The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department by Dainis Stikuts un Mārtiņs Kazāks

No. 5 • October 2010

Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: ek.sekr@swedbank.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.

Expenditure based post-election budget consolidation – an opportunity not to be missed when aiming for sustainable long-term growth

• 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 spending in Latvia was unsustainable because windfall revenues during the boom years were transformed into permanent and ever rising expenditures (e.g., higher wages, pensions, social benefits, and newly created public agencies). Latvia is now on a challenging fiscal consolidation path to put its budget and public debt on a sustainable footing, to fulfil Maastricht criteria and join the euro zone in 2014. To this end, the IMF/EC bailout programme sets the aim to reduce the budget deficit to below 6% of GDP in 2011 and 3% in 2012.

While producing the 2010 budget, the government made large efforts to achieve a consolidation of close to LVL 500 million (about 4% of GDP): it increased the personal income tax rate from 23% to 26% and broadened tax base to include capital income, and equalised the tax for self-employed with the standard personal income tax rate. However, some measures, due to a lack of political consensus, were poorly made, e.g., the introduction of a residential real estate tax of just

0.1-0.3% of cadastral value had little fiscal benefit and did not correct tax system imbalances. To be structural reforms that would make public sector more efficient and leaner largely relied on wage cuts (undermining employee motivation and increasing the risk of corruption) rather than on structural changes. Now, the government needs to consolidate the 2011 budget by about LVL 400 million.

What should be kept in mind while planning 2011 expenditures?

The government should take a forward-looking view and be sharp on fiscal discipline. It must address systemic inefficiencies and be aware of risks coming from the ESA95 methodology.

First, expenditure planning and fiscal discipline must be improved. For instance, the 2010 central government budget deficit (adopted on December 1, 2009) was planned at LVL 524 million; this by now has been increased to LVL 990 million.

The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 5 • October 2010

2 (4)

Approximately half of this is due to the Constitutional Court’s decision of December 22, 2009 that the pension decrease in 2009 was unconstitutional. The rest of the increase was due to higher expenditures coming from, e.g., the health system, and the systemic efficiency of this new spending is questionable.

Second, the government should reconsider the ownership and/or inefficient management of state owned companies that either do not bring in sufficient monetary dividends1 or place an additional burden on the budget. Investments and guarantees to such enterprises (like the Parex bank), according to the ESA95 methodology, are accounted as expenditures, thereby increasing the budget deficit. For instance, due to government investments into the Parex bank, the general government consolidated budget deficit increased by 0.9% of GDP in 2009.

Consolidation should be expenditure based and efficiency improving

A growing body of literature concludes that fiscal consolidation has a smaller negative impact on the real economy if it relies on spending cuts that improve structural efficiency, rather than on outright tax increases. Such policies are called “expansionary consolidation,” as they improve efficiency and thereby increase long-run growth potential.2 Higher taxes mean greater distortions to the economy (e.g., higher inflation), while public administration remains inefficient. Furthermore, cuts in public investments that politically are often favoured to cuts in government consumption result in larger output costs, because investments have long-term positive effects on economic potential. Aiming for a balanced budget will have a positive influence on the economy in the long term.

The IMF has estimated3 that Latvian budget consolidation in 2009 was accomplished predominately by temporary spending cuts. These expenditures will return and undermine future fiscal stability. Unfortunately, the 2010 budget consolidation was done in a similar mode and permitting to delay elimination of public sector inefficiencies.

1 See the Annual Review of State-Owned Enterprises 2009 published this autumn by the Baltic Institute of Corporate Governance; http://www.corporategovernance.lt/en/news/19 2 World Economic Outlook, IMF (October 2010). 3 Purfield and Rosenberg (2010), Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008-09, IMF Working Paper, No. 10/213.

Fiscal adjustments in the Baltics, 2009 (%

0

2

4

6

8

10

12

Estonia Latvia LithuaniaTemporary reduction in spendingStructural spending measuresOther revenue measuresDurable net revenue increase

Source: Purfield and Rosenberg (2010))3

Fiscal adjustments in the Baltics, 2009 (% of GDP)

For example, Latvia has 38 state-financed higher education institutions and no clear action plan on their consolidation. Meanwhile, the demographic situation is leading to a decrease in the number of students – in five years, the number of youths of student age will be about half of that in 2009. Such an extensive education infrastructure won’t be necessary. Expenditures on education remain inefficient, while the quality is often poor; e.g., Latvia scores extremely low in science citation index comparisons, Latvian universities are not ranked by The Times or Shanghai rankings at all. Regional comparisons show a clear lagging behind the best Estonian and Lithuanian universities.

