The Latvian EconomyMonthly newsletter from Swedbank’s Economic Research Departmentby Dainis Stikuts, Mārtiņš Kazāks No. 8 • 3 November 2011Latvian budget reforms: fiscal discipline needs immediateimprovement • Latvia has managed to reduce the budget deficit, and fulfilling the Maastricht budget deficit criterion in 2012 is possible. • The budget gap is not yet closed. The government needs to look into all possibilities for reducing expenditures and increasing revenues by improving tax administration, but not by raising taxes. • One of the tasks for the current government is to strengthen fiscal discipline by adopting the fiscal discipline law as soon as possible; this would be a cornerstone for ensuring a sustainable budget and lowering the debt level.So far, good budget revenues in 2011 In the first nine months of 2011, total budget revenues increased by 10.6%, whereasThe current situation of the general government expenditures were 3.5% higher than a year before.budget is better than expected, as tax revenues The cumulative general government budget deficitseem to have bottomed out. In 2011, tax revenues narrowed to 0.4% of annual GDP.1 Clearly, thishave thus far exceeded the plan every month, and performance is on target, and, if it continues, thecumulative revenues were 6.9% above the plan by actual budget deficit for this year is likely to bethe end of September. In the third quarter of 2011, smaller than the deficit ceiling criterion, set at 4.5%the annual growth of tax revenue accelerated to of GDP. However, for the whole of 2011, the budget17.2% (10.8% in the second quarter and 3.7% in deficits actual outcome will depend on fiscalthe first quarter), mostly due to better revenues discipline in the last three months. A further goal isfrom the value-added tax (VAT) (up 23.7% in the to reduce the deficit to below 3% in 2012 andthird quarter) and social contributions (16%). Retail thereby to fulfil the Maastricht criterion, so as to betrade and wage income appeared to be better than able to introduce the euro in 2014.had been projected during the initial budgetforecast. The government has introduced measures to reduce the size of the “grey” economy and toTax revenues, million LVL improve tax collection. However, tax evasion remains an issue, and many transactions may still 200 500 be underreported. For example, fuel consumption is 400 typically rather inelastic with respect to incomes 150 because people need to get to work and back. 300 Nevertheless, statistics show consumers’ behaviour 100 to be somewhat contradictory. In the first nine 200 months of 2011, new transport vehicle registration 50 increased by 56% (year on year), and that of private 100 cars by 69%. During the same period, however, fuel 0 0 sales were down by about 10% from the previous year ago, while other nonfood (excluding fuel) sales Jan.08 Jan.09 Jan.10 Jan.11 were up by almost 12%. Furthermore, textile and Total (rs) VAT footwear sales increased only by 1.3%, implying Social contributions Personal income tax that nonfood sales are mostly driven by other Corporate tax non-first-necessity-goods. These statistics raise Source: State Revenue Service concerns about tax evasion in fuel trade. 1 Cash-flow basis, Swedbank’s GDP forecast. Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: email@example.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. 8 • 3 November 2011Another conclusion from these statistics is that expansion of the exporting sectors, which are lesscurrent retail sales growth is driven by sales of tax intensive; however, tax revenues as a percentdurable goods, which are also generating a large of domestic demand diminished as well (frompart of tax revenues. But if consumer optimism falls 27.9% in the first half of 2009 to 26.5% in the firstdue to increasing economic uncertainty, demand for half of 2011). It seems that revenues as a percentdurable goods most likely will fall first. Thus, budget of GDP and domestic demand levelled out in therevenues from the VAT may significantly decrease. first half of 2011 – probably, in part because tax collection has improved.Further consolidation in 2012 to fall onexpenditures Tax revenues 40 Jan.2010: RE ↑ Jan.2011:The Latvian GDP growth trend has permanently Average Excise↑ PIT ↑ July.2010: Excise↑shifted downwards compared with the pre-crisis 2004- Transport ↑ Excise ↑ RE ↑ VAT ↑level, and the government’s budget revenues are 35 2006 PIT↓ Soc ↑closely following this trend. Thus, if expenditures do Transport ↑not follow revenues, the budget deficit will increase. 30Empirical evidence suggests that consolidationdone through well-balanced expenditure cuts is 25more efficient in the long run and has a lessnegative impact on GDP and employment than Jan.2009: Excise Jul.2011: 20 ↑ VAT ↑ PIT ↓ VAT↑tax-based adjustments.2 Tax increases are the RE ↑ Transport ↑ Excise↑easiest but least effective way to fill the budgetary 15gap because total revenues depend on overalltaxable income, which has diminished also. 1Q 07 1Q 08 1Q 09 1Q 10 1Q 11 % of GDP % of domestic demandUnfortunately, the Latvian government has beenrelying heavily on revenue-increasing measures Source: CSBL, State Revenue Service(the majority were pure tax increases), accountingfor almost half of all (totalling more than 15% ofGDP) budget consolidation measures during 2009- The budget gap is not yet closed. The government2011. needs to look into all possibilities for reducing expenditures and increasing revenues. AmongstGeneral government budget, billion LVL the biggest categories where expenditure cuts can be sought are grants and subsidies, amounting to 7 about LVL 1,000 million, and social transfers, 6 amounting to LVL 400 million (which can be made 5 more targeted and efficient). At the same time, the government must improve revenue collection – e.g., 4 by shifting the tax burden from labour to 3 consumption and real estate (an initiative that is 2 also part of the current government’s programme), and by reducing incentives to avoid tax payments, 1 including by improving the penalty system. 0 2001 2004 2006 2007 2009 2002 2003 2005 2008 2010 Fiscal discipline needs to improve straightaway Expenditures Revenues The risk of larger-than-expected expenditures has Source: Eurostat not yet been eliminated. In April 2011, the government approved supplementary budget, as IMF/EC had demanded additional reduction inIn 2009 and 2010, we saw that the ratio of tax budget deficit. Therefore, budget’s revenues wererevenues to GDP declined despite tax increases in increased by LVL 107 million and expenditures byeach quarter over the corresponding quarter of the LVL 15 million, which lowered the deficit by aboutprevious year. This can partly be explained by the LVL 90 million, or 0.6% of GDP. However, one-third of this gain has been already lost. Since then, planned expenditures have been increased by2 See, e.g., IMF (2010), “Will it hurt? Macroeconomic effects close to another LVL 30 million.of fiscal consolidation”, World Economic Outlook, October2010, Chapter 3. 2 (3)
The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 8 • 3 November 2011Central government budget balance planning, million An increase in planned expenditures in the secondLVL half of the year has become a standard. 0 Unfortunately, the fiscal discipline law is still under discussion in the parliament and has not yet been -200 passed. The current coalition is committed to adopting the law, which is necessary not only -400 successfully to close the IMF/EC bailout programme, but also to ensure a sustainable fiscal -600 policy and lower the debt level. -800 -1000 -1200 Dainis Stikuts Jan.09 Jan.10 Jan.11 Martins Kazāks * cash-flow basis Source: State TreasurySwedbankEconomic 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 use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages,Martiņš Kazāks, +371 6744 5859 direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter.Dainis Stikuts, +371 6744 5844Lija Strašuna, +371 6744 5875 3 (3)