The automatic indexation of pensions was introduced in 2019 along with other changes to the pension system (see European Commission, 2019a). Pensions were raised by 6.9% in 2018 and 7.6% in 2019. A further increase by almost 10% is likely in 2020, while an additional top-up is available for those receiving the lowest pensions. The social protection system provides limited protection to the most vulnerable groups. The at-risk-of-poverty rate among the unemployed stands at 62% amongst the highest in the EU (49%) and is increasing. The average unemployment benefit in 2019 was €337 while the minimum was €129, equivalent to only 51% of the ‘amount of minimum consumption needs’. Almost half of single parents (mostly mothers) are at risk of poverty. This is one of the highest rate in the EU. Among people with disabilities, about 43% were at risk of poverty or social exclusion in 2018, compared to 29% in the EU. In September 2019, Lithuania updated its Law on social enterprises but it is too soon to assess its effect on the integration of people with disabilities into the labour market or on the development of the social economy in the country. The risk of social exclusion is amplified by limited access to public services. Access to long-term care is a challenge and the availability of social housing remains scarce (European Commission, 2019a) There are around 10,000 people waiting for social housing with the waiting time ranging from 3 to 12 years depending on the municipality. Relatively high out-of-pocket payments prevent access to quality healthcare for vulnerable groups (see next subsection). The lack of public transport further from the major urban centres is a significant barrier for access to the labour market (see regional disparities in section 3.4.4 below). 3.3.3.Health, health care and long-term care The overall health of the population in Lithuania remains among the worst in the EU. Within SDG 3 "Good health and well-being" Lithuania fares poorly in most indicators. For instance, it has the lowest percentage of people in the EU who judge their health as "good" or "very good", barely 44% of the population (70% in the EU). Life expectancy at birth was 76 years in 2017, compared to an EU average of 81 years. The gender gap in life expectancy is almost double the EU average. The treatable mortality rate, deaths that could have been avoided through optimal quality healthcare, was more than twice as high as the EU average in 2016. Lifestyle related risk factors account for more than half of all deaths, one the highest rates in the EU. According to the State of Health in the EU 2019 report, one third of all deaths in 2017 were related to dietary risks, nearly twice the EU average. Tobacco consumption accounts for an estimated 15% of all deaths; about 10% of deaths are linked to alcohol consumption; 5% are related to insufficient physical activity. The setting of 2019 and 2020 objectives and actions for public health offices and the inclusion of lifestyle medicine specialists and social workers in primary care teams is a good step forward to deal with these challenges. Measures to tackle excessive alcohol consumption and reduce smoking rates have been introduced in the past few years. These measures, such as higher taxes, have shown some effectiveness. Although some efforts have been made to prevent suicide and detect depression earlier, suicide remains a serious public health concern in Lithuania, with one of the highest rates in Europe. The quality of healthcare for people with mental health issues is limited with insufficient coordination across different healthcare providers. Public spending on healthcare in Lithuania remains among the lowest in the EU. In 2017, public health expenditures amounted to €843 per capita (5.7% of GDP), substantially lower than the EU average of €2,110 (7% of GDP). Considering in addition compulsory insurance, voluntary schemes, and an estimate of out-of-pocket payments (OECD, 2019c), total expenditures in health amount to €1,605 per capita, still well below the EU average of €2,884 per capita. Only two thirds of health expenditure is publicly financed. Ongoing efforts to reduce co-payments on pharmaceuticals resulted in the decrease of the average co-payment for prescription from €5.7 in 2017 to €2.3 in 2019 and the share of out-of-pocket expenditure on reimbursable medicines fell from 21.2% to 6.6%. The amendment of the Law on health insurance adopted in October 2019 provides for the exemption of the lowest income groups and people aged 75 or more from co-payments on pharmaceuticals. A growing share of co-payments on services, food supplements, and medical devices is an emerging challenge. Box 3.3.4: EUROMOD simulations of announced tax and benefit changes This box presents the results of a simulation conducted by the European Commission’s Joint Research Centre using EUROMOD ( VII ) based on the reforms announced by the government in mid-2019. The simulation looked at the announced reforms in two separate blocks to identify the impact of increasing a) the minimum monthly wage to €607 and the tax allowance to €350; b) the universal and additional child benefit amounts (the simulation was done taking figures of €60 for the universal child benefit and €40 for the additional child benefit), and also taking into account the increases in the state supported income, the basic social allowance and other benefits, the changes in the threshold for personal income tax, and hypothetical changes to personal income tariff for the self-employed. The simulation estimates that, due to the increase in the minimum monthly wage and the tax allowance, the equivalised disposable income would increase for all deciles, except the first. The biggest shares of winners would be in the 5th to 9th deciles. As a result, the S80/S20 income quintile share ratio would be slightly reduced (by 0.013 point) while the effect on the Gini coefficient would be negligible. The increase of the minimum monthly wage and the tax allowance would have no impact on the poverty level, nor on the poverty gap. The changes would require €75.3 million from the budget. In line with the simulation findings, the increase in the universal child benefit and additional child benefit (including the revision of the eligibility requirements), the increases in state supported income and basic social allowance and related increases in other benefits, have a positive effect for households with children and reduce income inequality and poverty. The Gini coefficient decreases slightly (by 0.5 points) and S80/S20 decreases more significantly (by 0.22 points). The at-risk-of-poverty rate decreases by almost 0.9 pps overall and by 2 pps for households with children. For families with 3 or more children, the at-risk-of-poverty rate is reduced by 4.6 pps It also lowers the poverty gap by 1.1 pps for households with children. Equivalised disposable income increases for all deciles, more so for the 1st to 3rd deciles, and least for the top deciles. The increase in child benefits, basic social allowance, state supported income and other benefits, are estimated to have a total cost of €140 million.

