The Latvian Economy - No 8, November 3, 2011: Latvian budget reforms: fiscal discipline needs immediate improvement

1. The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department
by Dainis Stikuts, Mārtiņš Kazāks No. 8 • 3 November 2011
Latvian budget reforms: fiscal discipline needs immediate
improvement
• Latvia has managed to reduce the budget deficit, and fulfilling the Maastricht budget
deficit criterion in 2012 is possible.
• The budget gap is not yet closed. The government needs to look into all possibilities
for reducing expenditures and increasing revenues by improving tax administration,
but not by raising taxes.
• One of the tasks for the current government is to strengthen fiscal discipline by
adopting the fiscal discipline law as soon as possible; this would be a cornerstone for
ensuring a sustainable budget and lowering the debt level.
So far, good budget revenues in 2011 In the first nine months of 2011, total budget
revenues increased by 10.6%, whereas
The current situation of the general government expenditures were 3.5% higher than a year before.
budget is better than expected, as tax revenues The cumulative general government budget deficit
seem to have bottomed out. In 2011, tax revenues narrowed to 0.4% of annual GDP.1 Clearly, this
have thus far exceeded the plan every month, and performance is on target, and, if it continues, the
cumulative revenues were 6.9% above the plan by actual budget deficit for this year is likely to be
the end of September. In the third quarter of 2011, smaller than the deficit ceiling criterion, set at 4.5%
the annual growth of tax revenue accelerated to of GDP. However, for the whole of 2011, the budget
17.2% (10.8% in the second quarter and 3.7% in deficit's actual outcome will depend on fiscal
the first quarter), mostly due to better revenues discipline in the last three months. A further goal is
from the value-added tax (VAT) (up 23.7% in the to reduce the deficit to below 3% in 2012 and
third quarter) and social contributions (16%). Retail thereby to fulfil the Maastricht criterion, so as to be
trade and wage income appeared to be better than able to introduce the euro in 2014.
had been projected during the initial budget
forecast. The government has introduced measures to
reduce the size of the “grey” economy and to
Tax revenues, million LVL improve tax collection. However, tax evasion
remains an issue, and many transactions may still
200 500
be underreported. For example, fuel consumption is
400 typically rather inelastic with respect to incomes
150 because people need to get to work and back.
300 Nevertheless, statistics show consumers’ behaviour
100 to be somewhat contradictory. In the first nine
200 months of 2011, new transport vehicle registration
50 increased by 56% (year on year), and that of private
100 cars by 69%. During the same period, however, fuel
0 0 sales were down by about 10% from the previous
year ago, while other nonfood (excluding fuel) sales
Jan.08 Jan.09 Jan.10 Jan.11
were up by almost 12%. Furthermore, textile and
Total (rs) VAT footwear sales increased only by 1.3%, implying
Social contributions Personal income tax that nonfood sales are mostly driven by other
Corporate tax non-first-necessity-goods. These statistics raise
Source: State Revenue Service concerns about tax evasion in fuel trade.
1
Cash-flow basis, Swedbank’s GDP forecast.
Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000.
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46 8 5859 7720.
Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.

2. The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 8 • 3 November 2011
Another conclusion from these statistics is that expansion of the exporting sectors, which are less
current retail sales growth is driven by sales of tax intensive; however, tax revenues as a percent
durable goods, which are also generating a large of domestic demand diminished as well (from
part of tax revenues. But if consumer optimism falls 27.9% in the first half of 2009 to 26.5% in the first
due to increasing economic uncertainty, demand for half of 2011). It seems that revenues as a percent
durable goods most likely will fall first. Thus, budget of GDP and domestic demand levelled out in the
revenues from the VAT may significantly decrease. first half of 2011 – probably, in part because tax
collection has improved.
