The war in Ukraine has slowed the recovery from the pandemic and led to higher energy prices and disruptions in trade and supply chains, weighing on economic growth. Economic convergence had already slowed down before the pandemic, emphasising the need to accelerate structural reforms. To address rising spending pressures related to defence, internal security, health and old age poverty, there is a need to raise spending efficiency and tax revenue, while the tax burden should be shifted from labour towards other income, property, and environmental taxes. Continuing to improve the quality of public governance and public services, fostering investment and innovation and addressing skilled labour shortages are key for raising potential growth. High informality should be tackled by lowering labour taxes for low-wage earners, improving tax enforcement and continuing to fight corruption. Strengthening the powers of the Competition Council to enforce competitive neutrality of state-owned enterprises and challenge regulation that restricts competition would help to foster business dynamism and innovation. Addressing skilled labour shortages will require facilitating skilled migration and improving the quality of health, education and training services as well as active labour market policies.
OECD Economic Surveys: Latvia 2024
Abstract
After a decade of slow growth following the financial crisis, a strong recovery from the pandemic was under way when Russia’s war of aggression against Ukraine started. A spike in energy and food prices due to the war fuelled inflation and reduced the purchasing power of households. The war and related sanctions also disrupted supply chains and trade. This has affected the competitiveness of firms and increased uncertainty related to energy security, as Latvia has been highly dependent on energy imports from Russia. The government acted swiftly to secure energy supply and support households and firms facing record high energy prices. This strong government reaction has been enabled by ample fiscal space, which was generated due to successful reforms of the fiscal framework in the aftermath of the global financial crisis.
A deceleration of the income convergence process in the aftermath of the global financial crisis and the economic consequences of the war have emphasised the need for accelerating structural reforms (Figure 1.1). After a period of high growth with strongly rising investment and private consumption supported by a credit boom, the global financial crisis had hit the Latvian economy hard. Unemployment increased above 20% and wages dropped significantly, particularly in the public sector due to strong fiscal adjustments, reducing private consumption and increasing poverty rates (OECD, 2022[1]). Since then, growth rates have been much lower than before the crisis. Weak investment and skilled labour shortages exacerbated by a shrinking population have weighed on potential growth, and the competitiveness and export performance of Latvian firms (Figure 1.2). To raise productivity and economic growth it is key to improve access to finance, foster business dynamism and innovation, address skilled labour shortages and continue improving public governance. Accelerating the green transition would strengthen energy security and encourage the development of new business models. Implementing a comprehensive set of structural reforms would raise potential growth of GDP per capita by about 0.7 percentage points per year (Table 1.1).
Gap in GDP per capita against OECD average, %
Note: Percentage gap with the OECD average in terms of GDP per capita (in constant 2015 PPPs).
Source: OECD National Accounts database.
Weak credit supply has been a major factor for weak investment performance (see Chapter 2). Large losses during the financial crisis and several money laundering cases have strongly increased risk aversion of banks, leading to persistently low lending, despite rising deposits of firms and households and high profitability of banks. To increase access to finance for firms it is key to improve competition in the banking sector and deepen domestic capital markets, for example by listing minority shares of large state-owned enterprises (SOEs) and allowing pension funds to invest a larger share of their assets in domestic securities. Continuing to improve insolvency procedures and raising trust in institutions would help to attract international investors.
Contribution to potential output per capita growth, in % points
Source: OECD Economic Outlook 114 database and updates.
To strengthen innovation and investment demand of firms, it is crucial to lower informality, raise competition and business dynamism, and address skilled labour shortages. 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 innovation, and insufficient training provision for workers. Due to costly insolvency procedures and specific tax regimes for small firms, there is too little reallocation of production factors to more productive firms. Lowering labour taxes for low-income earners and further strengthening tax enforcement is key for reducing under-declaring of income and wages, which has negative consequences on profitability and innovation incentives of formal and more productive firms. Entry barriers in services sectors should be lowered, including by strengthening the power of the Competition Council to enforce competitive neutrality of SOEs and to challenge regulation that restricts competition. At the same time, facilitating skilled migration and continuing to improve education, training and health policies would help to address skilled labour shortages.
To finance key policy priorities in defence, education and health, there is a need to raise tax revenue and increase spending efficiency. The tax burden stood at 30.2% of GDP in 2022, which is 4 percentage points below the OECD average. Improving public revenues would also make public investment and other current spending less dependent on EU funding, improve policy continuity, and strengthen accountability and incentives for spending efficiency (OECD, 2019[2]). A comprehensive tax reform should shift the tax burden away from labour towards corporate and personal income, property and inheritance taxes, which account for a lower share of revenues compared to other OECD countries, as well as reduce generous tax expenditures, including for fossil fuels. The reform should also redesign fiscal relationships with municipalities to ensure sufficient and stable revenue sources for the provision of public services at the local level and improve incentives for spending efficiency.
For a successful design and implementation of structural reforms it is crucial to continue improving the capacity and governance of the public sector. This is also key for implementing public investment plans and other support programmes that will be financed by EU funds during the next years. Since the financial crisis in 2009, the quality of the public administration has suffered from strong wage cuts and high staff turn-over, particularly for skilled professionals and managers. This 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. A recent public administration reform aims to raise wages to at least 80% of private sector wages by 2027 and introduces more flexibility in wage setting for occupations that are in high shortage. This should be combined with expanding training opportunities for public employees, with a particular focus on digital and management skills, and continuing to improve recruitment procedures. Enhancing IT capacities as well as data exchange and analysis across the public sector is key for improving ex-ante and ex-post impact evaluation of laws, regulations and policy programmes, for example regarding cost-benefit analysis for infrastructure projects or competition assessment of regulation. Improving public procurement procedures and continuing the fight against corruption is key for raising spending efficiency and improving trust in institutions. It would also help create a level playing field to foster business dynamism and innovation.
Average yearly additional growth in GDP per capita during the next 15 years (in percentage points)
Note: The potential effects of structural reforms are quantified using the methodology of Guillemette and Turner (2021[3]). The set of structural reforms comprises: improving the Product Market Regulation index by reducing distortions related to state involvement and the assessment of the impact of regulation on competition to the OECD average and the quality of public governance measured as the rule of law to the OECD average; increasing public investment as a share of GDP by half of the distance to the average of the five top performers and R&D expenditure by half of the distance to the OECD average; a reduction in labour tax wedges by half of the distance to the OECD average; raising spending for active labour market policies to the OECD average and improving the quality of training and adult education to raise the average years of schooling of the working age population to the average level of other Baltic countries; improving educational quality to raise average PISA scores of students by half of the distance to Estonia; coupling the legal retirement age to life expectancy, while improving working conditions and training opportunities for older workers.
Source: OECD Long-Term Model.
Against this background, the main messages of the Survey are:
Gradually tighten the fiscal stance to reduce the high fiscal deficit and lower inflationary pressures. Conduct a comprehensive tax reform to help finance policy priorities in defence, health and education, shift the tax burden from labour towards other income, property, and environmental taxes, and ensure sufficient and stable revenue sources for municipalities.
Continue improving the capacity of the public sector by expanding training and the use and exchange of data to improve ex-ante and ex-post policy impact assessment and raise spending efficiency. Improve governance of SOEs, infrastructure planning and public procurement, and continue to fight corruption.
