Abstract
Selected Issues
Addressing Public Expenditure Challenges1
A. Introduction
1. Latvia has achieved significant fiscal consolidation since the crisis, but demographic challenges and needed structural reforms are likely to cause spending pressures in the future. Latvia has a relatively low public expenditure ratio, and the budget has a large share of non-discretionary spending (about 2/3 of total spending), leaving little room for spending flexibility. At the same time, a low revenue-to-GDP ratio limits the fiscal space for priority spending. With still relatively high poverty and inequality levels, aging infrastructure, and adverse demographic trends, spending pressures are likely to increase. Going forward, the tax revenue ratio is expected to decline as a result of the recently implemented tax reform and a decline in EU investment funds. Unless additional permanent sources of revenue are found, the authorities will face difficult expenditure policy decisions.
2. This paper reviews Latvia’s public expenditure efficiency with a view to identify areas where saving can be achieved by reducing efficiency gaps. By benchmarking Latvia’s public spending levels and composition against relevant country peers, the objective is to provide a first approximation of the areas where spending efficiency or spending rationalization could be made without affecting the delivery of public services. While efficiency gaps are assessed sector by sector, policy conclusions focus on broad expenditure policy recommendations rather than sector-specific recommendations, which would require a detailed expenditure review that is out of the scope of this analysis.
3. Given the limited resource envelope, options for a more growth friendly and equity enhancing revenue and expenditure policy mix are also discussed. In particular, we assess the economic impact of the new tax reform, and assess different budget financing options to absorb its cost. We also assess the scope and impact of reallocating resources towards growth-friendly expenditures.
B. Public Expenditure by Economic Classification: Overall Trends
4. Government expenditure in Latvia is relatively low compared to peer countries. At 38 percent of GDP in 2017, Latvia’s total expenditure ratio is well below the EU average of 45.8 percent. As in other countries, current spending accounts for about 90 percent of total expenditures. In Latvia, this is reflected primarily in expenditures on the wage bill, social benefits, and goods and services. While the spending on the wage bill and goods and services is broadly in line with the EU average (10 percent of GDP and 6 percent of GDP, respectively), spending on social benefits, at about 12 percent of GDP, is significantly below the EU average of 21 percent of GDP. Capital spending accounts for about 10 percent of total public expenditures, much higher than the average spending in EU countries (5.8 percent).
Government Spending Trends
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Source: IMF FAD Expenditure Assessment Tool (EAT), World Economic Outlook. Coverage refers to general government as per World Economic Outlook metadata.Goods and Services
5. The level of spending on goods and services is in line with the EU average, but Latvia’s spending priorities are very different. The largest share of goods and services is spent on economic affairs and education (24 percent and 19 percent of total goods and services expenditures, respectively), significantly exceeding the EU average of 13 percent. In contrast, only 3 percent is devoted to social protection vs. an EU average of 10 percent. The share of spending on goods and services in the health sector (14 percent) is substantially below the EU average of 21 percent.
Goods and Services, 2016
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Sources: Eurostat and IMF staff calculations.Wage Bill
6. Government wage spending has increased in recent years, reflecting mainly an increase in public employment. About 27 percent of general government spending in Latvia goes to the wage bill, which is above the EU average (22 percent) and the average of advanced economies (24.5 percent). Public employment as a share of the active working population (about 17 percent) is significantly above the average of other advanced economies (11.6 percent) and is the highest among EU countries (Figure 2).2 The sectoral composition of the wage bill suggests that there is significant scope for efficiency gains from downsizing and reallocation of public sector employment. The largest share of the wage bill (3.4 percent of GDP) goes to public employees in education, which is above the EU average (2.9 percent of GDP). In contrast, Latvia devotes a small share of the wage bill to health and social protection.
