Chapter 1. Scaling new heights: Achievements and future challenges for productivity convergence1

Lithuania’s product market regulations are generally conducive to efficient resource allocation

Since regaining independence in 1990, successive Lithuanian governments have undertaken reforms to improve the market orientation of the economy. Along with the country’s entry into the EU in 2004, advances have been made that reduce the burden of product market regulations deterring firm entry and hence the growth of high potential firms. By 2013, Lithuania’s overall product market regulation, as judged by the OECD PMR index, was roughly in line with the OECD average (OECD, 2013a).

Some aspects of Lithuania’s regulatory framework are particularly competition-friendly. Government has relatively little involvement in business operations through price controls and command and control regulation (Figure 1.6, Panel A). Furthermore, there have been large reductions in the complexity of regulatory procedures, especially when establishing a firm. The World Bank Doing Business indicators highlight that the time and cost to start a business were significantly reduced between 2003 and 2015 (Table 1.1), by which time Lithuania was ranked 8 of 189 countries for ease of starting a firm.

Figure 1.6. Product market regulations have become market-friendly but there is scope for further reform

Note: In Panel A, “OECD average” is a simple average for all the OECD countries that reported. The US is the only OECD country not included in this aggregate.

Source: OECD (2013a), Statistics Lithuania.

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Specific reforms in the past few years have included the introduction of a one-stop shop for online business registration and measures that reduce the difficulty of companies to register as a value added taxpayer. A new form of legal company (a “small partnership”) has also been established that has no minimum capital requirement and a reduced number of regulatory procedures, meaning registration now takes only one third the amount of time it previously did. As a consequence, the number of days it takes to register a business has fallen from 26 in 2005 to 3.5 in 2015 and the cost to start a business as a percent of income per capita has declined by 85% (World Bank, 2015). Unsurprisingly, this has coincided with a pick-up in the proportion of small businesses (Figure 1.6, Panel B). In particular, the proportion of firms with one employee has risen sharply.

Importantly, new OECD analysis suggests that the reduction in the cost to start a business contributed to the productivity-enhancing shift of labour resources recently observed in Lithuania (Box 1.1). Moreover, reductions in the number of procedures needed to start a business and the time it takes to start a business have been associated with higher within-industry productivity.

As highlighted in the recent OECD Regulatory Policy Review of Lithuania, further efforts should be made to establish a framework for evaluating whether well-designed regulatory policies are implemented in practice (OECD, 2015b). Encouragingly, compared with similar countries, firm level surveys suggest good alignment in Lithuania between the proportion of firms reporting obstacles to obtaining business licenses and permits, and the Doing Business indicator of the ease of starting a business (World Bank, 2013).

According to the OECD PMR indicators, non-explicit barriers to trade and investment is one area in which regulations in Lithuania are less conducive to firm growth than in the average OECD country. Specific regulations include tight restrictions and administrative costs on the employment of workers from outside the EU (Box 1.2). These regulations can cause delays for businesses that are trying to expand, particularly those in specialised sectors where the global talent pool is shallow. Furthermore, firms from non-EU countries that are trying to relocate operations to Lithuania may be deterred by the regulatory barriers to migrating firm-specific human capital. This reduces competition and can cause resources to be trapped in domestic incumbent firms that are less productive. Such barriers to foreign investment may also limit the potential for Lithuanian firms to embed themselves into GVCs (Kowalski et al., 2015), reducing their ability to raise market size and capture knowledge spillovers from foreign firms.

The large size of Lithuania’s shadow economy may contribute to inefficient resource allocation that limits aggregate productivity growth. Recent work suggests that despite falling in recent years, Lithuania’s informal economy is one of the largest in the EU (Schneider, 2015). Compared with other transition economies in the region, a relatively high proportion of Lithuanian firms responding to the EBRD-World Bank Business Environment and Enterprise Performance Survey (BEEPS) in 2013 identified practices of competitors in the informal sector as a barrier to their operations. By not paying tax, firms operating in the shadow economy are able to provide goods and services at a lower price, which may displace more efficient taxpaying firms. This means that informal sector firms absorb resources that would be allocated elsewhere if all firms operated on a level playing field. As informality tends to be concentrated in services industries (Hazans, 2011), Lithuania’s large informal sector may help explain the relatively disappointing productivity growth in services.

