Analytics, Economics, EU – Baltic States, Latvia, Legislation, Markets and Companies

Since July 2016, Latvia is an OECD member; Estonia joined it in December 2010. These two Baltic States’ contribution to OECD is 1.4% of GDP (Lithuania is not a member).

The OECD is a kind of global “think-tank” and “economy-monitoring” group of experts in such fields as national fostering economic development issues, combating poverty, ensuring environmental impact of growth and in general social development progress. It is also dealing with a range of issues, including raising the standard of living in the member countries, contributing to the expansion of world trade and promoting economic stability. It’s head-quarter is in the Chateau de la Muette in Paris, France.

See more on OECD: Organization for Economic Cooperation and Development (OECD), in: http://www.investopedia.com/terms/o/oecd.asp#ixzz4u3jEyoln  

OECD consists of 34 member countries with the main  purpose of discussing and providing the member states with economic reviews on national polit-econ development while supporting open market economy growth. Reference: http://www.investopedia.com/terms/o/oecd.asp.  

History and functions

The Organisation for European Economic Co-operation (OEEC) was established after World War II in 1948, to mainly administer the U.S.- funded Marshall Plan for post-war European reconstruction. The group emphasized the importance of working together for economic development, with the goal of avoiding any more European warfare. The OEEC was instrumental in helping the European Economic Community (EEC), which has since evolved into the European Union, in establishing a European Free Trade Area.

In 1961, the United States and Canada joined the OEEC, which changed its name to OECD to reflect the broader membership with numerous countries that joined the OECD since; as of 2016, there are 34 member states.  

The OECD’s main “products” are officially published economic reports (global, regional or national in orientation), statistical databases, analyses and forecasts on the outlook for economic growth around the world and in the member states. A group of experts analyzes and reports on the impact of social-economic growth, and makes policy recommendations.

OECD is the global leader in tax issues: it maintains a so-called "black list" of nations that are considered uncooperative tax havens. It led a two-year effort with the Group of 20 nations (G-20) to encourage tax reform worldwide and eliminate tax avoidance by constructive corporations. The recommendations included an estimate that such avoidance costs the world’s economies between $100 billion and $240 billion in tax revenue annually.

Besides, OECD provides consulting assistance and support to nations in Central and Eastern Europe in implementing market-based economic reforms. 

OECD assessment and recommendations

The yearly membership in the organisation for each of the two Baltic States (Lithuania is not a member) is 1.4% of GDP; hence for Latvia it is about €300 million. The two booklets of the OECD analysis with a total of about 200 pages, seems to be the most expensive survey: over one million euros per page! However, depending on the national economic power, other OECD members’ GDP share is much bigger, e.g. 5.4% for France, 7.4% for Germany, 4.1% for Italy, 3% for Spain and 5.5% for the UK (the US share is the largest – 20.6% of GDP). Quite notable: the states’ contribution to OECD is much larger than, for example, for the European Union, which is about 1%. Are these expenses well worth for Latvia?  

The OECD economic survey for Latvia consists of survey booklet (139 pages) and an overview (55 pages). Latvian economic situation was initially reviewed in May 2017and an agreed report was presented in June 2017; the survey’s presentation in Latvia occurred in mid-September. A previous survey was issued by OECD in February 2015.

OECD’s Latvian survey consists of: a) country’s economy assessment with some recommendations and b) evaluating progress in Latvian structural reforms. Besides, there are two thematic chapters: a) analysis of Latvian potentials in globalisation (global value chain) and b) analysis of country’s economic and social infrastructure. Survey is richly equipped with numerous tables and figures. 

Assessments: additional efforts needed

Showing some positive aspects in Latvian growth, e.g. GDP increase by 20% since 2010, rising wages, solid fiscal position (with balanced government budget and public debt near 40% of GDP with EU’s limits at 60%) and strong financial market confidence, to name a few.

Riga metropolitan area has been a key economic growth driver, contributing about 69% to national GDP. It’s good for the metropolitan region but shows a drastic discrepancy with the rest of the country, e.g. Latgale and Zemgale, where unemployment and risk-of-poverty rate are higher. Thus, although peoples’ income convergence “may have resumed” (p.14), growth shall be more inclusive: Latvians are still less satisfied with their lives (according to OECD’s Better Life Index).

The relative weakness areas are: little access to well-paid jobs, problems in health care system and the housing market, poverty being among the highest in the OECD, low availability of affordable quality housing, 15% of dwellings lack basic facilities, life expectancy is six years below the OECD level, etc. (p.15).

