Journal Issue
Share
Article

Republic of Latvia: Selected Issues

Author(s):
International Monetary Fund. European Dept.
Published Date:
September 2018
Share
  • ShareShare
Show Summary Details

Latvia’s Labor Market Challenges1

Latvia’s labor market has been buffeted by extreme economic swings since the country joined the European Union in 2004. In the boom period leading up to the global financial crisis, the economy experienced widespread labor shortages and soaring wage growth. The bursting of the bubble led to a deep recession, high unemployment, and a sharp contraction in wages. With the economy now in its eighth year of recovery, Latvia is once again experiencing a tightening labor market—a situation exacerbated by unfavorable demographic trends. Latvia’s future prosperity will depend critically on whether it is able to address its labor market challenges.

A. An Overview of Labor Market Developments

1. Labor market constraints pose serious challenges to Latvia’s long-term growth. Since the global financial crisis, the level of employment in Latvia has hovered at just under 900,000 people. Although the number of unemployed and inactive people has fallen by nearly two-thirds and one-third, respectively, from their crisis peaks, employment growth has been flat, constrained by a shrinking supply of labor. Should this trend continue, future economic growth will depend on raising productivity and investment—an outcome that appears far from certain given modest labor productivity gains and anemic credit growth over the past decade.

Working-Age (15–64) Population and Components

(Thousands)

Source: Eurostat.

2. The shrinking supply of labor can be attributed to two factors: emigration and negative natural population growth. Since joining the EU, Latvia has seen nearly a fifth of its population leave to work in more affluent EU countries—mainly the U.K., Ireland, and Germany. Emigration spiked during the crisis and remains high today, involving all age groups, especially the youth. Latvia’s fertility rate, although higher than the EU average and trending upward since 2011, remains below the rate of 2.1 necessary to keep the population size constant in the absence of migration. Together, emigration and negative natural population growth have resulted in a 24 percent decline in Latvia’s working-age population since 2000—more than in any other EU country. The 15–24 cohort has shrunk by almost half.

Change in Working-Age (15–64) Population, 2000–2017

(Percent)

Source: Eurostat.

3. Emigration has had a dampening effect on growth. In addition to reducing the size of the labor force, emigration has drained the country of skilled labor. Young people frequently choose to study abroad—many of whom do not return—or they leave Latvia after graduation. IMF staff estimate that the loss of labor due to outward migration, combined with a worsening composition of skills, shaved off more than 1 percent from annual growth rates between 1999 and 2014.2 Few emigrants return to Latvia, with over three quarters citing the inability to find a decent job and concerns about the adequacy of Latvia’s social safety net.3

Labor and Migration Contributions to GDP Growth

(Percent, average 1999–2014)

4. A range of indicators point to a labor market with less and less slack, reflecting bot demographic forces and an economy in its eighth year of expansion. The unemployment rate has fallen steadily since 2010. At 8.3 percent, it is now well below its historical average and likely close to the natural rate of unemployment4 More and more businesses are reporting labor shortages, albeit not to the extent seen in the run-up to the crisis. The job vacancy rate, on the other hand, is approaching its pre-crisis peak, with vacancy rates especially high in public administration, information and technology, construction, and manufacturing. Despite stagnant employment growth, the employment rate has reached historically high levels due to the shrinking population and now stands well above the EU average. Measures of underemployment confirm that the labor market is tightening. For example, the ratio of underemployed part-time workers to total employment, at 3.1 percent, is approaching pre-crisis levels.

Unemployment Rate

(Percent)

Source: Eurostat

Labor Shortages and Job Vacancy Rate

(Percent of respondents and percent)

Sources: EC Business and Consumer Survey; Eurostat.

1/ Proportion of total posts that are vacant.

Employment Rate (Ages 15–64)

(Percent)

Source: Eurostat

Underemployed Part-time Workers

(Percent of Total Employment)

Source: Eurostat

5. Wage growth has picked up in recent years. Between 2000 and 2007, nominal wages grew by 14.1 percent per year on average as Latvia enjoyed some of the highest economic growth rates in Europe. The ensuing global financial crisis resulted in unprecedented wage adjustment. With Latvia experiencing one of the worst output losses in the world and with unemployment soaring, average wages declined by 10.5 percent in nominal terms in less than two years. Wage growth resumed in 2011 as the economy began to recover, albeit at a more modest pace compared to the pre-crisis years. More recently, wage growth has accelerated, driven by tightening domestic and foreign labor market conditions.5

Wage Growth

(Percent year-on-year)

Sources: Eurostat; Central Statistical Bureau of Latvia; and IMF staff calculations.

