Tag: Latvia

Foreign-Owned Firms and Labor Tax Evasion in Latvia

Posted on November 29, 2021 | Policy Brief

20211128 Foreign-Owned Firms Image 01

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.

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

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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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Latvia Stumbling Towards Progressive Income Taxation

Posted on November 16, 2015 | Policy Brief

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The 2016 budget includes measures aimed at increasing the progressivity of the Latvian income tax system. In this brief we report some exercise on the impact of these measures using the Latvian EUROMOD tax-benefit microsimulation model. We show that by their design, the reforms are aimed at a reduction in income inequality and an increase in the progressivity of the tax system. However, there are risks that the behavioural response of the tax payers will subvert the intended impact of the reforms.

Ever since it was introduced in 1994 the Latvian personal income tax has been applied at a flat rate, albeit varying over time, mitigated only by a small untaxed personal allowance. Partly as a result of this, the Latvian tax-benefit system redistributes less original income than most other EU countries. Is this all about to change? The 2016 budget currently being debated in the Parliament contains two proposals aimed at introducing more progressivity in the personal income tax. These are the introduction of a “solidarity tax” aimed at high earners and the introduction of an earnings differentiated non-taxable allowance. The stated aims of these measures are to reduce inequality and help low wage-earners.

Description of the Reforms

Solidarity Tax

The solidarity tax foresees that income above 48,600 EUR per year will be taxed at a rate of 10.5% (employee’s part), plus 23.59% (employer’s part). The new tax will affect a very small share of wage earners. According to Finance ministry’s estimate, this tax will affect 4.7 thousand persons, whose income in 2015 exceeded this threshold, or 0.59% of all employed individuals (Finance Ministry, 2015).

Differentiated Non-Taxable Personal Allowance

The differentiated non-taxable personal allowance will be introduced gradually between 2016 and 2020. The basic idea is to make the allowance dependent on income: individuals receiving income below a certain threshold are eligible for the maximum possible allowance, then the allowance gradually declines with income until it is zero. The system will be introduced gradually in the sense that the minimum allowance will not reach zero until 2020 – it will be gradually reduced from 85 EUR in 2016 to 0 EUR in 2020.

The way the system will be implemented foresees that during a fiscal year, all individuals will be taxed applying the minimum non-taxable allowance (e.g., 85 EUR in 2016). At the beginning of the next year, people eligible for a higher tax allowance will have the opportunity to apply for a tax refund, by making an income declaration, and to get the overpaid tax back.

Simulations of Reforms: Inequality

Below we present simulation results from EUROMOD, which is an EU-wide tax-benefit microsimulation model (for more details see Jara and Leventi, 2014). The results show the first-round effect of the simulated policies, i.e., they show the pure effect of the proposed reforms abstracting from any behavioural responses that these reforms might induce. We simulate the effect of five reform scenarios: two scenarios of differentiated non-taxable allowance (one scenario reflects the system that is planned to be introduced in 2016, the second scenario represents the system that is planned to be introduced in 2020), one scenario that simulates introduction of the solidarity tax, and two scenarios that combine the solidarity tax with the new non-taxable allowances. We compare these reforms with the baseline system, which describes the tax-benefit rules that are in place in 2015.

It is important to note that we assume in the simulations that everyone who is eligible for a tax refund under the new non-taxable allowance rules does in fact apply for the refund, which means that we estimate the maximum possible effect from the introduction of the higher tax allowances.

Table 1 summarizes the effect of the proposed reforms on income inequality as measured by the Gini coefficient. All the proposed reforms reduce income inequality, but the solidarity tax achieves higher equality by reducing incomes in the top decile. The non-taxable allowance mainly affects people in the middle of the income distribution, as the bottom deciles contain proportionally fewer employed individuals, while in the top deciles the allowance, which is set in absolute terms, makes a smaller share of the income – hence, a weaker effect. Pensioners, who mainly belong to the lower deciles of the income distribution, do not gain from a higher allowance, because of a special taxation regime for pensions that already provides for a higher personal allowance. All major benefits (unemployment benefit, social assistance, child-related benefits) are not subject to personal income tax, hence benefit recipients also do not gain from the proposed changes (see Figure 1).

Table 1. Gini Coefficient Associated with the Reforms

Baseline ST* 2016 allowance 2020 allowance ST + 2016 allowance ST + 2020 allowance
Gini 0.361 0.358 0.360 0.357 0.357 0.355

 Source: authors’ calculations using EUROMOD

Note: ST – solidarity tax

Figure 1. Deviation of Equivalised Disposable Income from the Baseline Scenario, %

Figure1 Source: authors’ calculations using EUROMOD

Figure 1 also shows that the losers from the solidarity tax are in the highest decile, though it should be borne in mind that enterprises are also losers because they now have to pay part of the solidarity tax. The solidarity tax generates no direct gainers.