The corporate tax rate is low but differential tax treatment could cause distortions

Lithuania’s corporate income tax rate is low by international standards at 15% (Figure 1.7). However, the tax rate is reduced to 5% for micro companies that have up to 10 employees and EUR 300 000 (24 times GDP per capita) income per year. The rational for having a preferential rate for micro companies is not clear, as past OECD work suggests that the investment decisions of small firms tend to be less sensitive to corporate taxes than those of larger firms (OECD, 2010). Furthermore, such differential tax treatment can have negative consequences for the efficiency of resource allocation.

Figure 1.7. The corporate tax rate is relatively low

Statutory corporate income tax rate (%), 2015

Source: OECD Tax Database, KPMG.

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While many young highly productive Lithuanian firms may fall under the classification of a micro company, there will also be a number of businesses where their small size reflects underperformance. The tax advantage for micro firms in Lithuania will not discriminate between these firm types and may cause resources to be trapped in unproductive small businesses rather than being reallocated to more productive small firms, thereby allowing the latter to grow.

It is also possible that size-dependent tax advantages disincentivise firms from growing beyond the tax deduction threshold, and hence slow the reallocation process (Chen and Mintz, 2011). Nevertheless, the evidence of such a threshold effect in Lithuania was not conclusive in 2013. For example, there was not a disproportionately large share of firms reporting just below the employment threshold (10 employees or less; Figure 1.8). The distribution of firms should continue to be closely monitored to ensure that the small business tax advantages do not distort the pattern of firm growth. Such monitoring, along with other evidence-based advice on the economy-wide effects of government policies, could be performed by the establishment of an independent institution similar to the productivity commissions of Australia and New Zealand. Such an institution may be especially worthwhile in Lithuania given the importance of achieving productivity gains for the country’s future income convergence.

Figure 1.8. There is no strong evidence so far of differential tax rates distorting firm size

Proportion of firms by number of employees (%), 2013

Note: In addition to having 10 employees or less, eligibility for the preferential corporate tax rate in 2013 was also subject to firms having income of less than Lita 1 million (approximately EUR 300 000).

Source: Statistics Lithuania.

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Bankruptcy procedures are relatively time consuming and recovery rates are low

Costly and time consuming insolvency procedures can slow the movement of resources between lower productivity firms and better performing ones (Adalet McGowan et al., 2015). Such procedures may also deter entrepreneurship and experimentation by businesses with new risky technologies, having negative consequences for within-firm productivity. In the past decade there have been ongoing reforms in Lithuania to simplify bankruptcy procedures. These have included simplifying insolvency laws and reducing the timeframe for decisions on appeal. Nevertheless, it remains relatively time consuming to close a business in Lithuania. According to the World Bank Doing Business indicators, finalising an insolvency procedure took 2.3 years on average, relative to 1.8 years in the OECD.

The recovery rate for investors in the event of insolvency is low; 43 cents per dollar in Lithuania compared with 71 cents in the average OECD country (World Bank, 2015). While less punishing bankruptcy laws can be beneficial for encouraging entrepreneurship and the reallocation process, there may be unintended consequences that stifle firm growth. In particular, lower recovery rates for creditors may reduce access to finance for firms.

Access to finance is a constraint for some productive firms

Around 16% of the Lithuanian firms responding to BEEPS cited access to finance as a major or very severe obstacle to their operations in 2013. This was higher than in Estonia (5%) and about the same as in Latvia (15%). Across countries, access to finance can be an obstacle for the growth of young firms, slowing the reallocation process, as they often have an unproven track record and limited internal funds or physical collateral. This is more often the case in countries, such as Lithuania, where the financial system is heavily bank-based.

