OECD Economic Surveys: Latvia 2024

Executive Summary

Slowing economic convergence and the effects of the war in Ukraine call for accelerating structural reforms

Russia’s war of aggression against Ukraine has led to higher energy prices and disruptions in trade and supply chains, weighing on economic growth. Even before the pandemic and the war, economic convergence had slowed down (Figure 1).

Ample fiscal space has enabled strong support of households and firms during the pandemic and the energy crisis. However, weak targeting of support measures during the pandemic and the energy crisis increased fiscal costs and inflationary pressures in the context of intensifying supply-chain bottlenecks.

Table 1. Domestic demand will lead the recovery

	2022	2023	2024	2025
Real GDP growth	3.0	-0.3	1.8	2.9
Unemployment rate (%)	6.8	6.5	6.7	6.6
Harmonised consumer prices (%)	17.2	9.1	1.7	2.4
Fiscal balance (% of GDP)	-4.7	-2.3	-2.9	-2.5
Public debt (Maastricht, % of GDP)	41.5	43.5	45.7	47.3

Source: OECD Economic Outlook 114 database and updates.

Falling headline inflation due to lower energy and food prices and rising nominal wages will support real incomes and raise private consumption in 2024 and 2025. Although tight financial conditions will weigh on private investment, the significant inflow of EU funds will boost public infrastructure investment over the next years. Export demand will slowly recover. Wage growth will remain strong due to skills shortages and planned increases in public sector and minimum wages, leading to sticky core inflation. Fiscal policy should be gradually tightened to reduce high fiscal deficits, lower inflationary pressures and stabilise public debt.

Since the global financial crisis, weak investment, skilled labour shortages and slow digital adoption have weighed on potential growth and public sector capacity. High risk aversion of banks, weak competition and shallow capital markets have reduced access to finance for firms. A strong fiscal adjustment and falling wages after the global financial crisis weighed on public sector capacity and the quality of public services, particularly in health care and education. Many high-skilled young adults have left to work abroad, which has exacerbated skilled labour shortages, particularly in STEM and ICT professions. In addition to a lack of digital skills, digital adoption has been hampered by the prevalence of many small firms with low training investment.

Figure 1. The pace of convergence in living standards has slowed

Gap in GDP per capita against OECD average, %

Note: Percentage gap to the OECD average in terms of GDP per capita (in constant 2015 PPPs).

Source: OECD National Accounts database.

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Accelerating structural reforms is key to raise productivity and living standards. Reducing informality and barriers to competition and firm growth, particularly in services, would help strengthen business dynamism and innovation. Lowering informality requires reducing labour taxes for low-wage earners, improving tax enforcement and raising trust in institutions. Strengthening the powers of the Competition Council to enforce competitive neutrality of state-owned enterprises would help to reduce barriers to competition. Addressing skilled labour shortages will need facilitating skilled migration, improving the quality of health, education and training services as well as active labour market policies, and encouraging more young women to enter high-skilled occupations in short supply.

Strengthening public finances and the quality of public services to improve living standards

Financing rising spending needs in defence and health care and reducing old-age poverty will require raising tax revenue and spending efficiency and reallocating spending. The tax burden should be shifted from labour to other income, property, and environmental taxes.

High social security contributions, particularly for low-wage earners, reduce incentives to formalise work (Figure 2). The shadow economy has not decreased since 2012, which is mainly related to the practice of envelope wages, where workers earn the minimum wage and receive top-up payments in cash. Reducing the labour tax wedge for lower incomes while financing the reform through general tax revenue should be a priority.

Figure 2. The labour tax wedge is particularly high for low-wage earners

Average tax wedge decomposition in % of labour costs, by income level, 2022

Note: The tax wedge is the sum of personal income tax, employee plus employer social security contributions, minus social benefits as a percentage of labour costs. The tax wedge is shown for a single individual without children and by income level measured in percent of the income of the average worker (AW).

Source: OECD Taxing Wages database.

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Further strengthening tax enforcement and the fight against corruption and money laundering can do much to reduce the shadow economy and broaden the tax base. Implementing the planned mandatory filing of an electronic income tax declaration for all taxpayers should be combined with making electronic payment of wages mandatory. Moreover, raising trust in institutions is key to improve the tax morale. Implementing a comprehensive lobbying register at all levels of government would help to raise transparency and reduce corruption.