Impact on Progressivity

The progressivity of a tax or system is typically measured by the Kakwani index. The Kakwani index (Kakwani, 1977) can vary between −1 and 1 and the larger the index, the more progressive is the tax. A positive index indicates that the tax is progressive and a negative index indicates it is regressive. Table 2 shows the calculated Kakwani index for all major direct taxes (which include personal income tax, social contributions and the newly introduced solidarity tax) and separately for personal income tax (PIT) for each of the postulated scenarios. The results suggest that all of the proposed reforms increase the progressivity of the tax system.

Table 2. The Kakwani Index for the Six Scenarios

Baseline ST* 2016 allowance 2020 allowance ST + 2016 allowance ST + 2020 allowance
All income taxes* 0.034 0.040 0.048 0.058 0.054 0.064
PIT 0.07 0.07 0.10 0.12 0.10 0.12

 Source: authors’ calculations using EUROMOD

Note: ST – solidarity tax; income taxes include personal income tax, social contributions and the newly introduced solidarity tax

Qualifications and Risks

The above results capture the so-called first round impact of the tax changes. In practice people will react to the changed incentives by changing behaviour and thereby changing the impacts. For example, the higher net reward for working in low wage jobs may increase the supply of workers willing to work in such jobs thereby possibly having a bigger positive effect on the incomes of low income households than implied by the simulations.

Perhaps more significant is the potential effect of the solidarity tax on the behaviour of high earners and of the enterprises that employ them. This effect is captured by the concept of the elasticity of taxable income – defined as the change in taxable income in response to a change in the marginal tax rate. The taxable income elasticity concept takes into account all the behavioural aspects of the taxpayer in response to a change in the tax rate. As well as labour supply responses it includes other responses e.g. switching the form in which income is received as well as simple tax evasion (Saez et al., 2012). It is the switching of the form in which income is received, away from wage income towards other less-taxed forms of income that can be expected here. Thus according to an internal Latvian Employers Confederation employer survey, if the solidarity tax is implemented one third of employers will consider using legal tax optimization tools such as dividends or the microenterprise tax to avoid paying the tax. Here, employers are important as well as employees, because employers will pay the larger share of the tax. If this happens on a significant scale (high elasticity of taxable income) then the intention of the solidarity tax will be subverted.

There are also risks with the differentiated personal allowance. If the burden of annual reporting of income is too high then many may simply not do it and suffer the loss of income or find a way of recouping through shadow earnings.

Concluding Remarks

The Latvian authorities should be applauded for grasping the nettle of progressive taxation but perhaps only with one hand for the way they have chosen to do it. Thus, the solidarity tax creates an incentive for both employers and employees to find ways of avoiding it and find they surely will. A tax accountant once said of the 80% supertax applied to high earnings in pre-Thatcher UK that it was a ‘voluntary tax’. This is also the likely fate of Latvia’s solidarity tax.

The differentiated personal allowance will clearly benefit low earners, if they claim it. In fact it will also benefit people earning well over the average wage. But will the low earners claim? Very few people in Latvia have ever filed an income declaration and we fear that many low earners will not do so now.

Thus at the top end progressivity is likely to be largely avoided and at the bottom end may not be fully claimed.

References

  • Finance Ministry (2015). “Solidaritātes nodokli maksās tikai personas ar algu virs 48 600 eiro gadā,” available at http://www.fm.gov.lv/lv/aktualitates/jaunumi/nodokli/51253-solidaritates-nodokli-maksas-tikai-personas-ar-algu-virs-48-600-eiro-gada
  • Kakwani, Nanak C. (1977). “Measurement of Tax Progressivity: An International Comparison”. Economic Journal 87 (345): 71–80
  • Jara, X. and Leventi, C. (2014). “Baseline results from the EU27 EUROMOD (2009-2013),” EUROMOD Working Papers EM18/14, EUROMOD at the Institute for Social and Economic Research.
  • Saez, E., J. Slemrod, and S. H. Giertz, (2012). “The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review.” Journal of Economic Literature, 50(1): 3-50

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.

▪

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.

Equity and Efficiency in the Latvian Tax-Benefit System

Posted on November 3, 2014 | Policy Brief

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There is a trade-off between two major objectives of a tax-benefit system: equity and efficiency. The tax-benefit systems that redistribute a lot of income tend to generate disincentives to work. The tax-benefit systems that create good incentives to work and earn, are less effective in mitigating poverty, social exclusion and deprivation. In this brief we argue that, when contrasted to other EU countries, the Latvian tax-benefit system is less effective in achieving either of the objectives.