Further consolidation in 2012 to fall on
expenditures Tax revenues
40 Jan.2010: RE ↑ Jan.2011:
The Latvian GDP growth trend has permanently Average Excise↑ PIT ↑ July.2010: Excise↑
shifted downwards compared with the pre-crisis 2004- Transport ↑ Excise ↑ RE ↑ VAT ↑
level, and the government’s budget revenues are 35 2006 PIT↓ Soc ↑
closely following this trend. Thus, if expenditures do Transport ↑
not follow revenues, the budget deficit will increase. 30
Empirical evidence suggests that consolidation
done through well-balanced expenditure cuts is 25
more efficient in the long run and has a less
negative impact on GDP and employment than Jan.2009: Excise Jul.2011:
20 ↑ VAT ↑ PIT ↓ VAT↑
tax-based adjustments.2 Tax increases are the RE ↑ Transport ↑ Excise↑
easiest but least effective way to fill the budgetary
15
gap because total revenues depend on overall
taxable income, which has diminished also. 1Q 07 1Q 08 1Q 09 1Q 10 1Q 11
% of GDP % of domestic demand
Unfortunately, the Latvian government has been
relying heavily on revenue-increasing measures Source: CSBL, State Revenue Service
(the majority were pure tax increases), accounting
for almost half of all (totalling more than 15% of
GDP) budget consolidation measures during 2009- The budget gap is not yet closed. The government
2011. needs to look into all possibilities for reducing
expenditures and increasing revenues. Amongst
General government budget, billion LVL the biggest categories where expenditure cuts can
be sought are grants and subsidies, amounting to
7
about LVL 1,000 million, and social transfers,
6 amounting to LVL 400 million (which can be made
5 more targeted and efficient). At the same time, the
government must improve revenue collection – e.g.,
4 by shifting the tax burden from labour to
3 consumption and real estate (an initiative that is
2 also part of the current government’s programme),
and by reducing incentives to avoid tax payments,
1 including by improving the penalty system.
0
2001
2004
2006
2007
2009
2002
2003
2005
2008
2010
Fiscal discipline needs to improve
straightaway
Expenditures Revenues
The risk of larger-than-expected expenditures has
Source: Eurostat not yet been eliminated. In April 2011, the
government approved supplementary budget, as
IMF/EC had demanded additional reduction in
In 2009 and 2010, we saw that the ratio of tax budget deficit. Therefore, budget’s revenues were
revenues to GDP declined despite tax increases in increased by LVL 107 million and expenditures by
each quarter over the corresponding quarter of the LVL 15 million, which lowered the deficit by about
previous year. This can partly be explained by the LVL 90 million, or 0.6% of GDP. However, one-third
of this gain has been already lost. Since then,
planned expenditures have been increased by
2
See, e.g., IMF (2010), “Will it hurt? Macroeconomic effects close to another LVL 30 million.
of fiscal consolidation”, World Economic Outlook, October
2010, Chapter 3.
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3. The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 8 • 3 November 2011
Central government budget balance planning, million An increase in planned expenditures in the second
LVL half of the year has become a standard.
0 Unfortunately, the fiscal discipline law is still under
discussion in the parliament and has not yet been
-200 passed. The current coalition is committed to
adopting the law, which is necessary not only
-400 successfully to close the IMF/EC bailout
programme, but also to ensure a sustainable fiscal
-600 policy and lower the debt level.
-800
-1000
-1200 Dainis Stikuts
Jan.09 Jan.10 Jan.11 Martins Kazāks
* cash-flow basis Source: State Treasury
Swedbank
Economic Research Department
Swedbank AB. SE-105 34 Stockholm. Swedbank’s monthly newsletter is published as a service to our customers. We believe that
we have used reliable sources and methods in the preparation of the analyses reported in
Legally responsible publisher this publication. However, we cannot guarantee the accuracy or completeness of the report
Cecilia Hermansson, +46 8 5859 7720 and cannot be held responsible for any error or omission in the underlying material or its
use. Readers are encouraged to base any (investment) decisions on other material as well.
Neither Swedbank nor its employees may be held responsible for losses or damages,
Martiņš Kazāks, +371 6744 5859 direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter.
Dainis Stikuts, +371 6744 5844
Lija Strašuna, +371 6744 5875
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