Wage Bill Trends
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Source: IMF FAD Expenditure Assessment Tool (EAT), IMF FAD Government Wage Bill and Employment Dataset.1/ Dashlines represent the average for countries in the regional benchmark group.2/ Public-private wage differential (as a percent of private wages): based on a review of regression-based studies that control for skill differentials between the public and private sector. Numbers are calculated by taking the within-country average over time.| Compensation of employees (share of GDP, 2016) | |||
|---|---|---|---|
| Latvia | EU | ||
| Total expenditure | 10.2 | 10.0 | |
| General public services | 1.2 | 1.3 | |
| Defence | 0.5 | 0.6 | |
| Public order and safety | 1.4 | 1.2 | |
| Economic affairs | 0.7 | 0.6 | |
| Environment protection | 0.2 | 0.1 | |
| Housing and community amenities | 0.2 | 0.1 | |
| Health | 1.4 | 1.9 | |
| Recreation, culture and religion | 0.6 | 0.3 | |
| Education | 3.4 | 2.9 | |
| Social protection | 0.5 | 0.9 | |
| Compensation of employees (share of GDP, 2016) | |||
|---|---|---|---|
| Latvia | EU | ||
| Total expenditure | 10.2 | 10.0 | |
| General public services | 1.2 | 1.3 | |
| Defence | 0.5 | 0.6 | |
| Public order and safety | 1.4 | 1.2 | |
| Economic affairs | 0.7 | 0.6 | |
| Environment protection | 0.2 | 0.1 | |
| Housing and community amenities | 0.2 | 0.1 | |
| Health | 1.4 | 1.9 | |
| Recreation, culture and religion | 0.6 | 0.3 | |
| Education | 3.4 | 2.9 | |
| Social protection | 0.5 | 0.9 | |
7. There is a relatively large negative public-private wage premium, especially for skilled labor. Despite recent increases in public sector wages by more than 5 percent on average over the last three years, they remain 9 percentage points lower than wages in the private sector once skills and educational attainment are taken into account.3 This gap could represent an obstacle for retaining and attracting the most qualified staff in the public sector, especially in areas requiring highly specialized skills.
8. The ongoing public administration reform seeks to address these challenges, but needs to be more ambitious. Flexibility to adjust the level and composition of public employment is needed to ensure effective delivery of public services and to help ease the existing labor market tightness. In this spirit, the authorities envision a reduction in employment of about 6 percent by 2020, combined with further wage increases and transitioning to performance-related remuneration. However, since the reform covers only employees in the central administration (accounting for less than half of employees in the public sector), it would have a very small impact on the high public employment ratio. The savings may not be sufficient to reduce the wage premium in a budget neutral way, which could add more pressure to public expenditure and could spill over to overall wages in the economy, exacerbating rather than easing labor market pressures.4 The scope of the public administration reform thus needs to be expanded to include the broader general government.
Public Investment
9. Public investment in Latvia is in line with the average of EU countries; however, investment needs are much larger. Capital spending as a share of GDP is close to the EU average and has remained broadly constant for several years. However, while the capital stock has increased in recent years thanks to significant absorption of EU funds, Latvia has a relatively low capital-output ratio and public capital stock per capita compared to advanced economies.5 Furthermore, while the quality of infrastructure has improved, it still lags behind peer countries. The latest WEF survey-based quality of infrastructure index suggests that Latvia’s infrastructure quality is below that of advanced economies and the EU average. Only the quality of ports is on par with advanced economies. Other infrastructure areas are still in need of improvement. In particular, the quality of roads is significantly below that of advanced economies and the EU average (Figure 3).
Investment and Infrastructure
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Sources: IMF FAD Expenditure Assessment Tool (EAT), World Economic Outlook, World Development Indicators, IMF Investment and Capital Stock Dataset, and World Economic Forum.10. Catching up with advanced economies will require more capital investment. Structural policies that increase public investment could have a significant impact on GDP growth over the medium term by increasing the public capital stock and potentially inducing private investment, all of which could in turn increase the productivity of the economy as a whole.6 Increasing public investment will become even more pressing as EU investment funds level off. Staff simulations suggest that a permanent increase in capital expenditure of 0.5 percent of GDP per year, financed by a reduction in government consumption, could increase real GDP by about 0.7 percent above baseline projections and real GDP growth by about 0.2 percent per annum over the medium term (Figure 4).7
Impact of Boosting Public Investment
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
11. There is some limited scope to increase efficiency gains and ensure the highest return on public investment. Empirical studies have shown that the precise economic impact of public investment depends, in large part, on the efficiency of public spending. For example, using an efficiency frontier analysis, a recent IMF study assessed the efficiency of public investment in European countries by comparing the quality of infrastructure and access to public services with invested resources in each country.8 The results revealed that Latvia—along with Lithuania and Estonia—is slightly below the public investment efficiency frontier among countries with the same level of public capital stock per capita. The identified efficiency gaps relate to the process of project appraisal and management of PPPs, including disclosure of fiscal risks from PPPs in budget documents. While these efficiency gaps are small, boosting public investment should go hand in hand with policies that close the gaps to ensure that Latvia achieves quality along the efficiency frontier.