Shifting the tax burden towards property taxes would improve municipal finances, reduce distortions and lower inequality. Raising revenue from recurrent taxes on immovable property by updating cadastre values with market prices, while continuing to provide tax reductions for the primary residence of poorer households, would stabilise local public finances and raise incentives for spending efficiency. Introducing inheritance taxes, while allowing for exemptions for low-value inheritances, could help decrease inequality and raise revenue.

Continuing to improve human resource policies is key to raise the quality of the public administration. High staff turn-over has led to losses in human capital and institutional memory with negative consequences for the quality and effectiveness of public policies and services and the efficiency of public spending. The recent public employment reform and wage increases should be combined with better training opportunities for public employees, with a particular focus on digital and management skills.

Digitalisation of public services has significantly improved, strongly reducing the administrative burden. However, the use of data for ex-ante and ex-post impact evaluation of regulation remains weak, particularly at the municipal level. This reduces the effectiveness and efficiency of public spending, for example in infrastructure planning. Centralising procurement for standardised goods and services, such as pharmaceutical drugs or IT and software equipment, would help raise spending efficiency. Setting unified transparency, accountability and performance standards for all SOEs and centrally monitoring their performance is also key to improve spending efficiency.

Carbon emissions remain high in transport and heating. Lowering tax expenditures for fossil fuel and establishing a metropolitan transit authority to prioritise investments in public transport and facilitate coordination among municipalities are important steps to reduce transport emissions. Simplifying the administrative burden for support programmes and standardising technical documentations for renovations of similar multi-owner buildings would help reduce costs and support building renovations.

Raising investment to boost growth

Investment has slowed down since the global financial crisis. Credit supply decreased due to high risk aversion of banks, weak competition and shallow capital markets (Figure 3). High informality, barriers to competition and skilled labour shortages have weighed on business dynamism, innovation and investment demand.

Despite rising deposits and high profitability, banks have been reluctant to lend. Low customer mobility and weak competition in the banking sector have led to high borrowing costs and collateral requirements, reducing corporate borrowing (Figure 3). To improve access to finance it is key to foster competition in financial markets by raising transparency on deposit rates, commissions and fees, reducing switching costs for bank customers and strengthening competition enforcement.

Figure 3. Credit supply has decreased

Credit to non-financial corporations, 2010 Q3 = 100

Note: Credit refers to loans and securities other than shares.

Source: ECB Data Portal.

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High risk aversion of banks is related to low asset recovery and money laundering cases in the past. Recent reforms, including the establishment of a specialised Economic Court, have significantly improved insolvency procedures and the fight against corruption and money laundering. Expanding the remit of the Economic Court and establishing a deed register for all leased assets could further improve contract enforcement and help ease collateral requirements. Reducing the administrative burden related to the implementation of anti-money laundering regulation and requiring regular training of financial sector employees could foster corporate lending while minimising money laundering risks.

Capital markets are shallow, limiting non-bank financing for firms. Listing minority stakes in large SOEs, providing low-cost creditworthiness information on smaller firms and fostering financial literacy would help increase the supply of securities traded in capital markets. Facilitating greater exposure of second-pillar pension funds to domestic securities would help to deepen capital markets.

Barriers to firm growth and competition and high informality hinder the reallocation of resources to more productive firms, while labour shortages are high. Many firms in Latvia stay small, partly operate in the informal economy and have low productivity due to weak management skills, low digital adoption and insufficient training provision for workers. Raising incentives to formalise work, strengthening tax enforcement and the fight against corruption, and lowering barriers to firm exit, such as high costs for filing insolvency, would increase allocative efficiency and foster business dynamism and investment demand. Entry barriers in services sectors should be lowered, including by strengthening the power of the Competition Council to enforce competitive neutrality.

Raising innovation requires more investments in human capital. To reduce high drop-out rates, particularly in ICT and STEM studies, university funding should better incentivise raising graduation rates and funding for students’ living costs should increase. Improving coordination among firms and VET institutes in design and implementation of training is key to provide workers with the skills needed by firms.

