Location: Latvia

Foreign-Owned Firms and Labor Tax Evasion in Latvia

Posted on November 29, 2021 | Policy Brief

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It is well-documented that foreign-owned firms often pay higher wages than domestic firms. This phenomenon is usually explained by foreign firms being more productive. In this brief, we discuss another mechanism that drives the wage premium for employees of foreign-owned firms. By comparing income and expenditures of households led by employees of foreign-owned firms, domestic firms and public enterprises in Latvia, we show that employees of foreign-owned firms receive less undeclared cash payments than employees of domestic firms.

Introduction

A vast economic literature documents a wage premium for employees of foreign-owned firms (e.g., Heyman et al., 2007; Hijzen et al., 2013). This can result from self-selection of foreign firms in highly productive sectors (Guadalupe et al., 2012) or from a productivity increase (Harding and Javorcik, 2012). In a recent paper (Gavoille and Zasova, 2021), we provide evidence of a third driver: foreign-owned firms are more (labor) tax compliant than domestic firms.

Envelope wage, i.e., an unreported cash-in-hand complement to the official wage, is a widespread phenomenon in transition and post-transition countries (e.g., Gorodnichenko et al., 2009 in Russia, Putninš and Sauka, 2015 in the Baltic States, Tonin, 2011 in Hungary). Employees are officially registered, but the income reported to tax authorities is only a fraction of the true income, the difference being paid in cash. If domestic firms are more likely to underreport wages than foreign-owned ones, the documented wage premium for employees of foreign-owned firms is overestimated.

Methodology and data

To compare the prevalence of income underreporting in foreign and domestic firms, we use an approach similar to Pissarides and Weber (1989). This approach is based on two main assumptions. First, even though households participating in an expenditure survey can have incentives to misreport their expenditures, they accurately report their expenditure on food.

The second assumption is that if all households would fully report their income, similar households would report a similar share of spending on food. If, however, a group of households is likely to underreport income, their fraction of income spent on food will systematically be higher than that of tax-compliant households. Using the propensity to food consumption of a group of households that cannot evade payroll tax as a benchmark, we can identify groups of tax-evading households by comparing their food consumption with the reference group.

In this brief, we mainly focus on three household groups: households where the head is an (1) employee of a foreign-owned firm (reference group), (2) employee of a public sector enterprise, and (3) employee of a domestic firm. We introduce public sector employees as an additional comparison group, since they cannot collude with employers to underreport wages. Hence, our approach allows us to test whether households in the third group are more likely to receive undeclared payment than households in the first group, and additionally test if our reference group is systematically different from public sector employees.

We estimate Engel curve-type relationships for food consumption for different types of households, i.e., we estimate how households’ food consumption varies with income depending on employment of the main breadwinner (employed in a foreign-owned firm, public sector enterprise, domestic firm or self-employed), controlling for various household characteristics (number of adults, size of household, place of residence, level of education of the main breadwinner, and other).

Our data comes from three sources. First, we use the 2020 round of the Latvian Household Budget Survey (HBS), which provides information on household consumption, income and characteristics in 2019. Second, we use an administrative matched employer-employee dataset providing information on reported wages for the whole population of employees in Latvia. We match the second database with HBS using (anonymized) individual IDs contained in both datasets. Finally, we use (anonymized) firm IDs contained in the second database to merge it with a third data source, which provides detailed information on firms’ foreign-ownership status.

Results

For simplicity, in the rest of the brief we denote “household where the head is an employee of a foreign-owned firm” as simply “foreign-owned households”. A similar simplification applies to other household groups.

Comparing domestic and foreign-owned households, domestic households spend a higher share of their income on food. Figure 1 plots a non-parametric Engel curve for the two groups. The two curves exhibit fairly similar behavior, but the Engel curve for domestic households always lies above the one for foreign-owned households: for a given income, domestic households always spend a larger fraction on food than foreign-owned ones.

Our model estimations provide two main results. First, we find that the net wage premium for employees of foreign firms is 13-35%, depending on the sample and the source of data on income. Second, we show that domestic households are more likely to underreport income than foreign-owned households. On average, domestic firm households are estimated to conceal 26% more income than foreign-owned ones. At the same time, public sector households do not exhibit a significantly different food consumption pattern than foreign-owned firm households. Assuming that public sector households cannot evade, foreign-owned firm households hence do not underreport. The estimated share of concealed income is even larger (about 40%) if we restrict our sample to households where the head is aged below 50 years and is full-time employed.

Figure 1. Engel curve

Source: authors’ calculations. Note: We follow Hurst et al. (2014). We regress (administrative) wage and food consumption separately on demographic controls to condition out these factors. We recenter the residuals at the unconditional averages for each group and use these residuals to estimate the Engel curve with a cubic spline.

Conclusions

In a context of widespread labor tax evasion, the observed wage premium for employees of foreign-owned firms can be driven by payroll tax compliance. How much of the wage premium can underreporting explain? Our results for Latvia suggest a net wage premium of 13% to 35% for the group of foreign-owned households. This roughly corresponds to the magnitude of the underreporting factor, indicating that nearly all of the wage premium can be explained by labor tax evasion. Even though the precise underreporting point estimates should be cautiously interpreted, and this 1-to-1 relation is anecdotal, this nevertheless highlights the potential importance of envelope wages in explaining the wage premium of employees of foreign-owned firms when labor tax evasion is prevalent.

Acknowledgement: This brief is based on a recent article published in Economics Letters (Gavoille and Zasova, 2021). The authors gratefully acknowledge funding from LZP FLPP research grant No.LZP-2018/2-0067 InTEL (Institutions and Tax Enforcement in Latvia).

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Foreign Investors on the Investment Climate in Latvia

Posted on March 23, 2020 | Policy Brief

Railway bridge across river Daugava representing Foreign Investors on the Investment Climate in Latvia FREE Network Image 01

This brief summarizes the results of an annual study on the development of the investment climate in Latvia from the viewpoint of key foreign investors – companies that have made the decision to invest in the country and have been operating here for a considerable time period. The study was initiated in 2015 and aims to assess investors’ evaluation of the government policy initiatives to improve the investment climate in Latvia. It also aims to provide an in-depth exploration of the main challenges for and concerns of the foreign investors, both by identifying problems and offering solutions. The study draws on a survey/ mini case studies of the key foreign investors in Latvia. Our findings suggest that in recent years, some progress has been achieved on a number of dimensions that are crucial for the competitiveness of the investment climate in Latvia, such as the political efforts by the government of Latvia to improve the investment climate, the overall attitude to foreign investors, and labour efficiency. At the same time, foreign investors see little, if any, improvement with regards to other key areas, such as the availability of labour, the quality of education, the court system, corruption and the shadow economy.

Introduction

The study on the development of the investment climate in Latvia from the viewpoint of key foreign investors in Latvia was first launched in 2015 by the Foreign Investors’ Council in Latvia (FICIL) in cooperation with the Stockholm School of Economics in Riga (SSE Riga). This study aims to foster evidence-based policy decisions and promote a favourable investment climate in Latvia by:

  • (i) Assessing how foreign investors evaluate the government’s efforts and current policy initiatives aimed towards improving the investment climate in Latvia, and
  • (ii) Providing an in-depth exploration of the main challenges and concerns for the foreign investors, both by identifying problems and offering solutions.

The study draws on a survey/mini case studies of the key foreign investors in Latvia. The first 2015 wave of the survey covered 28 key foreign investors in Latvia. Our panel has gradually expanded over time, reaching 47 participating companies in 2019. From September to early November 2019, we interviewed 47 senior executives representing companies that are key investors in Latvia. Altogether, these companies (including their subsidiaries) contribute to 23% of Latvia’s total tax revenue from foreign investors, 9% of the total profit and employ 11% of the total workforce employed by foreign investors in Latvia, where by foreign investors we mean companies with above a 145 000 EUR turnover and 50% foreign capital (data form Lursoft, 2018).

All interviews were conducted by FICIL board members. The guidelines for the interviews consist of the following key parts:

  • (i) Assessment of whether, according to foreign investors, the investment attractiveness of Latvia has improved during the past 12 months;
  • (ii) Assessment of the work of Latvian policy-makers in improving the investment climate during 2019;
  • (iii) Evaluation of progress in the major areas of concern identified by foreign investors in Latvia in 2015, including demography, access to labour, level of education and science, quality of business legislation, quality of the tax system, support from the government and communication with policy-makers, unethical or illegal behaviour on the part of entrepreneurs, unfair competition, uncertainty, the court system and the healthcare system in Latvia.

Furthermore, in the 2019 study we included questions related to some of the key issues discussed between foreign investors and policymakers during 2019, including the tax system, the stability of the financial sector and the quality of higher education and science in Latvia.

Investment Attractiveness of Latvia: Key Concerns of Foreign Investors in Latvia

The results of the 2019 study suggest that, even though the assessment of foreign investors with regards to the investment attractiveness of Latvia and the work of policy-makers to improve the investment climate in Latvia is still at the average level, it shows some positive tendencies. Namely, on a scale from 1 to 5, where ‘1’ means that there are no improvements at all, ‘3’ some positive improvements and ‘5’ significant improvements, the development of the investment climate in 2019 was evaluated as ‘2.6’ (‘2.5’ in 2018 and 2017). Furthermore, when asked to score the policy-makers’ efforts to improve the investment climate in Latvia, using a scale of 1-5, where ‘1’ and ‘2’ were fail and ‘5’ was excellent, investors responded with an average of ‘2.9’ in both the 2017 and 2018 studies, whereas in 2019, the score improved to ‘3.1’.

Foreign investors were also asked to evaluate whether there has been any progress within the key areas of concern as identified in 2015. The results of the most recent study suggest that the demographic situation, which in the long term reflects both the availability of labour and market size, is still among the key challenges for the foreign investors. Namely, on the scale from 1-5 (where an indicator value of 1 means that Latvia is not competitive and 5 means that Latvia is very competitive in this dimension), investors assessed the demographic situation of Latvia with only ‘1.5’ in 2019. Furthermore, as many as 35 (out of 47) foreign investors stated that they had not seen any progress in this area over the past 12 months. This lack of progress is, perhaps, not very surprising as demographic changes may take substantial time.

Another two key areas where investors would like to see more progress are the quality of education and science and the availability of labour. On a 5-point scale, the quality of education and science was evaluated with ‘2.7’ in 2019 (‘3.0’ in 2018, ‘3.1’ in 2017) and 30 out of the 47 investors interviewed have seen no progress in the development of education and science in Latvia over the past 12 months. The availability of labour was evaluated with ‘2.8’ in 2019 (‘2.7’ in 2018 and 2017); investors scored the availability of blue-collar labour with ‘2.4’ in 2019 (‘2.3’ in 2018, ‘2.5’ in 2017) and the availability of labour at management level with ‘3.1’ (‘3.0’ in 2018, ‘2.9’ in 2017). The majority, i.e. 39 of 47 investors have also seen no progress with regards to the access to labour during the past 12 months. In this context, however, it should be emphasised that the efficiency of labour is increasing in Latvia, according to foreign investors: in 2018, it was assessed with ‘2.9’, yet, in 2019, investors evaluated the efficiency of labour in Latvia with ‘3.4’ out of ‘5’.

The quality of health and social security as well as the quality of business legislation are yet another two indicators of the competitiveness of the investment climate in Latvia that have been evaluated around the average level of ‘3’. Further, 33 of 47 investors have seen no progress with regards to improvement of the healthcare system in Latvia over the past 12 months.

While the overall standard of living is evaluated rather positively at ‘3.8’ in 2019, there is still not much improvement in this indicator as compared to the previous three years. One encouraging result of the 2019 study is that according to foreign investors, the attitude towards foreign investors is gradually improving in Latvia: from ‘3.2’ and ‘3.1’ in 2016 and 2017 to ‘3.6’ in 2018 and reaching ‘3.7’ in 2019.

