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Swedbank Analysis: The fiscal stance in Latvia


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Swedbank Analysis: The fiscal stance in Latvia

  1. 1. Swedbank Analysis October 30, 2009 Economic Research Department. Swedbank AB (publ). Mārtiņš Kazāks +371 6744 5859, Lija Strašuna +371 6744 5875, Dainis Stikuts +371 6744 5844 Legally responsible publisher: Cecilia Hermansson, Group Chief Economist, +46 8 5859 1588 The fiscal stance in Latvia – how to return to a sustainable path?  Structural deficits to be eliminated  Tax system to be changed  Public sector efficiency to be improved As fiscal policy in Latvia in the years after EU accession was procyclical, the necessary reserves were not created. Consequently, the fall in revenues due to the recession, the government’s need to bail out the largest domestically owned bank, Parex, and the nonexistent opportunity to borrow in financial markets due to the global credit crunch compelled Latvia to turn to the IMF and the EC for help in financing its expanding budget deficit. Latvia must now undertake a challenging fiscal consolidation to put its budget on a sustainable footing and to obtain further funding. For the government budget to return to a sustainable path, deep restructuring is necessary. This involves both expenditures (e.g., optimizing the public administration, education, and health care sectors) and revenues (i.e., changes in tax policy that support structural adjustment in the economy). Assessing the government suggestions for the 2010 budget, our opinion is that the fiscal policy adjustments are often not structural and therefore will make the journey to a sustainable budget and efficient public sector longer and more expensive. Unfortunately, too often the most attention is given to specific consolidation numbers, not to the achievable result. To ensure lasting recovery, the government’s credibility needs to be boosted. Of course, the 2010 budget should be approved in a timely fashion, but restructuring measures undertaken are equally important. Actions taken now will influence how the economy will look like in 5-10 years.
  2. 2. 2 Swedbank Analysis • October 30, 2009 Structural deficits should be eliminated The most important goal for the government is to return to a situation in which government revenues compensate expenditures.1 The so-called Golden rule of fiscal policy2 is that the government should borrow only for investments (not for current spending), otwerwise ensuring a balanced budget over the economic cycle. It is important to distinguish between discretionary measures of fiscal policy and the “automatic” response of fiscal variables to business cycle fluctuations (see, e.g., Gali and Perotti, 2003). The structural budget deficit accounts for discretionary fiscal policy and is usually used as a measure of the fiscal stance of policymakers. The cyclical deficit consists of causes outside the direct control of fiscal authorities (like business cycles fluctuations). Estimations by the Bank of Latvia show that the structural budget deficit in Latvia was 3.6% in 2006, 7% in 2007, and 8.2% in 20083. Thus, the nearly balanced government budgets in 2006-2007 were due only to their cyclical component (i.e., revenue expansion due to overheating of the economy). It is important to understand that, in order to achieve a long-term situation in which public finances are sustained on their own, structural deficits should be eliminated. General government budget (ESA) -10 0 10 20 30 40 2000 2003 2006 2009f Expenditure grow th, % yoy Structural balance , % of GDP Fiscal balance , % of GDP Source: CSBL, Bank of Latvia, Sw edbank forecasts To diminish structural budget deficits, it is of the utmost importance to change the budget planning approach and optimize public sector operations. Establishing an effective public sector may demand additional resources in the short term; however, it will pay off in the medium to long term with significantly smaller expenditures. Therefore, while drafting the budget it is necessary to focus on the desirable structure and functions of the public sector rather than on the precise amounts by which expenditures shall be cut now. This said, we do not mean that the targets set by the IMF and the EC should not be fulfilled: what we are concerned about is that, while focusing on the figures, the government often forgets what the underlying goal is. 1 According to the EU Stability and Growth Pact, the objective is to have a budgetary po- sition in balance or in surplus, but a fiscal deficit below 3% of GDP is permissible; see If the econ- omy is growing slower than public debt and its servicing costs, the deficit will not be sus- tainable in the long run. 2 See e.g. 3 See for details The goal is to return to a sustainable budget The budget planning approach should be changed, public sector operations optimized