Financial constraints are especially concerning if more productive firms are unable to gain access to funding. The BEEPS data suggests that this may be the case in Lithuania. Unlike in the other Baltic countries, the Lithuanian firms that cited access to finance as a major or very severe obstacle to their operations in 2013 were generally those with higher levels of labour productivity (Figure 1.9). These firms also tended to be smaller as measured by the number of full-time employees, suggesting that poor access to finance may constrain resources being reallocated to some small high-potential Lithuanian firms.

Figure 1.9. Some productive Lithuanian firms face difficulty accessing finance

Productivity level in 2013 (Index 100 = country average), by whether access to finance is an obstacle

Note: Calculations are based on 218 firm responses for Lithuania, 241 for Estonia, 269 for Latvia, 382 for Poland, 211 for Czech Republic, 190 for Hungary, 171 for Slovak Republic and 241 for Slovenia. Productivity is calculated as total sales per full-time employee. The survey is taken from a stratified random sample where the dimensions of the strata are firm size, business sector and geographic region within the country.

Source: OECD calculations, based on EBRD-World Bank Business Environment and Enterprise Performance Survey 2013.

In many countries, the financing gap for young firms is bridged by venture capital funds that overcome information asymmetries by investigating and monitoring firm performance (OECD, 2011). However, the venture capital market is in its infancy in Lithuania with businesses reporting greater availability of such funding in the other Baltic countries (World Economic Forum, 2014). There have been advances, such as through the JEREMIE initiative, whereby EU structural funds have been used to establish five venture capital funds. These venture capital funds are designed to finance the main stages of firm development (i.e. seed, start-up, later-stage venture and growth) and focus on businesses that have their principal location in Lithuania (Leichteris et al., 2015).

As much as possible, government support of equity investments in high-potential young firms should be done in partnership with the private sector (Wilson, 2014). Such an arrangement is likely to be more successful in fostering a sustainable venture capital sector and will help avoid the common pitfalls of government “picking winners”. An example is the Baltic Innovation Fund, which is a fund-of-funds that is partly financed by each of the Baltic country governments. The Fund invests in existing private equity and venture capital funds that then finance high potential Baltic firms.

Expanding the Lithuanian equity market could also improve financing conditions for some companies. Of the Baltic exchanges, the market capitalisation of the Nasdaq Vilnius is the largest. The adoption of the euro appears to have heightened investor interest in the Vilnius exchange, as it has enabled diversification with lower currency risk. Further development of the equity market may allow for new platforms such as an alternative investment market similar to those currently operating in the UK and Italy for smaller growing companies with lower listing values. These alternative platforms have services designed to help small companies become listed and a lighter regulatory environment more suited to their characteristics. Some other countries, such as Austria and Germany, have recently adjusted regulatory settings in order to promote equity-based crowdfunding of young businesses. Under such an arrangement, a modest amount of external finance is raised from small contributions by a large number of investors through a web platform, typically to finance a specific project (OECD, 2015d). Nevertheless, the scale of finance through this channel is limited, meaning that other sources of seed and early stage financing should be fostered in conjunction.

Labour markets are flexible but skill mismatch is high

Estimates of Lithuania’s structural unemployment rate, at 10-12%, are high by international standards. As well as the existence of a sizeable informal economy, high structural unemployment reflects problems with the allocation of labour resources. Significant occupational mismatches exist, with 31% of workers employed in a field not related to their study compared with 23% on average in the EU (IMF, 2015a). Such disconnects between the qualification and skill profile of labour and the demands of industry have been found to be associated with lower firm productivity (Adalet McGowen and Andrews, 2015).

The share of the working age population with tertiary education in Lithuania is well above the EU average. However, value added shares by industry (Figure 1.3, Panel A) and revealed comparative advantage (Saboniene et al., 2013) highlight traditional sectors, which generally have a larger share of jobs without specific skills requirements, as Lithuania’s major industries. A study by the Research and Higher Education Monitoring and Analysis Centre (MOSTA) found that 36% of employed bachelor graduates in 2013 held positions that did not require a higher education qualification. Substantial policy advances have been made that aim to develop the knowledge economy in Lithuania (discussed further below). Regardless, providing better information to students about the qualification requirements of different jobs is important. As are further efforts to ensure the education system teaches the skills needed by employers. For meeting both these objectives, the planned “qualifications map” – which uses registry and social insurance data to highlight the links between graduate fields and employment – should be utilised.

