Fiscal consolidation in the midst of the crisis: lessons from Latvia
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Presentation by Gabriele Giudice, Ingrid Toming, Francesco Di Comite and Julia Lendvai (DG ECFIN) at Country workshop: "EU Balance-of-Payments assistance for Latvia: Foundations of Success" organized ...

Presentation by Gabriele Giudice, Ingrid Toming, Francesco Di Comite and Julia Lendvai (DG ECFIN) at Country workshop: "EU Balance-of-Payments assistance for Latvia: Foundations of Success" organized by the European Commission, Directorate General for Economic and Financial Affairs, and the Bank of Latvia.
Brussels, March 1, 2012

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Fiscal consolidation in the midst of the crisis: lessons from Latvia Presentation Transcript

  • 1. EU Balance-of-Payments assistance for Latvia: Foundations of SuccessFiscal consolidation in the midstof the crisis: lessons from Latvia Gabriele Giudice Ingrid Toming Francesco Di Comite Julia Lendvai DG ECFIN, 1 March 2012
  • 2. Fiscal consolidation in Latvia:• How big has it really been?• What was the composition of consolidation?• What was its impact on the economy?• What can be learned from the experience of Latvia?
  • 3. Measuring fiscal consolidation• Two main approaches to measuring fiscal consolidation: • Change in cyclically-adjusted (primary) balance or structural (primary) balance • Policy action approach• Results between two approaches can be quite different; Latvia in 2009 is a particularly striking example of that: 2009 2010 2011 Change in cyclically-adjusted primary balance, European 0.6 1.0 3.3 Commission 2011 Autumn Forecast, % of GDP Change in structural primary balance, European Commission 1.1 1.7 1.8 2011 Autumn Forecast, % of GDP Consolidation measures as reported by the government 9.5 4.0 2.6 (Convergence Programme April 2011), % of GDP European Commission estimate of discretionary measures 8.9 4.9 2.2 (excluding exceptional restructuring costs) Difference between SPB and government estimate -8.4 -2.3 -0.8
  • 4. Possible reasons for the difference between two approaches (on example of 2009) ImpactCyclical adjustment underestimating fall in indirect taxes 1.4 – 2.3 ppsCyclical adjustment underestimating fall in labour taxes 1.2 ppsCyclical adjustment not capturing behavioural changes in social benefits outlays Ca 0.5 ppsPolicy action approach "missing" expansionary elements Up to 3.0 ppsTOTAL Up to 7 pps+ uncertainties related to real time estimates of output gap, differences in …measurement methodologies etc
  • 5. Composition of consolidation in Latvia in 2009-2012Frontloaded 9% consolidation: overall 8% around 17% of GDP, 7% Other measures o.w. ½ in the first year 6% Consumption taxesMore than half on the 5% Labour taxes expenditure side, in Government consumption 4% particular government consumption 3%Tax increases: overall by 2% ca 6% of GDP (ex-ante 1% estimate), mostly 0% consumption and -1% 2009 2010 2011 2012 property taxes % of GDP Source: Commission Services
  • 6. Consolidation in the Baltics: overall comparable LATVIA LITHUANIA ESTONIA9 9 98 Revenue Revenue 8 Revenue 87 Expenditure 7 Expenditure 7 Expenditure6 6 65 5 54 4 43 3 32 2 21 1 10 0 0 2009 2010 2011 2009 2010 2011 2009 2010 2011-1 -1 -1
  • 7. Latvian specific factors - revenue VAT compliance in the Baltics 100%Tax compliance seems to have 90% 80% fallen most in Latvia during 70% 60% the crisis 50% 40%Possible reason: 30% LAT VIA EST ONIA LIT HUANIA 20% - weakening of the State 10% 0% Revenue Service 2005 2006 2007 2008 2009 2010 2011 9m - higher level of dissatisfaction 41% Implicit tax rate on labour of entrepreneurs 39% 37%Lessons: tax offices to be 35% spared from cuts, keeping 33% 31% firms out of “grey area” easier 29% 27% L AT V IA E S T O NIA L IT HUANIA then bringing them back to 25% “white” 2005 2006 2007 2008 2009 2010 2011f