Equity-Efficiency Trade-Off

There is a fundamental trade-off between the two principal objectives of a tax-benefit system – income redistribution and efficiency. On the one hand, income redistribution is desirable as it helps to mitigate socially undesirable market outcomes such as poverty and deprivation. On the other hand, more income redistribution is often associated with higher distortions to labour supply and work effort.

There is no universal prescription as to how much a government should redistribute. The answer to this question depends, among other factors, on the relative value that society (government) assigns to the welfare of different population groups, and on the individuals’ labour supply elasticity.

However, a given degree of income redistribution can be achieved at a different cost of efficiency. In this brief, we analyse the degree of income redistribution generated by the tax-benefit system and work incentives in Latvia in the context of other EU countries. In our analysis, we use the European microsimulation tax-benefit model EUROMOD (Sutherland and Figari, 2013) version G2.0, EU-SILC data, and the analysis framework developed by Jara and Tumino (2013).

Income Redistribution in the EU

EU countries differ substantially in terms of inequality of original income and in terms of the degree of redistribution generated by the tax-benefit system (see Figure 1, data on 2007 and 2013). The Gini coefficient of equivalised household original income (which consists of income from employment and self-employment, property income, private pensions, private transfers and other relatively minor components) ranges from around 0.4 (Cyprus, Netherlands) to almost 0.55 (Romania in 2007, Ireland in 2013).

Inequality of original income in Latvia in 2007 was at the EU average level (Gini coefficient of 0.47), but the degree of income redistribution generated by direct taxes, benefits and pensions was the lowest in the EU. As a result, the inequality of disposable income in Latvia in 2007 was the highest in the EU (Gini coefficient of 0.37). Part of the answer as to why the degree of income redistribution in Latvia is so low is a relatively small contribution of pensions to redistribution – it is almost half of that observed in the EU on average, despite the fact that the share of public pension recipients in the total Latvian population in 2007 was above the EU average. Another important factor was the very minor role of means-tested benefits: in the EU on average, means-tested benefits generate a reduction in Gini coefficient by about 0.02, while in Latvia the corresponding figure is just one tenth of this.

Figure 1. Gini coefficients of original equivalised household income and degree of redistribution generated by tax-benefit systems in the EU in 2007 and 2013

fig1afig1b

Source: EUROMOD statistics, authors’ calculations.

In the course of the crisis and the following recovery, the degree of redistribution in Latvia increased (see lower panel of Figure 1). An important factor behind the increase was growing number of pension recipients and an increase in the average size of pensions (both in absolute terms and relative to employment income). The increase in the number of pension recipients was not a result of changes in eligibility criteria, but was due to population ageing and the fact that more people applied for other types of pensions. The growth in the average size of pension was due to generous indexation of pensions in 2008 and compositional changes, as pensions of new pensioners until 2012 were larger than the average pension. Another reason for a growing degree of redistribution was an increase in the size and the number of recipients of means-tested benefits (mainly Guaranteed Minimum Income (GMI) benefit). This was a result of reforms in the provision of the means-tested benefits and of falling incomes from employment, which made more people eligible for the social assistance programmes. Nevertheless, despite the increase in recent years, the degree of income redistribution in Latvia remains one of the lowest in the EU.

Work Incentives

The existence of a trade-off between income redistribution and better work incentives suggests that tax-benefit systems that ensure less income redistribution are likely to generate better work incentives. Jara and Tumino (2013) have demonstrated the existence of this trade-off in the EU countries in 2007-2010 by identifying a negative and statistically significant correlation between Gini coefficients and Marginal Effective Tax Rates (METR). The METR is a measure that is commonly used to quantify work incentives at the intensive margin. It shows what proportion of a small increase in earnings (which results from e.g. an increase in the supplied hours of work) is lost as a result of extra tax payments or foregone benefits that the person is no longer eligible for after the increase in earnings. The negative correlation identified in Jara and Tumino (2013) suggests that countries with less income redistribution (i.e., higher Gini coefficients) tend to have better work incentives (lower METRs).

In Latvia, the mean METR in 2013 was 32.2%, only slightly below the EU average (34.5%), and much higher than the average in Estonia (22.8%) and Lithuania (27.4%), despite a lower degree of income redistribution (EUROMOD statistics). Another feature of the Latvian tax-benefit system is that it is characterised by especially high METRs for poor individuals. Thus, in 2013, 94% of individuals who faced METRs in excess of 50% belonged to the two bottom deciles of distribution of equivalised disposable income. This is different from many other European countries, where distribution of high METRs is either more even across deciles or rising towards the top end of income distribution (Jara and Tumino (2013), data for 2007).

