Budget, Financial Services, GDP, Latvia, Taxation

"This will have to be done regardless of the current geopolitical situation, when we are faced with real threats of a hybrid war and have to allocate additional funds for security, both internal and external, in order to honor our obligations to the international partners," noted Sakss.

In this context, the Welfare Ministry's amendments to the Law on Pensions, which would increase spending by another 0.1% of GDP in 2016, are "incomprehensible," said Sakss. "There must be no such motions at the moment, as it has not been decided yet how the consolidation will proceed. If not, the problem that the government will be facing in the fall, when it will have to draft the 2016 state budget, will be further aggravated," he said.

"Realistically speaking, it will be impossible to avoid increase in some spending items, because there will always be circumstances urgently requiring extra funds. Let us assume that such circumstances would account for 25% of that additional funding that was allocated for new policy priorities in 2015, or 0.2% of GDP. Let us also assume that the Finance Ministry's opinion is disregarded and the government approves the amendments to the Law on Pensions proposed by the Welfare Ministry. In that case, consolidation measures would amount to 0.7% of GDP. A 0.7% consolidation is no laughing matter, and cosmetic measures will be of no help. The government will have to choose between bad options and worse," explained Sakss.

Consolidation can be done by reducing spending or increasing revenue, or combining both. If a decision was taken to reduce spending, then every ministry would have to cut costs 5%, said Sakss.

As for higher revenue, there are just three taxes that wield real fiscal effect – personal income tax (5.5% of GDP), value added tax (7.7% of GDP), and social insurance contributions (8% of GDP).

"We could postpone the 1% reduction in the personal income tax rate, but I can imagine what backlash from employees this would cause. In this case, revenue would increase 0.2% of GDP, but the effect on consolidation would amount to only 0.04% of GDP, as only 20% of personal income tax revenue goes to the state budget – 80% are paid into local governments' budgets. There are no grounds to expect that local governments will put this money aside, therefore the effect on the deficit will be neutral. The situation could be changed by altering the proportions of personal income tax that go to the state and municipal budgets, so more of the revenue was transferred to the state budget, but I imagine that local governments will be very dissatisfied," said Sakss.

Increasing social contributions will not help solve the problem, as the contributions cannot be used to cover state master budget expenditures.

Altering VAT would have the most immediate effect on reducing master budget deficit. Increasing VAT would result in consolidation equal to 0.3% of GDP, explained Sakss.

"I have to say that these estimates are simplified, but they offer a precise description of the choices we have. It would be wrong to expect that avoiding these painful decisions is possible. Combating the shadow economy, and the effect thereof on revenues, has its limits, and these limits have been largely achieved in the 2015 budget law. As you can see, any decisions concerning the budget that will be made in the fall will be painful and unpopular with society. Do we have to make this task even harder today?" added Sakss.