  3. 3. Swedbank Analysis • October 30, 2009 3 Latvia’s Supplementary Memorandum of Understanding with the EC4 and its updated Letter of Intent5 with the IMF provide the framework for changing its approach to public finances and the necessary restructuring, as well as the funding required to support the reforms. In order to receive further funding, the Latvian government needs to fulfil the obligations to which it has committed. The general government budget deficits are capped at 10% of GDP (ESA basis) in 2009, 8.5% in 2010, 6% in 2011, and 3% in 2012. Tax burden to increase, tax system to change Although increasing the tax burden is never popular, this time it is necessary to achieve fiscal consolidation. With diminishing employment and increasing public debt, the tax burden will inevitably increase. However, any further changes in tax policy should be in line with the underlying changes in the economic structure and labour market to ensure sufficient tax revenues and to support the restructuring path. For instance, a smaller consumption share in GDP and an ageing population will make it impossible to collect the same revenues (as a percent of GDP) with the existing tax rates. Tax policy globally is increasingly influenced by the globalization process and the greater international mobility of economic activity, as capital and labour are now easier to move across the borders (see, e.g., Hines and Summers, 2009; Norregaard and Khan, 2007). The general trend globally is thus to use expenditure taxes (e.g., value-added tax (VAT), excise) more than income taxes (see, e.g., Myles, 2009). The latest OECD study of possible tax responses to the financial crisis (OECD, 2009) argues that the focus should be shifted to property and general consumption taxation (the taxes least harmful for growth). The general suggestion is to set the tax that is less vulnerable to tax evasion relatively higher (see, e.g., Gordon and Nielsen, 1997). The authors compare tax evasion for VAT and income taxation using Danish data and conclude that the costs of tax evasion from VAT are smaller than those of income taxes. The key problem with the current tax system in Latvia is that, although the total tax burden is relatively light (ca 30% of GDP vs. an average of ca 40% in the EU25), it is not well-balanced, and distorts the economic structure and the motivation to pay taxes. There is a relatively high tax on wage income, which is subject to tax evasion due to difficulties in collection. The personal income tax (PIT) rate is flat at 23%, although due to tax allowances the effective tax rate is progressive in its essence. For example, in 2008 a minimum wage earner paid ca 7% in PIT, while highest income strata paid ca 21%. However, the loopholes in legislation make the total tax burden rather regressive, as some forms of income and assets characteristic of more affluent parts of society are not taxed at all (e.g., dividends, interest income on deposits, and residential real estate). Comparing tax revenues in Latvia with the average EU level, it can be seen that capital taxes currently constitute a much smaller part of government revenues, while the shares of labour and consumption taxes are closer to the EU average. The labour tax wedge6 in Latvia is wider than the EU25 average (41.2% vs. 37.1%), and this divergence is particularly wide for low and medium incomes. At the same 4 Signed on 13 July 2009 ( 5 See for details. 6 According to the Eurostat definition, the tax wedge is calculated as labour taxes divided by total labour costs. Changes in tax policy should be in line with the underlying changes in the economic structure and labour market Taxes that are less vulnerable to tax evasion should be relatively higher Current tax system is not well-balanced, and distorts the economic structure and motivation to pay taxes
  4. 4. 4 Swedbank Analysis • October 30, 2009 time, the implicit tax rate7 on labour in Latvia is only 31% (36% in the EU25). This difference between the underlying tax burden and government revenues points to tax evasion. Different taxes, % of total tax revenues (2007) * w/o Latvia Source: Eurostat Labour taxes 0 10 20 30 40 50 60 EE LT LV EU25 EU15 CEE* Consumption taxes 0 10 20 30 40 50 60 EE LV LT EU25 EU15 CEE* Capital taxes 0 10 20 30 40 50 60 LV LT EE EU25 EU15 CEE* We believe that the tax policy changes should (i) improve the collection and administration of existing taxes8, (ii) reduce barriers to economic activity, (iii) widen and simplify the tax base, and (iv) shift the system to taxes that are easier to enforce and are less distortive. Social fairness can be improved by taxing capital gains and residential real estate as such things as deposits or real estate are almost impossible to hide. While capital can be relatively easily moved across borders, tax evasion risks in real estate are largely nonexistent. Through these changes, the tax burden would be better balanced across different income groups and thus more socially fair. It is extremely important to maintain a systemic view, i.e., to analyze the total effect of all tax changes, rather than each tax separately. The regional aspect is also crucial, i.e., the tax rates in Latvia should not be much higher than in the countries with which Latvia is closely integrated. Expenditure structure – to improve public sector efficiency On the expenditure side, the most important actions to be taken are structural reforms to reduce structural deficits and return to a sustainable budget. The aim of attaining a small and efficient public administration is being communicated by the government, but unfortunately the current expenditure cuts often do not follow this target. The necessary optimization of the education and health care sectors has also started; however, reforms are often only partially introduced and are sometimes changed during the implementation process to become less efficient. The budget planning approach is awkward: first the funding is allocated and then it is decided how to spend it, a process that does not ensure system-wide efficiency. To improve the efficiency of the public sector, an assessment of its functions should be undertaken. By a function we understand a service that the public sector provides (e.g., in the spheres of education, heath care, and public administration). We believe that, first, it should be decided which functions should be done, to what extent, and in which way (e.g., some maybe handed 7 According to the Eurostat definition, the implicit tax rate is computed as the ratio of total tax revenues to a proxy of the potential tax base for each economic function. 