The foreign investors in Latvia who took part in the 2019 study also expressed an expert opinion with regards to whether there has been any progress during the previous 12 months in the other areas of concern. In this light, the perception of uncertainty should be highlighted. As many as 25 (out of 47 investors) have seen no progress in this area, 16 have seen partial progress and 6 stated that there has been progress in reducing uncertainty. The court system of Latvia is another area where many foreign investors have seen no progress, i.e. 22 said ‘no progress’, 23: ‘partial progress’ and only 1 that there has been progress in the development of the court system in Latvia.

Specific Issues: Tax System, Stability of the Financial System and Quality of Higher Education and Science

In the 2019 study, we also initiated an in-depth exploration related to three key issues of concern extensively discussed between foreign investors and Latvia’s government during the FICIL High Council 2019 spring meeting, and throughout the year 2019 in general. These are: (i) the tax system, (ii) the stability of the financial system, and (iii) the quality of higher education and science. Foreign investors were asked to comment on the current situation and progress over the past years, as well as to provide suggestions to the policymakers in order to improve the situation in the particular area.

(i) Tax system:

The most recent tax reform was implemented in 2018, and the newly elected government has announced that the next reform will take place in 2021. Therefore, this year we asked investors to evaluate the results of the previous tax reform in Latvia. We also asked investors to comment on whether the recent tax reform has brought any benefits to their company and the overall economy of Latvia. On average, foreign investors scored the results of the previous tax reform in Latvia with ‘3.1’, i.e. slightly above the average.

Overall, at least one part of the foreign investors who took part in the 2019 studies highlighted that the previous tax reform was a step ‘in the right direction’. In particular, the zero-rate on reinvested profit was highlighted by a large number of investors as a very positive improvement. In some cases, investors also praised the progressivity of labour tax rates. However, a number of foreign investors highlighted that the tax system has actually become more complex after the reform. Investors also expressed suggestions for further steps to improve the tax system in Latvia, and these are as follows:

Avoid uncertainty. Stability and predictability of the tax system is what the majority of the foreign investors wish to see. In essence, this means fewer changes to the tax system.

Simplify and explain. Investors highlight that paying taxes should be a “simple task” and easy to understand. According to the viewpoints of foreign investors, there is also the potential for improvement with regards to how the responsible organisations, such as the State Revenue Service, communicate changes in the tax system to the private sector.

(Continue) the shift from taxing labour to consumption. Some of the investors that took part in the 2019 studies see that the process has been initiated by the previous tax reform and recommend continuing in this direction.

(ii) Stability of the financial sector in Latvia.

On average, foreign investors evaluated the progress with regards to the effectiveness of combating economic and financial crime with 3.2, i.e. above average. We then asked foreign investors whether they have felt any negative effects on their companies with regards to the situations in the financial sector over the past 2 years. We received some positive opinions, yet the negative ones prevailed. Namely, foreign investors highlighted the reputation risks of Latvia that often impact upon the operation of their companies and create challenges when working with foreign banks.

(iii) Quality of university education and science in Latvia.

Here, foreign investors were asked to reflect upon whether they were aware of any activities that policymakers carried out during the past year to improve the situation. On a positive note, a number of investors mentioned the recent development of the University of Latvia and Riga Technical University’s campuses. Some investors also highlighted that the reform to change the governance model of higher education institutions, initiated by the Ministry of Education and Science, was a good step towards improving the quality of higher education and science in Latvia. However, we also received a number of negative opinions, such as “Nothing has been accomplished, just talking”.

When asked “What changes would you suggest to improve the quality of education and science in Latvia and why? How would this help the business environment, e.g. companies such as yours?”, foreign investors emphasised the following:

Higher education (and science) is too local, fragmented and outdated. In essence, investors pointed out that there are simply too many higher education institutions in Latvia, that they work with outdated methods and are afraid (with no good reason) to open up internationally – also by attracting top quality foreign staff.

Change the governance of higher education institutions in Latvia is another strong request from foreign investors in Latvia. Many investors believe that changes in the financing model should also follow.

Improved connection between education and science and the world of business was yet another important aspect which was highlighted during the 2019 interviews, and also strongly emphasised in the previous studies.

Further Investment Plans and Message to the Prime Minister

When asked whether they plan to increase their investments in Latvia, as many as 64% of the investors interviewed answered with ‘yes’ (in the 2018 study, 55% interviewed answered with ‘yes’), 25% said ‘no’ (35% in the 2018 study) and 11% answered that ‘it depends on the circumstances’ (10% in the 2018 study) or that they have not yet decided.

Finally, we invited foreign investors to send a message to the Prime Minister of Latvia: one paragraph on what should be done to improve the business climate in Latvia, from the viewpoint of a foreign investor. These messages closely parallel the other findings of the 2019 study, stressing a number of key concerns that foreign investors are still facing in Latvia: the situation with regards to demography, quality of education and science, availability of labour, challenges with corruption and the shadow economy as well as needs for improvements in the health care sector amongst others.

Conclusions

The findings of the 2019 study on the view of the key foreign investors of the investment climate in Latvia suggest that in recent years, some progress has been achieved on a number of dimensions, such as political effort to improve the investment climate, attitude towards foreign investors, and labour efficiency. At the same time, foreign investors see little, if any, improvement with regards to other key areas, such as the availability of labour, the quality of education, the court system, corruption and the shadow economy.

Our findings highlight the need to continue policy-makers’ efforts to improve the investment climate in Latvia and provide policymakers with better grounds for making informed policy decisions with respect to the entrepreneurship climate in Latvia. We also hope that our study will further facilitate constructive communication between foreign investors and the government of Latvia.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Long Shadow of Transition: The State of Democracy in Eastern Europe

Posted on November 25, 2019 | Policy Brief

Dark hill on the right side of the image with a shadow of a man holding his bicycle on the right side

In many parts of Eastern Europe, the transition towards stronger political institutions and democratic deepening has been slow and uneven. Weak political checks and balances, corruption and authoritarianism have threatened democracy, economic and social development and adversely impacted peace and stability in Europe at large. This policy brief summarizes the insights from Development Day 2019, a full-day conference organized by SITE at the Stockholm School of Economics on November 12th. The presentations were centred around the current political and business climate in the Eastern European region, throwing light on new developments in the past few years, strides towards and away from democracy, and the challenges as well as possible policy solutions emanating from those.

The State of Democracy in the Region

From a regional perspective, Eastern Europe has seen mixed democratic success over the years with hybrid systems that combine some elements of democracy and autocracy. Based on the V-Dem liberal democracy index, ten transition countries that have joined the EU saw rapid early progress after transition. In comparison, the democratic development in twelve nations of the FSU still outside of the EU has been largely stagnant.

In recent years, however, democracy in some of those EU countries, such as Bulgaria, the Czech Republic, Hungary, Poland and Romania have been in decline. Poland, one of the region’s top performers in terms of GDP growth and life expectancy, has experienced a sharp decline in democracy since 2015. Backlashes have often occurred after elections in which corruption and economic mismanagement have led to the downfall of incumbent governments and a general distrust of the political system. Together with low voter turnout, this created fertile ground for more autocratic forces to gain power helped by demand for strong leadership.

An example from Ukraine illustrated the role of media, both traditional and social, for policy-making. In some countries of the region, traditional media is strictly state-controlled with obvious concerns for democracy. This is less the case in Ukraine, where also social media plays an important role in forming political opinions. The concern is that, as elsewhere, opinions that gain traction on social media may not be impartial or well informed, affecting public perception about policy-making. A recent case showing the popular reaction to an attack on the former governor of the Central Bank suggests that those implementing important reforms may not get due credit when biased and partial information dominates the political discourse on social media.

Another case is the South Caucasian region: Armenia, Georgia and Azerbaijan. The political situation there has been characterized as a “government by day, government by night” dichotomy, implying that the real political power largely lies outside the official political institutions. In Georgia, the situation can be described as a competition between autocracy and democracy, with a feudalistic system in which powerful groups replace one another across time. As a result, trust in political institutions is low, as well as citizens’ political participation.

In the case of Azerbaijan, there is an elected presidency, but in reality, power has been passed on hereditarily, becoming a de facto patrimonial system. Lastly, in Armenia, the new government possesses democratic credentials, but the tensions with neighbouring Azerbaijan and Turkey have given increasing power to the military and important economic powers. Overall, democratisation in these countries has been hindered by a trend for powerful politicians to form parties around themselves and to retain power after the end of their mandates. Also, the historical focus on nation-building in these countries has led to a marked exclusion of minorities and a conflict of national identities.

The last country case in this part of the conference focused on the current political situation in Russia and on the likely outcomes after 2024. The social framework in Russia appears constellated by fears – a fear of a world war, of regime tightening and mass repressions, and of lawlessness – all of them on the rise. Similarly, the economy is suffering, in particular from low business activity, somewhat offset by a boost in social payments. Nonetheless, it was argued that it is not economic concerns, but rather political frustration, that has recently led citizens to take to the street. Despite this, survey data shows that trust in Putin is still over 60%, and that most people would vote for him again. However, survey data also points out that the most likely determinant of this trust is the lack of another reference figure, and that citizens are not averse to the idea of political change in itself. Lastly, Putin will most likely retain some political power after 2024, transiting “from father to grandfather of the nation”.

Voices from the civil society in the region also emphasized the importance of a free media and an active civil society to prevent the backsliding of democracy. With examples from Georgia and Ukraine, it was argued that maintaining the independence of the judiciary, as well as the public prosecutor’s office, can go a long way in building credibility both among citizens and the international community. The European Union can leverage the high trust and hopeful attitudes it benefits from in the region to push crucial reforms more strongly. For example, more than 70% of Georgians would vote for joining the EU if a referendum was held on the topic and the European Union is widely regarded as Georgia’s most important foreign supporter.

Weak Institutions and Business Development

The quality of political and legal institutions strongly affects the business environment, in particular with regards to the protection of property rights, rule of law, regulation and corruption. Research from the European Bank for Reconstruction and Development (EBRD) highlights that the governance gap between Eastern Europe and Central Asia and most advanced economies is still large, even though progress in this area has actually been faster than for other emerging economies since the mid-‘90s. This is measured through enterprise surveys as well as individual surveys. In Albania, for instance, a perception of lower corruption was linked to a decrease in the intention to emigrate equivalent to earning 400$ more per month. Another point concerned the complexity of measuring the business environment and the benefits of firm-level surveys asking firms directly about their own actual experience of regular enforcement. For example, in countries such as Poland, Latvia and Romania the actual experience of business regulation measured via the EBRD’s Business Environment Enterprise Performance Survey, is far worse than one would expect from the World Bank’s well known Doing Business rating.

From the perspective of Swedish firms, trade between Sweden and the region has remained rather flat in the past years, as the complexity and risks of these markets especially discourage SMEs. Business Sweden explained that Swedish firms considering an expansion in these markets are concerned with issues of exchange rate stability, and the institutional-driven presence of unfair competition and of excessive bureaucracy. Moreover, inadequate infrastructure and the presence of bribery and corruption make everyday business operations risky and costly. It was generally emphasized that countries have to create a safe investment environment by reducing corruption, establishing a clear and well enacted regulatory environment, having dependable courts and strengthening domestic resource mobilization. Swedish aid can play a part, but there is a need to develop new ways of delivering aid to make it more effective.

An interesting example is Belarus, that has seen more economic and political stability than most neighbours, but at the same time a lack of both economic and political reforms towards market economy and democracy. Gradually the preference towards private ownership, as opposed to public, has increased in recent years and the country has seen a rising share of the private sector, even without specific privatization reforms. Nonetheless, international businesses are still reluctant to invest due to high taxes, a lack of access to finance as well as to a qualified workforce, but most importantly due to the weak legal system. An exception has been China, and Belarus has looked at the One Belt One Road Initiative as a promising bridge to the EU. Scandals connected with the two main Chinese-invested projects have damped the enthusiasm recently, though.

