Perfectly wrong timing

Discussions about tax reform have been going on for months with nothing conclusive so far. 

Part of the reform seems to be an increase in the non-taxed minimum (good, albeit modestly so, for the lower incomes) and a decrease in the income tax rate from 23% to 20% for incomes below 45,000 EUR per year, i.e. some 95+% of incomes, a measure that mostly favours higher incomes.

Both measures, however, are costly in terms of lost tax revenue and a higher budget deficit. Lost tax revenue that will stay with income earners and will be spent, at least a good chunk of it, and this will stimulate economic activity. But is this what the economy needs at this very moment?

Nope.

After some years with rather humdrum economic activity, growth is actually picking up, see Figure 1 and is set to reach more than 3% this year and that is without tax reform.

Figure 1: Economic growth in Latvia, year-on-year, 2010 Q1 – 2017 Q1

Source: Central Statistical Bureau of Latvia

Why not just use a tax cut to accelerate economic growth? Well, the labour market may be hard pressed to deliver more workers. At an unemployment rate of 8.3%, the lowest since August 2008, the labour market is looking rather tight. Unfunded tax cuts will tighten it further.

Figure 2: Unemployment rate in Latvia, 2010-01 – 2017-04

Source: Central Statistical Bureau of Latvia

… and while the story may not play out like in the heydays of 2004 – 2007, it is likely to put further upward pressure on wages, already rising at quite brisk rates, see Figure 3. While very nice for income earners, rising wage costs will create problems for companies, less competitiveness and thus jobs lost later – and a need for an adjustment reminiscent of the one in 2008 – 2010. This must be avoided.

Figure 3: Wage growth in Latvia, year-on-year, 2010 Q1 – 2017 Q1

Source: Central Statistical Bureau of Latvia

In short, we have an economy that is picking up nicely by itself and that does not need extra stimulus.

This part of the tax reform is contrary to sound economic policy – a counter-cyclical fiscal policy where stimulus from the government is held back or even reversed in good times, as also envisaged by the Fiscal Discipline Law (see e.g. its section 4.3), adopted by lawmakers in January 2013 and thus the timing of the proposal is about as wrong as it can be.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council of Latvia

Points of view presented here are my own and not necessarily those of the Fiscal Discipline Council.