8 For instance, assuming that half (a very conservative assumption) of the 30-40% fall in diesel, alcohol, and tobacco sales in the first half of 2009 are due to tax evasion, the gov- ernment lost about LVL 30 million in excise tax revenues (0.25% of annual forecast GDP). According to TNS Latvia (media, market and public opinion research agency), a market share of illegal cigarettes has reached 29% in Riga and 69% in Latgale region (close to the border with Russia). The tax policy changes should improve the collection and administration of existing taxes Structural reforms are necessary to reduce structural deficits and return to a sustainable budget It should be decided which public sector functions, to what extent, and in which way to be done
  5. 5. Swedbank Analysis • October 30, 2009 5 over to or outsourced to the private sector). Only then should estimates be made of the cost and the impact on the budget. It is also crucial to analyze the interaction of different functions, in order to optimize the resources used (e.g., to improve data exchange between different administrative units). A comparison with successful models of other countries would be useful to find out which functions can be eliminated. 2010 budget: measures to improve public finances The target of 2010 requires a fiscal consolidation of LVL 500 million, compared with the second half of 2009. The key measures to achieve this fiscal consolidation, as outlined in the Letter of Intent and undertaken by the government, are as follows (to be effective as of 2010):  Broaden the tax base of the PIT, including capital income.  Unify the income tax regime of the self-employed with the standard personal income tax system (i.e., 23% instead of 15%).  Expand the base of the real estate tax, including all residential properties, on the basis of updated cadastral values.  Stop pension indexation, pending the pension reform.  Make structural reforms in many areas (e.g., public administration consolidation, culture, defence, transport, and social benefits). We believe these activities are well balanced; however, they should not be regarded as a panacea for the Latvian economy as they only fix some of the problems of e.g. tax system. The discussions on the 2010 budget have shown that fiscal consolidation is difficult, and some good ideas have been shelved due to a lack of political consensus (e.g., reducing the number of ministries). The government approved the draft 2010 budget9 on the 26th of October; meanwhile, discussions with external lenders continue and the budget will be submitted to the Parliament as soon as they are finished. 2010 budget: improving revenues – are the suggested measures adequate? Although the discussion on the issue of real estate tax for residential properties was put aside in the Parliament in September because of contradictory views in the ruling coalition, it is now back on stage. It has now been decided to apply a tax rate of 0.1% of the cadastral value. On the one hand, this final agreement is positive news, as introduction of this tax is long overdue. On the other hand, such a rate is too low and provides only a marginal fiscal effect (about LVL 6 million). It does not correct the shortcomings of the tax system (see above) and thereby does not ensure its sustainability. It seems that this decision has been taken just so a tickmark could be made on the “to-do list” specified by the EC and the IMF. For the future, a higher and perhaps more progressive rate should be considered. It can serve as a less distortive alternative for a progressive PIT. The government has drafted a further reduction of deductible tax allowances for the PIT (most recently reduced in July 2009). The planned fiscal effect of LVL 48 million is about 25% of total revenue-enhancing measures. This is a very arguable action, as it will hit low- and medium- income households harder, thus potentially increasing social stress. These 9 See Fiscal consolidation of LVL 500 million in 2010 Fiscal consolidation is difficult due to lack of political consensus Residential real estate tax can serve as a less distortive alternative for progressive PIT Reduction of deductible tax allowances makes the existing shortcomings of the tax system even worse
  6. 6. 6 Swedbank Analysis • October 30, 2009 reductions do not improve (but actually worsen) the existing shortcomings of the tax system. In our view, it would be more productive to raise the same revenues (or at least a part of them) by, e.g., taxing residential properties. For instance, a household with one child and two working parents would pay an additional LVL 160 per year due to decreased tax allowances – assuming they own an “average” apartment in Riga (e.g., with a cadastral value of LVL 20 000), they would pay the same amount with a residential real estate tax of 0.8%. The “arguments” that low- and medium-income households will be severely hurt by the real estate tax are plain wrong populist statements; it would be more productive and less regressive to increase the residential real estate tax10 and not to change the tax allowances. Additional possible fiscal consolidation measures outlined in the Letter of Intent11 are the