Lithuania’s Fiscal Future: Navigating Defense Costs, Aging Population, and Climate Challenges

Lithuania faces significant long-term fiscal challenges due to rising defense costs, an aging population, and climate change, which could raise public debt substantially by 2050. The IMF recommends comprehensive reforms in pensions, healthcare, and tax policy to ensure fiscal sustainability.

A new report from the International Monetary Fund (IMF), authored by Serhan Cevik and released in September 2024, provides an in-depth look at the significant fiscal challenges facing Lithuania. The research, supported by contributions from various institutions, including the Bank of Lithuania and Vilnius University, delves into the economic pressures driven by national security, demographic changes, and climate adaptation. It argues that while Lithuania has demonstrated resilience to global shocks, the country’s fiscal future is fraught with significant long-term risks that require urgent and complex policy solutions.

Rising Defense Costs and Borrowing Challenges

Lithuania’s most immediate fiscal challenge stems from national security concerns, amplified by Russia’s war in Ukraine. Defense spending, which was 0.9% of GDP in 2010, has surged to over 2.5% in 2023. With plans to increase it to 3% or more by 2030, the country faces a heavy fiscal burden. This increase is backed by broad political consensus, but the question of how to sustainably finance such expenditures remains unresolved. Meanwhile, monetary tightening by the European Central Bank (ECB) has increased Lithuania’s borrowing costs, with interest payments expected to rise from 0.4% of GDP in 2022 to 1.2% by 2030. These immediate issues, though significant, pale in comparison to the looming long-term pressures created by climate change and demographic shifts.

The Impact of a Shrinking and Aging Population

Demographic change is one of Lithuania’s most pressing concerns, as the country has experienced a dramatic population decline over the past few decades. From a population of 3.7 million in 1991, Lithuania’s numbers have fallen to 2.8 million in 2023, with projections suggesting a further decline to 2.3 million by 2050. The aging of the population is particularly alarming. The old-age dependency ratio of those aged 65 and above to the working-age population has risen from 18% in 1991 to 33% in 2023 and is expected to reach 53.4% by 2050. This demographic shift will place immense pressure on public finances, particularly in the areas of pensions and healthcare. Pension spending, which was 6.9% of GDP in 2023, is projected to rise to 11.8% by 2050, while healthcare costs, driven by the aging population and the increasing prevalence of chronic diseases, will increase by 1.2 percentage points of GDP. Overall, the long-term spending pressures related to demographic change could amount to as much as 11.2% of GDP annually by 2050, representing 30% of the current level of government spending.

Public Debt Sustainability at Risk

The report warns that financing these expenditures through debt is not a viable solution, as Lithuania’s public debt could rise from 35.6% of GDP in 2023 to 71.5% by 2050. Such an increase in debt would raise serious concerns about the country’s fiscal sustainability and macroeconomic stability. Therefore, the IMF suggests a combination of structural reforms and revenue-raising measures to address these challenges. Key among these recommendations are reforms to Lithuania’s pension and healthcare systems. The IMF advocates for linking the retirement age to life expectancy to help mitigate the impact of an aging population on pension costs. It also recommends improving labor market policies to encourage older workers to remain in the workforce longer, thereby easing some of the fiscal pressure caused by the rising old-age dependency ratio. On the healthcare side, the IMF suggests focusing on preventive care and increasing the efficiency of healthcare spending. Currently, healthcare spending in Lithuania is lower than the EU average, but demographic trends will push these costs higher in the coming decades. Reallocating resources to preventive care could not only improve health outcomes but also reduce long-term costs.

Climate Change Adding to Fiscal Pressures

In addition to structural reforms, the report emphasizes the need for tax policy changes to raise additional revenue. Lithuania’s tax-to-GDP ratio, at 31.6%, is significantly lower than the EU average of 40.2%, suggesting room for improvement. The IMF proposes rationalizing tax exemptions, raising property and environmental taxes, and introducing a carbon tax to generate additional revenue. An economy-wide carbon tax, for example, could raise about 1.5% of GDP by 2050 and contribute to climate change mitigation efforts. Modernizing the property tax system, which currently applies only to high-value real estate, could generate significant additional revenue—about 1.8% of GDP while making the tax system more progressive.

The Path Forward: Structural Reforms and Fiscal Adjustments

Climate change also presents a growing fiscal challenge for Lithuania. The annual fiscal cost of adapting to and mitigating climate change is estimated to reach 2.2% of GDP by 2050. Lithuania’s geographic location makes it particularly vulnerable to climate change, with rising temperatures and increased winter precipitation posing risks to biodiversity, agriculture, infrastructure, and other sectors. The report underscores the importance of investing in infrastructure resilience and developing financial buffers to mitigate the impact of climate-related disasters.

Lithuania faces significant fiscal challenges in both the short and long term, driven by national security needs, demographic changes, and climate change. Addressing these challenges will require a comprehensive and balanced fiscal strategy that includes structural reforms, tax policy changes, and investments in resilience. The IMF’s report makes it clear that Lithuania has the opportunity to tackle these issues gradually, avoiding drastic and politically contentious measures, but the time for action is now. Without decisive policy interventions, the country risks long-term fiscal instability and a decline in economic competitiveness.