References: www.oecd.org/eco/surveys/economic-survey-Latvia.htm     

Latvian economic growth has been consumption based; e.g. continued robust household consumption is supported by strong real wage growth. However, exports are still largely low value-added, reported the OECD experts. Still, the share of exports going to Russia remains the third largest after Lithuania (18%) and Estonia (12%). Latvia’s goods exports still largely consists of raw materials and natural-resource-intensive products: “in the medium-term the transit of exports from Russia is expected to continue declining but still contributes substantially to service export revenues” (p.17).   

There is much to do in the export sector: Latvia’s export is concentrated in activities with relatively small “quality upgrading and product differentiation”, argued the survey and further loss of cost competitiveness (partly due to strong wage growth, higher than in other two Baltic States) can undermine country’s export performance.  As a small open economy, Latvia is exposed to trade with main partners –the EU and Russia; exports to the UK will diminish and Brexit will lower emigrants’ remittance, which amounts to 0,8% of GDP, and possibly could boost return migration. 

High structural unemployment (instigated by local differences) raises the risk of poverty, underlines the survey: these two features are much higher in the East (particularly in Latgale region) than in the Riga municipality and Pieriga area. Thus, 72% of vacancies are registered in the latter, while 45% of the unemployed were registered for a year or longer, mostly in Eastern rural areas. Besides, unemployment benefits are reduced by half after six months and expire after nine months (p.22). And unemployment rate is almost five times higher for workers with low education; unemployment rate of workers aged 55-65 is close to 10%, which is among the highest in the EU. The hourly earnings gap between men and women (about 17%) also contributes to inequality.

The survey notes difficulties in credit growth while depicts supportive monetary policy. Thus, the three largest banks (two are owned by Nordic banks) are directly supervised by the ECB. Besides, Latvia benefits from the Single Resolution Mechanism (SRM), which provides an EU-wide framework for resolution of large banks. Other Latvian banks are supervised by the states’ Financial and Capital Market Commission (FCMC); the latter implements national macro-prudential policies as well together with the Bank of Latvia and Ministry of Finance. Foreign deposits in Latvian banks amount to around 43% of total deposits at the end of 2016; they are mostly related to business links with Russia, as OECD reports (p. 27).  

However, stricter anti-money laundering and other controlling finances’ rules will be further tightened to withstand large chocks. 

Attention to tax reforms

Latvian Parliament approved during 2016-17 reforms of personal and corporate income tax in line with the country’s general idea of broader tax reform. Reforms are reducing the basic personal income tax rate from 23 to 20% for incomes up to €20 thousand per year starting in 2018. Corporate tax rates are increased from 15 to 20% with the exception that non-distributed corporate tax income will be fully tax exempt, which turns such tax into a tax on distributed profits, as it is in Estonia where firms have responded to the tax system largely by accumulating cash rather than investing in fixed assets. Corporate tax reform could encourage investment by boosting retained earnings, which is the main source of finance for business investment. However the current corporate tax rate is already low and accelerated depreciation allowances are generous.

It is clear that lower personal income taxes reduce the taxation of labour; this is why the OECD notices that “in view of high poverty, targeting these tax reductions to low-wage workers may be preferable” (p. 30).  

Present micro enterprise tax system in Latvia exempts small companies from income tax and social security contributions: instead they pay a low turnover tax. This novice encourages firms to remain small (on one side) or to keep part of their activity in the informal sector (on the other) in order to benefit from low taxation. Young start-up firms financed with venture capital pay a low lump sum tax per worker, which the OECD report sees as “regressive”. The employees in the start-ups are not covered by unemployment or pension insurance; the report notices that such tax breaks should be abolished. There are also generous tax credits and exemptions for four Latvian special economic zones, mostly in the port areas.

Latvian government has taken steps, as recommended by OECD three years ago to lower labour taxes on low-income earners raised and increase excise and environmental taxes.

The labour tax wedge is still high; reducing it on low income earners further (presently at about 42%, with 32% as OECD’s average) could have particularly large benefits and reduce unemployment and undeclared employment and could damp emigration of young workers with low wages. Recent forms have increased the basic income tax allowance for low-income households. This tax allowance now diminishes as income rises.

The solidarity tax levied on high salaries progressivity in the personal income tax system could be a good thing in view of high income inequality.

The tax reform, argue OECD experts, foresees setting tax rates on capital income received by households (such as interest income) at 20%, at the same rate as other household income. Capital income received by households (such as interest income) is currently taxed at lower rates than other household income. Low taxes on such income tend to favour high-income households, making the tax system less inclusive. The tax reform could also reduce administrative costs to some extent.

Shadow economy

It is difficult to capture the exact size of the country’s informal sector (shadow economy), it was estimated in 2015 to amount to more than 20% of GDP (p.32). Latvian government has made considerable effort to improve tax collection by intensifying tax audits on individuals and firms operating in sectors where informal activity is widespread; introducing criminal sanctions against employers paying undeclared wages; strengthening controls, resources and co-ordination among relevant authorities (tax authorities, labour inspectors and customs); and raising fines and increasing personal liability of company board members. These steps helped increase tax revenues, which are estimated to have reached 31% of GDP in 2016, up from 29% in 2015.

