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 two
years. The ability to tax the economy and the effectiveness of tax collection have
diminished, 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 the
agreement with the IMF/EC, with more precise planning and stricter fiscal discipline
the outcome might have been better. The fiscal discipline law that defines
countercyclical budget rules is now in the parliament, but its approval is pending.
• The effectiveness of the public sector depends on the politicians’ will to initiate
reforms, as well as civil servants’ ability to provide them with qualitative proposals
and implement these proposals. A performance-based remuneration system in the
public sector linked to private sector wage developments would help to improve the
qualification and motivation of public sector employees.

The government budget situation is improving faster temporary measures (e.g., reducing payments to
than expected. The general government budget the second pension pillar, forcing dividend payouts
deficit for 2010 was 7.6% of GDP 1 (which is below from state-owned companies) and it has increased
the 8.5% cap set in agreements with the IMF/EC). taxes (including those on labour income).
In 2011, the government intends to reduce the
budget deficit faster than initially planned. In April, Tax revenues
the parliament passed a supplementary budget,
40
and the central government budget deficit has been Av erage Jan.2010: RE ↑ Jan.2011:
2004-2006 Excise ↑
reduced to 4.2% from 5.4% of GDP (cash-flow Excise↑ PIT ↑ Jul.2010:
RE ↑ VAT ↑
basis). During 2009-2011, the government has 35 Transport ↑ Excise ↑
PIT↓ Soc ↑
done much hard work to consolidate the budget by Transport ↑
about LVL 2 billion, or 15% of GDP. The target is to 30
put the economy and the budget on a sustainable
?
path, to fulfil the Maastricht criteria and introduce 25
the euro in 2014. Jan.2009: PIT ↓
Excise ↑ VAT ↑ Jul.2011:
20
The progress achieved so far has been reflected in RE ↑ Transport ↑ VAT↑
higher Latvian sovereign credit ratings. It provides Excise↑

the opportunity for the Latvian government to start 15

issuing bonds in international financial markets for a 1Q07 1Q08 1Q09 1Q10
more acceptable price and gradually to begin % of GDP % of domestic demand
Sources: CSBL, State Rev enue Serv ice
refinancing external debt. However, this does not
mean that public finances already stand on solid
grounds. In each subsequent budgeting round, fiscal
consolidation increasingly moved towards tax
Further increase in tax burden is not increases rather than expenditure cuts. While in
effective 2009 about. 70% of the consolidation measures
were on the expenditure side, in 2010 this share
So far, the government has undertaken the easiest, decreased to 42% and in 2011 it will fall to 31%.
least painful approach, i.e., instead of well-thought- This is in contrast with pre-election promises and
through structural reforms it has employed several empirical evidence, which suggests that
consolidation done through expenditure cuts has a
1
Accrual basis, i.e. according to Maastricht criterion.

Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000.
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46 8 5859 7720.
Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.
 The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 3 • 29 April 2011

less negative impact on GDP and employment than Tax share in total tax revenues in 2010
tax-based adjustments. 2

The tax burden has increased in 2009-2011 – the Social

government has raised tax rates and widened the contrib.
tax base; e.g., it has started to tax residential real 34%
estate and capital income. Despite tax increases,
Personal
the ratio of tax revenues to GDP has declined. This
income tax Excise
can partly be explained by the expansion of
23% 14%
exporting sectors, which are less tax intensive;
however, tax revenues as a percent of domestic
demand have diminished as well. This thus
indicates problems with tax evasion, implying that a VAT 24%
further tax increase is not efficient (not least, other 5%
because trust in government policy and the
incentive to pay taxes are falling). Source: State Treasury