B. Labor Market Structure

6. Latvia’s labor market is fragmented, both demographically and geographically. Labor market outcomes vary significantly depending on several factors:

  • Educational attainment. Those with a basic education are more than four times as likely to be unemployed than those with a higher education—a much larger dispersion than the EU average and indicative of the demand for skilled labor.

  • Age. Youth unemployment is double the rate of other age groups—a common phenomenon in Europe. The unemployment rate of older workers (55–64) is in line with the overall unemployment rate but is the fourth highest in the EU. Labor participation rates tell a similar story. Although the overall participation rate is at a historical high, it is lower than in Estonia and many Nordic countries, which have more active 15–24 and 55–64 cohorts.

  • Region. Unemployment is higher in the peripheral regions, especially in Latgale in the East, where the rate is twice as high as in Riga and the surrounding PierTga region. Riga accounts for one-third of the country’s population but two-thirds of job vacancies.

  • Gender. In contrast to the pattern seen in most of Europe, men in Latvia are more likely to be unemployed than women, but women suffer from a gender pay gap even when controlling for age, education level, and other characteristics.

Unemployment Rate by Educational Attainment, 2017

(Percent)

Source: Central Statistical Bureau of Latvia.

Unemployment Rate by Age Group, 2017

(Percent)

Source: Eurostat; and IMF staff calculations.

Labor Participation Rate (15–64), 2017

(Percent)

Source: Eurostat.

Labor Participation Rates by Cohort, 2017

(Percent)

Source: Eurostat.

Unemployment Rate by Region, 2017

(Percent)

Source: Central Statistical Bureau of Latvia.

Unemployment Rate by Gender, 2017

(Percent)

Source: Central Statistical Bureau of Latvia.

7. Unemployment is largely structural, reflecting severe skills mismatches. Notwithstanding a 12 percentage point decline from its crisis peak, the headline unemployment rate remains high. Nearly 40 percent of unemployed have been jobless for at least a year even as job vacancies and labor shortages have grown. Although this share has declined since 2011, it remains well above pre-crisis levels, leaving many workers vulnerable to skills depreciation. Older workers educated in the Soviet era have struggled to adapt their skills to changing labor market demands, while younger and more skilled workers are more likely to leave the country.6 The result is an economy that suffers from skills mismatches and skills shortages that are among the most severe in the EU.7

Long-term Unemployment 1/

(Percent of total unemployment)

Source: Central Statistical Bureau of Latvia.

1/ One year or more.

Youth (15–24) Not in Employment, Education, or Training

(Percent of total population)

Source: Eurostat.

Skills Mismatch Index, 2016

Source: Eurostat; and IMF staff calculations.

Skills Shortage Index, 2016

Sources: Eurostat; and IMF staff calculations.

8. Lack of affordable housing represents an obstacle to labor mobility. In Riga and other urban areas with good employment opportunities, affordable housing is scarce, reducing labor mobility, contributing to labor shortages, and keeping unemployment high in rural areas with fewer jobs. Rental dispute resolution mechanisms are time-consuming and costly, discouraging homeowners from renting their homes, and there is little investment in new rental housing. The situation is exacerbated by the fact that government spending on social housing is among the lowest in the OECD, with social housing representing only 0.4 percent of the total housing stock compared to an EU average of 8 percent.8 A more developed rental market would benefit those who seek employment in urban areas but do not have the means to purchase a home.

Share of Households in Rental Housing, 2014

(Percent)

Source: OECD.

Social Housing Stock, 2015

(Percent of total housing stock)

Source: OECD.