The quality of healthcare is one of the lowest in the EU. Lithuania lacks system-wide support for continuous care quality improvement. The development of the healthcare system performance assessment tools with strong policy feedback mechanisms has not yet been adopted. Recent improvement of health technology assessment may facilitate decisions on effective health interventions. Substantial efficiency gains could be expected from reorganising and downsizing the hospital sector. In this context, primary care, prevention measures and long-term care need to be expanded and improved. Lithuania has one of the highest ratios of hospital beds per population in the EU. High hospital discharge rates show the overuse of hospital care and a low acute bed occupancy rate with sizeable regional disparities (6.6 beds per 1, 000 population, i.e. 30% more than the EU average). A planned reform to consolidate the hospital system lacks political agreement. According to the 2018 audit report of the State Control Office, reforms in ambulatory and primary care could help to reduce hospitalisations by 20%. The quality of hospital care in Lithuania remains low. The 30-day mortality rates after hospital admission for acute myocardial infraction and stroke are the second highest in the EU and disparities across districts are huge. The quality of cancer care still lags behind most EU countries with five-year survival rates after diagnosis among the lowest in the EU. Many hospitals carry out too few surgical procedures in some clinical areas to ensure an acceptable level of quality of care and patient safety. Standards of quality of hospital care remain underdeveloped and not incentivised through proper monitoring tools and payment methods. Measures to strengthen primary care are under way to increase provision of healthcare services. This includes putting in place remote consultations, improving the system of registration of patients, expanding teams in primary care, and strengthening access to mental and dental care. The clinical competences of family doctors, general practice nurses, and nurse assistants have also been expanded. Progress with the quality accreditation programme remains slow, but the performance-based payment has begun to play a bigger role. In addition, the rating of primary care centres will made available publicly. The healthcare system faces challenges due to lack of qualified staff, especially nurses. In 2017 there were 3.6 nurses per 1000 inhabitants, compared to 4.6 in the EU, and 2 nurses per doctor (OECD average: 3) with no improvement in sight. Nurses are discouraged from taking up jobs and new roles in outpatient facilities due to outdated work places, high workload and resistance to recognising their expanding roles. The Ministry of Health estimates that one third of all registered nurses have emigrated. There is a lack of continuous training offers for nurses to improve their communication and managerial skills. Doctors are not given sufficient opportunities in university curricula to acquire management and quality management skills. Other challenges for healthcare professionals include: (i) an uneven distribution of healthcare professionals in cities, the countryside and among administrative regions; (ii) the ageing of currently practising clinical doctors (39% of physicians were aged over 55 in 2017); (iii) too many specialisations; (iv) an inflexible licence system, and (v) weak financial incentives to keep professionals in Lithuania. E-health solutions are not yet fully exploited. Only 19% of Lithuanians use health and care services provided online, 85% of general practitioners use e-prescriptions, and 25% of them exchange medical data digitally (Digital Agenda Scoreboard 2019). Stronger commitment from healthcare institutions, improved e-skills and resources as well as user-friendly systems are preconditions for increasing the take-up of e-health. The growing needs for long-term care exceed the system’s current capacities. Expenditure on long-term care in Lithuania stands at 1% of GDP, below the EU average of 1.6% but equal to the median expenditure. The working age population in Lithuania is shrinking quicker than in most EU countries. Health system reform aims to develop the system of long-term nursing care services in order to enable 25,000 informal carers to stay in the labour market. Resources in this sector remain insufficient, and any further investment needs to support community and home based care, avoiding the development of institutionalised care. Furthermore, co-operation between healthcare and social services remains weak. 3.3.4.Education and skills School education outcomes are below the EU average, with little improvement since 2015. The latest results of the OECD Programme for International Student Assessment (PISA) 2018 show that, Lithuania’s mean performance is below the EU average in all three subjects tested. The proportion of underachieving pupils in science, reading and mathematics remain practically unchanged since 2015 (OECD, 2019a). PISA 2018 also shows that socio-economic background strongly influences student outcomes. About 40% of pupils in the bottom socio-economic quartile fail to achieve a minimum level of skills in reading (compared to 35% at EU level). Successful implementation of the competence-based curriculum and student assessment reforms is crucial in addressing these challenges. The replacement of an aging teaching workforce is difficult due to low pay and unattractive work conditions. The teaching workforce is ageing. The proportion of pre-primary and school teachers aged 50 or more was 40% in 2017 (EU: 24%). Future shortages in teaching staff will be aggravated as