To raise credit supply, it is key to increase competition in the banking sector and deepen domestic capital markets. To strengthen innovation and investment demand of firms, it is key to lower informality, raise competition and business dynamism, and address skilled labour shortages by investing more in human capital and facilitating skilled migration.
When the pandemic hit, the government used its ample fiscal space to support households and firms with measures amounting to a total of 3.2%, 6.3% and 2% of GDP in 2020, 2021 and 2022, respectively (IMF, 2023[4]). This bolstered domestic demand, also supported by strongly rising public sector and minimum wages, underpinning a strong recovery from the pandemic (Figure 1.3). The introduction of job retention schemes and wage subsidies helped to stabilise employment relationships, particularly for high-skilled employees, in 2020 and 2021 (Benkovskis, Tkacevs and Vilerts, 2023[5]).
1. Including stockbuilding.
Source: OECD Economic Outlook database.
However, the large size of the support and weak targeting of some measures contributed to inflationary pressures, in the context of rising supply chain bottlenecks (Figure 1.4). As bankruptcies have strongly declined and are still about 60% below the level of 2019, untargeted firm support might have also hindered the reallocation of production factors to booming sectors and firms, thereby exacerbating existing labour shortages and capacity constraints, similar to experiences in other countries (Barnes et al., 2021[6]). In particular, generous grants that reimbursed a share of fixed costs depending on firm-specific revenue losses, amounting to a total of about 1.9% of GDP, have not only covered the aggregate pandemic shock, but potentially also firm-specific shocks. This could have been prevented by conditioning grants on sector-wide revenue losses and cost structures or focusing support on liquidity provision through subsidised loans and loan guarantees or tax deferrals (Demmou et al., 2021[7]; Bischof et al., 2021[8]).
Russia’s war of aggression against Ukraine has interrupted the post-pandemic recovery. High inflation and plummeting consumer and investor confidence due to uncertainty about energy security weighed on private consumption and investment. Producer prices increased strongly due to soaring energy costs and supply chain bottlenecks, and the pass-through to consumer prices broadened inflationary pressures (Figure 1.4). Inflation was above 20% (y/y) from July 2022 until February 2023. The much higher inflation rates in Latvia compared to other EU countries were related to a higher share of energy and food in household consumption and the higher prevalence of short-term contracts in retail energy markets (IMF, 2023[4]). Real wages fell by 13% per annum in the third quarter of 2022, and by July 2023 were barely above where they were a year earlier, strongly reducing the purchasing power of households (Figure 1.4).
Source: Central Statistical Bureau of Latvia; IEA Energy prices database; OECD calculations based on Eurostat database.
The government took bold actions to support households and firms, reduce uncertainty and secure energy supply. Expansion of the existing regional LNG infrastructure enabled a quick switching of gas imports to international suppliers, although this led to strongly rising gas prices (Figure 1.4). Measures to mitigate the consequences of higher energy prices for households and firms were introduced, such as untargeted price-caps, transfers to pensioners and low-income families, and grants to energy-intensive firms. The government has also provided crucial support to the more than 40 000 Ukrainian refugees (2.1% of Latvia’s population) who entered Latvia in 2022.
The total fiscal cost of energy crisis related measures, which were phased out in April 2023, amounts to 1.9% and 1.3% of GDP in 2022 and 2023, respectively, which was lower than expected due to falling energy prices but is still high compared to other OECD countries (Hemmerlé et al., 2023[9]). More than 80% of these measures were untargeted, which increased fiscal costs and reduced energy saving incentives. To improve the targeting of household support in the future, it is key to improve the data infrastructure to better identify vulnerable households (see below). Developing short-term monthly indicators on the financial situation and cost structures of firms, for example based on data from the State Revenue Service, could help to better target firm support measures ex-ante (Bischof et al., 2021[8]). Early-warning systems to detect firms at risk of insolvency can help to target support during and after a crisis and have been implemented in Denmark and France (Moeller and Mukherjee, 2019[10]; Epaulard and Zapha, 2022[11]; Demmou et al., 2021[7]).
Although Latvia had already reduced its dependency on eastern neighbours since Russia’s annexation of Crimea, the effects of the war and related sanctions on supply chains, trade and foreign direct investment (FDI) were still substantial. In 2021, exports and imports to Russia, Belarus and Ukraine accounted for 10% and 13% of total exports and imports, respectively, which decreased to 9% and 5% in the first half of 2023, respectively (Figure 1.5). Despite a rapid substitution by imports from other countries and domestic production, prices for some intermediate inputs strongly increased, particularly for wood, metal and mineral products. This has further reduced the competitiveness of manufacturing firms, besides higher energy costs, and led to strongly rising construction prices, weighing on housing investments and complicating the implementation of public infrastructure projects. Services exports to Russia and Belarus have strongly decreased since 2021. Due to their strong trade linkages with eastern neighbours, the border regions have been particularly affected by these disruptions. Before the war, Russia was the third largest country in terms of the stock of FDI, with investments concentrated in trade, financial services, real estate, energy and manufacturing (IMF, 2023[4]). Since then, the FDI stock from Russia has decreased by 29% or about 1.8% of GDP. However, this FDI outflow was more than compensated by increasing FDI inflows from other countries, mainly from the EU, as the total FDI stock increased by 10% since late 2021 (see Chapter 2). This indicates that geopolitical tensions also have the potential to benefit Latvia due to the near-shoring of manufacturing activities for the EU market.
1. Includes mechanical appliances; electrical equipment; transport vehicles; optical instruments and apparatus (inc. medical); clocks and watches; musical instruments.
2. Includes products of the chemical and allied industries; plastics and articles thereof; rubber and articles thereof; and base metals and articles of base metals.
Source: Central Statistical Bureau of Latvia; IMF DOTS database.
Although wholesale energy prices have fallen, energy prices for industrial consumers remain at much higher levels than before the war, weighing on the competitiveness of domestic manufacturing firms (Figure 1.4). Higher inflation rates than in the rest of the euro area have appreciated the real exchange rate since 2020 vis-à-vis Latvia’s main export partners (IMF, 2023[4]). Since 2010, export competitiveness of manufacturing firms had already suffered from relatively weak productivity growth coupled with strongly rising real wages and unit labour costs (Figure 1.6). This was related to high emigration and a shrinking working age population, which exacerbated skilled labour shortages, as well as rising minimum and public sector wages (see below). As higher wages are important to retain young and highly skilled Latvians and attract skilled migrants, raising productivity by fostering business dynamism, competition and innovation and improving access to finance is key to improve competitiveness and export performance (see Chapter 2). Policies to address skilled labour shortages should focus on reducing skills mismatches and informality in the labour market, create the conditions for older workers to work longer and facilitate skilled migration (see below). Accelerating the green transition in the energy sector and connecting to the EU electricity grid is key to sustainably reduce energy prices for firms and households (see below).
Note: Export performance is measured as actual growth in exports relative to the growth of the country’s export market. Central and Eastern Europe is calculated as an unweighted average of Czechia, Hungary, Poland, Slovak Republic and Slovenia.
Source: OECD Productivity Database; OECD Economic Outlook database.