9. Participation in active labor market policies (ALMPs) and lifelong learning is low. Latvia has improved the effectiveness of ALMPs by collaborating with social partners to design programs that respond to labor market demands and by better profiling job seekers to match them with the most suitable programs. But participation in ALMPs is low, and spending on ALMPs is minimal by international standards. Fiscal consolidation during the crisis resulted in substantial cuts in ALMP spending, especially on employment services (e.g., career counseling and job placement). The vocational education and training (VET) system, meanwhile, is transitioning from a highly centralized model to a more flexible one that seeks to promote collaboration between employers and schools. VET curricula have been revised in consultation with employers, and the provision of VET services has been consolidated by reducing the number of VET schools and creating modernized, regional VET hubs. While these reforms are encouraging, the participation rate in formal training and retraining programs (i.e., lifelong learning) among people aged 25–64 is just 7.5 percent—one of the lowest rates in Europe. Furthermore, the government estimates that only 27 percent of practical training in vocational education takes place in companies rather than in schools.

Public Expenditure on ALMPs, 2015

(Percent of GDP)

Source: OECO.

C. The Wage-Setting Framework and Impediments to Higher Employment

10. Latvia’s wage setting framework is flexible. Analysis by IMF staff shows that productivity gains in Latvia and other Baltic countries generally translate into similar real wage gains in the long-run.9 Over the past two decades, wages have at times outpaced productivity but have experienced corrections. In the run-up to the crisis, real wage growth accelerated to over 20 percent, opening a gap with productivity that later closed as wages adjusted lower. Since 2012, as the economy has recovered, wages have once again outpaced productivity, in part due to slower post-crisis productivity growth. In the critical manufacturing sector, however, post-crisis productivity has kept pace with real wages, helping Latvia maintain its competitiveness.

Real Wages and Labor Productivity

(Index, Q1 2000=100)

Sources: Eurostat; Central Statistical Bureau of Latvia; and IMF staff calculations.

1/ Real GVA/employment.

Real Wage and Labor Productivity Growth, 2010–2017

(Percent)

Sources: Eurostat; Central Statistical Bureau of Lativa; and IMF staff calculations.

1/ Real GVA/employment.

11. A highly decentralized collective bargaining framework has facilitated wage adjustment. Theory suggests that centralized collective bargaining can help an economy adjust to macroeconomic shocks insofar as worker representatives avoid wage increases that would lead to higher unemployment. A decentralized framework, on the other hand, enhances flexibility at the firm level. Latvia’s wage-setting framework is highly decentralized: trade union density, defined as the share of workers who belong to a union, is just 13 percent, and most private sector workplaces have no employee representation at all. In addition, only 15 percent of workers are covered by a collective bargaining agreement. This decentralized system has delivered wage growth broadly in line with productivity growth and allowed for rapid wage adjustment during the crisis.

Trade Union Density 1/

(Percent)

Source: OECD.

1/ Data as of 2015 or latest.

Collective Bargaining Coverage 1/

(Percent)

Source: OECD.

1/ Data as of 2015 or latest.

12. At the same time, decentralized wage setting has contributed to high wage inequality. The combination of low unionization and weak collective bargaining coverage has weakened the bargaining power of workers—particularly those with low skills. This, in turn, has exacerbated wage inequality, which is the second highest among OECD European countries. Low-paid employment is highly prevalent, with a quarter of workers earning less than two-thirds of median earnings.10

Earnings Inequality Ratio 1/

(Ratio of highest decile to lowest decile)

Source: OECD.

1/ Data as of 2014 or latest Ratio of gross earnings of full-time employees in the ninth decile compared to the first decile.

Incidence of Low-Paid Employment 1/

(Percent of full-time wage and salary earners)

Source: OECD.

1/ Share of workers earning less than two-thirds of median earnings.

13. High wage inequality exists despite successive increases in the minimum wage. Latvia has a unified statutory minimum wage, with no differentiation by region or group of workers. The minimum wage level—reviewed annually by a tripartite council comprising the government, the employers’ confederation, and the country’s single trade union—has been raised nearly every year since 2000 and has more than doubled in nominal terms since 2007, from €170 to €430 per month. Increases in the minimum wage have been motivated in part by a desire to boost tax revenues (a higher wage floor reduces envelope wages and increases official income subject to taxation). Given the significant downward adjustment for other wage earners triggered by the crisis, the minimum wage has increased relative to the average wage. The persistence of high wage inequality despite gains in the minimum wage reflects the high incidence of informal employment, earnings premia for skilled workers, and low incomes for pensioners and the long-term unemployed.

