Latvia

   

Economic Policies

#22
Key Findings
Despite recent gains, Latvia falls into the middle of the pack (rank 22) in the area of economic policy. Its score on this measure has improved by 0.8 points since 2014.

Growth rates have been strong and rising. Since joining the euro zone in in 2014, the country’s economic focus has shifted to longer-term issues of competitiveness and inequality. A budget-cap law is in place, but some structural reforms have met with resistance.

Though remaining moderate, unemployment rates have fallen dramatically in the past half-decade. Structural unemployment is a concern. Minimum monthly wage levels have been steadily increased for the last several years. Rising wages with labor shortages indicate a tightening labor market.

A significant tax reform aimed at reducing inequality came into effect in 2018. Social-security contribution rates have been increased slightly to bolster the health care system. Budget deficits have been below 1% of GDP for years, paired with low levels of general government debt. Despite the suspension of a large bank following money-laundering allegations, the banking system remains solid.

Economy

#10

How successful has economic policy been in providing a reliable economic framework and in fostering international competitiveness?

10
 9

Economic policy fully succeeds in providing a coherent set-up of different institutional spheres and regimes, thus stabilizing the economic environment. It largely contributes to the objectives of fostering a country’s competitive capabilities and attractiveness as an economic location.
 8
 7
 6


Economic policy largely provides a reliable economic environment and supports the objectives of fostering a country’s competitive capabilities and attractiveness as an economic location.
 5
 4
 3


Economic policy somewhat contributes to providing a reliable economic environment and helps to a certain degree in fostering a country’s competitive capabilities and attractiveness as an economic location.
 2
 1

Economic policy mainly acts in discretionary ways essentially destabilizing the economic environment. There is little coordination in the set-up of economic policy institutions. Economic policy generally fails in fostering a country’s competitive capabilities and attractiveness as an economic location.
Economic Policy
8
Following a difficult period of economic adjustment in 2009 and 2010, Latvia’s economy has fully rebounded, returning to the international markets and to favorable economic growth rates. In 2016, Latvia’s annual growth rate was 2.0%, in line with the EU average. In 2017 and 2018, the growth rate continued rising, with a 5.3% increase in GDP between the second quarter of 2017 and the second quarter of 2018.

Latvia’s economic policy had been governed by parameters accepted as part of financial assistance provided by the IMF and European Union. As this assistance has since been repaid, these parameters have been withdrawn. While these parameters led the economy into a difficult period of adjustment, they provided a framework in which the economy established fiscal discipline. For example, in 2013, Latvia introduced legislation that placed a cap on the public budget deficit and launched a multi-year planning cycle. The Fiscal Discipline Council (FDC) plays an oversight function, consulting with the government on fiscal planning issues and compliance with the budget deficit cap. In 2018, the FDC highlighted that the positive output gap trend observed in 2017 continued strongly through 2018. The FDC also emphasized the systematic practice of reallocating expenditure by the government, indicating unused appropriations as the source of funding, the amount of which was then used to calculate the maximum amount of government expenditure. According to the FDC, this practice was exemplified by the cabinet’s decision to reallocate funds from the Ministry of Welfare’s budget in October 2018.

Since meeting its policy goal of joining the euro zone in 2014, Latvia’s focus has necessarily shifted to longer-term issues of maintaining competitiveness within the euro zone and addressing social inequalities. The Latvian economy is continuing to grow strongly and, while the growth rate is projected to moderate by 2020, Latvia will need to maintain progress with economic reforms and participate more actively in international trade to ensure continued progress. Domestically, there should be a stronger focus on innovation and research, and access to jobs, housing and health care services should be improved to promote inclusion. While a number of reforms are already underway, especially in key areas (e.g., health care, education and public administration), their effectiveness remains varied and rapid wage growth represents a further challenge to economic stability.

Citations:
1. Central Statistical Bureau (2018), Growth Rate Indicators, Available at: https://www.csb.gov.lv/en/statistics/statistics-by-theme/economy/gdp/search-in-theme/2381-changes-gross-domestic-product-2nd-quarter-2018. Last assessed: 28.12.2018.

2. Fiscal Discipline Council of the Republic of Latvia (2018). Macroeconomic forecast endorsement, Available at: http://fiscalcouncil.lv/15102018-macroeconomic-forecast-endorsement. Last assessed: 28.12.2018

3. Fiscal Discipline Council of the Republic of Latvia (2018), Irregularity reports (05.02.2018, 23.05.2018, 29.08.2018, 01.11.2018). Available at: http://fiscalcouncil.lv/documents, Last assessed: 28.12.2018.

4. OECD (2018), Economic Forecast summary (2018), Available at: http://www.oecd.org/eco/outlook/economic-forecast-summary-latvia-oecd-economic-outlook.pdf. Last assessed: 28.12.2018.