Index of Public Capital Coverage and Quality
(Average 2012–13)
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Source: IMF (2016b), CESEE REI Fall 2016. Effective Government for Stronger Growth: Improving the efficiency of public investment and tax administration in CESEE.C. Public Expenditure Functional Classification: Spending vs. Objectives
12. A close look at the functional classification of public spending sheds light on its effectiveness in improving inequality and poverty outcomes. This assessment focuses on the functional classification areas that have the largest potential to improve inequality and poverty outcomes: social protection, education and health. For instance, some studies find that public spending on education and health, when efficiently implemented, can directly reduce market income inequality and have the potential to promote growth (IMF, 2017). Other studies show a strong link between higher pubic social spending and lower income inequality and aggregate poverty levels (IMF, 2018). Recent spending trends in Latvia indicate that public spending on education has been slightly above the EU average, but Latvia lags well behind the EU average on health and social protection spending. Furthermore, aside from the level of spending, the efficiency of spending, as measured by the quality of services provided, lags peer countries.
Public expenditure, functional classification, 2016
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Note:Non-social spending = total spending -education -health -socal protection.Sources: Eurostat and IMF staff calculations.Social Protection
13. Poverty and inequality levels in Latvia are among the highest in the EU and among OECD countries. Latvia’s per capita GDP of €14,000 is significantly below the EU and OECD averages of around €30,000 and €40,000, respectively. Latvia’s poverty rate is one of the highest in the EU and OECD across all age groups, especially among the elderly and those with lower education levels. And while unemployment has been declining, it still affects disproportionality more the low-skilled and young population. Income distribution also compares unfavorably to peer countries. Latvia’s Gini coefficient is several points above the average in the EU and OECD countries, and the income share of the richest 10 percent of the population is slightly higher than the EU and OECD averages (Figure 5).
Poverty and Inequality
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
14. At the same time, Latvia’s social protection spending is well below the EU average. Latvia spends about 12 percent of GDP on social protection, which is significantly below the EU average of 19 percent. The breakdown of social protection spending also shows that spending is well below the EU average in all categories. Areas related to social exclusion, housing programs, and unemployment benefits are the most underfunded.
Latvia: Break down of Social Spending GDP Share, 2016
Latvia: Break down of Social Spending GDP Share, 2016
|
|
|
||
|---|---|---|---|
| Pension | Old Age | 7.20 | 10.20 |
| Disability | 1.40 | 2.00 | |
| Survivors | 0.20 | 1.30 | |
| Pension | 8.80 | 13.50 | |
| Non pension Social Insurance | Sickness/Health Care | 3.60 | 8.00 |
| Unemployment | 0.40 | 1.30 | |
| Non pension Social Insurance | 4.00 | 9.30 | |
| Social Assistance | Family/Children | 1.20 | 1.70 |
| Social Exclusion | 0.40 | 0.90 | |
| Housing | 0.10 | 0.50 | |
| Social Assistance | 1.70 | 3.10 | |
Latvia: Break down of Social Spending GDP Share, 2016
|
|
|
||
|---|---|---|---|
| Pension | Old Age | 7.20 | 10.20 |
| Disability | 1.40 | 2.00 | |
| Survivors | 0.20 | 1.30 | |
| Pension | 8.80 | 13.50 | |
| Non pension Social Insurance | Sickness/Health Care | 3.60 | 8.00 |
| Unemployment | 0.40 | 1.30 | |
| Non pension Social Insurance | 4.00 | 9.30 | |
| Social Assistance | Family/Children | 1.20 | 1.70 |
| Social Exclusion | 0.40 | 0.90 | |
| Housing | 0.10 | 0.50 | |
| Social Assistance | 1.70 | 3.10 | |
15. The adequacy of existing social assistance programs is modest, dampening their poverty-reducing impact. Social assistance spending relies primarily on universal programs, with only about 1 percent of total social assistance spending devoted to means-tested programs, much lower than the EU average of 9 percent. The coverage ratio of social assistance programs is somewhat in line with the EU average, but is much lower than the OECD average. In addition, benefit incidence of social programs (i.e. the share of total social protection transfers received by the poorest 20 percent of households) is about 20 percent, significantly lower than the average in EU and OECD countries.9 Recent reforms to the pension system helped improve its adequacy and fiscal sustainability. However, low and declining aggregate replacement rates suggest that challenges to address pension adequacy for future retirees remain to be tackled in the medium term. Furthermore, operating costs of private pension managers are among the highest in OECD countries, affecting future returns from the second pillar pension scheme (Figure 6).