Reducing the shadow economy does remain one of

the government’s key areas of focus. However, the Now, there is less room for manoeuvre due to the
raising of taxes has in fact done the opposite, while planned euro introduction in 2014 to balance a
appropriate actions to improve tax administration trade-off between curbing inflation and reducing the
and collection so far have been weak and slow in budget deficit. The option of decreasing the tax
coming. Government credibility – and thus burden on wages (possibly compensating for this
motivation to pay taxes – has been undermined by with higher property taxes and abolishment of the
frequent and unpredictable tax changes, which in reduced value-added tax, along with an effective
many cases have been in contrast to long-term compensation mechanism for the less well off)
policy documents, e.g., “The Framework for Tax should be considered in the nearest future.
3
and Duty System for 2011-2015.”
Fiscal discipline and budget planning need
Despite an increase in consumption and property to be improved
taxes, Latvia’s current tax system is still not well
balanced – the motivation to pay taxes and the The recent recession shed light on a couple of
economic structure remain distorted. 4 There is a issues of fiscal discipline and budget planning that
heavy tax burden on wage income (personal prevented the actual budget deficit outcome from
income tax 25% and employer and employee social being better.
contributions 35.09%), which is subject to larger tax
evasion than property or consumption taxes; First, the deficit in the last couple of months of the
together with the large labour tax wedge, this year usually increases by 2-3 percentage points of
GDP due to the seasonal pattern of expenditures.
burden discourages job creation. 5 Unfortunately,
The question is whether this is a reflection of
the opportunity to pursue reforms – perhaps painful
specific payment terms for public orders made
in the short term, but promoting medium-term
during the current year or public institutions’
growth – during the post-election period in late 2010
wanting by all means to spend the whole funding
and early 2011 was by and large wasted.
planned for the year, thereby proving the validity of
their budgets and avoiding possible financing cuts
next year. Budget expenditures at the end of the
2
year regularly erode the improvement in the budget
See, e.g., IMF (2010), “Will it hurt? Macroeconomic effects balance achieved during the year (e.g., due to
of fiscal consolidation”, World Economic Outlook, October larger-than-expected revenues) and raise the issue
2010, Chapter 3.
3
See
of fiscal discipline.
http://www.fm.gov.lv/?lat/valsts_budzets/videja_termina_budz
eta_planosana (in Latvian)
4
For more details, see Swedbank Analysis (2009), “The fiscal
stance 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 tax
wedge is larger than in the EU27 on average (40% vs. 37%;
Eurostat data).

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 The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 3 • 29 April 2011

Accumulated general budget deficit, % of GDP of public finances; this proved to be quite efficient. 6
The framework includes central government
4
expenditure ceilings for the next three years, a
2
balanced budget requirement for local
governments, and a budget surplus target over the
0 business cycle for the general government. It
should be emphasized that such a medium-term
-2 framework has to be integrated into all aspects of
the budget process in order to be effective
-4 (including forecasting capacity).
-6 The Latvian government has taken the first steps in
this direction. The Ministry of Finance has prepared
-8
a fiscal discipline draft law that requires the
Jan Mar May Jul Sep Nov
government to make mid-term budget planning and
2007 2008 2009 2010 2011
defines countercyclical budget rules, starting in
* cash-f low basis Source: State Treasury 2012. This draft law has been approved by the
Cabinet of Ministers and is now pending in the
Second, during the last two years, an increase in parliament. It includes expenditure ceilings, requires
planned expenditures in the second half of the year the budget to be in surplus when the economy is
has become quite regular, for instance, the growing faster than 2%, and allows a budget deficit,
announcement of funding shortages and requests not to exceed 3% of GDP when the economy is
7
for additional financing in the health care sector in growing slower or decreasing. However, to make
autumn. Even taking into account the fact that not this law effective it is also crucial to enhance the
all expenditures can be forecasted at the beginning capacity to make realistic and reliable forecasts for
of the year, such regularity points to problems in macroeconomic parameters and revenue and
budget planning. Otherwise, it is hard to explain the expenditure development.
difference between the initial budget plan approved
at the beginning of the year and the revised plan in Still room for improvement in public sector
December. For instance, the planned budget deficit effectiveness
nearly doubled in 2010 from LVL 524 million in
January to almost LVL 1000 million in December. Taking into account the fact that further tax hikes
are not reasonable and consolidation should be
Central government budget balance planning, million achieved through expenditure cuts and a
LVL rebalancing of the tax burden, the issue of
effectiveness of the public sector takes centre
200
stage.
0
The effectiveness of the public sector depends on
-200
the politicians’ will to initiate reforms, as well as civil
-400 servants’ ability to provide them with, and to
implement, qualitative proposals. To ensure quality
-600
decision making, the question of remuneration is
-800 crucial – in many cases, civil servants in key
-1000 Budget positions are grossly underpaid compared with
amendments positions with similar responsibilities in the private
-1200 sector. Gross real wages in public administration
Jan.08 Jan.09 Jan.10 Jan.11 have decreased by about 30% from the peak in the
Budget plan Outcome first half of 2008. This diminishes the motivation of
* cash-f low basis
civil servants and increases the risk of poor policy
Source: State Treasury
decisions.