 

MAIN FINDINGS	KEY RECOMMENDATIONS
Improving fiscal policy
The fiscal stance will ease in 2024 and remain neutral in 2025, despite remaining inflationary pressures. The fiscal deficit is high and public debt is above the medium-term target.	Gradually tighten fiscal policy to reduce the fiscal deficit and lower inflationary pressures.
Spending needs for defence and internal security have increased due to the war in Ukraine, while the government committed to further raise education and health spending.	To stabilise debt, address rising spending needs by raising spending efficiency, reallocating spending and increasing tax revenue, including from income and property taxes and by reducing tax expenditures, including for fossil fuels.
Reforming the tax system
High social security contributions for low- and middle-income earners reduce incentives for formalising work. Informality is high. The progressivity of personal income taxes remains low.	Reduce the labour tax wedge for low-income earners, for example by reducing social security contributions at lower incomes or raising progressivity of the personal income taxes.
Property tax revenue is low, while many municipalities depend on central government transfers for core spending priorities. Cadastral property values are not linked to market prices.	Raise recurrent taxes on immovable property based on regularly updated market values, while continuing to provide tax reductions for the primary residence of poorer households.
Since the early 2000s, total GHG emissions have not fallen due to low effective carbon prices in transport and building sectors, which are related to fossil fuel and other environmentally harmful subsidies and tax expenditures.	Gradually phase out environmentally harmful tax expenditures and subsidies, such as the ones for fossil fuels, and consider introducing carbon pricing for sectors not covered by the EU ETS.
Improving the capacity of the public sector, raising spending efficiency and fighting tax evasion and corruption
High turnover, particularly for skilled professionals and managers, and the lack of digital and management skills has weakened institutional memory and the quality and effectiveness of public policies.	Continue to raise the attractiveness of public jobs and improve training of public employees, particularly in digital and management skills.
Ex-ante and ex-post policy impact analysis remain weak, reducing the quality of public services and spending efficiency. Capacity in local infrastructure planning is low.	Improve the data infrastructure and knowledge about methodologies for cost-benefit and impact analysis of policies and raise cooperation across the public sector.
Procurement of standardised goods, such as drugs or IT equipment and software, is still decentralised, despite large possible efficiency gains of centralised procurement.	Consolidate existing purchasing bodies, improve their IT and staff capacity and reduce legal exemptions that allow to opt out of mandatory centralised procurement.
Tax enforcement is hampered as not all taxpayers are required to file an income tax declaration. Under-declaration of income and wages is widespread.	Make the filing of an electronic income tax declaration mandatory, while continuing to reduce the administrative burden through pre-filling of declarations.
In contrast to many other OECD countries, plans for a centralised lobbying register to raise transparency and reduce undue influence of special interest groups have not yet been implemented.	Introduce a centralised lobbying register with a legislative and regulatory footprint.
Raising investment to boost growth
Banks have not passed on lower funding costs to lending rates due to a market practice of setting a zero lower bound for the base rate for lending. Common ownership among banks, and between banks and other financial market institutions, is weakening competition in the financial system.	Strengthen the legal and investigative powers and tools of the Competition Council to monitor anti-competitive behaviour in financial markets.
Low customer mobility related to high fees and information asymmetries is reducing competitive pressures on banks. The household saving ratio is low and few households save in time deposits, partly due to low deposit rates.	Extend the platform on payment account commissions to include information on bank deposit rates as well as other fees, such as minimum fees charged for refinancing loans, and provide standard switching packages and contract templates for loans.
Stock market capitalisation is very small and none of the large SOEs are listed in the stock market, in contrast to other Baltic countries.	Accelerate current plans to list large SOEs.
Investments of pension funds, mostly in foreign assets, have yielded low returns, while many domestic firms have difficulties in accessing financing through domestic capital markets.	Raise investment and concentration limits of second-pillar pension funds for single issuer assets, real estate and private investment funds, while ensuring appropriate risk management and governance processes.
Insolvency proceedings remain long on average. The establishment of the Economic Court in 2021 has improved the efficiency of judicial proceedings concerning complex commercial disputes and large economic-crime, money laundering and corruption cases.	Expand the remit of the Economic Court, while raising its resources.
A lack of digital and management skills holds back digital adoption and innovation. Firm-provided training is weak due to poaching concerns and a lack of cooperation with VET institutes and training providers.	Establish a tri-partite training fund and improve cooperation in training design and implementation among firms and training providers.
The assessment of the impact of regulation and SOE presence on competition remains weak. Entry barriers in services sectors are high.	Increase the power of the Competition Council to conduct market investigations and initiate evaluations of regulations and state ownership rationales of SOEs to ensure competitive neutrality.