The economic and political risks of extensively relying on badly diversified energy sources, as is the case with natural gas imports from Russia in many transition states were also discussed. It was shown how some countries such as Ukraine, Poland and Lithuania have improved their energy security by either benefitting from reverse-flow technology and the EU’s bargaining power or building their own LNG terminals to diversify supply sources. However, either of these, as well as other energy security improving solutions are likely to come with an economic cost, though, that not all countries in the region can afford.

A Government Perspective

The main focus of this section was the Swedish government’s new inspiring foreign policy initiative, “Drive for Democracy”. Drawing from a definition of democracy by Kerstin Hesselgren, an early Swedish female parliamentarian, democracy enables countries to realize and utilize the forces of the individual and draw them into a life-giving, value-creating society. It was emphasized that the values of democracy are objectives by themselves (e.g. freedom of expression, respect for human rights) but also that democracy has important positive effects in other areas of human welfare. The Swedish government views democracy as the best foundation for a sustainable society, equality of opportunity and absence of gender or racial bias.

The “Drive for Democracy” specifically identifies Eastern Europe as one of the main frontiers between democracy and autocracy, and the Swedish government promotes human rights and stability through various bilateral programmes through the Swedish International Development Cooperation Agency, Sida, and multilateral initiatives within the EU, such as the Eastern Partnership. It was also emphasized that democracy is a continuous process that can always be improved, as indeed experienced by Sweden. Political rights were granted to women only in 1919 followed by convicts and prisoners in 1933 and to the Roma people only in 1950. Political and democratic rights are thus never once and for all given, and it is crucial that the dividends from democracy are carried forward to the younger generation.

Conclusion

In sum, the day illustrated clearly how democracy engages all segments of society, from the business sector to civil society, and the potential for but also challenges involved for democratic deepening in Eastern Europe. To get more information about the presentations during the day, please visit our website.

Participants at the Conference

  • PER OLSSON FRIDH, State Secretary, Ministry for Foreign Affairs.
  • ALEXANDER PLEKHANOV, Director for Transition Impact and Global Economics at EBRD.
  • TORBJÖRN BECKER, Director, SITE.
  • CHLOÉ LE COQ, Associate Professor, SITE and Professor of Economics, University of Paris II Panthéon-Assas.
  • THOMAS DE WAAL, Senior Fellow at Carnegie Endowment for International Peace.
  • NATALIIA SHAPOVAL, Vice President for Policy Research at Kyiv School of Economics.
  • ILONA SOLOGUB, Scientific Editor at VoxUkraine and Director for Policy Research at Kyiv School of Economics.
  • KETEVAN VASHAKIDZE, President at Europe Foundation, Georgia.
  • MARIA BISTER, Senior Policy Specialist, Sida.
  • HENRIK NORBERG, Deputy Director, Ministry for Foreign Affairs.
  • YLVA BERG, CEO and President, Business Sweden.
  • LARS ANELL, Ambassador and formerly Volvo’s Senior Vice President.
  • ERIK BERGLÖF, Professor in Practice and Director of the Institute of Global Affairs, London School of Economics and Political Science.
  • KATERYNA BORNUKOVA, Academic Director, BEROC, Minsk.
  • ANDREI KOLESNIKOV, Senior Fellow, Carnegie Moscow Center.

Liberal Democracy in Transition – The First 30 Years

Posted on October 28, 2019 | Policy Brief

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This year marks 30 years since the first post-communist election in Poland and the fall of the Berlin Wall. Key events that started a dramatic transition process from totalitarian regimes towards liberal democracy in many countries. This brief presents stylized facts from this process together with some thoughts on how to get this process back on a positive track. In general, the transition countries that joined the EU are still far ahead of the other transition countries in terms of democratic development.

The recent decline in democratic indicators in some EU countries should be taken seriously as they involve reducing freedom of expression and removing constraints on the executive, but should also be discussed in light of the significant progress transition countries entering the EU have shown during the first 30 years of transition. The brief shows that changes in a democracy can happen fast and most often happen around elections, so getting voters engaged in the democratic process is crucially important. This requires politicians that engage the electorate and have an interest in preserving democratic institutions. An important question in the region is what the EU can do to promote this, given its overloaded political agenda. Perhaps it is time for a Greta for democracy to wake up the young and shake up the old.

This brief provides an overview of political developments in transition countries since the first post-communist elections in Poland and the fall of the Berlin Wall 30 years ago. It focuses on establishing stylized facts based on quantitative indices of democracy for a large set of transition countries rather than providing in-depth studies of a small number of countries. The aim of the brief is thus to find common patterns across countries that can inform today’s policy discussion on democracy in the region and inspire future studies of the forces driving democracy in individual transition countries.

The first issue to address is what data to use to establish stylized facts of democratic development in the region. By now, there are several interesting indicators that describe various aspects of democratic development, which are produced by different organizations, academic institutions and private data providers. In this brief, three commonly used and well-respected data providers will be compared in the initial section before we zoom in on more specific factors that make up one of these indices.

The big picture

The three indicators that we look at first are: political rights produced by Freedom House; polity 2 produced by the Polity IV project; and the liberal democracy index produced by the V-Dem project. Figures 1-3 show the unweighted average of these indicators for two groups of countries. The EU10 are the transition countries that became EU members in 2004 and 2007 and include Bulgaria, the Czech Republic, Estonia, Hungary, Lithuania, Latvia, Poland, Romania, Slovakia, and Slovenia. The second group, FSU12, are the 12 countries that came out of the Soviet Union minus the three Baltic countries in the EU10 group, so the FSU12 group consists of Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.

Figure 1. Freedom House

Source: Freedom House and author’s calculations
Note: Scale inverted, 1 is best and 7 worst score

Figure 2. Polity IV project

Source: Polity IV project and author’s calculations
Note: Scale from -10 (fully autocratic) to 10 (fully democratic)

Figure 3. V-Dem

Source: V-Dem project and author’s calculations
Note: Scale from 0 to 1 where higher is more democratic

All three indicators convey the message that the democratic transformation in the EU10 group was very rapid in the early years of transition and the indicators have remained at high levels since the mid-90s only to show some decline in the most recent years for two of the three indicators. The FSU12 set of countries have made much less progress in terms of democratic development and remain far behind the EU10 countries in this regard. Overall, there is little evidence at the aggregate level that the democratic gap between the EU10 and FSU12 groups is closing. While the average EU10 country is more or less a full-fledged democracy, the average FSU12 country is at the lower end of the spectrum for all three democracy measures.

The average indicators in Figures 1-3 obviously hide some interesting developments in individual countries and in the following analysis, we will take a closer look at the liberal democracy index at the country level. We will then investigate what sub-indices contribute to changes in the aggregate index in the countries that have experienced significant declines in their liberal democracy scores.

For the first part of the analysis, it is useful to break down the democratic development in two phases. The first phase is from the onset of transition (1989, 1991 or 1993 depending on the specific country) to the time of the global financial crisis in 2009 and the second phase is from 2009 to 2018 (the last data point).

Figure 4. Liberal democracy, the first phase

Source: V-Dem project and author’s calculations

Figures 4 and 5 compare how the liberal democracy indicator changes from the first year of the period (measured on the horizontal axis) to the last year of the period (on the vertical axis). The smaller blue dots are the individual countries that make up the EU10 group while the red dots are the FSU12 countries. The 45-degree line indicates when there is no change between start and end years, while observations that lie below (above) the line indicate a deterioration (improvement) of the liberal democracy index in a specific country.

In the first phase of transition (Figure 4), all of the EU10 countries increased their liberal democracy scores and the average increase for the group was almost 0.5, going from 0.26 to 0.74. This was a result of many of the countries in the group making significant improvements without any countries deteriorating. The FSU12 group had a very different development with the average not changing at all since the few countries that improved (Georgia and Ukraine) were counterbalanced by a significant decline in Belarus and a more modest decline in Armenia.

Figure 5. Liberal democracy, the second phase

Source: V-Dem project and author’s calculations

The very rapid improvement in the liberal democracy index in the EU10 countries in the first phase of transition came to a halt and also reversed in several countries in the second phase of transition. Of course, as they had improved so much in the first period, there was less room for further positive developments, but the rapid decline in some of the countries was still negative news. However, it does point towards that reform momentum was very strong in the EU accession process, but once a country had entered the union, the pressure for liberal democratic reforms has faded.

Overall, the EU10 average fell by 0.1 from 2009 to 2018. This was a result of declining scores in several countries. The particularly large declines in this period have been seen in Hungary (-0.28), Poland (-0.27), Bulgaria (-0.14), the Czech Republic (-0.14), and Romania (-0.12). Again, the average FSU12 score did not change much, although Ukraine (-0.2) put its early success in reverse and lost as much in this period as it had gained earlier.

Country developments

Since much of the current discussion centers on how democracy is being under attack, the figures name the countries that have seen significant declines in the liberal democracy score in the first or second phase of transition. Figures 6 and 7 show the time-series of the liberal democracy index in the countries with significant drops at some stage of the transition process.

Figure 6. FSU12 decliners

Source: V-Dem project and author’s calculations

In many countries, the drop comes suddenly and sharply, with the first and most prominent example being Belarus. There, it only took three years to go from one of the highest ranked FSU12 countries to fall to one of the lowest liberal democracy scores. In Poland, Romania, Bulgaria and Armenia, the process was also very rapid and significant changes happened in 2-3 years.

Figure 7. EU10 decliners

Source: V-Dem project and author’s calculations

In the Czech Republic and Hungary, the period of decline was much longer and in the case of Hungary, the drop was the most significant in the EU10 group. Ukraine stands out as more of an exception with a roller-coaster development in its liberal democracy score that first took it up the list and then back down to where it started. For those familiar with politics in these countries, it is easy to identify the elections and change in government that have occurred at the times the index has started to fall in all of these countries. In other words, the democratic declines have not started with coups but followed election outcomes where in most cases the incumbent leaders have been replaced by a new person or party.

How democracy came under attack

We will now take a closer look at what has been behind the instances of decline in the aggregate index by investigating how the sub-indices have developed in these countries. The sub-indices that build up the liberal democracy index are: freedom of expression and alternative sources of information; freedom of association; share of population with suffrage; clean elections; elected officials; equality before the law and individual liberty; judicial constraints on the executive; and legislative constraints on the executive (the structure is a bit more complex with mid-level indices, see V-Dem 2019a).

Table 1 shows how these indicators have changed in the time period the liberal democracy indicator has fallen significantly (with shorter versions of the longer names listed above but in the same order). The heat map of decline indicated by the different colours is constructed such that positive changes are marked with green, smaller declines are without colour, declines greater that 0.1 but smaller than 0.2 are in yellow and larger declines in red. Note that the liberal democracy index is not an average of the sub-indices but based on a more sophisticated aggregation technique (see V-Dem 2019b). Therefore, the Czech Republic and Bulgaria can have a greater fall in top-level liberal democracy index that what is indicated by the sub-indices.

Table 1. Changes in liberal democracy indicators at times of democratic decline

Source: V-Dem project and author’s calculations

For the countries with the largest changes in the liberal democracy index, it is clear that both freedom of expression and alternative sources of information have come under attack together with reduced judicial and legislative constraints on the executive. Among the EU10 countries, Hungary and Poland stand out in terms of reducing freedom of expression, while Romania has seen most of the decline coming from reducing constraints on the executive. Not surprisingly, Belarus stands out in terms of the overall decline in liberal democracy coming from reducing both freedom of expression and constraints on the executive in the most significant way.

On a more general level, the attack on democracy does differ between the countries, but in the cases where serious declines can be seen, the attack has been particularly focused on information aspects and constraints on the executive. At the same time, all countries let all people vote (suffrage always at 1) and let the one with the most votes get the job (elected officials).