The economy will recover on the back of rising private consumption and EU-funded investment
After a technical recession in the second and third quarter, GDP increased by 0.3% in the fourth quarter of 2023. Strong public investment related to the absorption of EU funds and rising private and public consumption have more than compensated for weak exports. Export demand has suffered from high inflation and weak investment in key export markets, particularly affecting exports of construction materials. Export values remained 10.4% lower in February than a year earlier, whereas annual imports fell by 3.1%. High interest rates due to monetary policy tightening and weak confidence have weighed on private investment and construction. Loan demand by firms has strongly decreased since early 2023 (see Chapter 2). Industrial production has been volatile in recent months and was 0.9% lower in February than a year earlier. Annual inflation has fallen rapidly to 1% in March, due to declining energy and food prices, but core inflation remains high at 3.8%, reflecting wage increases in the labour-intensive services sector (Figure 1.4). Gross wages rose by 11.6% year-on-year in the fourth quarter of 2023, with similar real wage growth due to rapidly falling inflation. The unemployment rate stood at 6.9% in February but the labour market remains tight with a vacancy rate of 2.5%, only 0.5 percentage points lower than its pre-pandemic value, indicating skill mismatch in the labour market (see below).
After a slight decline in 2023, real GDP will grow by 1.8% in 2024 and 2.9% in 2025, reflecting a rebalancing of growth towards domestic demand (Table 1.2). Falling inflation and rising nominal wages will support real incomes and raise private consumption over the next two years. Higher unit labour costs and weak export demand will restrain export growth. A gradual easing of financial conditions will support business investment, while significant inflows of EU funds will boost public infrastructure investment and spending on support measures for digitalisation and upskilling in small businesses. Grants from the EU Recovery and Resilience Facility will lead to yearly spending of about 1.6% of GDP in 2024-25 and do not influence the fiscal stance according to the national methodology (see below). According to the OECD methodology to compute the underlying primary balance, which includes the positive impulse from the EU Recovery and Resilience Facility grants in the fiscal stance, the fiscal stance is projected to ease in 2024 and remain broadly neutral in 2025 (Table 1.2). Wage growth was high in the second half of 2023 and will remain strong due to skills shortages and planned increases in public sector and minimum wages, leading to sticky core inflation. Thus, although the negative output gap will remain high in 2024, the fiscal stance should be tightened to reduce the high fiscal deficit and lower inflationary pressures (see below).
The main risks for the outlook relate to the geopolitical situation and are tilted to the downside. An escalation of the war in Ukraine, more aggressive behaviour of Russia towards its western neighbours or reduced international support for Ukraine could significantly affect risk premiums and the attractiveness of Latvia for foreign investors. Stricter sanctions against Russia and Belarus could hurt exports and supply chains. Domestic downside risks to the outlook relate to delays in the absorption of EU funds due to intensifying skilled labour shortages and weak capacity in infrastructure planning. Strong wage increases due to intensifying skilled labour shortages and strongly rising public sector wages could keep core inflation higher for longer, requiring a stronger fiscal adjustment weighing on growth. On the upside, a quicker easing of monetary policy in major export markets would raise export demand.
Annual percentage change, volume (2015 prices)
1. Contribution to changes in real GDP.
2. Percentage of potential GDP.
3. Harmonised index of consumer prices excluding food, energy, alcohol and tobacco.
Source: OECD Economic Outlook 114 database and updates.
Financial market risks have risen but remain contained
Vulnerabilities in financial markets remain contained. The banking system is well capitalised and highly profitable, with a stable deposit base and low levels of non-performing loans (Figure 1.7) (ECB, 2023[12]). Corporate deleveraging in the aftermath of the global financial crisis has improved corporate balance sheets and reduced financial vulnerabilities. Also due to strong energy price support, the increase in bankruptcies in 2022 was limited to sectors that were strongly affected by sanctions against Russia and Belarus. Nevertheless, the evolution of the non-performing loans ratio should be carefully monitored. Rapid monetary tightening in the euro area and reduced real disposable income due to high inflation have increased the debt burden of corporate and mortgage borrowers, as most corporate loans have a short maturity and most mortgage loans have a variable interest rate (see Chapter 2). High inflation has also led to one of the largest declines in the real pension plan returns in the OECD, suggesting that the risk diversification of the pension funds should be improved.
Source: OECD Timely Indicators of Entrepreneurship database; Central Statistical Bureau of Latvia; ECB; IMF Financial Soundness Indicators.
Rising mortgage rates could lead to sharp corrections in house prices, increasing risks associated with the indebtedness of poorer households and restricting the availability of credit to SMEs. Many SME owners pledge their personal real estate as collateral. House prices have increased faster than in OECD countries and have significantly outpaced rents and household income since 2015 (Figure 1.8). The high prevalence of variable-rate mortgages has led to the sharpest increase in interest rates on new mortgages in the euro area and reduced housing affordability (Figure 1.8) (Swedbank, 2023[13]). As a result, the issuance of new loans for house purchases has started to decline. On the upside, low total household indebtedness and the fact that a large share of the outstanding housing loans is held by higher-income households limit the mortgage credit risk for the banking system (Figure 1.8) (Bank of Latvia, 2023[14]). However, about 40% of households are unable to save due to high inflation and higher interest payments for other loan products such as leasing, which increases the risk of insolvency for poorer households (Bank of Latvia, 2023[15]). This has increased risks for other lending institutions, such as leasing companies. The evolution of the household loan-to-value ratio, which is already higher than in the other Baltic countries, should also be carefully monitored, as a sharp correction in house prices from high levels could further increase the balance sheet vulnerability of highly indebted households (IMF, 2023[16]). Given the low level of household debt and limited mortgage credit risk for the banking system, the central bank’s recent decision to transition to a positive neutral counter-cyclical capital buffer approach and to increase the counter-cyclical capital buffer rate to 0.5% in December 2024 and 1% in June 2025 is welcome. However, the authorities should stand ready to increase the counter-cyclical capital buffers further if house price-related risks continue to build up.
Source: OECD Analytical House Price database; Eurostat; ECB; OECD National Accounts database.
Recent stress tests indicate that the financial system is resilient to adverse shocks. The stress tests showed that only one credit institution would fall below the regulatory capital requirements and that significant credit institutions, which are directly supervised by the ECB, would be resilient to weather a stress scenario (Bank of Latvia, 2023[15]). The Bank of Latvia has for the first time applied a growth-at-risk methodology to its stress testing framework to assess the impact of tail events, such as a sharp decline in the GDP growth rate, on the resilience of the financial system. The variable-at-risk methodology should also be applied to the other macroeconomic variables, such as house prices or government borrowing costs, given the accumulation of risks in the housing sector and the rapid rise in global interest rates in the past two years. The stress-testing framework is also extended to include profit and loss provisioning projections in the baseline and stress scenarios, and to examine the resilience of the financial sector to climate change and green transition risks.
Addressing rising spending pressures is key to ensure debt sustainability
After a decade of low fiscal deficits and contained public debt, the fiscal balance turned negative due to strong fiscal support during the pandemic and the energy crisis (Table 1.5). With the phase-out of energy price support measures, the fiscal deficit declined to 2.3% of GDP in 2023, but under current budget plans the fiscal stance measured as the underlying primary balance will ease in 2024, and remain broadly neutral in 2025 (see above). As the strong inflow of EU funds adds to domestic demand, core inflation is still high and wages will continue to rise strongly, further fiscal tightening is needed to reduce inflationary pressures. Reducing the fiscal deficit is also needed to keep public debt on a sustainable path given rising spending needs in defence, health and education as well as the need to reduce old-age poverty (see below).
