However, downside risks to growth dominate, the most important of which relate to the pandemic, as well as to global geopolitical and trade tensions. Also, possible further negative supply shocks could keep inflation higher beyond the short term.

The government appropriately intends to ease the burden of the pandemic on vulnerable households and firms. However, with continued expansionary monetary policy in the euro area and large EU funding inflows, it is crucial that short-term fiscal settings not increase the risks of overheating. Furthermore, given the many demands on the budget, a credible fiscal strategy is needed to prepare for ageing- and climate-related challenges and stabilise the public debt at a sustainable level.

The main factor influencing medium-term growth prospects is demographics. The population has been shrinking for three decades (Figure 1), driven by net migration, low fertility and short (albeit rising) life expectancy. Going forward, continued population shrinkage will lead to further losses in agglomeration benefits and accentuate fiscal challenges in a context of worsening old-age dependency and an already fairly uneven distribution of income and wealth. It also puts the labour market under pressure from the decline and ageing of the labour force.

Although participation and employment rates have enjoyed trend improvement, labour-market performance could still be enhanced. Pervasive business informality and underreported wages result in lost training opportunities, pension rights and tax revenues. The government is preparing an action plan to combat informality, including welcome steps to step up enforcement; tax wedges should also be reduced. The long-term unemployment share in total unemployment is larger than in the average OECD country. This problem should be tackled by boosting active labour market spending, notably on job training of reasonable duration (Figure 2). Addressing gender stereotypes and enforcing anti-discrimination legislation need to continue in order to reduce the growing gender wage gap, which is among the EU’s highest.

The tax and transfer system could do more to alleviate income and wealth inequality. Recent efforts to confront poverty, especially severe among the elderly, should be strengthened. Similarly, the social safety net remains minimal, pointing to the need to further raise the Guaranteed Minimum Income.

Living conditions could be significantly improved by changes to the pension, health care and housing sectors. Poverty, and population ageing and shrinkage make these policy areas especially challenging.

Old-age pension replacement rates are modest and, under current rules, will fall in the future. More must be done to improve pension adequacy by encouraging longer working lives, including through future increases in the pension age as life expectancy rises.

Low life expectancy underscores the need for more health-care spending (Figure 3). Latvia spends about half the OECD average per capita on health care. As a result people rely heavily on out-of-pocket outlays to meet their medical needs. Widening public insurance coverage and lowering spending caps would be helpful. The tight supply of practitioners should be alleviated by continuing pay rises and making medical careers more attractive.

The efficiency of the hospital network should be re-examined, and more resources provided to preventive measures, primary and home care, mental health treatment and long-term care, all of which are underfunded. Making greater use of digitalisation and training nurses to perform more functions would help to improve treatment quality.

Excessive alcohol consumption, smoking and poor diets lead to adverse health outcomes. Raising applicable excise taxes and better informing citizens of the benefits of dietary change and more exercise are crucial steps towards healthier lifestyles. Warning labels for unhealthy foods would also be helpful.

The disadvantaged suffer from poor housing conditions, notably overcrowding. Housing investment as a share of GDP, especially in new construction, has been the OECD’s lowest for many years. Housing benefits are modest and poorly allocated. Rental markets are thin, with little social housing, reducing labour mobility and Latvia’s attractiveness to potential foreign investors. Meeting the National Development Plan’s housing objectives, notably by raising the supply of affordable and social housing and improving home-heating systems is crucial.

Despite some progress, more should be done to achieve green and sustainable economic growth. GHG emissions per capita are still rising, and air pollution from fine particles weighs heavily on health outcomes.

Latvia is committed to reducing GHG emissions by 65% from 1990 levels by 2030. Yet, this does not go much beyond reversing post-2000 increases. Lowering and ultimately removing the favourable treatment of natural gas and diesel for vehicle use (while protecting the poor) would help. Policies will also need to seek to raise the share of renewables and to integrate regional power and gas markets.

Air pollution is caused mainly by low-quality heating systems and industrial boilers. The relevant regulations need to be toughened. Agricultural activities are the major cause of diffuse-source water pollution, with nutrients causing negative impacts on water quality. Remaining untreated wastewater should be tackled by consolidating regional water companies. Finally, population shrinkage provides an opportunity to boost the share of protected land.

Demographic pressures and slowing income convergence underscore the need to rely more on investment, innovation and skills in the search for faster productivity growth.

Progress has been made in the fight against corruption, bribery and money laundering, which should encourage more investment. Yet, trust in government is low, and bribes are still seen as common. Meanwhile, the responsible agency has been given considerable additional resources, and Latvia has been deemed as largely or fully compliant in all dimensions of the MONEYVAL anti-money laundering process. The imminent government action plan to shrink the shadow economy must also be implemented effectively.

Investment is being held back by a lack of credit. While the large banks are in good shape, lending conditions are tight. Many households are credit constrained, and access to finance – along with its cost and collateral demanded – is a serious barrier to business investment. The authorities need to deepen capital markets, create a culture of investment, starting with improving financial literacy, and fully transpose the EU restructuring directive, including simplifying corporate debt restructuring through out-of-court and hybrid procedures. A larger role for nonbanks, notably fintechs, would be helpful.

Focusing on exports is the best growth strategy for Latvia, given its demographic outlook. However, Latvia’s exports have underperformed in recent decades (Figure 4). This may be attributable to the country’s industrial structure, which is still dominated by low- and medium-low tech firms, along with the persistent rise in real labour costs. The government should aim to support the development of Latvia’s exports of more complex products by fostering innovation, increasing worker skills and improving the business environment.

Poor basic digital skills and high tertiary dropout rates point to an insufficiency of workforce skills. So does a scarcity of employer-provided training and adult education more generally. Too few youth study STEM subjects. One way forward is to hire high-quality teachers by giving schools more flexibility in setting their wages, provide tertiary students with greater financial support and implement training funds through tripartite social dialogue.

Improving the innovation system is equally important. The framework conditions for innovation are weak, with limited private-sector adoption of digital technologies, low-quality higher education institutions with few doctoral graduates, and low R&D spending in relation to GDP, especially by businesses. The 2018 corporate tax reform resulted in treating R&D like any other investment; this should be re-examined in light of persistently weak outcomes. It should also allow its academic researchers to share in the returns to their inventions.