Social Protection Expenditure
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Source: OECD reviews Pension Systems: Latvia.201816. The impact of fiscal redistribution is low. Taxes and social benefits in Latvia have very low redistributional impact compared to other EU countries.10 Most of the fiscal redistribution effort (about 60 percent) is achieved through public pension benefits, significantly higher than the EU average (about 50 percent). The low redistribution impact of fiscal policy is also reflected in the relatively small difference between market income Gini (inequality before any government taxes and transfers) and disposable income Gini in Latvia compared to other EU countries. At the same time, the redistribution impact of social spending has potential: estimates indicate that a 1 percent increase in social spending could have a positive impact on the reduction of the Gini coefficient, even above the average impact in EU countries of 0.9 percent. (Figure 7)
Fiscal Redistribution
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Sources: IMF FAD Expenditure Assessment Tool (EAT); Eurostat; Euromod; World Economic Outlook; and IMF staff calculations.17. There is significant scope for improvement in the adequacy and targeting of social programs. Measures introduced in the tax reform package should help improve the redistributional impact of fiscal policies, including through the gradual increase in basic allowances for the low-wage earners and families and the introduction of progressivity in the PIT. Going forward, the coverage and adequacy of existing programs could be improved by introducing uniform standards across Latvia’s municipalities that would allow completing the guaranteed minimum income reform.11 Efficiency gains can be achieved by redesigning existing programs and linking eligibility requirements to socio-economic indicators. Disincentives to work typically associated with these programs can be effectively addressed by using appropriate in-work benefits and reallocating resources to active labor market policies. Progress in addressing shortfalls of future pensions can be achieved by introducing measures that facilitate employment for old age groups and measures to reduce the high operating cost of private pension funds managing the pension system’s second pillar.
Education
18. Public education spending in Latvia is relatively high. At 14.7 percent of total public expenditure, Latvia’s education spending is above the average of EU, OECD, and advanced economies. Spending per student has increased significantly in recent years, but adjusting for income levels, it is still significantly lower than the average of peer countries. Teacher student ratios in both primary and secondary schools stand well above the EU and OECD averages, reflecting the decline in school age population in Latvia (Figure 8). Teachers’ salaries are the lowest in absolute terms among OECD countries. However, compared to similarly educated workers in the country, teachers are relatively better paid than in other OECD countries.12
Public Expenditure in Education
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
19. Latvia’s educational outcomes are comparable to those of peer countries, but challenges remain. Latvia has achieved progress in improving education indicators. As of 2016, net enrollment rates in Latvia are in line with peer country averages and the most recent PISA scores are just at the EU average and slightly below the OECD average.13 However, an efficiency frontier analysis suggests better education outcomes can be achieved by reducing spending inefficiencies, in particular by reducing the high teacher-student ratios. For instance, more than half of EU countries have achieved similar or higher PISA scores with significantly lower teacher-student ratios. Countries with similar per student spending have also achieved better PISA scores than Latvia (Figure 9).14
Education Indicators
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Sources: IMF FAD Expenditure Assessment Tool (EAT) and World Bank.1/ Dashed lines are the EU average.Note: Charts are latest data available.20. Measures to improve the education system are ongoing. The authorities have rolled out a new competence-based curriculum to help improve outcomes in lagging subjects and have taken steps to improve vocational education and training with the aim to reduce labor skills mismatches. They have also introduced a new teacher remuneration model aiming to improve transparency and attract more qualified staff. These reforms have the potential to further increase the quality of education in Latvia and, more broadly, address skill mismatches in the labor market. Further steps require streamlining staff in institutions where teacher-student ratios are high and reallocating resources to further improve existing programs. Consideration should also be given to realigning budget expenditures with Latvia’s demographic developments.
Health
21. Healthcare spending in Latvia is low by many metrics. Latvia allocates around 10 percent of public spending to healthcare, compared to an average of about 15 percent in the EU and OECD countries. As a share of GDP and GDP per capita, public healthcare spending is also one of the lowest among EU, OECD, and advanced countries. At the same time, households’ out-of-pocket spending, at about 40 percent of total healthcare spending, is substantially higher than in peer countries (Figure 10).