These problems are not new, and Latvia can learn

how to deal with them from other countries’
experience. For instance, Sweden developed a
medium-term fiscal policy framework in the mid-
1990s to ensure the transparency and sustainability
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 on
requirements for budgetary frameworks of the Member States,
planned to be in force in 2014.

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 The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 3 • 29 April 2011

With this recommendation, we do not encourage If the public sector (including not only public
across-the-board linear wage increases in the administration, but also education, health care, and
public sector, especially taking into account further defence) is made more effective and productive,
fiscal consolidation – a possible solution is the thereby reducing expenditures, there is an
introduction of a performance-based remuneration opportunity to increase wages for qualified people
system in the public sector, which should be linked working there. There has been an optimisation in
to private sector wage developments. the work of the public sector; e.g., the share of
employment in public administration decreased
Employment in public administration in 2010, % of from 7.3% of total in 2009 to 6.6% in 2010.
total employment However, there is still room to improve cost-
Finland efficiency. 8 By delaying reforms that improve the
Romania remuneration system and effectiveness in the public
Ireland sector, there is a risk of losing qualified employees,
Denmark
Sw eden which, in turn, would endanger quality policy
Lithuania decisions and their implementation.
Slovenia EU
Italy
Portugal average
Netherlands
United Kingdom
Poland
Latvia '10 Dainis Stikuts
Czech
Austria Lija Strašuna
Estonia
Germany
Latvia '09
Bulgaria
Cyprus
Hungary
Slovakia
Greece
Malta
Belgium
France
Luxembourg

0 3 6 9 12
Source: Eurostat

9
Research by, e.g., the Bank of Latvia shows that cost
efficiency in Latvian education, health care, and social security
sectors is still way below the EU average; for more details, see
http://www.bank.lv/publikacijas/latvijas-valdibas-izdevumu-
efektivitate/6107 (in Latvian)

Swedbank
Economic Research Department
Swedbank AB. SE-105 34 Stockholm. Swedbank’s monthly newsletter is published as a service to our customers. We believe that
we have used reliable sources and methods in the preparation of the analyses reported in
Legally responsible publisher this publication. However, we cannot guarantee the accuracy or completeness of the report
Cecilia Hermansson, +46 8 5859 7720 and cannot be held responsible
8 for any error or omission in the underlying material or its
Research by, e.g., the Bank of Latvia shows that cost
use. Readers are encouraged to base any (investment) decisions on other material as well.
Neither Swedbank nor its employees Latvian
efficiency in may beeducation, health care,
held responsible and social
for losses security
or damages,
Martiņš Kazāks, +371 6744 5859 direct or indirect, owing to sectors is still
any errors way belowinthe
or omissions EU average;
Swedbank’s for more
monthly details, see
newsletter.
Dainis Stikuts, +371 6744 5844 http://www.bank.lv/publikacijas/latvijas-valdibas-izdevumu-
Lija Strašuna, +371 6744 5875 efektivitate/6107 (in Latvian)

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