Labor Markets

#21

How effectively does labor market policy address unemployment?

10
 9

Successful strategies ensure unemployment is not a serious threat.
 8
 7
 6


Labor market policies have been more or less successful.
 5
 4
 3


Strategies against unemployment have shown little or no significant success.
 2
 1

Labor market policies have been unsuccessful and rather effected a rise in unemployment.
Labor Market Policy
8
The unemployment rate in Latvia has fallen from 20% in 2010 to 8.9% in 2017 to 6.9% in 2018.

Following increases in 2016 and 2017, the minimum monthly wage was further increased in 2018 to €430. Accordingly, in the second quarter of 2018, compared to the second quarter of 2017, the average monthly gross wage grew by 8.4% or €78. The average monthly income now exceeds €1,000.

However, rising wages with labor shortages is indicative of a tightening labor market. The main labor market challenges for Latvia remain a rapidly shrinking working-age population, internal migration from rural regions to the capital city of Riga and high net emigration.

Citations:
1. European Commission, Unemployment Statistics (2018), Available at: https://ec.europa.eu/eurostat/statistics-explained/index.php?title=Unemployment_statistics. Last assessed: 28.12.2018

2. European Commission, Country Report on Latvia (2018), Available at: https://ec.europa.eu/info/sites/info/files/2018-european-semester-country-report-latvia-en.pdf, Last assessed: 28.12.2018.

3. Central Statistical Bureau (2018) Wages and salaries indicators, Available at: https://www.csb.gov.lv/en/statistics/statistics-by-theme/social-conditions/wages/search-in-theme/2385-changes-wages-and-salaries-2nd-quarter-2018, Last assessed: 28.12.2018

4. Central Statistical Bureau (2018) Changes in Wages and Salaries 2018/02 (in Latvian), Available at: https://www.csb.gov.lv/en/statistics/statistics-by-theme/social-conditions/wages/search-in-theme/310-changes-wages-and-salaries-2018-02-only. Last assessed: 28.12.2018.

Taxes

#17

To what extent does taxation policy realize goals of equity, competitiveness and the generation of sufficient public revenues?

10
 9

Taxation policy fully achieves the objectives.
 8
 7
 6


Taxation policy largely achieves the objectives.
 5
 4
 3


Taxation policy partially achieves the objectives.
 2
 1

Taxation policy does not achieve the objectives at all.
Tax Policy
7
Overall, Latvia has one of the lowest rates of tax in the European Union. However, more than in many other EU member states, the tax burden falls disproportionately on wage earners, particularly low-income earners. To address this issue, tax reforms were undertaken in 2016 and 2017 to shift the tax burden away from low-income wage earners and increased the tax burden on the wealthy. Following this trajectory, a significant tax reform came into force in 2018.

In 2016, a “solidarity tax” was introduced, to be levied on any income exceeding the mandatory social security contributions ceiling. The rate of this tax was set at 34.09%, of which 23.59% was to be paid by the employer and 10.5% by the employee. The legality of this tax was challenged in the Constitutional Court by a group of plaintiffs subject to the new tax. In October 2017, the Constitutional Court ruled that while the solidarity tax itself is constitutional, the differentiated application across taxpayer groups was unconstitutional. The court mandated that the tax expire on 1 January 2019, granting the government time to plan an appropriate tax-policy change.

The tax reforms that came into force in 2018 aim to reduce income inequality and increase the total amount of tax revenues to 30% of GDP. A progressive income tax system was introduced. The personal income tax rate of 23% was replaced with a three-tier system: 20% for annual incomes below €20,000, 23% for incomes between €20,000 and €55,000, and 31.4% for incomes above €55,000. The maximum non-taxable minimum income was increased from €115 to €200 per month, with further increases slated for 2019 and 2020. The non-taxable minimum for pensions was increased from €235 to €250 per month, with further increases slated for 2019 and 2020. The allowance for dependents was increased from €175 to €200 per month. The personal income tax rate for income from capital and capital gains was increased to 20% (with the exception of dividends taxed under corporate income tax).

In order to increase health care financing, social security contribution rates were increased from 34.09% to 35.09 % in 2018, of which 24.9 09% is paid by the employer and 11% by the employee. The solidarity tax, which will remain in effect until 2019, will be applied only to income that exceeds the cap for mandatory social insurance contributions: €55,000 in 2018.

In order to provide compensation for the loss in state and municipal budgets brought by the reform, the gambling tax and excise duties were increased in 2018 – a mechanism put in place to tackle the shadow economy and strengthen tax administration.