Policy conclusions

This brief has provided some stylized facts on the first 30 years of liberal democracy in transition and some details on how democracy has come under attack in individual countries. It leaves open many questions that require further studies and some of these are indeed ongoing in this project and will be presented in future briefs and policy papers here.

Some observations have already been made here that can inform policy discussions on liberal democratic developments in the region. The first is that changes can happen very rapidly, both in terms of improvements but also in terms of dismantling important democratic institutions, including those that provide constraints on the executive or media that provides unbiased coverage before and after elections. What is also noteworthy is that these changes have almost always happened after an election where a new person or party has come to power, so the democratic system is used to introduce less democracy in this sense.

It is also interesting that in all of the countries, the most easily observed indicators of democracy such as suffrage and having the chief executive or legislature being appointed by elections are given the highest possible scores. In other words, even the most autocratic regime wants to look like a democracy; but as the old saying goes, “it is not who votes that is important, it is who counts”.

The regime changes at election times that have led to declining liberal democracy scores have also in many cases come as a result of the incumbents not doing a great job or voters not turning up to vote. It was enough for Lukashenko in Belarus to promise to deal with corruption and rampant inflation that was a result of the old guard’s mismanagement to turn Belarus into an autocracy. In Hungary, the change of regime came after the Socialist leader was caught on tape saying he had been lying to voters. While in Romania, only 39% voted in the 2016 election. And in Bulgaria, around half of the voters stayed at home in the presidential election the same year.

In sum, both incompetent and corrupt past leaders and disengaged or disillusioned voters are part of the decline in a liberal democracy that we have seen in recent years. It is clearly time for policy makers that are interested in preserving liberal democracy in the region and elsewhere to think hard about how democracy can be saved from illiberal democrats. Part of the answer clearly will have to do with how voters can be engaged in the democratic process and take part in elections. It also involves defending free independent media and the thinkers and doers that contribute to the liberal democracy that we cherish. The question is if the young generation will find a Greta for democracy that can kick-start a new transition to liberal democracy in the region and around the world.

For those readers that want to participate more actively in this discussion and have a chance to be in Stockholm on November 12, SITE is organizing a conference on this theme which is open to the public. For more information on the conference, please visit SITE’s website (see here).

References

  • Freedom house data downloaded on Oct 4, 2019, from https://freedomhouse.org/content/freedom-world-data-and-resources
  • Freedom house methodological note available at https://freedomhouse.org/report/methodology-freedom-world-2018
  • Polity IV project data downloaded on Oct 4, 2019, from http://www.systemicpeace.org/inscrdata.html
  • Polity IV project manual available at http://www.systemicpeace.org/inscr/p4manualv2018.pdf
  • V-Dem project data downloaded on Sept 24, 2019, from https://www.v-dem.net/en/data/data-version-9/
  • Coppedge, Michael, John Gerring, Carl Henrik Knutsen, Staffan I. Lindberg, Jan Teorell, David Altman, Michael Bernhard, M. Steven Fish, Adam Glynn, Allen Hicken, Anna Lührmann, Kyle L. Marquardt, Kelly McMann, Pamela Paxton, Daniel Pemstein, Brigitte Seim, Rachel Sigman, Svend-Erik Skaaning, Jeffrey Staton, Steven Wilson, Agnes Cornell, Lisa Gastaldi, Haakon Gjerløw, Nina Ilchenko, Joshua Krusell, Laura Maxwell, Valeriya Mechkova, Juraj Medzihorsky, Josefine Pernes, Johannes von Römer, Natalia Stepanova, Aksel Sundström, Eitan Tzelgov, Yi-ting Wang, Tore Wig, and Daniel Ziblatt. 2019a. “V-Dem [Country-Year/Country-Date] Dataset v9”, Varieties of Democracy (V-Dem)
  • Pemstein, Daniel, Kyle L. Marquardt, Eitan Tzelgov, Yi-ting Wang, Juraj Medzihorsky, Joshua Krusell, Farhad Miri, and Johannes von Römer. 2019b. “The V-Dem Measurement Model: Latent Variable Analysis for Cross-National and Cross-Temporal Expert-Coded Data”, V-Dem Working Paper No. 21. 4th edition. University of Gothenburg: Varieties of Democracy Institute.

Latvia Stumbling Towards Progressive Income Taxation: Episode II

Posted on October 16, 2017 | Policy Brief

20171015 Latvia Stumbling Towards Progressive Income Taxation Image 01

In August 2017, the Latvian parliament adopted a major tax reform package that will come into force in January 2018. This reform was a long-awaited step from the Latvian authorities to make the personal income tax more progressive. Some of the elements of the adopted reform, e.g. the changes in the basic tax allowance are estimated to help reducing the tax wedge on low wages and help addressing the problem of high income inequality. At the same time, the way the newly introduced progressive tax rate is designed will effectively lead to a reduction in the tax burden on labor and will hardly introduce any progressivity to the system.

In recent years, reducing income inequality has become one of the top priorities of the Latvian government. Income inequality in Latvia is higher than in most other EU and OECD countries, and the need to address this issue has been repeatedly emphasized by the Latvian officials, the European Commission, the World Bank and OECD.

The main reason for high income-inequality is a low degree of income redistribution ensured by the tax-benefit system. The personal income tax (PIT) has been flat since the mid-nineties. While the non-taxable income allowance introduces some progressivity to the system, the Latvian tax system is characterized by a very high tax burden on low wages, compared to other EU and OECD countries.

Since the beginning of 2017, the government has worked on an extensive tax reform package that was passed in the parliament in August and will become effective as of January 2018.

Two years ago, we wrote about the tax reform of 2016. In this brief, we estimate the effect of the 2018 reform on the tax burden on labour and income inequality. We will only consider changes in direct taxes on personal income – the changes in enterprise income tax and excise tax are outside the scope of our analysis. Parts of our estimations are done using the tax-benefit microsimulation model EUROMOD (for more details about the EUROMOD modelling approach, see Sutherland and Figari, 2013) and EU-SILC 2015 data.

Tax reform 2018

We focus our analysis on four elements of the reform that are expected to affect income inequality and that are described below. In our simulations, however, we take into account all changes in the PIT rules.

First, the flat PIT rate of 23% will be replaced by a progressive rate with three brackets: 20% (applied to annual income not exceeding 20,000 EUR), 23% (for annual income above 20,000 EUR and below 55,000 EUR) and 31.4% (applied to income exceeding 55,000 EUR per year).

Second, the maximum possible PIT allowance will be increased and the structure of the PIT allowance will be made more progressive. Latvia has a differentiated allowance since 2016, which means that individuals with lower incomes are eligible for a higher tax allowance. Figure 1 shows the changes in the non-taxable allowance that will be introduced by the reform. Another important change is that the differentiated allowance will be applied to the taxable income in the course of the year. The current system foresees that, during a calendar year, all wages are taxed applying the lowest possible allowance (60 EUR per month in 2017), but workers eligible for a higher allowance have to claim the overpaid tax in the beginning of the next year.

Figure 1. Basic PIT allowance before (2017) and after (2018-2020) the reform, EUR

Source: compiled by the authors.

Third, the rate of social insurance contributions will be increased by 1 percentage point. Social insurance contributions are capped and the cap will be increased from 48,600 EUR per year to 55,000 EUR per year, i.e. to the same income threshold that divides the top PIT bracket.

Finally, the reform will modify the solidarity tax – a tax, which was introduced in Latvia in 2016 and which is paid by top income earners. When this tax was initially introduced, one of its objectives was to eliminate the regressivity from the tax system caused by the cap on social insurance contributions. Hence, the rate of the solidarity tax was set at the same level as the rate of social insurance contributions and was effectively replacing social insurance contributions above the cap. The reform foresees that part of the revenues from the solidarity tax (10.5 percentage points) will be used to finance the top PIT rate. This element of the reform implies that after January 2018 those falling into the top PIT bracket will, in fact, not face a higher PIT rate than those falling into the second income bracket – the introduction of the top rate will be offset by the restructuring of the solidarity tax.

Results

There are four main findings. First, the reform will reduce the tax wedge on labor income, whereas the tax wedge on low wages will remain high by international standards. Second, most of the PIT taxable income earners (93.5%) will fall into the bottom income bracket. Hence the reform will effectively reduce the tax burden, while the effect on progressivity is very limited. Third, the (small) increase in tax progressivity is ensured mainly by changes in the tax allowance, while the effect of changes in the tax rate on progressivity is negligible: Even those few PIT payers that fall into the top tax bracket will not experience any increase in the tax burden due to a compensating change in the solidarity tax. Finally, it is mainly the households in the middle of the income distribution that will gain from the reform.

Effect on tax wedge

We start with a simple comparison of the average labor tax wedge in Latvia and other OECD countries for different wage levels before and after the reform. The tax wedge measures the share of total labor costs that is taxed away in the form of taxes or social contributions payable on employees’ income.

Table 1. Average tax wedge for single wage earners without dependents in Latvia and other OECD countries, before and after the reform

 

67% of average worker’s wage

  

100% of average worker’s wage

  

167% of average worker’s wage
OECD average in 2016, % (a) 32.3 36.0 40.4
Latvia 2016, % (a) 41.8 42.6 43.3
Latvia’s rank in 2016* (a) 6 11 16
Latvia 2018, % (b) 39.4 42.3 42.6
Latvia 2019, % (b) 39.1 42.1 42.6
Latvia 2020, %(b) 39.0 41.9 42.8

Source: (a) OECD and (b) authors’ calculations. Note: * Ranking across 35 OECD countries. Higher ranking implies higher tax wedge relative to other countries.

Table 1 shows that the tax wedge on low wages (67% of an average worker’s wage) in Latvia is pretty high. In 2016, it was the 6th highest across OECD countries, while the tax wedge on high incomes (167% of the wage) is much closer to the OECD average.

While the reform will slightly reduce the tax wedge for low wage earners (from 41.8% to 39.0% in 2020), it will still remain high by OECD standards. Despite an increase in PIT rate for high-income earners, the reform will also lower the tax wedge for those who earn 167% of the average wage. Why? The explanation comes from the income thresholds for the tax brackets. The income of those earning 167% of the average wage is estimated to fully fall into the first tax bracket in 2018–2019 and only slightly exceed the income bracket for the second PIT rate by 2020. This means that most of the incomes of people earning 167% of the average wage will be taxed at the rate of 20%, which is lower than the current flat rate of 23%. Moreover, in 2020, only a small share of their income will be taxed at 23% – the same rate that these individuals would have had faced in the absence of the reform. Hence, we observe a reduction in the tax wedge for high-income earners.

Generally, only a very small share of taxpayers will fall into the middle and the top income brackets. According to our estimations, as many as 93.5% of all PIT taxable income earners will fall into the lowest income bracket, and only about 6.5% will fall into the second income bracket and about 0.5% will face the top PIT rate.

Apart from the progressive PIT schedule, the reform envisages important changes in the solidarity tax. As explained above, part of the revenues from the solidarity tax will be used to finance the top PIT rate. Therefore, even those (very few) taxpayers whose income will exceed the threshold for the top PIT rate, will not experience any increase in the tax burden because of the compensating change in the solidarity tax. Therefore, the reform will effectively reduce the tax burden on labour with very little effect on progressivity.

While lowering the tax burden is generally welcome, the motivation for applying the top rate to such a small group of taxpayers is not clear. For example, in their recent in-depth analysis of the Latvian tax system, the World Bank (World Bank, 2016) came up with a tax reform proposal that envisaged a considerably lower threshold for the top PIT rate, which, according to our estimations, would cover about 12% of the taxpayers. Given the limited budget resources and an especially high tax wedge on low wages, a more targeted reduction in the tax burden would be preferable. Similar concerns about insufficient reduction in the tax burden on low-income earners are expressed in the latest OECD economic survey of Latvia (OECD, 2017).

Effect on income distribution

Below we present the results from the tax-benefit microsimulation model EUROMOD. Figure 2 shows the simulated change in equivalized disposable income by income deciles compared to the baseline “no-reform” scenario in 2018-2020.

Figure 2. Change in equivalized disposable income by income deciles caused by the reform compared to “no-reform” scenario, %

Source: authors’ calculations using EUROMOD-LV model

The first thing to note is that these are mainly households in the middle of the income distribution who will gain from the reform – their income will increase due to both the increase in non-taxable allowance and the introduction of the progressive rate.

The gain in the bottom of the income distribution is smaller for several reasons. First, the proportion of non-employed individuals (unemployed and non-active) is larger in the bottom deciles. Second, individuals with low wages are less likely to gain from the reduction in the tax rate and the increase in the basic allowance, since they might already have most of their income untaxed due to the currently effective basic allowance. The same applies to pensioners who have a higher basic allowance than the employed individuals and who are mainly concentrated in the bottom of income distribution.

Our results suggest that the wealthiest households will also see their incomes grow as a result of the reform (by about 1% in 10th decile). The growth is ensured by the fact that annual income below 20,000 EUR will be taxed at a reduced rate of 20%, and, taking into account that even in the top decile only about half of the individuals get income from employment that exceeds 20,000 EUR per year, the gain from the tax reduction is considerable even in the top decile. A reduction in the tax allowance for high-income earners will have a negative effect on wealthy individuals’ income, but this will be more than compensated by the above positive effect of the change in the tax rate. Hence, the net effect on the incomes in the top deciles is estimated to be positive.

Finally, Table 2 summarizes the effect of the reform on the income distribution, measured by the Gini coefficient on equivalized disposable income. On the whole, the reform is estimated to slightly reduce income inequality – in 2020, the Gini coefficient is expected to be 0.6 points lower than it would have been in the absence of the reform. This reduction is mainly driven by the changes in the non-taxable allowance, while the three PIT rates are estimated to have an increasing impact on income inequality.

Table 2. Gini coefficient on equivalized disposable income in the reform and “no-reform” scenario

2018 2019 2020
“No-reform” scenario 35.2 35.4 35.7
Reform scenario 35.0 35.0 35.1

Source: authors’ calculations using EUROMOD-LV model

Conclusion

The 2018 tax reform was a long-awaited step from the Latvian authorities on the way to a more progressive tax system. The planned changes in the basic tax allowance are estimated to help reducing the tax wedge on low wages and help addressing the problem of high income-inequality.

At the same time, the second major aspect of the reform, the introduction of a progressive PIT rate, raises more questions than answers. The progressive rate, the way it is designed, will effectively lead to an across-the-board reduction of the tax burden on labor and will hardly help to reach the proclaimed objective of taxing incomes progressively. Given the limited budgetary resources and given that taxes on low wages will remain high compared to other countries even after the reform, a more targeted reduction of the taxes on low-income earners would have been a more preferred option.

References

  • OECD, 2017. “OECD Economic Surveys: Latvia 2017”, OECD Publishing, Paris. http://dx.doi.org/10.1787/eco_surveys-lva-2017-en
  • Sutherland, H. and Figari, F., 2013. “EUROMOD: the European Union tax-benefit microsimulation model”, International Journal of Microsimulation, 1(6), 4-26.
  • World Bank, 2016. “Latvia Tax Review”, available at http://fm.gov.lv/files/nodoklupolitika/Latvia%20Tax%20Review%20Draft%20231216%20D.pdf

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Higher Competition in the Domestic Market – A Way to Boost Aggregate Productivity

Posted on February 27, 2017 | Policy Brief

20170227 Higher Competition in the Domestic Market - FREE Policy Brief

Competition is a good thing not only because of lower prices and larger variety. Higher competition in the domestic market also shifts necessary labour and capital resources from less productive domestic-oriented firms to export-oriented productivity champions. Such firms will make better use of production factors and generate larger output. Thus, simply increasing the level of competition in the domestic market can boost the aggregate productivity of a country.

The aggregate productivity of a country can be boosted even without changing the productivity of individual enterprises. This can be achieved by improving the allocation of resources – the redistribution of labour and capital towards more productive firms. These firms will make better use of production factors and generate larger output. But how can one affect the allocation of resources? Economic theory says that allocation depends on the productivity of individual firms: more productive enterprises attract more labour and capital. However, there exists another factor behind allocation: distortions.

Distortions affect the allocation of resources

A model developed by Hsieh and Klenow (2009) – one of the most popular frameworks to study the allocation of resources – has a very important and realistic feature: it acknowledges that firms are not treated equally. Some firms may face lower supply of banking loans ending with higher capital costs. Other firms could confront with trade unions and higher wages. Tax rates may also differ across firms. These are all examples of distortions. Firms facing larger distortions are forced to underuse respective production factor, while firms that enjoy more favourable conditions tend to overuse capital and labour, generating more output.

While it is virtually impossible to imagine an economy without any distortions (the one where all firms face the same taxes, costs of labour, capital etc.), not all distortions damage the allocation of resources. Only distortions to productive firms create misallocation of resources by shifting labour and capital towards unproductive firms. Thus, removal of such distortions can improve the efficiency of allocation and raise the aggregate output of the country.

According to Hsieh and Klenow (2009) the distortions faced by every individual firm can be quantified from the balance sheets and profit/loss data. For example, observing lower-than-usual ratio of capital to intermediate inputs (comparing with other enterprises in a narrowly defined industry) indicates a capital distortion, possibly related with limited access to banking loans. Similarly, lower-than-usual share of wages in total production costs implies high labour distortions. Finally, the size of the distortion can be detected as a case of abnormally low share of intermediate inputs in total output, and signals about the restrictions to total output (e.g. due to higher taxes for large enterprises).

Misallocation of resources is small in Latvia

In my recent research (see Benkovskis, 2015), I use anonymised firm-level dataset for 2007–2013 and apply the Hsieh and Klenow (2009) model to study the allocation of resources in Latvia – a unique example of a small and open economy facing extreme structural shifts during the financial crisis. According to my estimates, the negative contribution of misallocation to aggregate productivity was close to 27% in 2013 (see Figure 1). In other words, it suggests that actual aggregate productivity could be boosted by 27% if all distortions were removed!

This may seem large but in fact 27% is a comparatively low figure. Hsieh and Klenow (2009) argue that full liberalisation would boost aggregate manufacturing productivity by 86–115% in China, 100–128% in India, and 30–43% in the US. Dias et al. (2015) show that removing distortions would lead to a 30% gain in output of Portugal in 2011. Thus, misallocation of resources is relatively small in Latvia. Even more important: the misallocation of resources decreased after the crisis in Latvia (contrary to the case of Portugal), adding more than 10 percentage points to aggregate productivity growth between 2010 and 2013.

Figure 1. Contribution from misallocation of resources to aggregate total factor productivity, %

Source: Benkovskis (2015). Note: shows the contribution of misallocation comparing with the counterfactual case of no distortions.

The finding that allocation of resources improved after the crisis is interesting per se, but uncovering the reasons behind the improvement is even more important. Figure 1 provides a decomposition, which shows that labour distortions are minor in Latvia due to high flexibility of labour market (in line with recent findings by Braukša and Fadejeva, 2016). The capital distortions, while being minor in 2007–2008, increased afterwards, pointing to some credit supply constraints faced by the highly productive enterprises after the financial crisis. However, by far largest contribution comes from the misallocation of intermediate inputs – the turnover of the most productive firms face some constraints. And it was the ease of constraints to turnover for the most productive firms that determined the improvements in aggregate productivity since 2010.

The level of competition matters for misallocation

My research stresses the importance of the competition level on the market, since higher competition serves as a natural constraint for the firm to increase its turnover. What if the most productive Latvia’s firms systematically come up against higher competition? I found that indeed this is the case. First, recent results by Fadejeva and Krasnopjorovs (2015) show that Latvia’s domestic market has lower competition level comparing with external markets. Second, it is widely acknowledged that exporters tend to be more productive comparing with domestically oriented firms (see e.g. Bertou et al., 2015, who report positive export premiums for EU countries, while Benkovskis and Tkačevs, 2015, find higher productivity of exporters in Latvia). Thus, Latvia’s productive export-oriented firms are subject to higher competition and cannot enlarge their turnover as easy as other entities. This shifts labour and capital towards small and less productive firms working solely on domestic market, creating the misallocation of resources.

The domestic competition factor can also explain the improving allocation of resources after 2010. The study by Fadejeva and Krasnopojorovs (2015) reveals that the competition gap between domestic and foreign markets narrowed after the financial crisis (see Table 1). Namely, life was too easy on the local Latvia’s market during the boom time, allowing unproductive firms to survive and drain away resources from more productive firms. But conditions became tougher after the crisis (although the competition level still remained lower than abroad). We can view this as a “cleansing effect of the crisis”: some of the least productive domestic oriented firms went bankrupt (or decreased their turnover), freeing the necessary capital and labour resources for productive exporters.

Table 1: Change in the competitive pressure on main product in domestic and foreign markets compared to the situation before 2008, %

Domestic market Foreign market
2008–2009 2010–2013 2008–2009 2010–2013
Strong decrease 2.9 2.2 0.9 1.0
Moderate decrease 11.8 3.8 7.6 5.9
Unchanged 33.8 24.7 45.7 51.5
Moderate increase 30.0 28.1 25.2 19.7
Strong increase 18.7 38.5 11.2 8.8
Does not apply 2.8 2.8 9.4 13.1

Source: Fadejeva and Krasnopjorovs (2015), Table A.102. Notes: based on the sample of 557 Latvia’s firms; results are weighted to represent firm population.

Conclusion

This research has an important policy conclusions applicable to any country that seeks to increase aggregate productivity. The competition level in the domestic market is important not only for consumers, who enjoy lower prices and higher variety. Higher competition in the domestic market also shifts necessary resources from less productive domestic-oriented firms to export-oriented productivity champions.

References

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Gaming the System: Side Effects of Earnings-Dependent Benefits

Posted on January 30, 2017 | Policy Brief

20170130 Gaming the System FREE Policy Brief Image

Today policy makers in developing and middle-income countries face tremendous challenges in combating various forms of tax evasion. Increasingly it is proposed to tie social security benefits to the reported income and in this way increase tax compliance incentives. We use administrative data from Latvia to study generous childcare benefits, which depend on the reported wages in the pre-childbirth period. Our analysis reveals pronounced wage growth shortly before the childbirth, which we rationalize by the legalization of previously undeclared wages. Obtained results show that the wage growth is temporary and lasts only until the end of the period, which is taken into account when calculating parental benefits.

Today policy makers around the world are increasingly preoccupied with reducing various forms of tax evasion. To provide tax compliance incentives it is often proposed to tie social security benefits to declared wages. For example, Kumler et al. (2013) show that a reform tying future pension benefits to the payroll tax in Mexico increased tax payments after the reform. Similarly, Cruces and Bergolo (2013) and Bergolo and Cruces (2014) demonstrate that a reform tying health care insurance of children to the reported earnings of parents increased “legal” labor supply in Uruguay.

On the other hand, Kreiner et al. (2016) document inter-temporal wage shifting in Denmark to enjoy significantly lower marginal tax rates. In light of the results by Kreiner et al. (2016), it is possible that employees and employers collude to increase the wage during the period, which is taken into account when calculating social security benefits. If the wage increase is temporary then the result of tying social security benefits to wages might be a net loss to the government finances. Hence, the question of whether tying social security benefits to reported wages is a solution to the problem of payroll tax evasion is still open.

We demonstrate that tying social security benefits to the declared wages can backfire to the extent that it can lead to the excessive payments of social security benefits, while doing almost nothing to reduce payroll tax evasion, in this way producing net fiscal loss to government finances. More specifically, we show that if the contribution period that determines the size of the benefit is relatively short and social security benefits are generous, then by colluding, employees and employers can temporally increase the legal wage to extract generous benefits afterwards. This result can have implications for the design of social benefit systems in many countries, where relatively short contribution periods ensure generous long-lived benefits afterwards.