High structural unemployment may also reflect uncertainty relating to labour market regulations. As discussed further in Chapter 2, the labour code is rigid for both regular and temporary workers, but is in some aspects weakly enforced. As a result, labour reallocation is swift in practice. This is highlighted by the relatively large contribution of shifts in labour resources across sectors to recent aggregate productivity growth (Figure 1.2) and the substantial fluctuations in employment observed during the financial crisis (Earle et al., 2015). However, gaps between legislation and practices create legal uncertainty for firms and insecurity for workers. This may undermine Lithuania’s attractiveness for FDI, as foreign firms are less aware of national practices. The anticipated reform of the labour code (discussed in Chapter 2) should help reduce such uncertainty by more closely aligning the legislation with current practices.

Basic skills are poor and workplace learning is underdeveloped

Relative to other comparable countries, a high proportion of Lithuanian firms cite an inadequately educated workforce as a significant obstacle to their operations (Figure 1.10). Furthermore, over 40% of businesses surveyed in the first half of 2015 for Lithuania’s Investor Confidence Index characterised the availability of qualified labour as insufficient. Human capital improvements are important for Lithuania’s future productivity growth as they will reflect in worker performance and the ability of management to organise production processes efficiently. For example, Bloom et al. (2013) estimate that managerial quality explains half the productivity gap between the United States and countries such as Italy and Portugal.

Figure 1.10. Lithuanian industry finds the education of the labour force inadequate

% of firms citing an inadequately educated workforce as a major or very severe obstacle to operations, 2013

Note: Calculations are based on 259 firm responses for Lithuania, 329 for Latvia, 243 for Czech Republic, 267 for Slovak Republic, 516 for Poland, 269 for Slovenia, 307 for Hungary and 268 for Estonia.

Source: OECD calculations, based on EBRD-World Bank Business Environment and Enterprise Performance Survey 2013.

Part of the explanation for insufficiently skilled labour in Lithuania may be large emigrant outflows in recent years. The number of high skilled Lithuanian workers that emigrated to OECD countries in the decade to 2011 constituted more than 8% of Lithuania’s domestic tertiary-educated population (Figure 1.11). There can be benefits to a country from emigration such as remittances and the potential for migrants to return with new skills. However, combined with a rapidly ageing population, the pace of skilled emigration makes it more pressing that the Lithuanians entering the domestic labour force have sufficient skills.

Figure 1.11. High skilled emigration has depleted Lithuania’s pool of human capital

High skilled emigrants to OECD at 2010-11 that moved in the past 10 years, % of domestic high skilled 15+ population

Note: High skilled workers are defined as those with tertiary education.

Source: Calculations based on OECD Database on Immigrants in OECD Countries (DIOC) 2010/11 and Eurostat data.

Post-secondary education

As noted earlier, the incidence of tertiary education in Lithuania is high. In 2014, 53% of Lithuanians aged 30-34 were tertiary educated compared with 38% across the EU. Nevertheless, firms report inadequate technical skills of graduates as a key factor behind labour shortages (European Parliament, 2015) and the extent of well-qualified managers in Lithuanian firms is modest (Figure 1.12). This reflects both failings in the skills being taught in the education system and the fact that lifelong learning participation rates are low (see Chapter 2for further discussion). In 2015, the proportion of 25 to 64 year-olds participating in education and training in Lithuania was around half the EU average (European Commission, 2014a).

Figure 1.12. Qualified professional managers are less common in Lithuania than in the OECD

Reliance on professional management (value), 2014-15

Note: The score is derived from the answers of business leaders to the question: “In your country, who holds senior management positions? (1 = usually relatives or friends without regard to merit; 7 = mostly professional managers chosen for merit and qualifications)”.