Economic recovery, structural reforms, improvements in tax collection and a reduction in the overall share of the informal economy have enabled the government to exceed its target for reducing the budget deficit. In 2013, the budget deficit was reduced to 1.0%, exceeding the target of 1.4%. In 2014, the deficit stood at 1.4%, declining to 1.3% in 2015. In 2016, the budget deficit was 0.0%. The general government deficit was 0.5% of GDP in 2017 and was forecasted to be 0.9% of GDP in the spring of 2018, but decreased to 0.8% in the autumn of 2018. Meanwhile, the general government gross debt is expected to increase to 1.0% of GDP in 2019, before declining again in 2020.

In the light of the extensive tax reforms, the short-term challenge for tax policy in Latvia will stem from the uncertainty around the cost and impact of the reforms. Therefore, prudent fiscal policies will be crucial for Latvia to preserve sound public finances.

Citations:
1. Intra-European Organisation of Tax Administrations (2018) , Tax reform in Latvia in 2018, Available at: https://www.iota-tax.org/sites/default/files/documents/iota-papers-tax_reform_latvia_2018.pdf, Last assessed: 28.12.2018

2. European Comission (2018), The Effect of Taxes & Benefits Reforms on Poverty and Inequality in Latvia, Available at: https://ec.europa.eu/info/sites/info/files/economy-finance/eb039_en_0.pdf, Last assessed: 28/12/2018.

3. European Commison (2018) Economic forecast for Latvia, Available at: https://ec.europa.eu/info/sites/info/files/economy-finance/ecfin_forecast_autumn_081018_lv_en.pdf, Last assessed: 28.12.2018.

4. IMF (2018), Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Latvia, Available at: https://www.imf.org/en/Publications/CR/Issues/2018/09/05/Republic-of-Latvia-2018-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-46206 , Last assessed: 28.12.2018.

5. Constitutional Court (2017) Solidarity Tax Paragraph 6 does not conform to the Constitutional principle of equal treatment before the law (in Latvian). http://www.satv.tiesa.gov.lv/press-release/solidaritates-nodokla-likuma-6-panta- noteiktas-nodokla-likmes-neatbilst-satversme-nostiprinatajam-vienlidzibas-principam/. Last assessed 28.12.2018

Budgets

#7

To what extent does budgetary policy realize the goal of fiscal sustainability?

10
 9

Budgetary policy is fiscally sustainable.
 8
 7
 6


Budgetary policy achieves most standards of fiscal sustainability.
 5
 4
 3


Budgetary policy achieves some standards of fiscal sustainability.
 2
 1

Budgetary policy is fiscally unsustainable.
Budgetary Policy
9
Latvia’s budgetary policy has been recognized as prudent and fiscally sustainable by the European Commission, the IMF, and the OECD. However, achieving medium-term structural-reform goals remains a challenge.

The budget framework and government-debt cap of 60% of GDP, prescribed by the Law on Fiscal Discipline, has been maintained. Latvia remains broadly compliant with the principles of fiscal discipline.

During 2018, Latvia has maintained policy continuity, which has not been impaired by the current election cycle.

In 2015, the budget deficit was 1.3% of GDP, above the target of 1.0%. In 2016, it stood at 0.0%. In 2017, the deficit (0.5% of GDP) was about 0.25% below the projections of the IMF. In addition, during the first quarter of 2018, the government recorded a cash surplus, supported by a strong increase in revenue from income tax, VAT and social security contributions.

Citations:
1. IMF (2018), Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Latvia, Available at: https://www.imf.org/en/Publications/CR/Issues/2018/09/05/Republic-of-Latvia-2018-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-46206 , Last assessed: 28.12.2018.

Research, Innovation and Infrastructure

#34

To what extent does research and innovation policy support technological innovations that foster the creation and introduction of new products?

10
 9

Research and innovation policy effectively supports innovations that foster the creation of new products and enhance productivity.
 8
 7
 6


Research and innovation policy largely supports innovations that foster the creation of new products and enhance productivity.
 5
 4
 3


Research and innovation policy partly supports innovations that foster the creation of new products and enhance productivity.
 2
 1

Research and innovation policy has largely failed to support innovations that foster the creation of new products and enhance productivity.
R&I Policy
4
Research and development (R&D) expenditure in Latvia was equal to 0.62% of GDP in 2015, but fell to 0.44% of GDP in 2016. Investment into R&D from foreign sources in Latvia is significantly higher than the EU average. In 2013, the EU average was 9.9%, while in Latvia it was 44% in 2014 and 45% in 2015. In 2014 and 2015, private sector investment in R&D was 0.19% and 0.12% of GDP respectively, significantly below the EU average of 1.3% in 2014.

Even though Latvia’s productivity growth has been solid, innovation performance remains average at best. In the Union Innovation Scoreboard 2018, Latvia ranked 24 out of 28 EU member states in terms of innovation, up from 25 in 2017. Consequently, Latvia remained in the category of “moderate innovators.” Despite the relatively high increase in venture capital, in absolute terms, investments remain small and largely dependent on EU support. Despite Latvia’s previous progress from “modest” to “moderate” innovator, the share of high-tech companies in the Latvian economy is small, as is the private sector’s demand for R&D activities. In budgetary debates, innovation remains a low priority.