Institutional background and methodology

We illustrate this phenomenon by studying the childcare benefit in Latvia, which in 2005-2008 depended on parents’ declared wage in the pre-childbirth period. This system, introduced in 2005, replaced a universal (very modest in size) childcare benefit. The new rules foresaw that one of the parents could receive a benefit that was equivalent to the parent’s previous net wage until the child became one year old. The average wage that determined the size of the benefit was calculated over the 12-months period that ended three months before the childbirth (hereinafter – benefit qualification period) and therefore included 5 months of pregnancy. Initially the benefit was not compatible with employment but as of March 2007 it became possible to simultaneously work full-time and receive the benefit.

Presumably, the 2005 reform created incentives to report higher earnings before the childbirth, because of the generosity of the new benefit and because the benefit qualification period included pregnancy, i.e., the period when the mother knows if/when she will be eligible for the benefit. To uncover the effects of the incentives to report more income, we use administrative data on declared monthly wages and use three sources of identifying variation in a difference in differences setup.

First, we compare wage growth during pregnancy with wage growth of women who did not become pregnant. The identifying assumption is that, in the absence of pregnancy, the wages of women who became pregnant would follow the same trend as the wages of other women. Under this assumption, any difference in the wage growth can be interpreted as a legalization of previously undeclared wages. However, this assumption may not hold because pregnancy is not randomly assigned across women: women can anticipate a wage increase (e.g. anticipate a promotion) and adjust the decision to have a child. Therefore, we use a second source of identifying variation by comparing wage growth during pregnancy for women employed in the private sector with wage growth for women employed in the public sector, where tax evasion is presumably absent. Assuming that promotion anticipation effects in the private and the public sector are identical, this difference in wage growth can be interpreted as the growth of wages resulting from wage legalization.

Our previous assumption might be violated if promotions in the public sector can be easier to predict (which means that anticipation effects in the private and the public sectors are not necessarily identical). To address this challenge, we use a third source of identifying variation coming from the 2005 reform, which tied the childcare benefit to the previous earnings. Since this reform increased incentives to disclose higher earnings during pregnancy, the difference in wage growth in the private sector versus public sector should not be observed before the reform.

Estimations are based on a matched employee – employer administrative dataset, which covers monthly-declared earnings of all employed workers in Latvia from 1996 to 2010.

Results

There are three main findings. First, wage growth during the first five months of the pregnancy in the private sector is always higher than that in the public sector. If we use this observation to obtain an estimate of the wage growth due to the legalization of previously undeclared wages, we find, depending on the regression specification, that it varies between 5 and 7 percent.

Second, this effect is mainly driven by the time period after the reform of 2005 (see Figure 1). Thus, if we use the time period before the reform of 2005 only to difference out permanent differences in the anticipation effects between public and private sector, our preferred regression specifications provide us with an estimate that varies from 5 to 6 percent.

Figure 1. Difference-in-difference-in-difference estimate by year, %

Note: difference in difference in differences estimate for a given year is calculated by first comparing wages of pregnant women with those of not pregnant before and during first five months of the pregnancy. Then this estimate is compared between public and private sectors. Everything is compared with respect to one year before the reform announcement – 2003.

The final finding shows that the sharp jump in the wage growth in private sector versus the public sector starts to appear exactly in the first month of the pregnancy (see Figure 2). It is important to note that we do not see any differential wage growth between the public and the private sector before the date of conception, indicating that potential anticipation effects are limited.

Figure 2. Difference-in-difference-in-difference-in-differences estimate by pregnancy month, %

Note: difference in difference in difference in differences estimate for a given month is calculated by first comparing wages of pregnant women with those of not pregnant in a given month with respect to one month before the date of conception. Then this estimate is compared between public and private sectors and finally previously calculated difference is contrasted before and after the reform tying parental benefits to reported wages.

Due to the fact that many women do not return to the same employer after childbirth, it is problematic to make inferences about the wage a woman receives once she returns to the labor market. To overcome this challenge we use the same social security data for men for the time period covering January 2007 until August 2010.

As explained previously, starting in March 2007 the childcare benefit became compatible with full time employment. The outcome of this reform was that many men started to receive the benefit, while continuing to work. This allows us to perform the previous analysis for the sample of men.

Results presented in the Figure 3 show that similarly as in the sample of women we see a sharp increase in the wage during the qualification period. Additionally, we see a slowdown in the wage growth once the qualification period ends. It is important to mention that displayed coefficients describe the difference between public and private sector in the change in wages between men whose partners became pregnant and those who did not with respect to the reference period (here one month before the conception date). We also record a sharp growth in wages in the public sector in the months following the childbirth. On the contrary, wages in the private sector stay the same, hence the large difference in the months following the childbirth.

Figure 3. Difference-in-difference-in-differences estimate for men by month of partner’s pregnancy, %

Note: difference in difference in differences estimate for a given month is calculated by first comparing wages of men whose partner became pregnant with those men whose partner did not become pregnant with respect to one month before the date of conception. Then this estimate is compared between public and private sectors

Conclusion

Drawing on the example of the childcare benefit in Latvia, we show that declared wages sharply increase during the period that is taken into account when calculating social security benefits. This wage growth is temporary and does not continue once the benefit qualification period is over. We interpret this phenomenon as the legalization of previously undeclared wages: this temporary legalization of earnings is possible, because the benefit qualification period is relatively short (12 months), and includes 5 months of pregnancy, which makes the average wage during the qualification period relatively easy to affect. Such setting creates bad incentives – an employee and an employer can collude to increase the average wage that determines the size of the benefit.

Additionally, our research casts doubts on policies tying parental benefits to declared earnings with an aim to reduce opportunity costs of high earners and increase their fertility. Researchers analyzing such policies should be very cautious when interpreting their results because the effect that they capture might not come from high earning women, but rather from women who manage to increase their income during pregnancy. Absent monthly data, it might be challenging to disentangle the two.

Many countries implement earnings-dependent benefits. Our results show that even very well designed social security benefits can and will be abused if people are given wrong incentives. Thus to achieve the best outcomes policy makers when deciding whether to tie social security benefits to declared earnings should take into account side effects described in this brief.

References

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The Political Economy of the Latvian State Since 1991: Some Reflections on the Role of External Anchors

Posted on February 2, 2015 | Policy Brief

This brief discusses the role of external anchors or goals such as WTO accession, NATO and EU accession in Latvia’s development strategy since 1991. On the one hand the external goals ‘depoliticised’ many potentially contentious areas of Latvian life. On the other hand, some developments would not have happened or would not have happened as fast without the constraints imposed by the external goals. For example liberalisation of the citizenship laws was prompted by NATO accession and the balance was tipped when the rejection of Latvia from fast-track EU accession talks in December 1997 led Latvia to abandon its quota or ‘windows’ naturalisation system. Most recently, Eurozone accession was an externally defined exit strategy from the austerity episode induced by the economic and financial crisis. Today there are no big external goals left to guide policy making. Home grown problems such as inequality require home grown solutions. But even now an external dependency persists. For example a long needed reform of the financing model of higher education has had to wait for a World Bank report published in September 2014 for action to be taken.

On January 1st, 2015 Latvia assumed the Presidency of the European Union. This milestone represents a certain level of maturity of the Latvian state and offers an opportunity for reflection on some aspects of how politics and political economy have evolved in Latvia between 1991 and today.

After Latvia regained independence in 1991, it faced (at least) two political economy challenges: one was to disentangle the economy from the Soviet system in which it had been deeply integrated, and the second, perhaps more difficult challenge, was to create an independent nation state. At a formal level, the solution to the latter challenge appeared straightforward – assume continuity of the Latvian state. Effectively this meant reinstating the pre-war constitution, which was indeed done for the most part. Symbolically this continuity was signalled by, for example, calling the first post-Soviet parliamentary elections held in June 1993 the elections for the 5th Saeima (parliament). The elections for the 4th Saeima had taken place more than 60 years earlier in October 1931.

At a practical level the challenges were more complex – Latvia had had no practical experience of statehood for nearly fifty years and mistakes were made. For example, Latvia initially diplomatically recognised Taiwan rather than the Peoples Republic of China.

There was a presumption that newly independent Latvia should become a market economy but little consensus on how this should be achieved. This is in contrast to Estonia where a group of ‘young market economy Turks’ were able to implement a kind of zero option i.e. zero tariffs, fast privatisation, etc. In Latvia there were strong protectionist sentiments and the initial privatisation was a muddled process.

Advice and advisers were abundant in post-independence Latvia. In the early 1990s, Latvia was awash with international advisers: the IMF and the World Bank were both present, the Germans were advising on a constitution for the Bank of Latvia, the British were active in public administration reform, the Danish advised on research and higher education and so on. Advice was often conflicting with different advisers promoting their own visions of structures as models that Latvia should adopt e.g. on legal and education systems. Today, we see something akin to this in the Eastern Partnership countries such as Moldova and Ukraine.

There was a general sense of the desirability of a ‘return to Europe’ but no plan or strategy. Nevertheless, even without a conscious plan a strategy emerged – namely a strategy of external anchors.

The external goals or anchors that emerged included the following:

  • World Trade Organisation, 1998
  • NATO, 29 March 2004
  • European Union, 1 May 2004
  • Eurozone, 1 January 2014

The most important effect of the external anchors was that they ‘depoliticised’ many potentially contentious areas of Latvian life. This has been particularly important given the fragmentation that has historically dominated Latvian politics. Thus, in the interwar period, no less than 32 different political parties were represented in the Saeima. In the early post-Soviet parliaments, similar tendencies were observed with newly created parties being the winners in terms of the number of seats in the first four elections. The election of 2006 was the first in which the previously largest party returned as the largest party. Between the first post-Soviet election in 1993 and the 2014 election, there have been no less than 17 governments which mostly have been uneasy coalitions of 3 or 4 partners with divergent views and interests. In this context the benefit of external anchors is self-evident.

The external anchors each contributed in different ways: WTO accession contributed to modify the protectionist sentiments that were rife in the early years of independence. Rather curiously, Estonia, which adopted a radical free trade policy right from the first days of independence, had more difficulties in achieving their WTO membership than ‘protectionist’ Latvia. Estonia was obliged to implement additional economic regulations in order to conform to the rules of the WTO and the EU (to which it was committed to join as its WTO application proceeded), and as a consequence, Estonian WTO accession was delayed to 1999. The WTO accession process also gave Latvia’s fledgling Foreign Ministry invaluable experience of multi-lateral negotiation.

Apart from the obvious security benefit, NATO membership was conditional on the creation of the Latvian anti-corruption Bureau (KNAB) and on the liberalisation of citizenship legislation, the latter because NATO was concerned about the prospect of a member state with a large number of non-citizen residents.

EU accession represents the biggest and most significant anchor. The requirement of candidate countries to accept the EU acquis communautaire took huge swathes of economic and social legislation out of the political arena. While the economic criteria for accession presented few difficulties of principle for Latvia – most people were in favour of a market economy – the requirement of respect for and protection of minorities presented problems for many Latvian politicians and liberalisation of the citizenship law was resisted until after 1997 when the rejection of Latvia from fast-track EU accession talks in December 1997 prompted a rethinking of Latvia’s intransigent position on the quota or ‘windows system’.

It is hard to over-estimate the impact of EU accession on Latvia. What would Latvia be like today if it were not a member state of the EU? There are sufficient tendencies even now in Latvia to suggest we would observe something like a tax-haven, off-shore economy, probably with weak democratic institutions. EU accession has saved the Latvian people from something like such a fate.

Even later in Latvia’s largely self-inflicted financial and economic crisis of 2008-10 it was the ‘Holy Grail’ of accession to the Eurozone that politically anchored Latvia’s famous austerity programme.