introduction of a progressive PIT and an increase in the VAT from 21% to 23%, effective January 1, 2010. We see these measures as counterproductive in the current situation. The positive news is that so far the government is committed not to raise the VAT or introduce a progressive PIT, and current plans for fiscal consolidation suggest that these additional measures will not be needed. We see an option of introducing a progressive PIT as premature as its revenues will be hit through legal tax optimization (e.g., businesses transferring their cost centres abroad) and illegal tax evasion. Although a VAT is easier to enforce than a PIT and does not worsen the competitiveness of exporters, the significantly lower VAT rates in neighbouring countries pose a risk that consumers will shift their spending abroad, thereby undermining revenues. We believe that a higher VAT and a progressive PIT would severely damage tax discipline. Before considering introduction of a progressive PIT, better tax compliance should be ensured. 2010 budget: spending cuts – where, when and how sustainable? Although an assessment of current functions provided by the public sector has been carried out and the largest part of the spending cuts in 2010 have been made in line with it (up to 70%, according to the Ministry of Finance), the budget planning approach in many cases has not been changed in essence. Although expenditures are now planned across the functions, the general practice is still to limit the spending for a particular function and then to figure out how to allocate these resources. One can only guess how much the reduction in the budgets of the different ministries owing to, e.g., layoffs, is due to optimization and increased efficiency, and how much is attributable to merely the abolition of some operations. Hence, at this stage we cannot evaluate the sustainable structural content of the cuts. Poor communication results in a lack of awareness of the structural reform process, even if something is being done. The structural reforms being communicated are often significantly modified in the implementation process, costing efficiency. For instance, the initially suggested “funding follows the pupil to the school” approach has been changed to “funding follows the pupil to the relevant municipality”; this change, however, does not necessarily mean that the specific school that 10 It can be applied in a more targeted fashion to specific society groups. For instance, municipalities are able to reduce or abolish real estate tax payments for the lowest- in- come households. 11 Necessary if other measures are insufficient to keep the budget deficit below 8.5% of GDP in 2010. Progressive PIT and higher VAT (if introduced) would severely damage tax discipline Despite functional audit, the budget planning approach has not been changed Poor communication results in lack of awarness of restructuring process
  7. 7. Swedbank Analysis • October 30, 2009 7 provides better value for money obtains the funding. This solution is less efficient for ensuring cost efficiency and quality. A significant share of the spending cuts intended for 2010 are one-off events that do not improve the budget situation in the longer term. Examples are cuts in spending for infrastructure12 or postponing the refunds of the overpaid PIT for deductible expenses (e.g., education, dentistry, and health care) from 3 to 12 months13. The latter measure simply postpones the government expenses from 2010 to 2011. This does not influence the budget deficit calculated on an ESA basis, as these expenses are attributed to 2010 on an accrual basis. Although this measure would improve the liquidity situation in 2010, the fiscal effect is very small (LVL 8 million) and adds nothing to the sustainability of the budget14. The harmonization of the public sector wage system should be considered with caution. The aim of decreasing wage differences for similar positions is welcome; however, this will not solve structural problems, as the wage system is simply a reflection of the organizational structure. Significant wage cuts weaken employee motivation and increase the risk of corruption. Since the government started to lower labour costs through linear wage cuts at the beginning of this year, the remuneration of the public sector has already fallen back to the 2006 level (while consumer prices have increased by ca 30% since then). Fiscal policy to determine the recovery path The government so far has not always acted consistently to improve the sustainability of fiscal policy. The restructuring process has started, but reforms continue to lag behind schedule and intentions are often badly communicated, thereby increasing social tensions. There has been some progress on structural reforms: the network of schools and hospitals is being optimized, measures to support start-ups (e.g., reducing minimum fixed capital requirements) are about to be introduced, several loopholes in legislation are about to be closed (e.g., taxing the corporate-owned vehicles used for personal needs), and budget expenditures are reviewed by functions to avoid across-the-board linear expenditure cuts. However, the reforms are often enforced only partially, which makes restructuring more costly. The adoption of the 2010 budget will reduce short-term uncertainty in the economy, but the structural framework will not be complete and the government will still need to return to the same issues later. The credibility of the government should be boosted, which demands consistent and timely action. An adjustment of the fiscal policy will determine not only the recovery process, but, even more important, also medium-term growth. Lija Strašuna Mārtiņš Kazāks Dainis Stikuts 12 This is a one-off measure if maintenance works are reduced, but a structural one if, e.g., some country roads are not upgraded permanently because of their light use. 13 Although this is included in revenue measures (as it is tax administration), it is expendi- ture reduction in essence. 