Source: World Economic Forum Global Competitiveness Index.

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No Lithuanian university was ranked in the top 400 universities published by the Times Higher Education World University Rankings 2014-15. This contrasts with some of the smaller OECD economies such as Finland and Denmark that have seven and five universities in the top 400 respectively. Scope for improvement in the quality of Lithuanian universities was highlighted by a MOSTA study in 2015 that found that the short-run returns to university education were low relative to other forms of education (MOSTA, 2015). Higher education expenditure by the government (as a percent of GDP) is in line with many OECD countries, but the system may benefit from some rationalisation: there are 14 state universities and 13 state colleges in Lithuania which, on a per capita basis, is relatively high (Mitchell, 2014). In this process, there may also be scope for increased specialisation by institutions.

Government reforms have improved the responsiveness of universities to student demand, but differences in course fees may contribute to skill mismatch. In 2009, the government replaced direct funding for institutions with the provision of education vouchers to the best-performing students. This sought to foster a competitive funding environment and ensure institutions were more responsive to student needs. Nevertheless, roughly half the full-time students do not receive vouchers but pay full tuition fees. The fact that such fees for social sciences courses are relatively low has been blamed for an oversupply of social sciences graduates (IMF, 2015b). Indeed, the estimated returns to such courses are the lowest among the fields of study offered by Lithuanian universities and colleges (MOSTA, 2015). Greater efforts to communicate to students the labour market outcomes of graduates by field of study may be needed.

More work-based training that teaches practical skills is necessary given the difficulties faced by firms in finding adequately-skilled workers. The Lithuanian government has prioritised reform of vocational education and training (VET), which is largely school-based and has low enrolment rates. Only 29% of students in upper secondary education in 2013 were enrolled in vocationally-oriented programmes compared with 50% on average in the EU (OECD, 2015c). A recent initiative has been the establishment of sectoral practical training centres, which are modern training facilities that can be used by VET students along with higher education students and members of industry. The government is aiming to double the proportion of work-based learning in higher education and in-company training/apprenticeships that VET institutions provide by 2020. As highlighted in the recent OECD Policy Note on Youth in Lithuania (OECD, 2015c), complementary measures that further encourage participation by businesses may also be needed. These could include direct subsidies to participating firms. In most countries with well-functioning VET systems, the future employers of VET graduates as well as social partners play an important role in school governance and curriculum development. Such systems often emphasise a strong foundation in basic and transferable skills (like numeracy and literacy) in the VET programme (OECD, 2012a).

Secondary and early childhood education

The inadequate skills of the labour force may also reflect deficiencies in the education system at early ages. Lithuanian secondary students participating in the most recent wave of the Programme for International Student Assessment in 2012 (PISA; Figure 1.13, Panel A) scored particularly poorly for reading and mathematics compared with students in OECD countries. Low participation in early childhood education in Lithuania, especially in rural areas (Figure 1.13, Panel B; Poviliūnas, 2014), may contribute to students’ future poor test scores. Furthermore, there is scope for improvement in the quality of the school system.

Figure 1.13. Poor basic skills partly reflect low participation in early childhood education

Source: OECD (2015), Education at a Glance 2015, Indicator C2; Eurostat Education Indicators Database; OECD, PISA 2012 Database.

Talented graduates may be discouraged from becoming teachers because teacher salaries are low. Indeed, young teachers are scarce in Lithuania compared with other EU countries (European Commission, 2013). Past empirical work suggests that up to one-third of the variation in PISA scores between OECD countries can be explained by differences in teacher salaries (Ali, 2009). In general, teacher salaries are relatively low in the Baltics (Figure 1.14, Panel A). In Lithuania they are in line with GDP per capita, while they are around 20% higher than GDP per capita in the average OECD country.

Figure 1.14. Teacher salaries are low and there is scope for improving quality assurance

Note: The ratios in Panel A are calculated as a simple average of those for lower and upper secondary education.