General government, % of GDP
1. Defence; public order and safety; housing and community amenities; recreation, culture and religion; environment protection.
2. OECD estimates and projections from the OECD Economic Outlook 114 database and updates.
Source: OECD National Accounts database; OECD Economic Outlook 114 database and updates.
Planned increases in health and education spending are important to improve human capital and potential growth but should be financed by increasing spending efficiency and tax revenue. Analysis for this survey shows that raising expenditures towards health and education by increasing their share in total expenditures by 1 percentage point, while reducing other expenditures, would increase GDP per capita by 1.4% in the long term due to improved human capital (Figure 1.9, Box 1.1). When keeping public investment constant and only reducing other expenditures, the effect would increase further to 1.8%. In the 2024 budget, spending for health and education will increase by 0.9% and 0.4% of GDP, respectively, in line with recommendations of the previous OECD Economic Survey of Latvia. To address national security concerns related to the war in Ukraine, internal security and defence spending will be raised by 0.5% of GDP in 2024.
During the next years, spending pressures will further rise due to increasing interest payments, which are estimated to reach around 1% of GDP by 2025, and planned increases in defence spending from around 2.4% of GDP in 2024 to 3% of GDP by 2027. Moreover, reducing old-age poverty in line with recommendations from the previous OECD Economic Survey of Latvia has become even more pressing due to the war in Ukraine, as more support may be needed to re-integrate many poorer elderly persons in border regions, who had accepted Russian citizenship in the past to receive Russian pension payments (OECD, 2022[1]). Reducing old-age poverty, which is particularly high for women, by half of the distance to the OECD average would increase spending by about 0.5% of GDP. Raising investments in the green transition, which would improve energy security, and making public investments, fiscal support for private investments and other programmes more independent from EU funding cycles to ensure policy continuity will also require further fiscal resources (OECD, 2019[2]).
Percentage point change in long-term real GDP per capita resulting from compositional shifts in the expenditure or revenue structure, holding total government revenue and expenditure in terms of GDP constant
Note: Simulations are obtained from a dynamic general equilibrium model calibrated using the average structure of government expenditure and revenue in Latvia over the period 2000-19. Both the baseline and each policy change follow a balanced budget assumption. The policy changes are government size neutral, so that the ratio of total government revenue-to-GDP remains unchanged across the simulations. In Panel A, “other expenditure” refers to the sum of three expenditure items: public investment, government consumption and government transfers. Thus, in the simulation denoted by the first bar, all three items decrease in proportion to their size before the policy change to compensate for the increase in health and education expenditure. In the simulation denoted by the second bar, only government transfers and government consumption decrease. In Panel B, consumption taxes refer to VAT and excise duties. Labour taxes refer to the sum of taxes paid by employees and employers. Raising corporate income taxes (CIT) by 5 percentage points of total revenue to compensate for the decrease in labour tax revenue implies raising CIT revenue from 1.6% of GDP to the OECD average over the period 2000-19 of 2.9% of GDP. See Box 1.1 for further details.
Source: (Sunel, forthcoming[17]).
The study conducted for this Survey calibrates a dynamic general equilibrium model to the Latvian economy and complements previous empirical work on the effects of compositional shifts in government expenditure and revenue (Fournier and Johansson, 2016[18]; Akgun, Cournède and Fournier, 2017[19]; Bloch et al., 2016[20]). The model assumes a closed-economy environment with a representative household, a representative firm and a government. The household maximises preferences over consumption flows and leisure, earns wage, dividend and transfer income, and decides how much to save in firm shares. The representative firm maximises the present value of future dividend flows by deciding how much to invest and demand labour. The government taxes wage and dividend income, household consumption and corporate profits. Each of these taxes affects the optimal decisions of private agents and finances spending on government consumption, which does not influence the production of goods, public investment, investment in education and health, and transfers to households. A balanced budget is assumed throughout. Spending on health and education increases human capital measured as the efficiency of the hours of labour supplied. Public investment increases the public capital stock, which increases the productivity of the private factors of production used by firms.
The model is calibrated with Latvian data to reflect the various main macroeconomic variables averaged over the period 2000-19. In the next step, policy experiments are run in which the government expenditure or revenue structure (defined by the shares of budget items in total expenditure/revenue) is changed, while the total size of government (the ratio of total expenditure or revenue to GDP, as a balanced budget is assumed) is fixed at its level in the initial state of the economy. In the expenditure side experiments, the revenue structure is fixed at its initial level, and vice versa. The policy experiments lead to a change in the level of GDP per capita or welfare in the long term, because, for example, a change in the structure of government spending affects how much expenditure is split between more productive and less productive expenditure. Similarly, a change in the structure of government revenue, implying changing labour, corporate and consumption tax rates, affects the consumption, saving, labour supply and investment decisions of the private sector.
Source: Sunel (forthcoming[17]).
To address these important spending needs, more tax revenue should be raised. The tax burden stood at 30.2% of GDP in 2022, which is 4 percentage points below the OECD average and more than 2 percentage points lower than in Estonia. As the tax structure is already heavily skewed towards labour and consumption taxes, higher tax revenue should be raised by increasing corporate and personal income, property and inheritance taxes (see below). Medium-term budget plans foresee a slight increase of tax revenue by about 0.5 percentage points by 2026, among other factors due to taxing undistributed profits of credit institutions, a gradual increase of reduced VAT rates for fruits and vegetables, and increases in excise tax rates for tobacco and alcoholic beverages. Dividends from large SOEs also significantly contribute to the budget, with about 0.8% of GDP on average from 2018 until 2021. Gradually reducing state ownership in larger SOEs, which would help deepen capital markets and improve competition (see below and Chapter 2), would lower dividend revenue, which could be compensated by raising tax revenue further. Implementing structural reforms recommended by this Survey would raise growth of GDP per capita by 0.7 percentage points and lead to an increase in tax revenue by 1.8% of GDP, which is sufficient to address rising spending needs and reduce public debt (Table 1.1; Table 1.6; Figure 1.10, Panel A).
1. The estimate for rising spending needs assumes that defence spending increases by 0.6% of GDP, that old-age and survivors’ cash benefits are increased by 0.5% of GDP to reduce old-age poverty by half of the distance to the OECD average, and that health care spending is increased by 0.4% of GDP to reach the OECD average.
2. The effects of reforms related to prioritising spending and raising spending efficiency at all levels of government are difficult to quantify using available methodologies, but would significantly contribute to increasing fiscal space. The existing spending review process has led to savings of about 0.5% of GDP in 2021 and 2022.
3. The estimate for the fiscal impact of improved public procurement procedures is related to an OECD study which has estimated the gains in spending efficiency to be about 1 percentage point of GDP in Germany, if risk assessment and analysis of market capacity for infrastructure contracting decisions are improved across all levels of government by applying the OECD Support Tool for Effective Procurement Strategies (STEPS) (Makovšek and Bridge, 2021[21]; OECD, 2021[22]).
Source: OECD calculations.
