Latvia’s economy continues to grow. Household consumption remains the main growth engine. Export growth has become slower and competition challenges are becoming more and more complicated. In order to resolve them, it is necessary to secure more rapid productivity growth, as concluded in the latest Swedbank economic outlook.
Good news is that investment activity seems to be starting to recover in spite of delayed allocation of European funds by the state. The current state of the budget is tense. But in order to significantly increase budget expenses without increasing deficit, politicians have to increase tax revenue. But it needs to be done in a clever and sustainable way. Unfortunately, the 2016 budget does not do that at all, notes Swedbank Latvia head economist Martins Kazaks and senior economist Lija Strasuna.
Concerns about the current economic situation in China worry politicians and financial markets around the world. Even economic growth in developed countries has been slower lately. With that, central banks have become more cautious as of late. Swedbank economists do expect additional stimuli from European central banks; policies of central banks in Sweden and Norway are becoming more and more expansive as well. Economy in USA has become stronger. The Federal Reserve Bank will likely go the opposite road and will increase rates for the first time since 2006. This will result in the world’s monetary policy becoming out of synch. Uncertainty and fluctuations will likely rise on financial markets as well. Economists have slightly reduced their global economic growth rates for 2015. Nevertheless, global economy continues to grow, which is largely because of supportive monetary policy and growing purchasing power of households in developed countries.
Although the external environment is unstable and brittle, the rise of external demand for Latvia is expected to be more rapid in the next two years. Oil price rise will likely be slower than previously expected, which will have a positive impact on the purchasing power of Latvian residents. Interest rates in Europe remain low. It can be fixed with investments, however. Latvia’s economy may grow 2.4% this year, 3.3% next year and 3% in 2017.
«Latvia’s export market share in Europe, which grew rapidly throughout 2010-2012, has been the same in the past couple of years. It seems it has begun to decline this year. This means there are competitiveness problems on a rise. We had warned about them some time ago. Wage rise has been higher than the rise of productivity in the past three years. In order to achieve more rapid export growth, exporters have to have quality breakthrough. Established exporters already do that. Structural changes from policy-makers are necessary in order to help improve productivity and added value growth in industries and companies, as well as to support the formation of innovative industries and companies,» – said Strasuna.
Weak productivity growth means larger investments are necessary. It seems investment activity is on a rise – demand for loans and new loan services have increased this year. This may be a temporary improvement, however. Companies remain cautious and wish to see more stable growth of demand before investing in output growth. Companies currently focus on improving efficiency by investing in machinery and equipment. This is reflected in import indexes. Many companies still await EU funds to come through. Although two years have passed since the beginning of the planning period, fund programmes have not yet been announced. This delays development.
Meanwhile, powerful wage rise sustains household consumption, which remains rather cautious nonetheless. This year’s average net wage rise will be close to 7%. Average consumer prices will remain practically on the level of 2014. Inflation of 2016-2017 is expected at 1.5% and 2.3% respectively. With that, purchasing power will continue growing, only slower.
«Although the state budget of 2016 is based on rather realistic macro assumptions, it seems that it will not be possible to collect enough tax, which will likely lead to higher budget deficit in the end. In order for it to be possible to increase expenses for priorities like defence, healthcare and education, it is necessary to improve budget use efficiency and increase tax revenue and its proportion with GDP. It is necessary to come up with a tax policy plan with a long-term perspective. It is also necessary to apply systematic approach to the reduction of shadow economy. The 2016 budget does not resolve those matters enough. In order to make sure 2017 budget talks to not suffer the same fate, it is necessary to hold tax talks now. One solution is increasing real estate tax fee,» – said Kazaks.
Research on international practises and theories regarding good tax policies show that the tax system should be as neutral and progressive as possible. Neutral so that it does as little as possible to change residents’ general behaviour and attitude toward taxes and progressive so that it helps make tax income division more effective, giving more advantages to people who earn less and motivate them to work and earn money. The country’s tax system should delay economic growth as little as possible. The tax system should encompass all taxes, not classify every tax separately. It is important to secure a general effect from the tax system as a whole – not all taxes have to be progressive as long as the tax system is progressive as a whole.
Reduced VAT rates do not provide an effective method for reducing income inequality. Replacing reduced rates with direct benefits is a more accurate and cheaper way for the state to support the poor. In order to increase the progressiveness of Latvia’s tax system, policy-makers have been focusing too much on income from employment. Other forms of income are rarely discussed. In Latvia, the tax burden on wages is significantly higher than the tax burden of other kinds of income. It is also larger than that in Estonia, Lithuania and Europe on average. Further increase of taxes on wages would only hurt competitiveness.
The tax burden on corporate income and income from capital – the forms of income that are most often received by wealthy residents – is significantly lower than the tax burden on wages. This does not mean tax burden on this type of income should be increased. It should be said that tax burden increase for income from capital can potentially cause an outflow of capital and reduce tax revenue. If it is not possible to collect more taxes from such income, it is possible to do that indirectly and increase income where people who earn that money spend it. Real estate tax would be an adequate choice because it is impossible to hide, it has progressive nature and it has less negative impact on the country’s general level of competitiveness.