fewer than 15% of teaching graduates actually enter the profession. Recent measures, such as offering opportunities to teachers to acquire the qualifications needed to teach a second subject, may help to address these shortages. However, despite the introduction of the new salary system in 2019 which resulted in an increase in the average teacher’s salary, the average starting statutory salary of a full-time teacher at the lower general secondary level is almost 60% below the EU average even when corrected for purchasing power. By career-end, the teacher’s salary increases by only 7.2%, compared to 60% in the EU. This is the lowest salary progression in the EU (European Commission / EACEA / Eurydice, 2019). Outdated teaching practices and low quality of teaching instruction are probable causes of low student outcomes. Reform of the initial teacher education system is progressing at a slow pace. The 2018, the OECD Teaching and Learning International Survey (TALIS) shows that Lithuanian teachers report the lowest professional development in ICT skills for teaching (23.6% vs 16.1% in the EU). Teacher professional development remains fragmented and not associated with school development needs: 43% of teachers (39% in the EU) consider that the professional development offered is not relevant. The decreasing number of students in rural areas and the difference in reading performance between children studying in rural and urban areas (78 score points in PISA 2018, OECD, 2019) calls for measures to increase efficiency and address inequalities in education. Some steps have been taken in this regard: in 2019 the number of joint classes decreased by 19% due to the new school funding system. Ensuring equal access to quality education has been hindered by the lack of a detailed plan to create efficient and effective school clusters with broad territorial coverage, while addressing the lack of quality, the social costs of reorganisation and poor central coordination. Participation in early childhood education is increasing, but access for all is not ensured. Participation by children over four years of age was 92% in 2017, up by 0.5 pps since 2016, but below the EU average of 95%. Participation in formal childcare by children under the age of three remained stable at 21% in 2018 (20% in 2017), still well below the EU average of 35%. Children over the age of three from households at risk of poverty or social exclusion are less likely to be enrolled in pre-school than those from a more advantaged background (66.7% vs. 82.4% compared to EU levels of 77.8% vs. 89.1% in 2016). This has negative consequences when it comes to breaking patterns of poverty or social exclusion patterns in the long run (European Commission, 2019b). Access to tertiary education remains unequal across social classes. The tertiary attainment rate was the highest in the EU in 2018 and stood at 57.6% for those aged 30-34, well above the EU average of 40.7%. Recent tertiary graduates have a high employment rate (90.4% v 85.5% at EU level in 2018), but at the beginning of their career they tend to work in jobs requiring lower qualifications because they lack job relevant skills. However, there are considerable disparities across socioeconomic backgrounds: only 16% from households in the lowest income quintile completed tertiary education, compared to 80% in the highest income quintile (OECD, 2017). Adult participation in learning remains low. At 6.6% in 2018, adult participation in learning remains well below the EU average of 11.1%. The coordination role of the Ministry of Education, Science and Sports in adult learning has been strengthened, but funding of different measures remains dispersed among several ministries. The adult education system does not have the potential to respond to the challenges of the ageing population and skill shifts related to innovation, the robotisation of work and the potential demand for green jobs. Lithuania is continuing to modernise its vocational education and training (VET) system. The consolidation of the providers of VET continues. The number of public VET providers is planned to decrease further from 61 in 2019 to 56 in 2020. The introduction of the modular VET curriculum is advancing well, with around 70% of VET students studying in modular programmes in 2019. However, enrolment in upper-secondary VET is among the lowest in the EU, with just 27.4% of all upper-secondary students in 2017 undertaking VET programmes vs. an EU average of 47.8%. This highlights a substantial under-utilisation of the potential of VET to contribute to addressing national and regional skills challenges and mismatches in Lithuania. Digital skills are not widespread among the general population although growing numbers of Lithuanians are going online. Basic and advanced digital skills levels remain below the EU average, with 44% of Lithuanians aged 16 to 74 not keeping up with the digital environment and lacking basic digital skills. There is a significant digital divide between those Lithuanian internet users who are very active online (using new services via their mobile phones, banking services, mobile e-signature, car parking) and 15% of the population that has never used the internet. The low proportion of ICT specialists hampers the country’s capability to fully exploit its innovation potential. It also limits the potential for productivity growth linked to digitisation. Despite growing demand on the labour market and policy measures taken to fill this gap, the availability of ICT specialists in Lithuania is below the EU average (2.7% vs. 3.9%). Among businesses that have recruited or tried to recruit ICT specialists, 47% reported difficulties in