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Scalpel needed for structural reforms in Latvia

RIGA - In keen competition with ‘quantitative stimulation’(in Latvia, we call it the Expanded Asset Purchase Programme or EAPP), the notion ‘structural reforms’  will vie for the status of the most popular phrase of the year.  These concepts are moreover interrelated, for an active monetary policy, with structural reforms missing, can have only a short-lived positive impact. This time, when in the economies of the European Union (EU) additional funds are flushed in, should be used precisely for reform – both in Latvia and in the EU at large.

International organizations, officials, and commentators of economic processes have more than once mentioned the various weak spots of Latvia and the directions in which its economic and social policies could be perfected. Below, I have summarized these directions, adding ideas of my own. The expanded Latvian version of this article (in which I also explain the question on everyone’s mind – what exactly are structural reforms) can be found on the macroeconomic page of Latvijas Banka www.makroekonomika.lv (here and here), whereas below I provide the most important conclusions on the homework to be done by Latvia.

It may hurt today but tomorrow we’ll be in better health

There are many definitions of structural reforms. In the macroeconomic context, structural reforms are usually understood as political measures that reduce or liquidate obstacles to a smooth functioning of the market. In other words, governments must help the markets to work effectively. Yet this approach seems incomplete to me – previous crises show that measures for doing away with the imperfections of the market are necessary. Moreover, it should not be forgotten that state administration, healthcare, social benefits and pension systems and other areas not directly related to the operations of the market could also be objects of reform. In an informal conversation with colleagues we found a definition for structural reforms: they are measures that in the shorter term are painful and unpleasant but in the longer term provide benefits for society.

In this, they resemble a surgical operation to do away with some health problem. Yet, in contrast to a surgical operation, anaesthesia, at least general anaesthesia, cannot be used to prevent pain caused by economic reforms – it is only possible to provide a partial compensation to those who have been negatively impacted by them.
Evaluating proposals and analyzing economic developments, six main reform directions for Latvia stand out, combining several tasks and measures. In and of themselves, they will not always be considered reforms, yet their complex combination could qualify as such.

Regulation of infrastructure and business environment

The Latvian business environment is generally rather competitive, which is confirmed by the relatively good performance in the Doing Business evaluation – of 189 countries, Latvia placed 23rd in 2015. Administrative obstacles have been reduced over the years, tax administration has been improved and the tax burden is not heavy overall (a redistribution of the tax burden from the workforce to consumption and capital would be more conducive to growth, however). Yet further improvements are possible and necessary. What should be done in this area?

The business environment should continue to be improved by reducing the time and costs required by various registrations, increasing the protection of investors, improving tax administration etc. In the Doing Business evaluation, Latvia’s weakest performance is in Getting Electricity, Protecting Minority Investors and Dealing with Construction Permits. TheEuropean Commission (EC) recommends: Latvia has made significant progress in reforming the judicial system. However, the rate of resolving civil and commercial cases remains low creating additional burden to business and the role of the Judicial Council and court chairpersons in implementing judicial reforms should be strengthened.. It is worth taking into account the proposals included in The Action Plan for business environment improvement for 2014 – 2015 developed in cooperation with the Foreign Investors’ Council in Latvia (FICIL) and strategic initiatives of the Employers’

Confederation of Latvia (LDDK).
Gas and electrical power interconnection and the road and port infrastructure should be improved. In late 2013, the World Bank (WB) conducted a study of Latvian ports, listing also directions of improvement of port administration, improvement of infrastructure and other areas. Even though many Latvian officials and organizations criticized this study, the Organization of Economic Cooperation and Development (OECD) and the International Monetary Fund (IMF) both refer (here and here) to this study and the improvements it lists as necessary and emphasize the need to effect the improvements quickly. OECD highlights the need to improve the compatibility of the power networks with other EU countries, and other international organizations also point to such a need.  

The fight against corruption should continue. Even though substantial improvements have been achieved in this area, business surveys still suggest that it is necessary to do away with corruption in the country. Developments at the Corruption Prevention and Combating Bureau also have an unfavourable impact on the situation.

The interest of local governments in attracting investment should be stimulated. Investors are not offered the necessary infrastructure everywhere. The local population often blocks potential investment projects (particularly factories and farms), for it does not see them as related to the welfare of the local population – jobs, tax income, which could be used for improving the infrastructure, kindergartens, benefits, etc. The benefits versus inconveniences should be explained; a redistribution of the business income tax to benefit local governments should be considered in order to foster their motivation in attracting investors.

The shadow economy should continue to be reduced. Even though the level of the shadow economy has dropped compared to the crisis period, which is borne out by the fact that tax income is outpacing economic growth, it is still relatively high. One can only hope that the Ministry of Finance will be successful in carrying out its ambitiously conceived measures.

Productivity

According to the purchasing power parity per inhabitant, the Latvian GDP is at 64% of the average EU level, which means a similar difference in the prosperity level of the population. In the future, the well being of the population will be directly related to Latvia’s success in improving productivity, for that is the only hope for a more stable and higher income. The productivity of Latvian manufacturing is approximately four times lower than that of the EU, and its improvement in recent years has slowed substantially. Productivity is influenced by many factors: capital (land, buildings, structures, equipment, current assets), workforce (skills, health, demographics), technological processes, energy efficiency, etc.

The proportion of large enterprises should be increased – active policies in creating new enterprises and stimulating the growth of existing enterprises are needed. To this end, cutting the rates for reinvested profits, at the same time increasing the rate for dividends, should be considered. I think that applying the micro tax for a certain period of time is the right approach. Yet it should be an instrument for an initial support for a new enterprise instead of a constant benefit, which would provide advantages compared to larger enterprises with a higher tax burden. Business incubators, purposeful and timely use of EU funds and other state support instruments for creating enterprises and ideas, as well as expanding production, should also be on the agenda.

Export should be promoted. Exporting enterprises, particularly permanent exporters, are more productive than non-exporting ones. State policies should thus continue to provide a stimulus for increasing exports and the number of exporters, promote participation in global value chains, attract foreign investment, and help with conquering new export markets. Decreasing the tax burden for the workforce would also help with regard to this policy direction.

Investment in research and development should be increased; the participation of the private sector should be fostered; the efficiency and excellence in research of research institutions should be stimulated. I addressed these issues at length in my article on Latvian science. Here, I will limit myself to mentioning the recommendation of the EC to take measures for a more integrated and more encompassing research system, including concentrating financing on internationally competitive research institutions.

Energy consumption should be reduced – this would improve cost competitiveness, reduce energy dependence and the amount of carbon emissions, as well as increase productivity.
Education of the population should be encouraged and the connection of the education system with demand in the labour market should be fostered. There is no doubt that the skills and education level of employees and employers have an effect on the productivity of each individual and, as a result, total productivity. Therefore the question of raising the quality of education and a more active involvement of the population in continuing education is topical also in terms of increasing productivity.

The efficiency of the public sector and management of state enterprises should be improved. Among the most striking state administration reforms, the unified compensation system in state administration, the establishment of a unified emergency medical assistance service, and regional reform can be mentioned. Latvia’s experience is less successful with regard to e-government, including the electronic signature. Yet there has been undeniable progress in this area as well. The EC recommends to intensify reforms in public administration, including the implementation of the reform of state enterprise management and augmenting the institutional and financial independence of the Competition Council. The IMF concurs, recommending centralizing management of enterprises belonging to the state, and at the same time getting out of areas unrelated to basic activities.

Income inequality

Latvia has inequality and poverty risk indicators that are among the highest in the EU. Perfect equality is not possible or desirable, for it would not motivate people to work and study, yet there should be public/state support in cases of illness, disablement, or loss of work, as well as in periods of child-rearing. An EU model which has the best results in the area of social security system and one to strive for is Sweden; in fact, all of Scandinavia. Yet at the same time it means a higher tax burden for financing the social system. In Latvia, those at the bottom of the pay-scale still have a relatively high tax burden. In this area, the issue of the shadow economy is also topical.

The tax burden should be reduced for low income households and raised for well-to-do households. Workforce taxes should be cut, raising the capital growth and real estate taxes at the same time.
For reducing regional inequality, the equalization of finances of local governments is an important instrument; in this regard, a new law is being drafted. EU funds and infrastructure improvement plans should also be used, which will foster a polycentric development of the economy. True, this direction will be in conflict with the objective of raising productivity, for this concentrating forces in Riga would be more efficient; however, polycentric development could serve as a compromise to try to reduce inequality while, at the same time, concentrating funds, skills etc. in several centres.
A more goal-oriented benefits policy is needed. EC: “Take concrete steps to reform social assistance, ensuring adequacy of benefits, and take measures to increase employability.”

Long-term unemployment should be reduced. In IMF’s evaluation, unemployment is still high in Latvia, yet currently mostly structural unemployment is observed (this coincides with Latvijas Banka’s assessment). IMF is encouraging Latvia to institute labour market reforms. The organization is suggesting that Latvia consider introducing a system that would provide support for the participation of unskilled workforce in the labour market. The OECD is of the opinion that the heavy tax burden in Latvia is the main reason for the high level of structural unemployment, and is encouraging Latvia to increase the scale of active labour market policies.

Education

The situation in education in Latvia is rather grim. The previously highly touted higher education reform has remained half-baked. A national independent accreditation agency is being set up and a new quality targeting financing model is being developed for Latvia’s higher education. Despite some progress in reforming the research and innovation system, in line with the Smart Specialisation Framework, inadequate public funding in a fragmented research and innovation system is leading to poor scientific outcomes.” In the Research Excellence Assessment, which is closely related to the performance of higher education and was developed by the EU Joint Research Centre (JRC), Latvia placed last in the EU.

Territorially closely-placed educational institutions should be merged. In Latvia, 37% of all educational establishments are those with 100 and fewer pupils. As a result, the possibilities for ensuring competitive wages for teachers and quality teachers in smaller schools are limited. The average number of pupils per class is among the lowest in the OECD countries.  In Finland and Estonia, the number of pupils per teacher is greater, but the results (according to PISA ) are better. It is a positive development that the level of knowledge of Latvian pupils is improving, but this dynamic may not hold for the future. Latvia has to pay particular attention to improving quality in rural schools, to more serious work with the outstanding pupils (and a better motivational system for talented teachers), as well as to pay extra care regarding the results of male pupils.

Lifelong learning should be popularized; there should be more information about study possibilities (particularly remote learning) and the relation between knowledge and income. There should be more purposeful use of EU funds.
The connection between education and demand in the labour market should be improved. The IMF recommends: “Reforms to higher and vocational education, which could help reduce skills mismatches and lower structural unemployment should also be prioritized. Reforms are needed in higher and professional education. The EC suggests: “

Ensure that the new financing model of the higher education system rewards quality. Better target research financing and incentivise private investment in innovation on the basis on of the Smart Specialisation Framework “ I would also like to particularly stress the need to raise the qualifications of the teachers at higher educational establishments, improve their knowledge of foreign languages, their involvement in research and publishing in international scientific journals. Work is being done in this direction.

Health

Healthcare financing, expressed as % of GDP, is among the lowest in the EU, moreover the proportion of public financing in the total financing of the healthcare system is relatively low. Thus to a great degree, the population covers health expenses from private sources, which means less availability of services to low-income populations. Just like in continuing education, the problem is closely related to the income of the population and the high number of the population subject to deep indigence.