1. Including teacher and student attendance and graduation rates, test results and professional development of teachers.

2. Such as a school curriculum with shared instructional materials accompanied by staff development and training.

Source: OECD PISA 2012, OECD Education at a Glance 2013, PISA system-level data collection in 2013.

For countries with low teacher salaries, performance-based pay scales have been found to benefit student performance (OECD, 2012b). Such mechanisms help preserve incentives and may be particularly useful in countries where budget constraints limit a broad-based salary increase. Teacher performance has typically not been a criterion for setting base salary and supplementary payments in Lithuania (OECD, 2013b). Nonetheless, it can be difficult to evaluate the impact of an individual teacher on students’ results. A system based on the evaluation of good practices or group performance (i.e. A grade level team) may be more beneficial for encouraging teamwork and teacher training.

There is also scope to improve the professional development of Lithuanian teachers. While most Lithuanian schools collect data to monitor student and teacher progress and seek written feedback from students, mentoring programmes for teachers are relatively uncommon (Figure 1.14, Panel B). Furthermore, in relation to mathematics courses, school principals report that it is not common for senior staff to observe lessons to monitor the practices of teachers (OECD, 2013b). Mentoring and development programmes that help young teachers develop their skills in motivating students to learn, classroom management and assessing student work, can benefit teaching quality and combat early dropout from the profession (OECD, 2009).

External evaluations of Lithuanian schools should be undertaken more frequently. Schools have a relatively high level of autonomy in making decisions about salaries, recruitment and budget allocations (Figure 1.14, Panel C). This is positive given such autonomy allows more tailored educational offerings that reflect student needs. However, in 2012, school principals reported that external evaluations in Lithuania were less common than in the OECD (Figure 1.14, Panel B) and in subsequent years their frequency appears to have declined (OECD, 2016b). As such, the role of the school inspectorate or other external review body could be boosted to ensure schools are more regularly evaluated.

The costs involved in further improving educational quality may be partly offset by efficiency gains in the system. A decline in Lithuania’s school-aged population has prompted the government to consolidate schools. However, the student-teacher ratio is still fairly low compared with most OECD countries (Figure 1.15). Furthermore, population projections by the United Nations suggest that the school-age population will fall by over 20% between 2010 and 2030, assuming constant fertility (United Nations, 2015). Some further consolidation of schools may enable cost savings and facilitate better co-ordination of curricula and teaching standards. However, this should be accompanied by measures such as improved transport infrastructure that ensure educational opportunities for students, especially those in rural areas, are not reduced.

Figure 1.15. The student-teacher ratio is relatively low and likely to further decline

Student-teacher ratio, 2012

Source: OECD PISA 2012.

Innovation intensity is low despite a number of supportive government policy measures

Advances in productivity can also be fostered through the implementation of firm-level innovations which will, in turn, be influenced by the policy environment. Measures include many of the structural policies already discussed but also innovation-specific policies.

Lithuanian firms report relatively low levels of innovation. The EU Summary Innovation Index for Lithuania was around half the EU average in 2014 and below most comparable countries (Figure 1.16, Panel A). The most recent EU Community Innovation Survey found that just 32.9% of Lithuanian enterprises undertook innovation activity in the 2010-12 period compared with 48.9% on average across the EU (Eurostat, 2015). Compared with the average EU business, Lithuanian firms reported particularly weak product and organisational innovation activity (Figure 1.16, Panel B). Part of the problem may be that businesses in Lithuania suffer from poor capacity to absorb new foreign ideas and technologies (Angelis et al., 2014). A recent survey suggests that over 80% of Lithuanian Small and Medium Enterprises (SMEs) can be classified as having “low-absorptive capacity”; that is, they underperform in knowledge and technology transfer activities (Leichteris et al., 2015).