filling their vacancies. Lithuania performs less well than most EU countries in training new ICT graduates. Lithuanian enterprises are underinvesting in the enhancement of digital skills. The country’s digital agenda strategy seeks to tackle the shortage of ICT specialists by encouraging more young people to choose ICT as a career, by attracting more women and by improving vocational training for ICT specialists. ‘Women Go Tech’ is a nationwide professional mentorship programme designed to attract more female talents into ICT and engineering careers. The Akademija.IT project encourages vocational training, trains trainers, and retrains people with educational backgrounds for which there is less demand, in close partnership with businesses. Despite these initiatives, challenges remain, as only 11% of companies provide training for staff, compared to 24% in the EU (Digital Scoreboard 2020). 3.4. Competitiveness, reforms and investment

3.4.1.Investment and productivity trends Productivity Productivity is growing but at lower rates than in pre-crisis years and mostly due to capital accumulation. From 2014 to 2016, economic activity and productivity stalled because of international political instability and its impact on trade with Russia, a major trading partner of Lithuania. Despite this uncertainty, firms perceived the situation as temporary and kept their employees. The drop in GDP therefore mechanically reduced measured productivity, limiting the potential for productivity growth. Most of the growth in labour productivity after the financial crisis can be attributed to capital accumulation rather than technical change in general. Graph 3.4.1:Hourly productivity relative to the EU Source: European Commission There are substantial differences in productivity across sectors and types of firms. Productivity growth in manufacturing has been faster than in services since 2000. In 2018 productivity growth stalled in manufacturing and was driven mostly by services but growth resumed in 2019. Firm-level-based indicators show that productivity growth since 2000 has been greatest in large firms, has occurred to a lesser extent in small firms, and has been almost negligible in microenterprises. Improvements are also concentrated in exporting firms while productivity growth in non-exporting firms was flat. These diverging trends point to a weak diffusion of technological advances across the economy (see Box 1.1). Institutional constraints limit the growth of companies and inhibit innovation. The share of microenterprises ( ) has grown since 2004 from 9% to 16% while the share of large companies has decreased by a similar magnitude. The trend accelerated in 2010 linked to the preferential tax treatment of small companies. There is evidence that companies choose not to grow and remain just below the preferential taxation threshold. There is also evidence of an unusually large number of self-employed people declaring income just under the VAT threshold of €45,000 ( ). Taken separately, many of these tax exceptions make sense but the accumulation of such distortions discourages firms from achieving their optimal size and from eventually growing to become more productive (see Box 1.1). The slow technological transition weighs on productivity growth. According to the National Productivity Board, an additional reason for the slowdown in labour productivity is insufficient investment in developing or adopting new technologies. This is reflected in the stagnant level of sophistication of the economy since 2011 as measured by the Economic Complexity Index ( ). Increasing the share of knowledge-based activities requires long-term investments, particularly in education. The composition of the labour force and R&D capital have not contributed to productivity growth in recent years. Recent research (Adarov and Stehrer, 2019) shows that the positive effect of higher employment is offset by a deterioration in the skill composition of the labour force. The contributions of ICT assets (tangible information and communication capital and intangible software and databases) have significantly declined, reducing productivity growth in 2016. This is linked to inefficient R&I policy coordination and measures supporting science-industry cooperation (see section below on R&I). The main growth driver was investment in tangible assets and to a less extent technical change. Competitiveness Export growth continues but is expected to slow down. At present, risks associated with cost-competitiveness seem mitigated because nominal wage growth is moderating while productivity is picking up. Growth in unit labour costs is expected to slow down while the labour share in national income remains below the euro area average and below peak levels witnessed before the crisis, particularly in those sectors more exposed to international competition. The Commission is forecasting a decline in exports because of the uncertain international environment. Graph 3.4.2:Export market shares (EMS) Source: European Commission Internationalisation is pivotal to boosting competitiveness. With the exception of the 2009 contraction and the 2014-2016 period, Lithuania has continuously gained export market shares despite the overall increase in world trade volume (Graph 3.4.2). Between 1999 and 2015, exporting companies experienced higher labour productivity growth and lower growth in unit labour costs. This further increased the productivity gap between exporting and non-exporting firms. The more productive firms were able to increase their mark-ups, whilst the mark-ups of less productive firms stagnated. Supporting the digitalisation of the economy will enhance competitiveness furthe