Table I: Size of shadow economy in the Baltic States, %

=The size of shadow economy (% in GDP): Estonia -15; Lithuania -17; Latvia -20.

=Underreported corporate profits (% of actual profit): Estonia -8; Lithuania-12, Latvia-18.   

=Underreported wages (% of actual wages): Estonia-16; Lithuania-15; Latvia-18.

The following measures are envisaged by the Latvian government to raise tax revenues: to provide essential social services and lower the tax burden on low income earners; to make better ICT-use for tax law enforcement; to require electronic record keeping in cash registers; to combat tax evasion in electronic commerce and to enable electronic exchange of information between credit institutions and tax authorities. Presently, tax revenues collection in Latvia is one of the lowest in the EU-28: about 30%, with about 42-47% in other Baltic Sea region’s states (e.g. Sweden, Denmark and Finland). Surveys show that company owners and managers accept “informal activity” as a result of their strong dissatisfaction with business legislation. Compared to Estonia and Lithuania, Latvian businesses display lower trust in the government: this trust is at the level of 20% compared to over 40% on OECD’s average and about 60% in Denmark (p.34).   

Therefore increasing trust in public governance helps improve tax morale more direct political participation possibilities for the population’s willingness to pay taxes.

Latvian main corruption prevention and combating bureau budget (KNAB) is formed by a proposal from the Council of Ministers with parliament’s annual approval, which is weakening its independence. Full bureau’s independence in necessary for investigating corruption cases properly. As is the case for competition authorities, budgetary independence should be reinforced by mechanisms reducing government discretion, such as fixed multiannual budget allocations and allocation of fixed revenue sources.

Energy policy: contributing to green- growth and environment

Latvia’s primary energy supply is still dominated by fossil fuels, in particular oil and gas (see table below), which is mostly imported from Russia, as well as by locally generated renewables.

Renewable energy consumption is growing; it largely reflects use of hydropower and bio-mass (mostly fuel-wood).

Latvia’s implicit tax rate on energy is among the lowest in the EU; though taxes for heating are much lower than for transport and the difference is bigger than in other EU countries. There is a possibility, according to OECD, to gradually align tax rates according to the carbon content of the taxed fuels. Carbon taxes on heating and transportation fuels exist in a number of EU states; however, higher taxes on heating fuels would need to be accompanied with measures to ensure that the real incomes of low-income households are protected. This can in part be achieved through policies to improve energy efficiency.

Energy consumption in residential buildings in Latvia is 7-10% higher than in the EU states.

Conclusion

In the three general executive summaries experts in the OECD’s survey have been “honestly positive”:

a) Latvian economy has grown robustly but not enough for strong convergence in living standards;

b) boosting growth requires better export performance, and

c) better access to housing, jobs and health care would boost inclusive growth.  

In improving access to low-cost housing, the following measures are recommended by OECD:

= Improving legal certainty in rental regulation and encourage out-of-court procedures;

= Simplify the administrative process for obtaining a building permit.

= Provide more funding for low-cost rented housing in areas of expanding employment.

= Expand the mobility programme, which provides temporary support for relocation and transport.

= Create a nation-wide registry that allows eligible persons to apply for housing assistance where they expect better job opportunities.

= Require housing developers to allocate a proportion of their dwellings as affordable units.

In improving access to health services:

= Reduce out-of-pocket payments especially for the low-income population.

= Develop key service quality and performance indicators for health care providers at

national, local and provider-level.

= Deliver preventive care more effectively by expanding the activities nurses and pharmacists

are allowed to carry out, notably in rural areas where health services are scarcer.

In improving transport infrastructure:

= Apply the same cost-benefit tests to large national projects as are applied to EU funded

projects.

= Introduce incentive regulation for the prices of monopoly services set by the infrastructure manager and the incumbent rail service operator.

= Set wages of managerial staff in the railway regulator independently from the Transport Ministry.

= Make use of the latest technologies to favour demand-responsive collective road transport services tailored to the needs of customers in rural areas.

= Raise the priority of investment in safer road infrastructure. Improve maintenance of rural roads, Raise the quality of the most densely trafficked roads with investments in motorway sections and develop pedestrian-friendly infrastructure in urban areas.

In strengthening energy policy:

= Gradually raise and harmonise the taxation of fossil fuels in transport and heating according to their carbon content.

= Encourage energy efficiency investment in the building sector through tax-lien financing and utilities’ on-bill financing.

= Support the deployment of wind energy through competitive tendering.