Figure 1.16. Firm level innovation in Lithuania is low

Note: The Summary Innovation Index in Panel A is a composite indicator obtained by an aggregation of 25 innovation indicators. In Panel B, a product innovation is the introduction of a good or service that is new or significantly improved with respect to its characteristics or intended uses. A process innovation is the implementation of a new or significantly improved production or delivery method. This includes significant changes in techniques, equipment and/or software. An organisational innovation is the implementation of a new organisation method in the firm’s business practices, workplace organisation or external relations. A marketing innovation is the implementation of a new marketing method involving significant changes in product design or packaging, product placement, product promotion or pricing.

Source: European Commission (2015b), Eurostat (2015).

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Innovation-specific policies

Relatively weak innovation performance coincides with low business research & development (R&D) intensity in Lithuanian firms (Figure 1.17, Panel B). Past cross-country analysis has highlighted the importance of R&D for enhancing the absorptive capacity of the economy (Griffiths et al., 2004). Compared with other countries, a higher proportion of R&D in Lithuania is undertaken by the higher education and government sector. Much of this focuses on basic research which is critical for innovation but can take many years before it is applied commercially (Sheehan and Wyckoff, 2003).

Figure 1.17. Business R&D intensity is very low

% of GDP, 2013 or last available year

Source: OECD Main Science and Technology Indicators and Eurostat Statistics on Research and Development Database.

The Lithuanian government has set a national R&D target for 2020 at 1.9% of GDP, aiming for half to be contributed by the business sector. Achieving this objective may be challenging given that firms already report a shortage of researchers (Angelis et al., 2014), due in part to Lithuania’s elevated high skill emigration rate and the significant administrative burden associated with hiring some foreign specialists (Box 1.2). Indeed, the share of researchers working in the business enterprise sector in Lithuania was 12% in 2012. This was lower than in the other Baltic countries and markedly lower than in some OECD members such as France (60%) and the Netherlands (68%). Any improvement in the availability of researchers should complement the policy measures already in place to encourage business R&D.

Along with an accelerated depreciation allowance for some R&D capital, since 2008 companies have been able to deduct 300% of R&D expenditures from taxable income. This is generous compared with such tax incentives in OECD countries (Figure 1.18). Nevertheless, the utilisation of R&D tax incentives by Lithuanian businesses remains low even though it has increased in recent years (European Commission, 2015c). Poor research capacity at the firm level and a relatively large number of firms operating in the informal economy may be partial explanations for low utilisation. However, poor understanding about the tax incentives also appears to be a problem. A recent survey of Lithuanian businesses found that two-thirds of the respondents were unaware that a tax deduction for R&D expenditures existed (Deloitte, 2015). Of those that were aware, a commonly cited deterrent to applying for incentives was uncertainty relating to the definition of eligible R&D. Upon request by a firm, the agency for Science, Innovation and Technology (MITA) is able to verify whether activities can be classified as R&D. Along with the existence of R&D tax incentives, this service should be better communicated to firms.

Figure 1.18. Tax incentives for R&D are generous in Lithuania

R&D tax subsidy rate, 2015

Note: The index is for large profitable firms. The tax subsidy rate is calculated as (1 – B-index), where the B-index is a measure of the before-tax income needed to break even on 1 dollar of R&D outlays (Warda, 2001). A decline in the B-index reflects an increase in R&D tax generosity. The calculation of the measure for Lithuania is based on the 300% deduction of R&D expenses, a 15% corporate tax rate, 2 year straight line depreciation and no expenditure ceiling for the tax advantage. The value for Lithuania is calculated based on these parameters, whereas published numbers from the below source are used for all other countries presented in the figure.

Source: OECD Science, Technology and Industry Scoreboard 2015, OECD calculations

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While R&D tax incentives can encourage business R&D expenditures, they may favour incumbents at the expense of young firms. This is because the implicit subsidy rate of such measures increases with firm profitability and young firms are often in a loss position in the early years of an R&D project (Adalet McGowan et al., 2015). While the R&D tax deduction can be carried-over to future years, the value of future claims for young loss-making firms is lower than the value of present claims for profitable firms due to time-discounting. To ensure that this does not create a barrier to firm entry or growth, other measures such as government R&D grant and loan schemes, which are often particularly important for young innovative firms, should continue to play a prominent role in the innovation policy mix.