An outright tax increase, which in many cases has been chosen by the past governments, is the easiest option. However, if a tax-increasing decision is made on the premise that the Latvian tax burden is relatively light (about 30% of GDP in comparison to 40% in the EU) is too simplistic and mistaken. The low proportion of tax revenues to GDP is partly because of an ineffective (and not well-balanced) tax system that distorts tax payment incentives and collecting capability. Therefore, a general tax increase may not give the needed result but instead act as a stimulus to avoid paying taxes, especially if there is weak trust in the government’s spending prudency. With any new change in the tax system, the government must balance fiscal gains with incentives to pay. In the current situation, tax rates must stimulate economic activity and motivate it to move out of the shadow. In many of our earlier studies4 we have pointed to the necessity to ease the tax burden on labour incomes in order to stimulate job creation and income legalisation (according to Eurostat, labour tax wedge in Latvia is on par with the EU25 average whereas implicit tax

4 E.g., see Swedbank Analysis (October 30, 2009), http://www.swedbank.lv/eng/docs/materiali.php?nmid=0&naid=3

The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 5 • October 2010

3 (4)

rate is significantly below that, which suggests widespread tax evasion) and compensate the revenue shortfall with a higher residential real estate tax.

Tax revenues, % of GDP (2008)

11 12 11 11

20 1814 15

93

4 4

0

10

20

30

40

50

EU27 Estonia Latvia LithuaniaTaxes on capital Taxes on labour Taxes on consumption Source: Eurostat

New parliament – opportunity not to be missed

On October 2, a new parliament was elected. The result gives credit to the current coalition and the incumbent Prime Minister V. Dombrovskis who is expected to remain in the office, allowing continuation of the IMF/EC-supported bailout programme and implying further budget consolidation. The current shape of the new parliament provides a good opportunity to form a lasting government, possibly until the next parliamentary elections in 2014. If the government is formed with no delay and the 2011 budget is based on structural reforms, there is a good chance that Latvia’s credit rating outlook will soon improve to positive from stable and the rating itself return to investment grade (among the three major rating agencies, only Moody’s has retained an investment grade rating for Latvia), as early as the late first quarter or second quarter of 2011.

Harmony Center

17For Human Rights in United Latvia

People’s Party23

For Fatherland&Freedom/

LNNKNew Era

18

First Party and Latvia’s

Way

Union of Greens and

Farmers18

Source: Central Election Commission

The 9th parliament's composition, number of seats

10

6

8

Ruling coalition

The Parliament's composition,

Union of Greens and

Farmers22

Harmony Center

29

All for Latvia and FF/LNNK

For a Good Latvia

Unity (incl. New Era)

33

Source: Central Election Commission

The 10th parliament's composition, number of seats

8

8

Possible coalition

Of course, economic recovery (for 2011, we expect GDP to grow by about 3%) somewhat eases the budgetary situation because revenues increase with rising economic activity. The improving economic situation has already led to rising tax incomes since the beginning of the year, particularly for the personal income tax, social contributions, and the value-added tax (VAT). Tax revenues were 2.1% above the plan in the nine month of the year. But 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.

The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 5 • October 2010

4 (4)

Tax revenues, LVL mill

0

20

40

60

80

100

120

140

160

Jan.08 Jul.08 Jan.09 Jul.09 Jan.10 Jul.10VAT ExciseSocial contributions Personal income tax

Source: State Treasury

The current crisis proved the existing budget structure was not ready to face the challenges of local recession and global financial market volatility. Therefore, the government should not delay the consolidation. The post-election period is a good time to take measures that are tough in the short run but necessary in the long run to ensure fiscal sustainability and improve the efficiency of the overall economy. Politicians should not be afraid of a temporary fall in their popularity ratings as positive results from the reforms would be seen before the next elections (municipal in 2013 and parliamentary in 2014).

Dainis Stikus

Mātiņš Kazāks

Swedbank Economic Research Department Swedbank AB. SE-105 34 Stockholm. Legally responsible publisher Cecilia Hermansson, +46 8 5859 7720 Martiņš Kazāks, +371 6744 5859 Dainis Stikuts, +371 6744 5844 Lija Strašuna, +371 6744 5875

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 in 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 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, direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter.