The Latvian government budget for 2020 is now underway and will, according to Prime Minister Krišjānis Kariņš, exceed 10 billion EUR for the first time, helping to provide more spending here, there and, well, everywhere. Everybody happy? Nope. Expect trouble ahead and for several reasons:
1) Times are good, part one – the economy has grown for about nine years in a row and unemployment is down to its lowest level in ten years. But under such conditions the pressure for more spending is high: Health, education, civil servants in general. Everybody expects and wants more. Stopping fiscal profligacy will prove very difficult.
2) Times are good, part two – with the economy doing so well, tax revenues are very strong since many people are at work and most companies do well; both cases leading to much tax being paid. Still, however, spending is even higher than these very high levels of tax revenue or, in other words, Latvia still manages in these good times to run a budget deficit, see Figure 1.
3) Not only is e.g. the health sector set for increased spending – given a government consisting of no less than five parties, each of those will try to make its own mark and pursue its own policies and those typically involve more spending and/or lower taxes and only seldom – very seldom! – the opposite, putting more pressure on the budget.
4) The tax reform of 2017 with lower tax rates for most persons and no tax on reinvested profits by firms has resulted in lower tax collection to the tune of about one percent of GDP according to research from the EU. This also puts pressure on the budget due to fewer sources to obtain revenue from.
The question then is: How well-prepared is Latvia for such spending pressures when at the same time facing constraints on the tax revenue side?
Answer: Reasonably prepared but a) could have been better and b) less well-prepared than our Baltic counterparts.
In Figure 1 I put the EU countries in different brackets according to their fiscal performance – budget balance and level of government debt as a share of GDP – in 2018, the most recent year for which we have data.
The simple or ‘old’ rules of the EU (from the Maastricht criteria) are a budget balance at maximum 3% of GDP and a level of debt of maximum 60% of GDP. Latvia is quite comfortable within both of these measures but debt is higher than in Estonia and Lithuania runs a budget surplus where Latvia had a deficit of 1% of GDP in 2018. And, yes, many countries look much worse than Latvia, but still…
Given spending pressures, one might easily imagine a deficit edging upwards.
Add to this what looks like a slowing world economy (due to Brexit, US-China tariff wars and what might simply be the end of a very long boom following the financial crisis) – this will negatively affect the Latvian economy due to its substantial openness and this will reduce tax revenue and thus also increase the budget deficit.
Better preparation would have mirrored Lithuania: Coming from a budget surplus and allowing for a budget deficit via more spending and less tax revenue. But Latvia does not really have a history of more prudent fiscal policy than its neighbours.
Big impact and a rerun of 2009-10? Not at all – although Latvia was also fiscally imprudent during the big boom up to 2008, the situation is not at all the same. But some profligacy combined with a semi-botched tax reform will make a 2020 budget more complicated and painful to reach than was needed.
Even a record 10,000,000,000 EUR is not a guarantee against problems.
Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council
Points of view expressed here are not necessarily those of the Fiscal Discipline Council