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The Latvian Economy


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The Latvian Economy

  1. 1. The Latvian EconomyMonthly newsletter from Swedbank’s Economic Research Departmentby Dainis Stikuts un Mārtiņs Kazāks No. 5 • October 2010Expenditure based post-election budget consolidation – anopportunity not to be missed when aiming for sustainable long-termgrowth • The recent economic crisis showed that budget spending in Latvia was unsustainable because short-term windfall revenues during the boom years of 2004-2007 were transformed into permanent expenditures. Latvia is now on a challenging fiscal consolidation path to put its budget and public debt on a sustainable footing, in order to return to sustainable growth and fulfil Maastricht criteria to adopt the euro in 2014. • Budget consolidation in 2009 was done mainly via tax increases and temporary spending cuts without wide-ranging systemic changes, meaning that many of such expenditures may return, undermining future fiscal stability. The 2010 budget consolidation was done in a similar mode. A growing body of literature suggests that expansionary consolidation (i.e., expenditure cuts that improve structural efficiency) must play a more important role in budget consolidation. • The current shape of the newly elected parliament provides a good opportunity to form a lasting government working till the next elections. Implementing tough, unpopular reforms in the short-term should not scare away forward-looking politicians – if implemented soon, the positive yields of such policies would become evident before the next municipal elections in 2013 and parliamentary elections in 2014. Fiscal consolidation in the 2011 budget must be based on expenditure cuts that improve structural efficiency.The recent economic crisis showed that budget 0.1-0.3% of cadastral value had little fiscal benefitspending in Latvia was unsustainable because and did not correct tax system imbalances. To bewindfall revenues during the boom years were structural reforms that would make public sectortransformed into permanent and ever rising more efficient and leaner largely relied on wageexpenditures (e.g., higher wages, pensions, social cuts (undermining employee motivation andbenefits, and newly created public agencies). Latvia increasing the risk of corruption) rather than onis now on a challenging fiscal consolidation path to structural changes. Now, the government needs toput its budget and public debt on a sustainable consolidate the 2011 budget by about LVL 400footing, to fulfil Maastricht criteria and join the euro in 2014. To this end, the IMF/EC bailoutprogramme sets the aim to reduce the budget What should be kept in mind while planningdeficit to below 6% of GDP in 2011 and 3% in 2012. 2011 expenditures?While producing the 2010 budget, the government The government should take a forward-looking viewmade large efforts to achieve a consolidation of and be sharp on fiscal discipline. It must addressclose to LVL 500 million (about 4% of GDP): it systemic inefficiencies and be aware of risksincreased the personal income tax rate from 23% to coming from the ESA95 methodology.26% and broadened tax base to include capitalincome, and equalised the tax for self-employed First, expenditure planning and fiscal disciplinewith the standard personal income tax rate. must be improved. For instance, the 2010 centralHowever, some measures, due to a lack of political government budget deficit (adopted on Decemberconsensus, were poorly made, e.g., the 1, 2009) was planned at LVL 524 million; this byintroduction of a residential real estate tax of just now has been increased to LVL 990 million. Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: Legally responsible publisher: Cecilia Hermansson, +46 8 5859 7720. Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.
  2. 2. The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 5 • October 2010Approximately half of this is due to the Fiscal adjustments in the Baltics, 2009 (% of GDP)Constitutional Court’s decision of December 22, 122009 that the pension decrease in 2009 wasunconstitutional. The rest of the increase was due 10to higher expenditures coming from, e.g., the health 8system, and the systemic efficiency of this newspending is questionable. 6 4Second, the government should reconsider theownership and/or inefficient management of state 2owned companies that either do not bring in 0sufficient monetary dividends 1 or place an Estonia Latvia Lithuaniaadditional burden on the budget. Investments andguarantees to such enterprises (like the Parex Temporary reduction in spending Structural spending measuresbank), according to the ESA95 methodology, are Other revenue measures Source: Purfield andaccounted as expenditures, thereby increasing the Durable net revenue increase Rosenberg (2010)) 3budget deficit. For instance, due to governmentinvestments into the Parex bank, the general For example, Latvia has 38 state-financed highergovernment consolidated budget deficit increased education institutions and no clear action plan onby 0.9% of GDP in 2009. their consolidation. Meanwhile, the demographic situation is leading to a decrease in the number ofConsolidation should be expenditure based students – in five years, the number of youths ofand efficiency improving student age will be about half of that in 2009. Such an extensive education infrastructure won’t beA growing body of literature concludes that fiscal necessary. Expenditures on education remainconsolidation has a smaller negative impact on the inefficient, while the quality is often poor; e.g.,real economy if it relies on spending cuts that Latvia scores extremely low in science citationimprove structural efficiency, rather than on outright index comparisons, Latvian universities are nottax increases. Such policies are called ranked by The Times or Shanghai rankings at all.“expansionary consolidation,” as they improve Regional comparisons show a clear lagging behindefficiency and thereby increase long-run growth the best Estonian and Lithuanian universities.potential. 