Due to larger fiscal deficits since 2020, government debt has increased to 43.5% of GDP and is expected to further increase over the next two years to about 47% of GDP, which is significantly above the medium-term target of 40% (Table 1.5). Moreover, if rising spending needs in defence and internal security, health and targeted social transfers to the elderly are not addressed by raising tax revenue and spending efficiency or reducing other spending, public debt would grow further (Figure 1.10). Addressing these spending needs while ensuring public debt sustainability will require significant policy action. According to medium-term fiscal plans detailed in the Stability Programme for Latvia 2023-2026, the structural fiscal deficit will need to be reduced from 2.2% of GDP in 2024 to 1% of GDP in 2027 and maintained at that level thereafter, which would slow the increase of public debt. This implies a need to turn a structural primary deficit of 1.5% of GDP into a surplus of 0.2% of GDP by 2027, as interest payments are expected to rise from 0.7% of GDP in 2024 to 1.2% of GDP in 2027. Implementing the comprehensive set of structural reforms recommended in this Survey would allow to achieve these objectives, stabilise public debt and create additional fiscal buffers, which could be used in the case of future emergency situations. Rising risk premia due to an escalation of the war in Ukraine, a more aggressive behaviour of Russia towards its western neighbours or reduced international support for Ukraine would lead to higher interest payments and a rising trajectory of government debt (Figure 1.10, Panel B). Lower GDP growth rates due to higher trade barriers or disruptions in global energy markets would also result in higher public debt-to-GDP ratios.
Government gross debt, Maastricht definition, as a percentage of GDP
Note: The “Medium-term fiscal plans” scenario is based on medium-term budget plans detailed in the Stability Programme of Latvia 2023-2026. It uses the projected real growth and interest rate paths from the baseline of the OECD Long-term model and assumes that the structural budget deficit reaches 1% of GDP in 2027 and remains constant thereafter. This requires that the structural primary surplus reaches 0.2% of GDP in 2027 and approaches 1% of GDP over the projection horizon. The scenario “Spending pressures due to defence, old-age poverty, and health related costs” uses the same projected real growth and interest rate paths, but assumes that defence spending is increased by 0.6% of GDP, that old-age and survivors’ cash benefits are increased by 0.5% of GDP to reduce old-age poverty by half of the distance to the OECD average, and that health care spending is increased by 0.4% of GDP to reach the OECD average; all this additional spending is assumed to be debt financed, leading to a deterioration in the primary balance of 1.5 percentage points of GDP compared to the “Medium-term fiscal plans” scenario. The “Implementing structural reforms” scenario shows the impact on government debt of a comprehensive set of structural reforms and recommendations (Table 1.1, Table 1.6), which lead to higher nominal GDP growth over the projection period relative to the baseline scenario of the OECD Long-term model and result in additional fiscal savings of 0.2% of GDP (Table 1.6). In the “Higher government borrowing rates” scenario, interest rates increase by 200 basis points over the projection period relative to the baseline scenario of the OECD Long-term model. In the “Lower GDP growth rates” scenario, nominal GDP growth is lowered by 1 percentage point over the projection period relative to the baseline scenario of the OECD Long-term model. Following the OECD Economic Outlook guidelines, the ratio of general government financial assets to GDP is assumed to remain at its 2023 level in all scenarios.
Source: OECD Economic Outlook 114 database and updates; OECD Long-term model (2023[23]); and OECD calculations.
Deviations from the EU accounting practices reduce transparency and the credibility of the fiscal framework, further emphasising the need to tighten the fiscal stance. The national fiscal framework treats COVID-19 support measures, energy support measures, increased funding for defence and internal security, and support for Ukrainian refugees as one-off expenditures, which amount to about 2.5% of GDP in 2023, and does not include them in the structural fiscal balance (Ministry of Finance, 2023[24]). According to the national accounting methodology, the structural fiscal balance stood at 0.2% of GDP in 2023, while according to the EU accounting methodology it stood at -2.3% of GDP (Ministry of Finance, 2024[25]). The reclassification of some energy support expenditures from 2023 to 2022 and the recognition of some state budget expenditures as advance payments to be made in 2024 have led to a better-than-expected budget outturn in 2023 (Ministry of Finance, 2024[26]). The higher deficit in 2022 together with a lower-than-expected nominal GDP growth outcome in 2023 has increased the general government gross debt-to-GDP ratio in 2023 by three percentage points to 43.5%. As the escape clause will be deactivated in 2024, the current EU fiscal rules would require reducing the high fiscal deficit according to the EU methodology by 0.5 percentage points of GDP per year until it falls to 1% of GDP in the medium term. To increase transparency and maintain the credibility of the fiscal framework, structural and durable expenditure in key policy areas such as defence and internal security, which would increase the public capital stock and public employment, and support measures that are spread over several years, should be gradually included in the structural fiscal balance and not be counted as one-offs.
A comprehensive tax reform is needed
A comprehensive tax reform should shift the tax burden away from labour towards corporate and personal income, property and inheritance taxes, which account for a lower share of revenues than in other OECD countries (Figure 1.11). Lower labour taxes, particularly for low-income earners, would help to raise formal labour supply and reduce persistently high informality, which is a major factor for weak productivity growth, low access to finance for firms, and weak training opportunities and social protection for many workers (see Chapter 2) (OECD, 2022[1]). Analysis for this Survey shows that financing a decrease in the share of labour taxes in total revenue by 5 percentage points (of total revenue) by raising corporate income taxes (CIT) would raise GDP per capita by 0.8% (Figure 1.9). This would imply raising CIT revenue from 1.6% of GDP to the OECD average over the period 2000-19 of 2.9% of GDP. When further raising high consumption taxes to finance the decrease in labour taxes, the positive effect on GDP per capita would be smaller, as incentives for raising labour supply to finance consumption would be indirectly mitigated by higher consumption taxes.
General government tax revenue, % of total, 2022
Source: OECD Revenue Statistics.
High labour taxes for low- and middle-income earners reduce incentives for formalising work. The shadow economy has not decreased since 2012 and stood above 20% of GDP in 2022 (Sauka and Putnins, 2023[27]; Schneider, 2022[28]). High labour taxes are due to high and flat social security contributions of 34.09% of the gross wage, with 23.59% paid by the employer and 10.5% by the employee, and which apply from the first Euro of labour income until a threshold of EUR 78 100 (Figure 1.12) (OECD, 2023[29]). Pension contributions account for 24% of the gross wage. Given the relatively low labour productivity and wages in Latvia, such high marginal tax rates present a major obstacle to the formalisation of workers (see Chapter 2) (World Bank, 2017[30]) (OECD, 2022[31]). Experiences from other countries such as Colombia show that lowering social security contributions for lower incomes and making them increase progressively with incomes, while maintaining social security benefit levels and financing the reform through general tax revenue, can significantly improve labour supply incentives and the formalisation of low-skilled workers (Arnold et al., 2023[32]). Reducing the labour tax wedge for low-income earners should be financed by making personal income taxes more progressive at higher incomes and raising revenue from corporate and capital income, inheritance and property taxes. Lithuania has recently started to fund its minimum pension partly through general tax revenue, which has allowed lowering social security contribution rates (OECD, 2022[31]). As the minimum pension is financed out of the social security fund in Latvia, financing it through general tax revenue could be one way to enable reductions of social security contributions rates for low-income earners.
Average tax wedge decomposition, % of labour costs, 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. Panel B and C show the tax wedge by income level measured in percent of the income of the average worker (AW).
Source: OECD Taxing Wages database.