To complement the various supply-side policies, the Lithuanian government is also developing demand side measures to support innovation. Such measures can be useful in creating a market for innovations that address particular environmental and societal challenges (e.g. healthcare and pollution reduction). Innovative pre-commercial public procurement is one such measure. In this case, a public contracting authority, for the purpose of purchasing goods, services or works, introduces into the procurement terms criteria that require innovative solutions. While the government’s procurement-related objectives under the Strategy of the Development and Improvement of the Lithuanian Public Procurement System for 2009-13 were not met (Leichteris et al., 2015), public institutions such as the Ministry of Economy and MITA are currently reforming the regulatory and legal framework to be more conducive to such innovative public procurement practices. Legislation providing guidelines for pre-commercial public procurement was adopted by the government in July 2015 and a draft law is being considered that provides advantages in the bidding process for innovative suppliers. The design of further policy initiatives in this area must ensure that there is not undue favouritism to large firms that are well-connected to the government and that technology lock-in is avoided. To counter such unintended consequences, some OECD countries have put in place incentives for the participation of young firms in the bidding process and improved the transparency of the procurement framework (OECD, 2014b).

Transport infrastructure

There are persistent issues with the railway system. Some narrow gauge rail tracks still exist (a hangover from the Soviet period), limiting interoperability with the European gauge railway network. Furthermore, over half of Lithuania’s railway network does not have double tracks, reducing the potential for trains to overtake and causing problems with trains travelling in opposite directions. As well as economic consequences, an inefficient rail network can reduce energy efficiency which has environmental impacts. Adding to this, the degree of electrification of the railway network in Lithuania is substantially lower than the EU average. Rail infrastructure will be boosted by the completion of the Rail Baltica project which will run through Kaunas and connect Finland, Poland, Germany and the Baltic States.

Water transport has benefitted from a sequence of recent port investments, but there is scope to further increase the use of inland waterway transport. The expansion of the capacity of the Klaipeda port enabled cargo volumes to rise by one third between 2007 and 2014. However, the use of inland waterway transport remains low: the proportion of total inland freight transport by water is less than 1% compared with over 5% on average in the EU. Any initiatives to further develop inland waterways could reduce costs and environmental damages given that this form of freight transport tends to be relatively energy efficient.

Energy infrastructure

Connection to the electricity network has become less of an impediment to business operations. In 2013, over one third of Lithuanian firms responding to BEEPS reported electricity as either a major or very severe obstacle to their operations, which was high compared with the other Baltic countries. Such obstacles can create a barrier to firm entry and potentially deter FDI. However, new measures including stricter enforcement of the legal time period for connection works appear to have improved the ease of getting an electricity connection. From a year earlier, the time it took to obtain electricity connection fell from 135 days to 95 days in Lithuania in 2015 (World Bank, 2015).

A risk to business conditions is Lithuania’s high vulnerability to disruptions in electricity supply. Until 2010, Lithuania’s Ignalina Nuclear Power Station was the main source of electricity. However, following the closure of the plant, reliance on imported electricity from Latvia and Kaliningrad increased substantially. This was partly due to poor connectivity with the main electricity networks in continental Europe and Scandinavia (Miliauskaitė, 2012). Several infrastructure projects that will diversify the sources of electricity supply have been undertaken. These include the NordBalt electricity transmission line between Klaipeda and Nybro (Sweden) and the LitPol link with Poland that commenced operation at the end of 2015.

Lithuania should continue to improve integration with the European gas market to reduce potential disturbances to business operation from disruptions to gas supply. Until recently, Russia was the sole supplier of gas to Lithuania. However, the completion of the Klaipeda liquefied natural gas (LNG) terminal at the end of 2014 began to diversify the sources of Lithuania’s gas. The announcement of the Gas Interconnector Poland-Lithuania project is very welcome, as completion will connect the gas networks of all the Baltic countries with that of the EU.