Health Sector
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Sources: IMF FAD Expenditure Assessment Tool (EAT); World Bank; World Health Organization; OECD (2017); OECD Health Statistics (database); and Eurostat.22. Low healthcare funding and efficiency gaps have resulted in poor quality of services. The public healthcare system in Latvia suffers from many shortcomings, most notably a shortage of labor, with the number of doctors and nurses below that of peer countries. At the same time, the number of primary health care units is well above the EU average, thus exacerbating the shortage of specialized staff to work in these clinics and contributing to the relatively poor outcomes compared to other countries. In addition, given the large out-of-pocket costs, Latvia has the second largest share of low-income households that report foregoing medical treatment. As a result, Latvia’s health profile lags that of peer countries in some important areas. For example, the number of maternal deaths, smoking related deaths, and heart and circulatory system diseases are still significantly above the EU average. Latvia also has one of the lowest healthy life expectancy (HALE) at birth in the EU—about 67 years, compared to 70 years in the EU.15 Not surprisingly, the self-perception of health in Latvia is poorer than the EU average across all income levels, especially among the population in the lowest-income brackets (Figure 10).
23. The authorities have undertaken a comprehensive healthcare reform. It aims to: i) reduce the key shortcomings in the healthcare system (quality and accessibility) and improve its cost-effectiveness;16 ii) improve the efficiency of the health system administration; and iii) reform the financing of healthcare services by moving away from the provision of public universal healthcare. The latter separates the provision of public health services in two “baskets”: a full basket of services available to persons paying social security contributions and to those considered as vulnerable population (children and pensioners), and a “minimum basket,” which provides for a reduced set of health care services for those who do not pay social security contributions. An option to access the full basket is allowed upon paying social security contributions.
24. The reform entails a significant increase in healthcare spending. The implementation of the reform is estimated to cost about 0.9 percent of GDP during 2018–19, for which the European Commission has granted budget flexibility to Latvia. Additional long-term funding has been secured through a 1 percent increase in social security contributions. This will be used primarily for an increase in the remuneration of health care workers, aiming to address the shortage of labor in the healthcare sector.
25. The health care reform is timely, but success in improving the quality and availability of healthcare services will depend on how efficiently the resources are used. Latvia’s distance to the “efficiency frontier”—measured in healthy life expectancy—is not significantly large given the current level of healthcare spending.17 Still, there is some loss in HALE of approximately 4 years, suggesting that there is scope for better allocation of healthcare spending. For instance, efficiency gains can be achieved by reducing information gaps about healthcare quality.18 Better and more granular information about service delivery and patient outcomes will help identify key deficiencies in the system and areas where resources should be reallocated, thereby improving the efficiency and quality of healthcare services. At the same time, the new financing law for healthcare could have a negative impact in long term HALE if the share of population eligible only for basic coverage are unable to buy into the full package. Given the already high out pocket costs, this would make improving basic healthcare services all the more important.
Health Efficiency Frontier, Latest Value Available 1/
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Source: IMF FAD Expenditure Assessment Tool (EAT), World Bank.1/ Dashed lines are the EU average.D. Towards an Inclusive and Growth-Enhancing Policy Mix
26. Latvia’s low tax revenue ratio limits the government’s scope to meet its vast spending needs. The ratio of tax revenue to GDP in Latvia is well below the OECD average, and one of the lowest in the EU. Under current policies, total revenues are expected to decline, reflecting the limited scope to increase tax revenues and the expected decline in EU investment funds (Figure 11). Fiscal costs associated with the implementation of the recent tax and healthcare reforms have also put pressure on the budget and absorbed existing fiscal space.
Government Revenue Indicators
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
27. The recent tax reform limits the scope for raising the revenue ratio. While the reform is likely to have a positive impact on future growth, the largest gains are not likely to be seen in the short term, and its cost entails a permanent dent on tax revenues. The reform introduces measures to reduce the large share of informality in the economy, which, if successful, could help increase tax revenues, but their impact is hard to estimate and will likely take some time to materialize.