Despite the introduction of differential tax rates, the progressivity of personal income taxes remains low (Figure 1.13). The tax rate is 20% for the first bracket of yearly income until EUR 20 004, 23% for the second bracket ending at EUR 78 100, which is almost five times the average yearly gross wage income in Latvia, and 31% thereafter (OECD, 2023[29]). As income inequality in Latvia is among the highest across the OECD and the share of personal income taxes in total tax revenue is relatively low, the progressivity of the personal income tax should be increased by applying the maximum tax rate of 31% at a lower income threshold (Figure 1.11) (OECD, 2022[1]). A differentiated tax allowance, which is EUR 500 below a monthly income of EUR 500 and then decreases to zero until a monthly income of EUR 1 800, has introduced some additional progressivity since 2018 but leads to steep marginal tax rates at low incomes, raising incentives to underreport wage income above the minimum wage (OECD, 2022[31]). To reduce underreporting of income and incentivise take-up and expansion of formal employment, the existing tax allowance could be replaced with a refundable earned income tax credit which increases with income above the minimum wage until a certain threshold. Above this threshold, the tax credit should be gradually phased out to maintain sufficient incentives for further expanding labour supply (Eissa and Liebman, 1996[33]; OECD, 2022[31]).
Percentage of gross wage earnings, 2022
Note: Data refer to single person without dependant.
Source: OECD Tax database.
A comprehensive tax reform to strengthen incentives for formal labour supply should be closely coordinated with the design of social benefit programmes. The withdrawal rate of social benefits with rising income has been shown to strongly affect incentives for low-income earners to raise labour supply and formalise work (Pritadrajati, 2023[34]; OECD, 2022[31]). The guaranteed minimum income has been raised to EUR 125 in July 2023 and is planned to be indexed to 20% of the median wage starting in 2024, with a regular review of this threshold, which is welcome as poverty and inequality are high in Latvia (OECD, 2022[1]). However, to reduce inequality and at the same time improve labour supply incentives it is crucial to better target the guaranteed minimum income to vulnerable households, while phasing it out more gradually when these vulnerable households start earning more income (OECD, 2022[31]). The substantial heterogeneity of living costs across regions should also be taken into account in benefit calculations, as undifferentiated nation-wide transfers might lead to stronger disincentives for formal labour supply in regions with lower living costs and where labour shortages are already large. The government is currently working on improving its data infrastructure to better target social benefits to vulnerable households. Other benefits, such as child benefits, should be well coordinated with the guaranteed minimum income to strengthen labour supply incentives (Lippold, 2019[35]). Conducting a comprehensive review of the tax and transfer system could help to design an efficient, growth friendly and equitable tax system.
To finance decreases in labour taxes, there is scope to raise revenue from the corporate income tax (CIT), which is low compared to other OECD countries (Figure 1.11). Since 2018, corporate profits are only taxed at a rate of 20% when they are distributed to shareholders. This created strong incentives to keep profits within the company to avoid taxation, leading to a strong decrease of CIT revenue by more than 1.5 percentage point of GDP from 2017 to 2019, although revenue has recovered since then. The purpose of this measure is to stimulate investment by incentivising higher firm equity, reducing incentives to under-declare profits and improving access to finance. However, experiences from a similar reform in Estonia show that effects on investments in productive assets are weak, as firms prefer to accumulate excess liquidity instead of investing in productive assets (Hazak, 2009[36]; Masso, Meriküll and Vahter, 2013[37]). Moreover, OECD research indicates that the elasticity of investment to effective corporate income tax rates has fallen since 2009 (Hanappi, Millot and Turban, 2023[38]). The government has recently decided to subject profits of banks and other credit providers to direct taxation irrespective of profit distribution. This step could be expanded to include all other economic sectors, as the non-taxation of retained earnings is costly and budget resources are scarce. Moreover, the international agreement on the global minimum tax on corporate profits will require adjustments in Latvia’s CIT system, which should be taken as an opportunity to evaluate and redesign the system, and raise revenue from CIT.
Special tax regimes for small businesses reduce tax revenue and can hinder firm growth and the allocation of capital and labour to more productive firms, thereby contributing to weak aggregate productivity growth (see Chapter 2) (World Bank, 2017[30]). The micro-enterprise tax regime introduced in 2010 provided strong incentives for firms to stay small or split into smaller units to avoid growing above the eligibility threshold (OECD, 2019[2]). This effect was most pronounced in sectors with high labour costs, such as professional services, and led to an increase in the number of firms registered under the regime to over 47 000 in 2017, which employed around 85 000 workers or 14% of private sector employees (OECD, 2019[2]). Since then, eligibility conditions have been tightened, but about 7 600 firms still remain in the system. From 2024, the single tax rate is 25% on turnover, which includes social security contributions and personal income tax for the micro-enterprise owner. Firms can remain in the system without time restrictions, as long as their annual turnover remains below the threshold of EUR 50 000. Since 2021, any employee needs to be fully registered with the general tax system, which has led to a decrease of registered micro-enterprise employees by 75% to about 17 000 employees in 2021 and zero employees in 2022, likely increasing informal employment. Although this tax regime might have facilitated the formalisation of small firms, it hinders firm growth and provides an incentive to under-declare revenue above the turnover-threshold (see Chapter 2). It also hinders reallocation of firm owners and potentially informally employed workers to more productive firms, which suffer from strong labour shortages. Although tax revenue foregone from owners of firms under the micro-enterprise tax regime is estimated at only 0.1% of GDP in 2021 (Ministry of Finance, 2021[39]), the loss of efficiency due to such threshold-induced distortions can be significant and has been estimated at around 3.5% of GDP in the case of France (Garicano, Lelarge and Van Reenen, 2016[40]). The regime should be evaluated and redesigned to allow micro-enterprises to grow and flourish under the general tax system.
There is scope to reduce tax reductions and exemptions, which amount to 8.6% of GDP or a quarter of all public revenues in 2021 (Ministry of Finance, 2021[39]). Special economic zones (SEZ), such as the free ports in Riga and Ventspils and the SEZ in Rezekne, Latgale, and Liepaja, provide reductions or complete exemptions in VAT, CIT, property and fuel taxes to attract international and domestic firms (Næss-Schmidt et al., 2020[41]). Even a share of salary payments can be deducted from tax payments in Rezekne and Latgale. While such support can stimulate foreign direct investment (FDI) and foster knowledge spill-overs to the local economy, the continuous evaluation of these incentives is key to ensure effective use of public resources (Grundke and Cassimon, 2022[42]). This is particularly important, as the introduction of the global minimum tax on corporate profits might allow other countries to tax the exempted corporate income. Several studies indicate that the performance of Latvian SEZs in terms of employment and FDI has been much weaker than in other countries (Næss-Schmidt et al., 2020[41]). An important function of SEZs is also to provide organisational and administrative support and facilitate cooperation with local firms and suppliers as well as vocational and educational training (VET) institutes to equip the local workforce with the skills needed by firms. Simplifying regulation and improving management of SEZs, which are operated as local state-owned enterprises (SOEs), could help to make SEZs more effective.
Various tax reductions and exemptions in value added and excise taxes also contribute to high tax expenditures. For example, excise tax expenditures for fuels, alcoholic beverages and tobacco amount to 0.6% of GDP (Ministry of Finance, 2021[39]). Reducing these tax expenditures and establishing transparent criteria and regular evaluations for the remaining ones would improve tax fairness and raise revenue (OECD, 2020[43]) (OECD, 2022[44]). Moreover, it would support health and environmental policy objectives by reducing the consumption of alcohol and tobacco and the use of fossil fuel and environmentally harmful substances in production (see below). This should be combined with raising carbon taxes in the building and transport sector until the EU ETS 2 is introduced in 2027. To support vulnerable households, which might be relatively more affected by the reduction of VAT expenditures and increases in carbon taxes, the guaranteed minimum income should be expanded and better targeted.