14 It is argued that the reason for doing this is the inability of the State Revenue Service (SRS) to deal with the workload. In our opinion, the more efficient approach would be to optimize the operation of the SRS. A large part of the 2010 budget spending cuts are one-off events Significant wage cuts in public administration weaken employee motivation and increase the risk of corruption Restructuring is underway, but the government will need to return to the same issues later, as the structural framework to be implemented in 2010 is still incomplete
  8. 8. 8 Swedbank Analysis • October 30, 2009 References Gali, Jordi, Roberto Perotti (2003) “Fiscal policy and monetary integration in Europe,” NBER Working Paper Series No. 9773 Gordon, Roger H., Soren Bo Nielsen (1997) “Tax evasion in an open economy: Value-added vs. income taxation”, Journal of Public Economics 66, 173-197 Hines, James, Lawrence Summers (2009) “How globalization affects tax design,” NBER Working Paper Series, Working paper No. 14664 Myles, Gareth D. (2009) “Economic growth and the role of taxation – theory,” OECD Economic Department Working Paper No 713 Norregard, John, Tehmina S. Khan (2007) “Tax policy: recent trends and coming challenges”, IMF Working Paper WP/07/274 OECD (2009) “OECD’s Current Tax Agenda”, Centre for Tax Policy and Administration, September 2009 Abbreviations CEE – Central and Eastern European countries EC – European Commission ESA – European System of Accounts EU – European Union GDP – Gross Domestic Product IMF – International Monetary Fund OECD – Organisation for Economic Co-operation and Development PIT – Personal Income Tax SRS – State Revenue Service VAT – Value-added Tax
  9. 9. Swedbank Analysis • October 30, 2009 9 Economic Research Department Sweden Cecilia Hermansson +46 8 5859 1588 Group Chief Economist Chief Economist, Sweden Magnus Alvesson +46 8 5859 3341 Senior Economist Jörgen Kennemar +46 8 5859 1478 Senior Economist Helena Karlsson +46 8 5859 1028 Assistent Estonia Maris Lauri +372 6 131 202 Chief Economist, Estonia Elina Allikalt +372 6 131 989 Senior Economist Annika Paabut +372 6 135 440 Senior Economist Latvia Mārtiņš Kazāks +371 67 445 859 Deputy Group Chief Economist Chief Economist, Latvia Dainis Stikuts +371 67 445 844 Senior Economist Lija Strašuna +371 67 445 875 Senior Economist Lithuania Lina Vrubliauskienė +370 5 268 4275 Chief Economist, Lithuania Ieva Vyšniauskaitė +370 5 268 4156 Senior Economist
  10. 10. 10 Swedbank Analysis • October 30, 2009 Disclaimer This research report has been prepared by economists of Swedbank’s Economic Research Depart- ment. The Economic Research Department consists of research units in Estonia, Latvia, Lithuania and Sweden, is independent of other departments of Swedbank AB (publ) (“Swedbank”) and responsible for preparing reports on global and home market economic developments. The activities of this re- search department differ from the activities of other departments of Swedbank and therefore the opin- ions expressed in the reports are independent from interests and opinions that might be expressed by other employees of Swedbank. This report is based on information available to the public, which is deemed to be reliable, and re- flects the economists’ personal and professional opinions of such information. It reflects the econo- mists’ best understanding of the information at the moment the research was prepared and due to change of circumstances such understanding might change accordingly. This report has been prepared pursuant to the best skills of the economists and with respect to their best knowledge this report is correct and accurate, however neither Swedbank or any enterprise be- longing to Swedbank or Swedbank directors, officers or other employees or affiliates shall be liable for any loss or damage, direct or indirect, based on any flaws or faults within this report. Enterprises belonging to Swedbank might have holdings in the enterprises mentioned in this report and provide financial services (issue loans, among others) to them. Aforementioned circumstances might influence the economic activities of such companies and the prices of securities issued by them. The research presented to you is of informative nature. This report should in no way be interpreted as a promise or confirmation of Swedbank or any of its directors, officers or employees that the events described in the report shall take place or that the forecasts turn out to be accurate. This report is not a recommendation to invest into securities or in any other way enter into any financial transactions based on the report. Swedbank and its directors, officers or employees shall not be liable for any loss that you may suffer as a result of relying on this report. We stress that forecasting the developments of the economic environment is somewhat speculative of nature and the real situation might turn out different from what this report presumes. IF YOU DECIDE TO OPERATE ON THE BASIS OF THIS REPORT THEN YOU ACT SOLELY ON YOUR OWN RISK AND ARE OBLIGED TO VERIFY AND ESTIMATE THE ECONOMIC REASONABILITY AND THE RISKS OF SUCH ACTION INDEPENDENTLY.