2 Higher taxes mean greater distortions tothe economy (e.g., higher inflation), while public An outright tax increase, which in many cases hasadministration remains inefficient. Furthermore, cuts been chosen by the past governments, is thein public investments that politically are often easiest option. However, if a tax-increasing decisionfavoured to cuts in government consumption result is made on the premise that the Latvian tax burdenin larger output costs, because investments have is relatively light (about 30% of GDP in comparisonlong-term positive effects on economic potential. to 40% in the EU) is too simplistic and mistaken.Aiming for a balanced budget will have a positive The low proportion of tax revenues to GDP is partlyinfluence on the economy in the long term. because of an ineffective (and not well-balanced) tax system that distorts tax payment incentives andThe IMF has estimated 3 that Latvian budget collecting capability. Therefore, a general taxconsolidation in 2009 was accomplishedpredominately by temporary spending cuts. These increase may not give the needed result but instead act as a stimulus to avoid paying taxes, especially ifexpenditures will return and undermine future fiscal there is weak trust in the government’s spendingstability. Unfortunately, the 2010 budgetconsolidation was done in a similar mode and prudency. With any new change in the tax system, the government must balance fiscal gains withpermitting to delay elimination of public sector incentives to pay. In the current situation, tax ratesinefficiencies. must stimulate economic activity and motivate it to move out of the shadow. In many of our earlier 4 studies we have pointed to the necessity to ease the tax burden on labour incomes in order to1 See the Annual Review of State-Owned Enterprises 2009 stimulate job creation and income legalisationpublished this autumn by the Baltic Institute of Corporate (according to Eurostat, labour tax wedge in Latvia isGovernance; on par with the EU25 average whereas implicit tax2 World Economic Outlook, IMF (October 2010).3 Purfield and Rosenberg (2010), Adjustment under a Currency 4Peg: Estonia, Latvia and Lithuania during the Global Financial E.g., see Swedbank Analysis (October 30, 2009),Crisis 2008-09, IMF Working Paper, No. 10/213. 2 (4)
  3. 3. The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 5 • October 2010rate is significantly below that, which suggests The 9th parliaments composition, number of seatswidespread tax evasion) and compensate therevenue shortfall with a higher residential real For Fatherlandestate tax. &Freedom/ New Era 8 18 LNNK Tax revenues, % of GDP (2008) Union of Harmony Greens and Center 50 Farmers For Human 17 Rights in 18 40 United 6 Latvia 9 People’s 30 3 Party First Party 4 4 10 23 and Latvia’s Way 20 20 18 15 14 Ruling coalition 10 Source: Central Election C ommission 11 12 11 11 0 The 10th parliaments composition, number of seats Parliaments composition, EU27 Estonia Latvia Lithuania Taxes on capital Taxes on labour Taxes on consumption Source: Eurostat Union of Greens and Farmers All forNew parliament – opportunity not to be Unity (incl. 22 Latvia and 8 New Era) FF/LNNKmissed 33 8 For a GoodOn October 2, a new parliament was elected. The Harmony Latviaresult gives credit to the current coalition and the Centerincumbent Prime Minister V. Dombrovskis who is 29expected to remain in the office, allowingcontinuation of the IMF/EC-supported bailoutprogramme and implying further budget Possible coalitionconsolidation. The current shape of the new Source: Central Election Commissionparliament provides a good opportunity to form alasting government, possibly until the next Of course, economic recovery (for 2011, we expectparliamentary elections in 2014. If the government GDP to grow by about 3%) somewhat eases theis formed with no delay and the 2011 budget is budgetary situation because revenues increase withbased on structural reforms, there is a good chance rising economic activity. The improving economicthat Latvia’s credit rating outlook will soon improve situation has already led to rising tax incomes sinceto positive from stable and the rating itself return to the beginning of the year, particularly for theinvestment grade (among the three major rating personal income tax, social contributions, and theagencies, only Moody’s has retained an investment value-added tax (VAT). Tax revenues were 2.1%grade rating for Latvia), as early as the late first above the plan in the nine month of the year. Butquarter or second quarter of 2011. one should not rely on economic growth to obviate the need for further fiscal consolidation – it will improve revenues but will not improve the sustainability and efficacy of the public sector or of the economy at large. 3 (4)
  4. 4. The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 5 • October 2010Tax revenues, LVL mill The current crisis proved the existing budget structure was not ready to face the challenges of160 local recession and global financial market volatility.140 Therefore, the government should not delay the120 consolidation. The post-election period is a good100 time to take measures that are tough in the short run but necessary in the long run to ensure fiscal 80 sustainability and improve the efficiency of the 60 overall economy. Politicians should not be afraid of 40 a temporary fall in their popularity ratings as 20 positive results from the reforms would be seen before the next elections (municipal in 2013 and 0 parliamentary in 2014). Jan.08 Jul.08 Jan.09 Jul.09 Jan.10 Jul.10 VAT Excise Dainis Stikus Social contributions Personal income tax Source: State Treasury Mātiņš KazāksSwedbankEconomic Research Department 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 inSwedbank AB. SE-105 34 Stockholm. this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or itsLegally responsible publisher use. Readers are encouraged to base any (investment) decisions on other material as well.Cecilia Hermansson, +46 8 5859 7720 Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter.Martiņš Kazāks, +371 6744 5859Dainis Stikuts, +371 6744 5844Lija Strašuna, +371 6744 5875 4 (4)