In Latvia’s Stability Programme for 2015 – 2018, it is stated that the planned health system reform is one of Latvia’s crucial structural reforms to foster quality of life, increase potential growth and improve efficiency of expenditure. To that I can certainly agree, yet I am not sure that the described measures match the essence of the reform, for basically it concerns increasing financing to several areas which will result in better health indicators, reduce emigration of medical workers, etc. To me the concept of health reform is more related to the conceptual project on the financing model of the healthcare system at one time developed by the Ministry of Health, which provides for tying the reception of planned healthcare with the payment of a “health tax”.

I cannot deny, however, that the presence of reform has been notable in fostering healthcare and healthy lifestyles. There have been much publicized battles to optimize expenditures in the healthcare sector by merging different hospitals. Currently, merging the Pauls Stradina Clinical University Hospital, Children’s Clinical University Hospital and Riga Stradina University and other plans are on the agenda. The provision of healthier food in schools has been promoted, there is a ban on buying alcohol at night, excise taxes have been raised on alcohol and tobacco products, substantial restrictions are in place for smoking in public places, and new medical equipment has been purchased with the help of EU funds (a separate issue is how rational and well thought out is the use of this equipment), the opportunities to do sports, ride bicycles etc. have been expanded, etc.
I hope that along with increased financing, reduction in wasteful expenditures will also be on the agenda.
 
Counter-cyclical economic policies

Much has been done to reduce the possibility of a crisis in the future, yet currently economic growth is negatively impacted by the conflict between Russia and Ukraine, and the weak growth of European economies. Therefore, to foster the growth rate of GDP, additional possibilities for heating the economy have to be sought, at the same time retaining prudent budget policies.  

Fiscal discipline must be observed. The scenario for macroeconomic development included in the Latvian Stability Programme for 2015-2018 was developed based on conservative assumptions regarding increases in external and domestic demand. We can only hope that such an approach will be the rule also later, as budget amendments are made.
Financial sector stability must be maintained. A year ago, the Plan for the Development of the Financial Sector for 2014 - 2016 was approved; the Plan is aimed at fostering the stability of the financial sector and promoting sustainable growth of the Latvian economy. As far as the financial sector is concerned, currently stimulating lending is also important to promote faster growth of the economy. Even though this task should be undertaken in accordance with the relevant development stage of the economic cycle, there are a number of measures which are necessary to undertake, not only in order to stimulate lending but also for the long-term gain of improving the business environment.  

The financial vulnerability of households should be reduced and a sustainable system of benefits and pensions should be created. Given the ageing trends observed within the entire EU, raising the retirement age (incl. for the recipients of service pensions) is and will continue to be one of the politically most difficult but unavoidable tasks for the maintenance of a sustainable system. Currently, a gradual raising of payment amounts into the second pension level is taking place, to reach 6% of the income from state social insurance payments (SSIP) by 2016 (which constitutes the EC’s previously mentioned possible departure from the medium term goal of the budget), raising the retirement age to  65 years by 2025, raising the early retirement age, raising the minimum length of insurance payments in order to qualify for a state old age pension, as well as changing the procedure for indexing pensions. Against the background of ageing trends, measures for promoting positive demographics are also important. As far as the formation of private savings, the possibility to receive an income tax refund is an instrument promoting saving money. In addition, however, financial literacy and more activity in informing the population about the possibilities of investment should be kept on the agenda.
 
Brief summary

Summarizing these main directions of reform, we can conclude that among them are both those on whose implementation the government, entrepreneurs and the general public would be in agreement (for example, improving the business environment) and those where a sharp counter-reaction can be predicted. These are the directions where redistribution will have to take place and thus there will be winners and losers. Almost everyone usually agrees that income disparity should be reduced but, as soon as it means greater tax payments, the reaction is no longer as welcoming. Just as complicated is the path to reducing the shadow economy, because for some it would also mean a reduction in income.  

It will not be easy, and the politicians who undertake to carry out the reforms are likely to be condemned, not praised. Their main motivation would likely be the thought that they are doing it for their children and grandchildren, for it takes time for reforms to bear fruit.

The writer is an economist at Latvia’s central bank, Latvijas Banka

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