As the progressivity of the personal income tax is low, the authorities should also consider introducing gift and inheritance taxes to raise revenue and reduce inequality. Latvia already taxes the inheritance of real estate through estate and notary fees, but revenues from wealth transfer taxes as a share of total tax revenues are less than half of the OECD average (OECD, 2021[45]). Distortive effects of inheritance and gift taxes on savings and investment behaviour and work efforts of wealthy taxpayers are found to be much smaller compared to labour or capital income taxes, while the effects on labour supply of the heirs are significantly positive (OECD, 2021[45]) (Guvenen et al., 2023[46]). When combined with an exemption for low-value inheritances, recipient-based inheritance taxes can significantly lower wealth inequality and contribute to the equality of opportunities. Experience from other countries show that for inheritance and gift taxes to be effective, it is key to ensure a broad tax base, particularly avoiding too generous exemptions for business assets, and set lower tax rates for the average household (OECD, 2021[45]). To address concerns about forced liquidation of family-owned firms, instalments for tax payments could be introduced. Another option to raise revenue while reducing inequality could be to tax capital gains and dividend income in line with the PIT schedule.
Improving intergovernmental fiscal relations
Many municipalities lack sufficient revenue sources to finance their autonomous functions and are dependent on conditional and unconditional transfers from the central government to fulfill these functions (Figure 1.14). Latvian municipalities are responsible for providing a broad range of public services from education, health and social services to infrastructure and land planning, issuance of commercial permits and licenses, law enforcement, utilities, transport infrastructure, public transport, housing and economic development policies. They receive 75% of PIT revenues and 100% of real estate taxes of residents in their jurisdiction as their main income sources. However, these revenues make up only 47% of their total expenses on average across municipalities in 2022, while 43% is financed by conditional and unconditional transfers (Figure 1.14). Compared to the average between 2011 and 2019, tax revenue received by municipalities has decreased by about 2.3 percentage points of total tax revenues in 2022 according to OECD data. On the other hand, spending pressures for municipalities have strongly increased since early 2022, mainly due to increases in energy prices, public sector wages, the guaranteed minimum income threshold, interest rate expenses and the additional costs for integrating Ukrainian refugees, further increasing the dependency on central government transfers.
Municipalities, share of retained tax revenue, other revenue, conditional and unconditional central government transfers in total expenditure (in %), 2022
Note: Retained tax revenues are computed by subtracting contributions to the municipal equalisation (ME) fund from total received tax revenue, which includes personal income tax and property tax revenues. Unconditional grants are grants received through the municipal equalisation fund as well as additional unconditional grants for particularly poor municipalities and discretionary grants allocated during the annual budget negotiations. Conditional transfers include transfers to finance base salaries of teachers, salaries of medical and elderly care staff, investment projects, road maintenance, public transport, and social protection. Non-tax revenue and self-earned revenue include fees and dividend income from public companies owned by the municipalities. The unweighted average across municipalities does not account for the size of municipalities.
Source: Ministry of Finance; State Treasury.
Financing a high share of local expenditure with central government transfers might reduce incentives for spending efficiency, as local populations might have less incentives to scrutinise local governments for their spending decisions (Herrmann, 2022[47]; Blöchliger and Kim, 2016[48]). This is a particular problem for conditional grants, which make up around 29% of municipal expenditures on average and comprise transfers to finance base salaries of teachers, wages of medical and elderly care staff, investment projects, road maintenance, public transport, and social protection. Such earmarked grants tend to reduce incentives for spending efficiency, in particular if they do not require co-funding by the municipality receiving the grant (Bergvall et al., 2006[49]). Although there is a complex formula to compute grants for teacher wages based on the number of students, their age structure and the remoteness of the school, grants do not go to the school directly but are managed by municipalities who can decide on the allocation across schools. This contributes to strong variation of student to teacher ratios and teaching quality across schools, although one objective of these conditional grants is to reduce differences in public education quality across municipalities.
Some of the existing non-earmarked transfers from the central government are not automatic and are negotiated each year in the preparation of the national budget. This introduces high uncertainty in budget planning for municipalities and complicates longer-term spending commitments, for example for infrastructure projects. It might also blur incentives for spending efficiency, as municipalities might expect a bail out by the federal government (OECD, 2016[50]). The equalisation fund is designed to reduce the difference of municipal revenue per capita to the average revenue per capita across municipalities by 60%, whereby differences in spending needs due to differences in population age structure and territorial size are accounted for. However, the payments from richer municipalities to the fund do not fully cover the transfers to poorer municipalities, and the central government has to step in every year to cover the difference, which was 34% of payments to poorer municipalities in 2022. In addition, further unconditional grants are disbursed each year, amounting to 44% of equalisation fund disbursements in 2022. The government provides municipalities with a tax revenue forecast for the next three years and guarantees forecasted personal income tax revenues to municipalities for each current year to reduce budget uncertainty for municipalities. However, government transfers to cover the deficit in the municipal equalisation fund are still decided each year during the state budget negotiations.
To improve the quality of public services and spending efficiency at the local level, it is key to provide the municipalities with sufficient automatically allocated tax revenue, which should preferably be directly linked to local economic activity. As revenue from recurrent taxes on immovable property is low in international comparison (Figure 1.15), it is a key priority to update cadastral values with market prices of properties and raise revenue for municipalities, while continuing to provide tax reductions for the primary residence of poorer households. A lack of a systematic methodology to determine cadastral values of property and low capacity of the responsible central government agency have led to a situation, where raising property tax rates could exacerbate inequalities. Modernising the cadastre system and regularly updating cadastral values with market prices would significantly contribute to reduce high wealth inequality. A larger weight for property taxes in revenues would also make municipal finances less sensitive to business cycle fluctuations and provide more planning certainty for longer-term infrastructure projects (Kim and Vammalle, 2012[51]). To prevent detrimental tax competition, national minimum property tax rates should be raised, while giving municipalities more flexibility to introduce top-up rates. This could be combined with allocating a higher share in PIT revenue or sharing parts of national VAT and CIT revenues with municipalities, which would increase with the reforms proposed in this Survey. Municipalities could also be allowed to introduce top-up tax rates on PIT above the national rate, as for example done in the U.S. (Blöchliger and Kim, 2016[48]).
Linking municipal tax revenue more to local economic activity is key for incentivising the local population to hold local governments accountable, which in turn should motivate local governments to improve public service quality and spending efficiency (OECD, 2016[50]). However, as economic differences across municipalities are large, the equalisation fund needs to continue redistributing resources from richer to poorer municipalities but should be based on transparent and stable allocation criteria and independent from further financial transfers from the central government. The equalisation formula should use measures for municipal tax capacity, for example based on a measure of average updated cadastral values in the case of property taxes instead of projected tax revenue based on past revenues, to calculate contributions and transfers, as using actual revenue provides incentives to not fully use local tax revenue potential (Bergvall et al., 2006[49]). Improving the incentives for municipalities to develop their tax base and raise spending efficiency is particularly important, as the scope for municipalities to issue debt in international and domestic markets has been expanded.