What of today? The ‘big’ external anchors are used up, and Latvia today:

  • Is the fourth poorest country in the EU with GDP per capita in 2013 at 67% of the EU average (only Croatia, Romania and Bulgaria are poorer);
  • Is a particularly unequal society – Latvia has some of the worst poverty and inequality indicators in the EU;
  • Has a shadow economy at 23.8% of GDP (data on 2013; Putniņš and Sauka (2014)); and
  • Has an internationally uncompetitive higher education system.

These and other problematic aspects of Latvian life and society are home grown and it is hard to imagine external anchors that can improve poverty or inequality, that can reduce the size of the shadow economy, or which can improve the quality of the Latvian higher education system.

Nevertheless, Latvian policy makers seem to be addicted to the external anchor concept and often find difficult to progress without it. The recent experience of reform of the financing of higher education illustrates. Latvia has historically had a funding mechanism for universities and other higher education institutions based entirely on student numbers. The lack of a link between funding and quality has resulted in a Latvian higher education system that is strong on enrolment but low on quality e.g. as measured by peer-reviewed publications. At some level this has been understood and there has been much talk of reform. Although various reports and evaluations have been published, there has been little progress on concrete reform until the Ministry of Education commissioned the World Bank in December 2013 to produce a report on funding models for Latvia. The final report was delivered in September 2014 and action has now been taken to adopt the World Bank recommended three-pillar model where the funding criteria will now include performance and innovation.

Of course, the new model will not solve all the problems of Latvian higher education – far from it – but it illustrates the pervasive nature of policy makers seeming dependency on external anchors.

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References

  • Putniņš, Tālis & Arnis Sauka (2014). “Shadow Economy Index for the Baltic Countries. 2009-2013,” The Centre for Sustainable Business at SSE Riga, May 2014.

And Then There Were Eighteen? Will Latvia Join the Euro Zone in 2014?

Posted on February 4, 2013 | Policy Brief

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Latvia’s government is zealously preparing for accession to the Euro Zone. Prime Minister Valdis Dombrovskis is expected to request the European Central Bank (ECB) and European Commission (EC) prepare their respective convergence reports on Latvia’s readiness to enter Economic and Monetary Union (EMU) within the next two months. The expectation is that Latvia will join on 1 January 2014. Indeed, the three-party coalition government has long been readying for the technical changeover to the euro. The Cabinet of Ministers adopted a detailed national euro changeover plan in September 2012 and appointed a high-level steering committee to manage the process. The government has launched a controversial multi-million euro advertising blitz aimed at winning over Latvia’s skeptical public.[1]  Parliament passed the law on euro adoption in a 52-40 vote on 31 January 2013.

What could possibly go wrong? Although unlikely, a referendum or the collapse of the Dombrovskis coalition government could yet derail Latvia’s euro ambitions.

Latvia and Europe

All Latvian governments have steered a steady pro-Western course in the two decades since the fall of the Soviet Union. International recognition was followed by membership of the Council of Europe, World Bank and the other minor and major international organizations that make up the international community. However, the big attractions were the Western clubs – NATO and the European Union. Membership of both was achieved in the two ‘big bang’ enlargements of 2004. In all the giddy excitement of finally joining the Western world and seemingly slipping away from Russia’s bear-hug, Latvia initially aimed to quickly join the Euro Zone, setting a target of 1 January 2008.

However, the government proved half-hearted in its efforts, preferring to enjoy the low-hanging fruit of a cheap credit-driven booming economy rather than balance the budget. Both government and public entered a period of rabid consumption and spending that resembled nothing so much as sailors in a pub after a year at sea. Unsurprisingly, Latvia rapidly slipped far away from meeting the Maastricht criteria on inflation. Accession to the Euro Zone was quietly dropped from the political discourse.

However, euro adoption returned as a frontline government initiative after the dramatic economic collapse of 2008, and the advent to power of Valdis Dombrovskis, the Baltic Angela Merkel. Dombrovskis will soon have been in power for four years, a lifetime in Latvian politics where, prior to Dombrovskis, the average prime minister served for less than a year.[2] He has overseen harsh austerity measures of tax hikes and spending cuts, but remains surprisingly popular (not least because his party was in opposition during the post-2004 economic bubble years). He has twice been re-elected to office, proving once again that Latvians favour monochrome technocrats over colourful populists.

Despite a return to growth (in 2012 Latvia recorded the highest GDP growth in the EU), the government has maintained tight control over spending. Indeed, it has even perhaps been over-zealous, with both the IMF and EU recently chipping in with criticism of the social spending cuts that Latvia has made to its 2013 budget.[3] Nevertheless, Latvia is now applauded as a model of austerity and frequently used as a positive contrast to Greece.[4]

Moreover, Latvia is now on the cusp of meeting the Maastricht criteria for accession to the Euro Zone. A January 2013 IMF staff report argued that Latvia meets the public debt and budget deficit criteria, although inflation and interest rates may be a hurdle depending on the EU member states used for the reference value calculation (will Greece be treated as an outlier?).[5] The informal political signals from both the EC and ECB are clearly positive. However, euro accession could still be derailed by either a referendum or a change of government.

Let the People Decide?

The biggest potential hurdle remains the threat of a public referendum. The EC and ECB will not contemplate Latvia’s accession to the euro zone with the Damocles Sword of a referendum hanging over the process. Moreover, public support for the euro remains low, with just 8% of the public wanting the euro introduced quickly and 41% being absolutely opposed to the currency.[6] A vote would be a real throw of the dice.

A citizen’s initiative aiming to delay euro adoption, by demanding a vote on the timing of accession, was submitted to Latvia’s electoral authority (by the awkwardly named Latvia’s Social Democratic Movement for an Independent Latvia, a fringe party that has never been elected to parliament) in late 2012. The Central Election Commission must make a final decision on whether to allow the initiative to go ahead by February 3. However, the legal opinions provided by scholars, the Latvian ombudsman’s office and the Latvian parliament’s legal advisers indicate that the initiative is likely to be rejected because:

  • Latvians effectively voted to join the euro when voting on accession in 2003;
  • The Council of Ministers is the only institution authorized to choose the date of accession to the euro zone, thus any initiative specifying a date (or conditions that need to be met) is not legal;
  • The text of the initiative conflicts with the constitution.[7]

While the ruling could be challenged in Latvia’s Constitutional Court or a reworded initiative submitted to the Central Election Commission, the weight of the legal opinions already delivered indicates that these efforts would be unlikely to succeed. At worst, the uncertainty could delay euro adoption past January 1, 2014 (and the Latvian legal system can certainly be ponderous at times). The same is true of any parliamentary attempt to initiate a referendum by having a one-third minority of deputies force the president to sit on the euro adoption law while citizens sign an initiative.[8] Indeed, legal opinions cited by the President state that because euro introduction is a treaty obligation, a majority of parliamentarians (51 of 100) would need to sign any initiative attempting to call a referendum. The opposition will not be able to rustle up a majority of parliamentary deputies (although the legal haggling could delay the date of euro adoption).

Coalition Collapse?

The other risk is a collapse of the government coalition. While the Reform Party and the prime minister’s Unity Alliance are firm supporters of euro adoption, the third coalition member – the radical right populist National Alliance is more torn. Its rank and file membership is largely against the euro, primarily for nationalist reasons (they see the Latvian Lat as a symbol of sovereignty and national identity). One NA parliamentarian even broke coalition ranks and voted against euro adoption. A motley conglomeration of far right radical groups and nationalist intellectuals has begun speaking out against the ‘commercialization’ and ‘westernization’ of Latvia, and sees the euro adoption battle as the opportunity to draw a final line in the sand. They are likely to put the National Alliance’s ministers and parliamentary deputies under severe pressure.

Indeed, the National Alliance already played the ‘euro card’ in November 2012, successfully extracting budgetary concessions for pet projects from Prime Minister Dombrovskis. They may well play it again, as they seek a greater number of ministerial portfolios. However, as Dombrovskis pointed out, opening up of the coalition agreement could well lead to the collapse of a government already creaking at the edges.

Conclusion: After Dombrovskis

There is strong political resolve to lever Latvia into the Euro Zone. Moreover, the unusual confidence emanating from both government officials and the Bank of Latvia indicates that certain reassurances have been made in Brussels and Frankfurt. Indeed, Latvia’s glowing current reputation as the poster child of austerity gives it a once-in-a-decade political momentum. Latvia’s entry into the euro on schedule on January 1, 2014 is more likely than not.

However, looking to the future, one pertinent question needs to be addressed. Which Latvia will we see in the Euro Zone? The grey, serious, disciplined almost Teutonic Latvia of Valdis Dombrovskis? Or the reckless drunken sailor, that has marked much of Latvia’s post-communist era?

Naturally, Dombrovskis holds the key to this question. He is expected to leave domestic politics after the October 2014 parliamentary election, probably to cash in his international political capital with a well remunerated European post (the timing is right for a 2014-2019 European Commissioner portfolio). At best, if re-elected, he might be persuaded to stay on to oversee Latvia’s presidency of the European Union in 2015.  In any case, while Latvia has been reborn as a paragon of economic virtue under his watch, these assets have not been institutionalized. Dombrovskis will leave behind the same old fractured, frail and quarrelsome parties, politicians and oligarchs that he inherited. Recent international criticism of disequilibrium in government welfare and tax policies hints that political backsliding has already begun.

Latvia is at its strongest when its political, economic and administrative elite units in pursuit of some concrete target. Independence from the Soviet Union, then NATO and EU accession, followed by harsh austerity measures and now even Euro Zone accession were achieved far quicker than many observers had believed possible. International conditionality has made up for the absence of ideology and ideas as moral and political compasses in Latvian politics. However, when left to their own devices, Latvian politicians have tended to run amok. After Latvia enters the Euro Zone it will be left without an all-encompassing political plan. Quite frankly, that is rather worrying.

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References

 

[1] See the Latvia euro changeover site. Available at:  http://www.eiro.lv

[2] Pettai, Auers and Ramonaite (2011), ‘Political Development’ In Marju Lauristin (ed.), Estonian Human Development Report 2010/2011: Baltic Way(s) of Human Development: Twenty Years On. Tallinn: Eesti Koostoo Kogu. 144-163.

[3] Aaron Eglitis (2013), ‘EU joins IMF in criticizing Latvian cuts to tax, social spending’. Bloomberg news.

[4] Anders Aslund, an ardent cheerleader of Latvia’s austerity programme, puts the country’s success down to ‘front loading’ reforms, particularly fiscal adjustment . See Anders Aslund (2013) ‘Why austerity works and stimulus doesn’t’.

[5] IMF Staff Report No. 13/28 (January 2013). Also see Swedbank Analysis (1 August 2012). ‘Fulfilling the Maastricht Criteria – mission possible for Latvia and Lithuania?’

[6] Although another 42% had a positive attitude towards the euro, but did not want to see it hurriedly introduced. See DNB Banka (November 2012), ‘Latvijas Barometrs: Eiro ieviešana Latvijā’.

[7] The legal opinions can be found on the Central Election Commission’s homepage.

[8] See Article 1, paragraph 3 in the law on referendums and initiatives.

The Distributional Impact of Austerity Measures in Latvia

Posted on February 6, 2012 | Policy Brief

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For a country of its size, Latvia was mentioned in the last decade’s macroeconomic discourse remarkably often: first, for its exceptional growth up to 2007, then – for a dramatic GDP contraction in the aftermath of the 2008 financial crisis, and for the so-called “internal devaluation” policy that was the cornerstone of Latvia’s recovery strategy. Now, when GDP recovery is underway for 9 quarters, Latvia is held up as an example of a country that paved its way out of the crisis with decisive and timely budget austerity measures. The size of budget consolidation package was remarkable, reaching almost 17% of GDP in 2008-2011. Today, when there is so much talk about austerity in the context of the Eurozone debt crisis, Latvian consolidation experience is of particular interest. In this brief, we are looking at the distributional impact of selected implemented austerity measures, using a microsimulation tax-benefit model EUROMOD. Our results suggest that the impact of these measures is likely to have been progressive, meaning that rich population groups are bearing a larger part of the burden.

