The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department by Dainis Stikuts and Lija Strašuna No. 3 • 29 April 2011
Fiscal policy – still room for improvement
•
Despite tax increases, the ratio of tax revenues to GDP has decreased in the last twoyears. The ability to tax the economy and the effectiveness of tax collection havediminished, implying that further consolidation measures should be based on well-thought-through expenditure cuts and rebalancing tax burden.
•
Although the government budget deficit last year was below the cap set by theagreement with the IMF/EC, with more precise planning and stricter fiscal disciplinethe outcome might have been better. The fiscal discipline law that definescountercyclical budget rules is now in the parliament, but its approval is pending.
•
The effectiveness of the public sector depends on the politicians’ will to initiatereforms, as well as civil servants’ ability to provide them with qualitative proposalsand implement these proposals. A performance-based remuneration system in thepublic sector linked to private sector wage developments would help to improve thequalification and motivation of public sector employees.
The government budget situation is improving faster than expected. The general government budgetdeficit for 2010 was 7.6% of GDP
(which is belowthe 8.5% cap set in agreements with the IMF/EC).In 2011, the government intends to reduce thebudget deficit faster than initially planned. In April,the parliament passed a supplementary budget,and the central government budget deficit has beenreduced to 4.2% from 5.4% of GDP (cash-flowbasis). During 2009-2011, the government hasdone much hard work to consolidate the budget byabout LVL 2 billion, or 15% of GDP. The target is toput the economy and the budget on a sustainablepath, to fulfil the Maastricht criteria and introducethe euro in 2014.The progress achieved so far has been reflected inhigher Latvian sovereign credit ratings. It providesthe opportunity for the Latvian government to startissuing bonds in international financial markets for amore acceptable price and gradually to beginrefinancing external debt. However, this does notmean that public finances already stand on solidgrounds.
Further increase in tax burden is noteffective
So far, the government has undertaken the easiest,least painful approach, i.e., instead of well-thought-through structural reforms it has employed several
Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000.E-mail: ek.sekr@swedbank.com www.swedbank.comLegally responsible publisher: Cecilia Hermansson, +46 8 5859 7720.M
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1
Accrual basis, i.e. according to Maastricht criterion.
temporary measures (e.g., reducing payments tothe second pension pillar, forcing dividend payoutsfrom state-owned companies) and it has increasedtaxes (including those on labour income).
Tax revenues
1520253035401Q071Q081Q091Q10% of GDP% of domestic demand
Sources: CSBL, State Revenue ServiceAverage2004-2006
Jan.2011:
Excise
↑
RE
↑
VAT
↑
PIT
↓
Soc
↑
Transport
↑
?Jul.2011:
VAT
↑
Excise
↑
Jul.2010:
Excise
↑
Jan.2009:
PIT
↓
Excise
↑
VAT
↑
RE
↑
Transport
↑
Jan.2010:
RE
↑
Excise
↑
PIT
↑
Transport
↑
In each subsequent budgeting round, fiscalconsolidation increasingly moved towards taxincreases rather than expenditure cuts. While in2009 about. 70% of the consolidation measureswere on the expenditure side, in 2010 this sharedecreased to 42% and in 2011 it will fall to 31%.This is in contrast with pre-election promises andempirical evidence, which suggests thatconsolidation done through expenditure cuts has a
The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued No. 3 • 29 April 2011
2 (4)
The tax burden has increased in 2009-2011 – thegovernment has raised tax rates and widened thetax base; e.g., it has started to tax residential realestate and capital income. Despite tax increases,the ratio of tax revenues to GDP has declined. Thiscan partly be explained by the expansion of exporting sectors, which are less tax intensive;however, tax revenues as a percent of domesticdemand have diminished as well. This thusindicates problems with tax evasion, implying that afurther tax increase is not efficient (not least,because trust in government policy and theincentive to pay taxes are falling).Reducing the shadow economy does remain one of the government’s key areas of focus. However, theraising of taxes has in fact done the opposite, whileappropriate actions to improve tax administrationand collection so far have been weak and slow incoming. Government credibility – and thusmotivation to pay taxes – has been undermined byfrequent and unpredictable tax changes, which inmany cases have been in contrast to long-termpolicy documents, e.g., “The Framework for Taxand Duty System for 2011-2015.”
Despite an increase in consumption and propertytaxes, Latvia’s current tax system is still not wellbalanced – the motivation to pay taxes and theeconomic structure remain distorted.
There is aheavy tax burden on wage income (personalincome tax 25% and employer and employee socialcontributions 35.09%), which is subject to larger taxevasion than property or consumption taxes;together with the large labour tax wedge, thisburden discourages job creation.
Unfortunately,the opportunity to pursue reforms – perhaps painfulin the short term, but promoting medium-termgrowth – during the post-election period in late 2010and early 2011 was by and large wasted.
2
See, e.g., IMF (2010), “Will it hurt? Macroeconomic effectsof fiscal consolidation”,
World Economic Outlook
, October2010, Chapter 3.
3
4
For more details, see Swedbank Analysis (2009), “The fiscalstance in Latvia – how to return to a sustainable path?”,October 30, 2009.
5
Although tax revenues from labour income as a percent of GDP in Latvia are lower than in the EU27 on average (14.5%vs. 19.7% in 2008, possibly due to tax evasion), the labour taxwedge is larger than in the EU27 on average (40% vs. 37%;Eurostat data).
Tax share in total tax revenues in 2010
Excise14%other 5%VAT 24%Personalincome tax23%Socialcontrib.34%
Source: State Treasury
Now, there is less room for manoeuvre due to theplanned euro introduction in 2014 to balance atrade-off between curbing inflation and reducing thebudget deficit. The option of decreasing the taxburden on wages (possibly compensating for thiswith higher property taxes and abolishment of thereduced value-added tax, along with an effectivecompensation mechanism for the less well off)should be considered in the nearest future.
Fiscal discipline and budget planning needto be improved
The recent recession shed light on a couple of issues of fiscal discipline and budget planning thatprevented the actual budget deficit outcome frombeing better.First, the deficit in the last couple of months of theyear usually increases by 2-3 percentage points of GDP due to the seasonal pattern of expenditures.The question is whether this is a reflection of specific payment terms for public orders madeduring the current year or public institutions’wanting by all means to spend the whole fundingplanned for the year, thereby proving the validity of their budgets and avoiding possible financing cutsnext year. Budget expenditures at the end of theyear regularly erode the improvement in the budgetbalance achieved during the year (e.g., due tolarger-than-expected revenues) and raise the issueof fiscal discipline.
The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued No. 3 • 29 April 2011
3 (4)
Accumulated general budget deficit, % of GDP
-8-6-4-2024JanMarMayJulSepNov20072008200920102011
Source: State Treasury* cash-flow basis
Second, during the last two years, an increase inplanned expenditures in the second half of the year has become quite regular, for instance, theannouncement of funding shortages and requestsfor additional financing in the health care sector inautumn. Even taking into account the fact that notall expenditures can be forecasted at the beginningof the year, such regularity points to problems inbudget planning. Otherwise, it is hard to explain thedifference between the initial budget plan approvedat the beginning of the year and the revised plan inDecember. For instance, the planned budget deficitnearly doubled in 2010 from LVL 524 million inJanuary to almost LVL 1000 million in December.
Central government budget balance planning, millionLVL
-1200-1000-800-600-400-2000200Jan.08Jan.09Jan.10Jan.11Budget planOutcome
Source: State Treasury* cash-flow basis
Budgetamendments
These problems are not new, and Latvia can learnhow to deal with them from other countries’experience. For instance, Sweden developed amedium-term fiscal policy framework in the mid-1990s to ensure the transparency and sustainabilityof public finances; this proved to be quite efficient.
The framework includes central governmentexpenditure ceilings for the next three years, abalanced budget requirement for localgovernments, and a budget surplus target over thebusiness cycle for the general government. Itshould be emphasized that such a medium-termframework has to be integrated into all aspects of the budget process in order to be effective(including forecasting capacity).The Latvian government has taken the first steps inthis direction. The Ministry of Finance has prepareda fiscal discipline draft law that requires thegovernment to make mid-term budget planning anddefines countercyclical budget rules, starting in2012. This draft law has been approved by theCabinet of Ministers and is now pending in theparliament. It includes expenditure ceilings, requiresthe budget to be in surplus when the economy isgrowing faster than 2%, and allows a budget deficit,not to exceed 3% of GDP when the economy isgrowing slower or decreasing.
However, to makethis law effective it is also crucial to enhance thecapacity to make realistic and reliable forecasts for macroeconomic parameters and revenue andexpenditure development.
Still room for improvement in public sectoreffectiveness
Taking into account the fact that further tax hikesare not reasonable and consolidation should beachieved through expenditure cuts and arebalancing of the tax burden, the issue of effectiveness of the public sector takes centrestage.The effectiveness of the public sector depends onthe politicians’ will to initiate reforms, as well as civilservants’ ability to provide them with, and toimplement, qualitative proposals. To ensure qualitydecision making, the question of remuneration iscrucial – in many cases, civil servants in keypositions are grossly underpaid compared withpositions with similar responsibilities in the privatesector. Gross real wages in public administrationhave decreased by about 30% from the peak in thefirst half of 2008. This diminishes the motivation of civil servants and increases the risk of poor policydecisions.
6
Ljungman, G. (2007) „The Medium-term Fiscal Framework in Sweden”,
OECD Journal on Budgeting
No. 3 (6)
7
This law would also be in line with the EC directive onrequirements for budgetary frameworks of the Member States,planned to be in force in 2014.
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