28. With limited revenue sources, public spending should focus on growth-friendly spending and reducing efficiency gaps. Investing in health, education, and social protection can help increase human capital and labor productivity, while investing in physical capital can have a large impact on future growth. As Latvia is close to the efficiency frontier in many areas, gains from improving spending efficiency may be limited, but can be obtained through some focused reforms:
a. Reducing government employment: Savings can be achieved by reducing the size of government employment, particularly in the education sector through streamlining institutions with high teacher-student ratios. To increase the impact of the ongoing civil service reform, its scope could be expanded to include staff beyond the central government. This would also allow for more flexibility in reducing the public-private wage gap without increasing the government wage bill. More generally, this reform could also help ease the tightness in the labor market.
b. Improving the targeting of social protection: public resources can be more effectively used by relying on means-tested programs, linking eligibility requirements of existing programs to income levels.
c. Improving the efficiency of healthcare spending: efforts should focus on improving the provision of primary care, enhancing information systems to better identify the investment needs in the healthcare system, and reducing the high out-of-pocket costs, which disproportionally affect low income households.
d. Increasing public investment: boosting public investment is needed to improve productivity and boost growth over the medium term, especially as EU funds gradually level off. While efficiency gains on public investment seem small, further improvements can be achieved by strengthening the project approval and management of PPPs.
29. The authorities should also seek to expand tax revenues sources. An effective way to increase tax revenue is making use of less distortionary taxes, such as property taxes. Additional revenues can be achieved by updating cadastral values to align them with market values, and ensuring that property tax rebates and deferrals are only used by low-income households. There is also scope to raise additional revenues by reducing inefficiencies in the VAT system by simplifying the VAT rate structure and strengthening VAT compliance.
Appendix I. Modeling the Impact of Permanent Fiscal Reforms
1. The economic impact of the tax reform package and alternative expenditure policies are analyzed using the IMF’s Global Integrated Monetary and Fiscal model (GIMF).1 GIMF is a general equilibrium model that can help policymakers assess the economic implication of different fiscal and monetary policies. The model has been calibrated to represent Latvia’s characteristics by using historical data and staff projections.
2. The impact of the tax reform is assessed under two financing scenarios. The first scenario, reflecting staff’s current baseline and authorities’ assumptions, assumes the tax reform is partly financed by an increase in excise duties, thus having a negative impact on the fiscal balance, which is debt creating. We also simulate an alternative budget neutral scenario that fully covers the cost of the fiscal reform, where we assume an increase in excises together with an increase in lumpsum taxes (as a proxy for an increase in property taxes). While the tax reform also includes important administrative reforms, which should have a positive impact on tax revenues, these simulations focus only the most direct reforms: the change to the PIT and CIT, which are treated as permanent fiscal measures. A Latvia-specific reform scenario is calibrated using the authorities’ estimates of the change in the effective PIT rates post reform. The CIT reform is calibrated to simulate similar behavioral dynamics as observed in Estonia, given the uncertainty in estimating behavioral dynamics.
Impact of the Tax Reform: Baseline Scenario
3. The tax reform is likely to have a positive permanent impact on the economy, though its magnitude largely depends on the potential behavioral response. The reform will have a positive effect on net incomes of individuals and firms, thereby supporting an increase in consumption and investment. Over the medium term, the combined PIT and CIT reforms result in a higher real GDP by almost 1.5 percent, compared to a pre-reform scenario. A key assumption in this scenario is that firms’ tax relief gradually translates into productive investment. Furthermore, over the medium to long term, automatic fiscal stabilizers are assumed to cover the fiscal cost of the reform not financed by an increase in excises (this is modeled as a decline in government lump-sum transfers). Financing of the reform is a key factor in estimating its impact. Clearly, deficit financing of the reform will have a large positive upfront impact on growth, which will dissipate quickly. Over the long term, implementing the tax reform without resorting to debt financing would still deliver a larger benefit (Figure A.1).
Tax Reform Scenario
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Source: IMF staff calculations.Impact of the Tax Reform: Revenue Balancing Scenario
4. Absent further reforms, the tax reform will permanently dent tax revenues. After the introduction of the progressive system, with lower rates for lower income brackets, PIT revenues as a share of GDP are projected to be permanently lower than the pre-reform baseline by up to 1 percent of GDP on average. CIT revenues could have an even larger initial impact—by about half for the first two years of implementation (similar to the pattern observed in Estonia), but could gradually increase over time converging to below pre-reform levels as firms normalize dividend payments. An alternative policy option to achieving a budget neutral reform, would be to absorb the remaining cost of the tax reform through a tax increase, for example by raising property taxes. While the impact on real GDP and investment will not significantly differ from a debt financing scenario, under this scenario the impact on government finances is much lower, thus providing room for social spending and a longer, stable source of revenues, thereby partly offsetting the revenue shortfall from the tax reform (Figure A.2).