The main reason for high METRs faced by the poorest population groups in Latvia is the design of means-tested benefits (GMI and housing benefits), which generates 100% METRs for the recipients of these benefits. Namely, for each additional euro earned, the amount of benefit is reduced by one euro, which leaves the net income unchanged. This adversely affects employment incentives for the poorest individuals and increases the poverty risk.

Figure 2 illustrates mean METRs by deciles of equivalised disposable income in Latvia and shows the contribution of taxes, benefits and social insurance contributions (SICs) to the mean METRs. It clearly demonstrates that high METRs in the bottom deciles result mainly from the contribution of benefits, which disappears in the fourth decile. The contribution of SICs is slightly smaller in the bottom decile, which is due to the fact that the proportion of employed individuals is smaller in the bottom decile. For the same reason, and also because of basic tax allowances, the contribution of direct taxes is smaller in the bottom deciles, but then the contribution of taxes levels off, reflecting the Latvian flat tax rate.

Figure 2. The contribution of direct taxes, benefits and social insurance contributions (SIC) to METRs in Latvia by deciles of equivalised disposable income in 2013

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Source: authors’ calculations using EUROMOD-LV

In their study on the incentive structure created by the tax and benefit system in Latvia, the World Bank (2013) pointed out the problem of bad work incentives generated by Latvian means-tested benefits. Our results, which are based on a population-representative database of incomes, also identify means-tested benefits as the major contributor to high METRs in the lowest deciles of the income distribution. Another concern expressed by the World Bank (2013) was that the problem of informal employment (either in the form of undeclared wages or work without a contract) can be exacerbated by high participation tax rates and METRs.

Conclusion

The Latvian tax-benefit system is characterized both by a relatively low degree of income redistribution and relatively weak work incentives, as measured by METRs. Recipients of means-tested benefits (GMI and housing benefits) are faced with 100% METRs, as benefits are withdrawn at the same rate as household income rises. This creates disincentives to increase labour supply for low-paid/low-skilled individuals, and hence creates a risk of poverty traps. Evidence from the literature suggests that the labour supply of low paid workers is particularly sensitive to the incentives generated by the tax-benefit system, hence reforms that would bring down METRs in the bottom deciles could yield positive results in terms of employment of low paid/low skilled workers.

A potential reform is to introduce either a gradual phasing out of the means-tested benefits, or to exclude a certain amount of employment income from the income test for the means-tested benefits. Such reforms would be targeted at the bottom end of the income distribution, help combat poverty, improve the incentive structure of the Latvian tax-benefit system, and positively affect the labour supply of low-skilled/low-paid workers.

References

  • EUROMOD statistics on Distribution and Decomposition of Disposable Income, accessed at http://www.iser.essex.ac.uk/euromod/statistics/ using EUROMOD version no. G2.0, retrieved on October 14, 2014
  • Jara, H. Xavier & Alberto Tumino (2013). “Tax-benefit systems, income distribution and work incentives in the European Union,” International Journal of Microsimulation, Interational Microsimulation Association, vol. 1(6), pages 27-62.
  • Sutherland, Holly & Francesco Figari (2013). “EUROMOD: the European Union tax-benefit microsimulation model,” International Journal of Microsimulation, Interational Microsimulation Association, vol. 1(6), pages 4-26.
  • World Bank (2013). “Latvia: “Who is Unemployed, Inactive or Needy? Assessing Post-Crisis Policy Options”. Analysis of the Incentive Structure Created by the Tax and Benefit System. Financial Incentives of the Tax and Benefit System in Latvia,” European Social Fund Activity “Complex support measures” No. 1DP//1.4.1.1.1./09/IPIA/NVA/001

Entrepreneurship in Latvia and Other Baltic States: Results from the Global Entrepreneurship Monitor

Posted on November 4, 2013 | Policy Brief

Entrepreneurship in Latvia Policy Brief Image

This policy brief summarises the results and implications of an upcoming Global Entrepreneurship Monitor (GEM) 2012 Latvia Report: a study on the entrepreneurial spirit and the latest trends in entrepreneurial activity in Latvia. The results suggest that Latvia is a rather entrepreneurial country (it rates second out of all EU countries by the share of population in early-stage entrepreneurial activity). GEM also finds that Latvian early-stage entrepreneurial activity is counter-cyclical. Early-stage entrepreneurship and self-employment have been important supports for those who were hit by the crisis in 2008-2009. Latvian entrepreneurs are measured to have strong international orientation and growth ambitions. The majority of them are young and middle-age males; in turn, females and the older age group (55-64) represent an “untapped entrepreneurial resource” potential to be addressed by policymakers.

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.