The Latvian EconomyMonthly newsletter from Swedbank’s Economic Research Departmentby Dainis Stikuts and Lija Strašuna No. 3 • 29 April 2011Fiscal 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 tothan expected. The general government budget the second pension pillar, forcing dividend payoutsdeficit for 2010 was 7.6% of GDP 1 (which is below from state-owned companies) and it has increasedthe 8.5% cap set in agreements with the IMF/EC). taxes (including those on labour income).In 2011, the government intends to reduce thebudget deficit faster than initially planned. In April, Tax revenuesthe parliament passed a supplementary budget, 40and 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 30put the economy and the budget on a sustainable ?path, to fulfil the Maastricht criteria and introduce 25the euro in 2014. Jan.2009: PIT ↓ Excise ↑ VAT ↑ Jul.2011: 20The 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 15issuing bonds in international financial markets for a 1Q07 1Q08 1Q09 1Q10more acceptable price and gradually to begin % of GDP % of domestic demand Sources: CSBL, State Rev enue Serv icerefinancing external debt. However, this does notmean that public finances already stand on solidgrounds. In each subsequent budgeting round, fiscal consolidation increasingly moved towards taxFurther increase in tax burden is not increases rather than expenditure cuts. While ineffective 2009 about. 70% of the consolidation measures were on the expenditure side, in 2010 this shareSo 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 andthrough structural reforms it has employed several empirical evidence, which suggests that consolidation done through expenditure cuts has a1 Accrual basis, i.e. according to Maastricht criterion. Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: firstname.lastname@example.org 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 2011less negative impact on GDP and employment than Tax share in total tax revenues in 2010tax-based adjustments. 2The tax burden has increased in 2009-2011 – the Socialgovernment 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, Personalthe ratio of tax revenues to GDP has declined. This income tax Excisecan partly be explained by the expansion of 23% 14%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 a VAT 24%further tax increase is not efficient (not least, other 5%because trust in government policy and theincentive to pay taxes are falling). Source: State TreasuryReducing the shadow economy does remain one ofthe government’s key areas of focus. However, the Now, there is less room for manoeuvre due to theraising of taxes has in fact done the opposite, while planned euro introduction in 2014 to balance aappropriate actions to improve tax administration trade-off between curbing inflation and reducing theand collection so far have been weak and slow in budget deficit. The option of decreasing the taxcoming. Government credibility – and thus burden on wages (possibly compensating for thismotivation to pay taxes – has been undermined by with higher property taxes and abolishment of thefrequent and unpredictable tax changes, which in reduced value-added tax, along with an effectivemany 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. 3and Duty System for 2011-2015.” Fiscal discipline and budget planning needDespite an increase in consumption and property to be improvedtaxes, Latvia’s current tax system is still not wellbalanced – the motivation to pay taxes and the The recent recession shed light on a couple ofeconomic structure remain distorted. 4 There is a issues of fiscal discipline and budget planning thatheavy tax burden on wage income (personal prevented the actual budget deficit outcome fromincome tax 25% and employer and employee social being better.contributions 35.09%), which is subject to larger taxevasion than property or consumption taxes; First, the deficit in the last couple of months of thetogether 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 ofthe opportunity to pursue reforms – perhaps painful specific payment terms for public orders madein 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 fundingand 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 the2 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 toof fiscal consolidation”, World Economic Outlook, October larger-than-expected revenues) and raise the issue2010, Chapter 3.3 See of fiscal discipline.http://www.fm.gov.lv/?lat/valsts_budzets/videja_termina_budzeta_planosana (in Latvian)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 ofGDP 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). 2 (4)
The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 3 • 29 April 2011Accumulated 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 theSecond, during the last two years, an increase in parliament. It includes expenditure ceilings, requiresplanned expenditures in the second half of the year the budget to be in surplus when the economy ishas 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 7for additional financing in the health care sector in growing slower or decreasing. However, to makeautumn. Even taking into account the fact that not this law effective it is also crucial to enhance theall expenditures can be forecasted at the beginning capacity to make realistic and reliable forecasts forof the year, such regularity points to problems in macroeconomic parameters and revenue andbudget planning. Otherwise, it is hard to explain the expenditure development.difference between the initial budget plan approvedat the beginning of the year and the revised plan in Still room for improvement in public sectorDecember. For instance, the planned budget deficit effectivenessnearly doubled in 2010 from LVL 524 million inJanuary to almost LVL 1000 million in December. Taking into account the fact that further tax hikes are not reasonable and consolidation should beCentral government budget balance planning, million achieved through expenditure cuts and aLVL 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 learnhow to deal with them from other countries’experience. For instance, Sweden developed a 6 Ljungman, G. (2007) „The Medium-term Fiscal Frameworkmedium-term fiscal policy framework in the mid- in Sweden”, OECD Journal on Budgeting No. 3 (6)1990s to ensure the transparency and sustainability 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. 3 (4)
The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 3 • 29 April 2011With this recommendation, we do not encourage If the public sector (including not only publicacross-the-board linear wage increases in the administration, but also education, health care, andpublic 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 anintroduction of a performance-based remuneration opportunity to increase wages for qualified peoplesystem in the public sector, which should be linked working there. There has been an optimisation into private sector wage developments. the work of the public sector; e.g., the share of employment in public administration decreasedEmployment 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)SwedbankEconomic Research DepartmentSwedbank 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 inLegally responsible publisher this publication. However, we cannot guarantee the accuracy or completeness of the reportCecilia Hermansson, +46 8 5859 7720 and cannot be held responsible for any error or omission in the underlying material or its 8 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 may be held responsible for and social security efficiency in Latvian education, health care, losses or damages,Martiņš Kazāks, +371 6744 5859 direct or indirect, owing to sectors is stillomissions inthe EU average; for more details, see any errors or way below Swedbank’s monthly newsletter.Dainis Stikuts, +371 6744 5844 http://www.bank.lv/publikacijas/latvijas-valdibas-izdevumu-Lija Strašuna, +371 6744 5875 efektivitate/6107 (in Latvian) 4 (4)