Minimum vs. Average Monthly Wage

(Euros)

Sources: Central Statistical Bureau of Latvia; OECD; and IMF staff calculations.

Minimum Wage Relative to Average Wage

(Percent)

Source: OECD; Central Statiscal Bureau of Latvia; and IMF staff calculations.

1/ 2017 for Latvia.

14. A unified minimum wage risks pricing some workers out of formal employment. At 41 percent of the average wage, Latvia’s minimum wage is arguably on the high side.11 Moreover, a uniform minimum wage is not well suited to a fragmented labor market with large wage disparities across regions and groups of workers. A generous minimum wage that applies across the board can prevent first-time entrants and other low-productivity workers from finding jobs in the formal sector and can contribute to high structural unemployment. This is particularly true in rural areas where average wages are lower and the incidence of minimum wage is higher. There is also evidence that Latvia’s minimum wage is hindering the development of apprenticeships, since employers are obligated to pay apprentices the same statutory minimum wage as for all other employees. In 2016, Latvia adjusted the minimum wage-setting framework by introducing the obligation to take into account more extensive analytical data, such as an analysis of economic and social conditions and the impact of the minimum wage on low-skilled workers.

Minimum Wage and Unemployment Rate by Region, 2017

(Percent)

Sources: Central Statistical Bureau of Latvia; and IMF staff calculations.

Minimum Wage and Unemployment by Cohort, 2014

(Percent)

Sources: Central Statistical Bureau of Latvia; and IMF staff calculations.

D. Other Impediments to Higher Employment

15. The labor tax wedge for low-wage earners is high, which further encourages informality. At 42 percent in 2017, the tax wedge for workers earning two-thirds the average wage was among the highest in the EU and OECD.12 A high labor tax wedge makes it more difficult for low-skilled workers to find formal employment and creates incentives for envelope wages. The comprehensive tax reform enacted earlier this year partially addressed this issue by introducing a more progressive personal income tax (PIT) schedule, with a lower PIT rate and income tax allowances for low-income individuals. The authorities estimate the post-reform tax wedge to be 39 percent—a welcome decline but still much higher than the 32 percent average in OECD countries. Moreover, PIT reductions are not effective at alleviating the tax burden of the lowest wage earners, who typically pay little or no income tax. Nonetheless, a further reduction in the tax wedge—e.g. by reducing social security contributions—needs to be considered carefully in view of the fiscal costs and potential impact on future social benefits of the most vulnerable.

Labor Tax Wedge, 2017 1/

(Percent of total labor compensation)

Source: OECD.

1/ For single workers earning 67 percent of the average wage.

16. Employment protection legislation (EPL) is relatively restrictive. EPL refers to the procedures and costs associated with hiring and dismissing workers. Theory suggests that overly restrictive EPL reduces both job creation and job destruction and may slow productivity growth by raising labor adjustment costs for firms. Easing EPL can enhance the relative job prospects of underrepresented groups, such as low-skilled youth, but can have an unpredictable impact on aggregate employment since it increases incentives both to hire and dismiss workers.13 Latvia’s EPL is among the most stringent in the OECD. Although EPL for temporary employment is much less strict, the share of temporary contracts in total employment is small (2.6 percent compared to an average of 12.2 percent in the EU). While the EPL framework has not prevented rapid labor market adjustments, flexibility of the labor market is due not to flexible rules but rather to non-compliance with the rules.14 Recent reforms have aimed to increase de jure flexibility, including by extending the period over which temporary contracts can be renewed from 3 to 5 years.

Employment Protection Legislation

(0=least restrictive; 6=most restrictive)

Source: OECD.

Employment Protection Legislation, Temporary Workers

(0=least restrictive; 6=most restrictive)

Source: OECD.

E. Policy Options

17. Latvia’s tightening labor market calls for reforms that make the most of the country’s human resources. Reforms should aim to tackle barriers to employment, encourage more labor market participation, help Latvia’s citizens build new skills, and stem the decline in the working-age population. Options include:

  • Continue to reform vocational education and training and encourage lifelong learning. Improving links with employers by expanding workplace-based learning and formal apprenticeships would make Latvia’s VET system more effective. Promoting lifelong learning would help workers adapt their skills to the demands of a rapidly changing economy and could boost labor participation rates among older workers. A more skilled and productive labor force would support higher wages, helping to alleviate wage inequality and discourage emigration.