From Boom to Recession

The “Baltic Tigers” – a term coined to praise the Baltic countries for their dynamic development in the 2000s, especially after their accession to the EU in 2004. During 2004-2007, average annual GDP growth in the Baltics exceeded 8% (in Latvia average growth was 10%). The growth was to a large extent driven by an externally financed credit bubble, leading to overheating of the Baltic economies: inflation was skyrocketing, unemployment was at historically low levels, and current accounts posted double-digit deficits. Before the outbreak of the crisis, the Latvian economy was in the most vulnerable position: Estonia was better situated thanks to prudent fiscal policy implemented in the “good” times, whereas Lithuania was less exposed thanks to its private sector being relatively less indebted.

The growth slowdown in Latvia began in 2007 and was initially triggered by the government’s adopted “anti-inflation plan” and the two of the biggest banks’ actions aimed at restricting credit expansion. Altogether, this initiated a decline in real estate prices. By December 2007, the average price of a square metre in a standard-type apartment in Riga had fallen by 12% from its peak in July (Arco Real Estate, 2008). Construction, retail trade and industrial production growth slowed down in the second half of 2007. GDP quarter-on-quarter growth approached zero by end-2007 and turned negative in the 1st quarter of 2008. In August 2008, the second largest Latvian commercial bank, domestically owned Parex Bank, faced deposit run and was unable to finance its syndicated loans, and in November 2008, the Latvian government took the decision to nationalize the bank. By the 3rd quarter of 2008, GDP quarter-on-quarter contraction exceeded 6%. The budget revenues lagged behind the expenditures, resulting in a gradually growing budget deficit, which reached about 5.5% of GDP in the 3rd quarter of 2008 (see Figure 1).

Figure 1: Year-on-year growth of general government budget total revenues, tax revenues and expenditures, %; seasonally adjusted budget balance, % of GDP

Source: Eurostat, authors’ calculations

In circumstances where the fiscal position was quickly deteriorating but world financial markets were frozen, the Latvian government was forced to seek financial assistance from international lenders. After tough negotiations in November and December 2008, Latvia received a 7.5 billion euro (about 1/3 of GDP) bailout facility from the IMF, the European Commission, the World Bank and the Nordic countries. Latvia received the funding in a series of tranches, with the transfer of each tranche being subject to implementation of a strict reform package agreed with the lenders.Given that introduction of the euro in 2014 remained the Latvian government’s target, one of the key elements of the reform programme was maintaining the lat’s peg to the euro. Therefore, the Latvian government had to accept especially strict and wide-ranging budget consolidation measures.

Budget Consolidation

The total size of budget consolidation achieved in 2008-2011 was impressive: overall, the fiscal impact of the reforms is estimated at 16.6% of GDP (Ministry of Finance of Latvia, 2011). Under the pressure of international lenders, budget consolidation was front-loaded and was achieved astonishingly fast – the fiscal impact of the reforms implemented in 2009 reached almost 10% of GDP, whereas the impact of 2010 and 2011 year measures was much smaller – 4.1% and 2.6%, respectively (see Figure 2).

Figure 2: Size of the implemented consolidation measures and budget deficit outturn, % of GDP*

* Budget deficit in 2011 is the Bank of Latvia’s autumn forecast
Source: Ministry of Finance, Bank of Latvia, Eurostat

Yet the way the consolidation was done was rather chaotic. The 2009 consolidation was mainly implemented by expenditure cuts, including strong wage and employment reductions in the public sector (public pay and employment cuts were continued in the following years, wages were cut by 15-20% in each round and most bonuses were abolished). On the revenue side, the government stuck to the goal of shifting tax burden from labour to consumption, thus the consolidation was mainly achieved by raising indirect taxes, while the personal income tax was reduced. Another line followed by the government at the time was to strengthen support to those affected by the crisis, for example, the duration of unemployment benefits was increased.

Nevertheless, by the time preparation of the 2010 budget started, it became clear that in circumstances of continuing GDP fall and peaking unemployment (in 2009, GDP fell by 17.7%, and the rate of unemployment reached 17.1%), the reduction in labour taxes could not be sustained while the social budget could not bear the burden of growing expenditures. Consequently, the reduction in the personal income tax was reversed (the tax rate was raised even above the pre-crisis level). To consolidate the social budget, the government implemented an across the board cut by introducing ceilings on the size of many benefits. In 2011, the tax burden on labour was further increased by raising the rate of mandatory social security contributions.

Budget consolidation was done under the pressure of the crisis and the reform package was designed in a great rush. What also may not be disregarded, is that the three years – 2009, 2010 and 2011 – were election years in Latvia: in 2009, there were local government elections, in 2010 – parliamentary elections and in 2011 – parliamentary re-elections . Elections have arguably affected the composition of implemented austerity measures. Thus, in June 2009, just ten days after local government elections, amendments to the Law on State Pensions were passed, which stipulated that old-age pensions should be cut by 10%, but pensions to working pensioners should be cut by 70%. This decision caused a strongly negative public reaction and on December 21, 2009, the Constitutional Court ruled that the government’s decision was unconstitutional arguing that the state must guarantee peoples’ right to social security. In the following budget consolidation rounds, even in the face of convoluted IMF recommendations to find a constitutional way of ensuring sustainability of the pension system (IMF, 2010), the government remained strictly opposing any pension cuts.

The mix of implemented reforms is crucial not only because it determines the effectiveness with which the budget consolidation is achieved. What is equally important is that the mix of reforms affects the distribution of costs of the crisis and shapes the economic recovery path. The consequences of the crisis – the dramatic rise in unemployment and wage reductions in the private sector – had a strong impact on incomes, yet policy makers can do little to directly affect this process. On the other hand, policy makers can offset or aggravate those effects by implementing reforms, such as those that made up the austerity packages. In this brief, we assess the distributional impact of selected austerity measures, which were implemented in 2009 – 2011.

Modelling Approach and Limitations

We use the Latvian part of the tax-benefit microsimulation model EUROMOD and follow a similar approach as that taken by Callan et al (2011). We limit our analysis to reforms in direct taxes, social contributions, and cash benefits . In particular, the following austerity measures are included in the analysis:

  • removal of income ceiling for obligatory social insurance contributions (in 2009);
  • increase in the rate of social insurance contributions for employees, employers, and self-employed (June 30, 2011);
  • reduction of tax exemptions (July 1, 2009);
  • increase in the rate of personal income tax (2010);
  • introduction of benefit ceiling for unemployment benefits (2010), maternity, paternity, and parental benefit (November 3, 2010);
  • cuts in state family benefit (2010);
  • cuts in child birth benefit (2010);
  • reduction in the amount of parental benefit by limiting eligibility to non-working parents only (May 3, 2010);
  • making stricter income assessment criteria for guaranteed minimum income (GMI) and reducing amount of the GMI benefit for some groups (2010).

We assess the distributional impact of these austerity measures by comparing two alternative scenarios:

  1. the baseline scenario – simulation of 2011 tax-benefit policy system (with austerity measures implemented), and
  2. the counter factual scenario – simulation of tax-benefit policy system that would have emerged in 2011 in the absence of austerity measures.

If a policy was changed as a part of the austerity package (e.g. income tax increase), we implement a pre-austerity policy (e.g., reduce the income tax to its pre-austerity level). However, if the changes in the policies were regular (e.g. an increase in minimum wage that was planned long before the discussion of austerity measures had started) or not related to austerity measures (e.g. increase in duration of unemployment benefit) we include them in the counterfactual scenario, as well as in the austerity package scenario. By defining the counterfactual scenario in this manner we focus on the impact of austerity measures only holding other things equal.

Despite Latvia is one of the countries where the size of the austerity package was especially large, the distributional effect of the implemented measures has not been analysed neither before nor after the policies had been implemented. Until recently Latvia didn’t have a national microsimulation model which could be used to assess the impact of taxes and benefits on household income. This paper is the first attempt to do this.

However, our analysis is subject to some drawbacks. First, EUROMOD’s input data is based on the European Union Statistics on Income and Living Conditions 2008 (with the income data referring to 2007). We adjust 2007 incomes up to 2011 using updating factors based on the aggregate evolution of such incomes according to national statistics. However, we do not adjust for the changes in the labour market that happened during this period. Therefore, we estimate the effect of austerity measures on data that represent the population with pre-crisis labour market characteristics (e.g. relatively low number of unemployed people).

Second, the analysis is limited to the direct impact of the implemented measures, disregarding the secondary effects such as e.g. behavioural responses of people on the implemented policies.

Results

The simulation results suggest that the impact of the analysed austerity measures was progressive with top income groups being the most affected (see Figure 3). The six countries considered in Callan et al (2011) show different degrees of progressivity: Greece demonstrated a clearly progressive impact, while Portugal was the only country where the effect was regressive. The result for Latvia is likely to be a consequence of introduced ceilings on contributory benefits, as well as the increases in income tax and social insurance contributions. While income tax in Latvia is flat (except for a relatively small untaxed personal allowance), the lowest income deciles contain proportionately more unemployed people and pensioners.

Figure 3: Percentage change in household disposable income due to austerity measures by income deciles

Source: based on own calculation using EUROMOD

Higher progressiveness was observed for households with children (see Figure 4), which is explained by the introduction of ceilings on child-related contributory benefits. At the same time, the impact on the households with elderly was more even.

Figure 4: Percentage change in household disposable income due to austerity measures for different types of households by income quintiles



Source: based on own calculation using EUROMOD

While the introduction of austerity measures made all income groups poorer, progressivity of the impact reduced income inequality. The Gini coefficient of the counter factual scenario is 1 percentage point higher than that of the base scenario. After implementation of the austerity measures, the poverty line decreases because the median income decreases. As a result, poverty rates using relative poverty lines decreased. The poverty rate of the elderly was affected the most, because pension income was not cut and pensioners became relatively better off as compared to other population groups. However, if measured against the fixed poverty threshold, the poverty rate increased in all population groups (see Table 1).

Table 1: Poverty rates and Gini coefficient before and after implemented austerity measures

Source: based on own calculation using EUROMOD

Concluding Remarks

The austerity measures analysed in this paper have had a progressive impact, with the richest population groups likely to be bearing most of the costs. This result should be interpreted with caution. It should be taken into account that we do not model all of the austerity measures that were implemented in 2009-2011. E.g., we do not model the impact of changes in VAT rates, which is likely to have been quite strong and regressive.

Latvia is a society with extremely high income inequality. For example, the income quintile share ratio calculated by the Eurostat (S80/S20), which measures income inequality, in 2009 was the second highest in the EU (6.9 as compared with an EU average of 4.9). It is unlikely that the progressive impact identified in this paper will significantly reduce income inequality gap in Latvia relative to other European countries.

References

  • Arco Real Estate (2008). Real estate market overview (Sērijveida dzīvokļi, 2008. gada decembris)
  • Callan, Tim, Chrysa Leventi, Horacio Levy, Manos Matsaganis, Alari Paulus & Holly Sutherland (2011). “The distributional effects of austerity measures : a comparison of six EU countries”, Social situation observatory, Research note 2/2011.
  • International Monetary Fund (2010). Republic of Latvia: Second Review and Financing Assurances Review Under the Stand-By Arrangement, Request for Extension of the Arrangement and Rephasing of Purchases Under the Arrangement and Request for Waiver of Nonobservance and Applicability of Performance Criteria. IMF Country report No. 10/65, March 2010.
  • Ministry of Finance of Latvia (2011). Budget consolidation in 2008-2011 (Veiktā budžeta konsolidācija laika posmā no 2008.-2011. gadam)