Financing Scenarios for the Tax Reform
Citation: IMF Staff Country Reports 2018, 267; 10.5089/9781484375310.002.A003
Source: IMF staff calculations.References
Bom, P. and J. Ligthart, 2014: What Have We Learned from Three Decades of Research on the Productivity of Public Capital? Journal of Economic Surveys, Vol. 28, No. 5, pp. 889—916
European Commission, 2017. European Economy – Discussion Paper N. Inequality and Structural Reforms: Methodological Concerns and Lessons from Policy: Workshop Proceedings.
International Monetary Fund, 2010. The Global Integrated Monetary and Fiscal Model (GIMF) – Theoretical Structure. Working Paper No. 10/34
International Monetary Fund, 2013, “Getting to Know GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Mode,” Working Paper No. 13/55.
International Monetary Fund, 2016a, “Managing Government Compensation and Employment—Institutions, policies and reform Challenges.
International Monetary Fund, 2016b, “Effective Government for Stronger Growth: Improving the efficiency of public investment and tax administration in CESEE,” CESEE REI Fall.
International Monetary Fund, 2017, Fiscal Monitor, “Tackling Inequality.”
International Monetary Fund, 2018, “Inequality and Poverty Across Generations in the European Union,”
Organisation for Economic Co-operation and Development (OECD), 2017a, “OECD Economic Surveys: Latvia,” September 2017 (Paris).
Organisation for Economic Co-operation and Development (OECD), 2017b, Education at a Glance 2017: OECD Indicators, OECD Publishing, Paris.
Organisation for Economic Co-operation and Development (OECD), 2017c, Latvia: Country Health Profile 2017.
Prepared by Karina Garcia (EUR). GIMF simulations done by Michal Andrle (RES).
Throughout this document, advanced economies refer to the income group classification according to WEO.
This estimate is based on official figures of average wages, which do not correct for the impact of the shadow economy on wage estimates. If accounted for, the wage premium could be larger. For the methodology to estimate the wage premium, see IMF (2016a).
Evidence suggest that increases in public sector wages, besides the associated deterioration in fiscal balances, can spill over to overall wages. See IMF (2016a).
Capital stock data is taken from AMECO database, which has some measurement shortcomings with regard to capital stocks in Latvia. Therefore, the purpose of this comparison is to assess relative investment needs in Latvia to those in wealthier EU countries, rather than providing a point estimate of capital stock levels.
For a specific discussion of structural policy priorities in Latvia see IMF Country Report No. 17/195.
This scenario simulates a permanent increase in public investment, financed through a reduction in government consumption. It is based on output elasticity to public investment of 0.2 percent, which is consistent with Bom and Ligthart (2014).
The efficiency frontier shows the level of infrastructure quality at a given capital stock per capita. The closer a country is to the efficiency frontier, the more efficient its public investment. Countries with the highest level of infrastructure coverage and quality. Countries with the highest efficiency scores for a given level of public capital stock and income per capita are assigned the efficiency score of 1 and form the efficiency frontier, while other countries are assigned a score of between 0 and 1, based on their proximity to the frontier. See IMF (2016b)
The data is obtained from the ASPIRE project, which classifies social assistance into the following categories: unconditional cash transfers, cash transfers, social pension, food and in-kind transfers, school feeding, public works, fee waivers, and other social assistance.
Reduction in inequality is calculated as the difference between the Gini coefficient for market income and the Gini coefficient for disposable income.
The reform aims to address shortcomings of the narrow eligibility requirement and the poor adequacy of the program. It aims to: increase the minimum income level to 40 percent of the median disposable income, and set a minimum budget of goods and services for different types of households depending on the territorial dimension.
See OECD (2017b).
See OECD (2017).
The “efficiency frontier” analysis was done using FAD’s Data Envelopment Analysis (DAE) and compares Latvia’s relative efficiency both against the efficiency frontier and other countries.
Healthy life expectancy (HALE) is a measure of health expectancy that applies disability weights to health states to compute the equivalent number of years of life expected to be lived in full health.
The authorities commissioned a study to evaluate the economic return of specific indicators and identify key reform objectives. Results of this study and specific measures are summarized in the 2018 Stability Plan.
This should be interpreted carefully as the efficiency frontier analysis assesses the efficiency of total expenditure, and thus a more granular approach would need to be taken to assess the efficiency of public spending separately.
See OECD (2017a) and OECD (2017c).