  • Increase participation in active labor market policies. Implementing effective ALMPs is difficult but not impossible. Resources should be directed to programs that have proven to be most effective based on regular, data-driven evaluations. Spending on programs without a proven track record should be discontinued. In addition, Latvia should move away from spending on direct job creation programs and instead improve the accessibility of unemployment benefits. Higher participation in effective ALMPs could help address skills mismatches and reduce long-term unemployment.

  • Introduce differentiated minimum wages to alleviate adverse side effects. Latvia could consider introducing a lower minimum wage for apprentices (as in France, Germany, and Portugal) and for the young (e.g., UK and Netherlands). Another option is to differentiate minimum wages by region, as is common in emerging and high-income economies (e.g., Mexico, Canada, Japan, and the United States).

  • Facilitate labor market mobility. A more developed rental housing market would help address the lack of affordable housing in high-activity urban areas. Reforms should aim to liberalize the market and improve legal certainty for landlords and tenants. To encourage homeowners to offer housing for rent, landlords should be allowed to evict tenants who fail to pay their rent without having to go through costly and lengthy court procedures. Separately, providing subsidies to defray the cost of relocating could also facilitate labor market mobility.15

  • Reduce employment protection. Although some employment protection is desirable, too much protection hampers the reallocation process and is likely to decrease productivity growth. The effect of employment protection on the probability of being hired is particularly strong for those workers whose productivity is uncertain, such as new entrants and the long-term unemployed.16 The current system of dual employment protection—where high employment protection on permanent contracts coexists with lighter regulation on temporary contracts—should be avoided.

  • Promote inward labor migration. Since 2000, Latvia has received about 7,000 immigrants per year on average—a low rate by OECD standards relative to overall population size and less than a third the size of emigration flows. Foreign workers are not actively targeted, and international students who complete their studies in Latvia cannot easily integrate the Latvian labor market. Greater inward labor migration would ease skills shortages and facilitate knowledge transfers. One option is to start by relaxing immigration restrictions for sectors that are sensitive to the business cycle and are currently experiencing shortages (e.g., the construction sector). Latvia could also do more to try to entice its sizable diaspora, especially Latvian graduates abroad, to return to their country of origin.

References

Prepared by Andrew Jewell.

See Atoyan et al., 2016. Skill shortage (or excess) is defined as the difference between the demand for a skill—the share of skill i in employment—and supply of that skill—the share of skill i in working-age population.

The Bank of Latvia estimates a natural unemployment rate of about 10 percent, based on the Beveridge Curve Model, which suggests that the unemployment rate may have even declined below its natural rate.

See OECD, 2013. Between 2000–10, emigrants with a tertiary education represented a quarter of all emigrants from Latvia. More recent data also show that the population aged 15–54 is three times more likely to emigrate than the population aged 55–64. See Central Statistical Bureau, 2017, Statistical Yearbook of Latvia.

See IMF, 2018b. The skills mismatch and skills shortages indexes shown in the figures are constructed based on a framework presented by Estevao and Tsouta, 2011.

See International Monetary Fund, 2018.

Given the prevalence of envelope wages, wage inequality and the incidence of low-paid employment might be less than reflected in official statistics.

Rutkowski (2003) concludes that, as a rule of thumb, the minimum wage should not exceed 40 percent of the average wage in developing economies, with the threshold lower when unemployment is high and concentrated among the young and low-skilled. A joint ILO, OECD, IMF, and World Bank report concludes that a minimum wage of 30–40 percent of the median wage would strike a suitable balance (G20, 2012). This roughly corresponds to a range of 25–35 percent for the minimum-to-average wage ratio.

The tax wedge is defined as income tax on gross wage earnings plus the employee’s and the employer’s social security contributions, expressed as a percentage of the total labor costs of the earner.

The government has introduced a mobility allowance for unemployed workers who accept a job or training opportunity at least 15 kilometers from their residence.

Other Resources Citing This Publication