  • 8. Latvian specific factors - expenditure Government consumption index 2000=100, valuesCuts in government consumption 350 clearly visible in ex-post statistics 300 ESTONIA only in Latvia (albeit from higher LATVIA level) 250 LITHUANIAParticularly sizeable savings in 200 healthcare and education 150Possible reason: plans were ready for 100 reforms in these sectors (but lack of 00 01 02 03 04 05 06 07 08 09 20 0 (f) will to implement them before the 1 11 20 20 20 20 20 20 20 20 20 20 20 crisis), administrative reformLessons: cuts “across-the-board” give Change in nominal expenditure between 2008 and 2010, % Estonia Latvia Lithuania limited and temporary results, but General public services -3.8 -8.6 1.2 sizeable expenditure restraint can Defence -9.7 -47.3 -28.3 Public order -3.4 -8.5 1.4 be achieved through a structural Health -9.6 -26.7 -6.8 reform strategy Education -10.1 -25.8 -10.3 Social protection 10.8 13.4 0.1
  • 9. Overall successful consolidation: better deficit outcomes and smaller debt accumulation than feared at the depth of the crisis Latvia: general government deficit, Latvia: general government debt projections in summer 2009 and outcome projections in summer 2009 and outcome 24 100 21 90 IMF July 2009 18 Initial 80 IMF July 2009 (IMF Jan. 2009) 70 15% of GDP 12 60 % of GDP COM June 2009 COM June 2009 50 Forecasts 9 Outcome 40 Outcome 6 30 3 Forecasts 20 Initial 0 (IMF Jan. 2009) 10 -3 2008 2009 2010 2011 2012 2013 2014 0 2008 2009 2010 2011 2012 2013 2014
  • 10. To summarise• Measuring consolidation can be a daunting task in quickly changing environment;• Revenue collection rates will likely fall and behaviour of agents likely change in the crisis – special attention needed to keep taxpayers out of "grey area";• Frontloaded consolidation is better as it allows to bear the fruits of fiscal discipline soonerBUT• Expenditure cuts should be based on comprehensive reform strategy and that takes time (Latvia was lucky to have structural reform plans ready beforehand)
  • 11. Have government cuts depressed the economy?Many like to depict thecorrection in GDP frompeak to trough (-24%) as amajor social costBut one should not loosesight of how much GDPhas increased over thepast decade (5.1% p.a.) oreven still since 2004(+2.5% p.a.)The graphs showsremarkably well how theeconomy turned around asthe consolidation took off.
  • 12. The impact on the economy, depends on composition of consolidationCountry-specific fiscal multipliers for Latvia (QUEST model): Impact of 1 pp of GDP consolidation on GDP 2 2 Employment (rigid LM) Consumption taxes 1.5 1.5 Gov. consumption Property tax 1 Transfers 1 Labour taxes Employment (flexible LM) 0.5 Capital Income tax 0.5 Government investment 0 0 -0.5 -0.5 -1 -1 -1.5 -1.5 0 1 2 3 4 5 6 7 8 9 10 50 0 1 2 3 4 5 6 7 8 9 10 50 • Most of the consolidation in Latvia was implemented through measures with more limited negative impact on growth in the short term, but positive in the longer term, notably consumption taxes and cuts in government consumption. (But social fairness of these measures could be an issue)
  • 13. Non-keynesian effects ? Decisive action is key to affect expectationsChannels proposed in the literature: • DEMAND: Consumer and investors gain in confidence, consuming and investing more because of lower future uncertainty and taxes; • SUPPLY: wage reductions and relocation of employment to more productive sectors foster productivity and competitiveness. Composition of the adjustment is key, together with flexibility and openness
  • 14. A confidence effect likely took placeFrom mid-2009, asthe fiscal Consolidation kicked-offconsolidation kicks in,investments andconsumption recoverquickly.At the same time,bonds yield decreaseand surveys ofconsumer confidenceincrease.
  • 15. The initial increase in investment and consumption was hardly driven by higher wages, profits or employment…
  • 16. But real wage decreases have progressively helped stimulate the industrial recovery.
  • 17. Public employment cuts and tax policy helped reallocationThe flexibility of Latvian economy allowed resources to be quickly reallocatedto manufacturing after the crisis.
  • 18. Confidence now – Competitiveness then• Non-Keynesian demand effects of fiscal consolidation showed up as soon as confidence was restored• Supply-side effects kicked in after some quarters• The way consolidation was brought about (decisive, frontloaded and well balanced in terms of composition) probably made the difference, laying down the foundations for the recovery.