The OECD has recognized Latvia for improving in its framework on research and development innovations, noting the consolidation of research institutions, introduction of quality-based financing models, and incentives to boost research. For example, a support program for the development of new products and technologies has been set up, managed nationwide by eight Competency Centers. The program seeks to attract at least €12.8 million in private sector investment for research and development. As of September 2018, 186 projects had been launched, which signals an appetite for similar incentives to be introduced in the future.

In Latvia, a high proportion of the population has completed tertiary education, which – paired with favorable business conditions – creates an advantageous climate for innovation-driven growth. In the coming years, the quality of public R&D has to increase, and links between academia and business need to be strengthened.

Citations:
1. Ministry of Economics (2018) Competency Centers Continue to Develop New Products and Technologies, (In Latvian) AvaibleAvailable at: https://www.mk.gov.lv/lv/aktualitates/kompetences-centri-turpina-attistit-jaunus-produktus-un-tehnologijas, Last assesed: 28.12.2018.

2. European Comission (2018),European Innovation Scoreboard 2018, Available at: http://europa.eu/rapid/press-release_IP-18-4223_en.htm, Last assessed: 28.12.2018

3. European Commission (2018), Research and Innovation performance and Horizon 2020 Country Participation for Latvia, Available at: http://ec.europa.eu/research/horizon2020/index_en.cfm?pg=country-profiles-detail&ctry=latvia, Last assessed: 28.12.2018

4. OECD (2017) Going for Growth-Latvia 2017. http://www.oecd.org/eco/growth/Going-for-Growth-Latvia-2017.pdf. Last assessed 28.12.2018

Global Financial System

#18

To what extent does the government actively contribute to the effective regulation and supervision of the international financial architecture?

10
 9

The government (pro-)actively promotes the regulation and supervision of financial markets. It demonstrates initiative and responsibility in such endeavors and often acts as an international agenda-setter.
 8
 7
 6


The government contributes to improving the regulation and supervision of financial markets. In some cases, it demonstrates initiative and responsibility in such endeavors.
 5
 4
 3


The government rarely contributes to improving the regulation and supervision of financial markets. It seldom demonstrates initiative or responsibility in such endeavors.
 2
 1

The government does not contribute to improving the regulation and supervision of financial markets.
Stabilizing Global Financial System
7
The volume of bank deposits made by non-residents has presented a systemic risk to the Latvian financial system. However, this risk is declining. The share of non-resident deposits to total deposits shrank from 53.4% in 2015 to 42.8% in 2016. The share of non-resident deposits continued to fall in 2017 as Latvia’s membership in the OECD and new international banking regulations saw Latvia’s regulators and banks tighten their anti-money laundering practices, Latvia was lauded for this in an annual report from the OECD. Non-resident deposits in Latvian banks dropped further to an historic low of 20.5% in August 2018.

Latvia’s banking system is increasingly interconnected with the Nordic and Baltic regional system, requiring increased collaboration to address Nordic parent bank vulnerabilities and their spillover effects.

Overall, despite the suspension of activities of Latvia’s third largest bank following allegations of money laundering, the banking system remains well capitalized and liquid, with capital-to-risk-weighted assets of 22.4% and liquid assets exceeding 80% of short-term liabilities at the end of March 2018.

In addition, Latvia adopted a National Risk Assessment for money laundering and terrorist financing in 2017, articulating an understanding of the vulnerabilities and risks that the country faces. However, the absence of a robust risk assessment (e.g., which would address confusion between unusual and suspicious transaction reports) for terrorist financing still represents a key deficiency in the effective supervision of international financial security. Furthermore, there is a lack of clarity in the legal system regarding targeted financial sanctions. With the exception of the Financial Capital Market Commission, Latvia’s supervisory authorities are not active in international cooperation regarding money laundering and terrorist financing.

Citations:
1. Finance and Capital Market Commission (2018), Non-resident investementsinvestments in Eurozone, Available at: http://www.fktk.lv/attachments/article/7212/INFOGRAFIKA_2015-2018_11-09-2018_LV.pdf, Last assessed: 28.12.2018

2. IMF (2018), Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Latvia, Available at: https://www.imf.org/en/Publications/CR/Issues/2018/09/05/Republic-of-Latvia-2018-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-46206 , Last assessed: 28.12.2018.

3. Council of Europe (2018), Anti-money laundering and counter-terrorist financing measures: Latvia, Fifth Round Mutual Evaluation Report. Available at: https://rm.coe.int/moneyval-2018-8-5th-round-mer-latvia/16808ce61b , Last assessed: 28.12.2018
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