EU – Baltic States, Financial Services, GDP, Latvia, Taxation

According to the European Union's fiscal discipline rules, Latvia's structural deficit in 2018 may not exceed 1.7% of gross domestic product. Latvia's Stability Program estimates headline deficit at 1.6% of GDP in 2018.

The Commission emphasizes that if no effective compensatory mechanisms are agreed upon to make up for the effect of the tax reform measures, Latvia's structural deficit may amount to 2.4% of GDP, and that would be a significant deviation.

Martins Zemitis, economic advisor at the Commission's Representation in Latvia, points out that the Commission finds the tax reform justified, and many of the measures therein necessary, however, these measures are costly and potentially may compromise Latvia's fiscal discipline. "The reform is pro-cyclic, it offers an additional stimulus to the economy at a time when lending is gathering pace and EU funds are being invested in the economy. The economy is warming up already, and it will get even warmer because of the tax reform. The Commission doubts whether now is the right time for such stimuli," said Zemitis.

The Commission's report says that the main measures of the tax reform include a reduction of the standard rate of personal income tax from 23% to 20%, an increase in the income-differentiated basic allowance, an introduction of zero percent corporate income tax rate for reinvested profits and aligning of capital tax rates at 20%. The reform will cost the state budget of Latvia approximately 1.8% of GDP, which will be partly offset by measures increasing revenue equal to approximately 0.6% of GDP.

According to the Commission, reducing personal income tax rate from 23% to 20% is the costliest part of the tax reform (0.9% of GDP), which is also expected to benefit high-income earners the most. A zero percent corporate income tax for reinvested profits will also lead to a substantial reduction in budget revenue (estimated at 0.7% of GDP in 2018). The reform will mostly benefit households with medium to high incomes, believes the Commission.

In its Stability Program, the government plans a deterioration of the headline balance from a balanced position in 2016 to a deficit of 0.8% of GDP and of 1.6% of GDP in 2017 and 2018 respectively, as a result of the tax reform, followed by an improvement to a deficit of 0.5% of GDP in 2020. The Stability Program says the tax reform will have a profoundly positive macroeconomic effect, but the Commission considers it a very optimistic assumption given the current economic and fiscal projections.