Recurrent taxes on immovable property, % of GDP, 2022 or latest available year
1. Unweighted average.
Source: OECD Revenue Statistics.
Improving the capacity of the public administration and raising spending efficiency
Effective enforcement of property rights and implementation of laws and regulations facilitate economic transactions and provide firms and households with the planning certainty needed for longer-term investments. Rising complexity of bureaucratic processes can hinder such effective enforcement and implementation and act as an administrative burden for firms and households. However, recent empirical research has shown that given the same level of regulatory complexity on product and labour markets, the quality of the public administration is a key determinant of firm growth across OECD countries (Kritikos, Amoroso and Herrmann, 2023[52]). For example, public planning and approval procedures for infrastructure investments can be simplified to a certain extent but will always keep a certain level of complexity due to the many different stakeholders and concerns involved in such projects. To ensure that these processes are effective and do not act as a barrier to investments, it is crucial to ensure a high capacity of the public administration (Becker, Egger and von Ehrlich, 2013[53]).
Continuing to improve public employment policies is key for raising public sector capacity
In Latvia, the quality of the public administration had suffered from strong wage cuts in the aftermath of the financial crisis in 2009. Public sector wages have decreased by over 22% from 2008 until 2010, while private sector wages only decreased by 5% (Figure 1.16). This strong decrease in relative wages between the public and the private sector coupled with rising skilled labour shortages in the Latvian labour market caused many experienced employees to leave the public sector and strongly increased staff turnover, as it remains difficult to retain newly hired talent (OECD, 2015[54]). This is a particular issue for management positions and skilled professionals, and less so for occupations with lower skill requirements, such as clerks (Figure 1.16). In many parts of the administration, institutional memory has been weakened and capacity lost, with negative consequences for the quality and effectiveness of public policies and services and the efficiency of public spending. Low public sector wages also facilitate corruption. The government has started to address this issue with a public administration reform in 2022, which aims at raising public sector wages to at least 80% of private sector wages for comparable jobs by 2027. It also introduces more flexibility in wage setting for occupations that are in high shortage and indexes public wages to past GDP growth rates. As the public sector wage premium for clerks is already relatively high, there is scope to finance higher wages for managers and skilled professionals by slowing wage increases for clerks and evaluating options for consolidating the workforce. Recent wage increases for other parts of the public sector not covered by the recent reform, for example judges, employees in law enforcement, teachers and medical staff, are welcome, but more flexibility in wage setting should also be considered for these occupations.
The recent public administration reform should be combined with improved human resource policies to enhance the skills and motivation of public employees and further raise the attractiveness of public jobs through non-monetary benefits. Training for public employees should be expanded and its quality improved, with a particular focus on digital and management skills. Expanding performance-related pay and fostering employee engagement, better defining career paths and job profiles and improving public sector branding is necessary to attract and retain qualified personnel (European Commission, 2020[55]). Improving non-monetary benefits, such as providing more flexibility regarding part-time and remote work, increasing the number of vacation or paid sick days or longer notice periods, can also play an important role to raise the attractiveness of public jobs. In addition, centralising public recruitment procedures would bundle resources and raise the quality of recruitment, and facilitate mobility across institutions, thus improving peer-learning, coordination and cooperation across different parts of the government (OECD, 2023[56]). Expanding recruitment activities to attract external and international candidates, including from the Latvian diaspora, could significantly improve management skills sets and organisational quality in the public sector. This would help make the administration more agile and client-oriented, for example concerning the use of digital tools for programme evaluation and better cooperation and data exchange across the government.
Source: World Bank, Worldwide Bureaucracy Indicators (WWBI); and Central Statistical Bureau of Latvia.
To finance more attractive conditions for working in the public sector, there is scope for further consolidation in the public sector. The public wage bill relative to GDP is above the OECD average, which is due to an above average public workforce and relatively high wages for occupations with low skill requirements (Figure 1.16, Figure 1.17). The relatively large public workforce is related to the fact that Latvia is a small country with a broad set of responsibilities for its many relatively small municipalities (see above) (OECD, 2019[2]). A recent territorial reform has reduced the number of municipalities from 119 to 43 in 2021, providing scope for the realisation of returns to scale in public services provision and a consolidation of the public workforce, but the implementation of this administrative reform will take some time. The ongoing reform of the school network will also likely lead to a more efficient employment of public resources in education services, creating larger schools with higher student to teacher ratios, better equipment and better teacher training and monitoring. A relatively large number of local state-owned enterprises also contributes to relatively high public sector employment with room for rationalisation (see below). There is also room for consolidation within the central government. Duplication of agencies and responsibilities is a problem that not only consumes public resources and reduces returns to scale, but also increases coordination costs within the government and raises the administrative burden for the private sector (OECD, 2019[2]).
Source: OECD (2023), Government at a Glance 2023; OECD Economic Outlook database; and OECD calculations based on OECD National Accounts database and OECD (2017), The Size and Sectoral Distribution of State-Owned Enterprises, OECD Publishing, Paris, https://doi.org/10.1787/9789264280663-en.
Continuing the digitalisation of the public sector to improve policy impact assessment and raise spending efficiency
Digitalising administrative procedures is key to improve public sector capacity in the context of rising skilled labour shortages. Latvia has made important progress in digitalising administrative procedures for firms and households and has increased transparency of the public sector (Figure 1.18, Panel A). The share of individuals using the internet to interact with the government is close to the average OECD country (Figure 1.18, Panel B). This has contributed to a strong reduction in the administrative burden, for example for starting a company or receiving an operating license or a construction permit (Figure 1.19). The introduction of an online one-stop-shop for setting up a company has strongly reduced the administrative burden for start-ups. However, data sharing and analysis for policy planning and impact assessment, which is measured by the sub-indices on “government as a platform” and “data-driven public sector” in Panel A of Figure 1.18, has still room for improvement. The administrative burden for internal government processes remains high (OECD, 2023[57]). Proactiveness and stakeholder involvement in the design of public policies through digital technologies could also be improved (OECD, 2021[58]).
Note: In Panel A, data are not available for Slovakia, Switzerland and the United States. The OECD Digital Government Index (DGI) is based on the six dimensions of the OECD Digital Government Policy Framework (DGPF): digital by design, data-driven, government as a platform, open by default, user driven and proactiveness. It measures the capacity of the public sector to deliver a coherent and human-centric digital government transformation, as well as the strategic approaches, policy levers, implementation, and monitoring mechanisms in place to deliver the digital government strategy. Thus, it captures much more than just digitising analogue processes.
Source: OECD Survey on Digital Government 2.0. OECD ICT Access and Usage by Households and Individuals database.
Although digitalisation has progressed at the level of the central government, digitalisation of public services at the municipal level is still lagging due to weak financial capacity and a lack of management and digital skills (OECD, 2021[59]; VARAM, 2022[60]). It is key to better incentivise municipalities to conduct joint ICT and software procurement initiatives to lower costs and foster the harmonisation and digitalisation of administrative procedures as well as the exchange and analysis of data across municipalities and within the central government. Common IT standards and data formats should be developed and made mandatory for all levels of government, including obliging all IT services providers to develop products for the public administration in conformity with these standards (OECD, 2023[61]). Incentivising compliance with the existing guidelines for good public service delivery and setting a timeline to provide public services digitally for firms could help to accelerate progress at the municipality level (OECD, 2021[59]; VARAM, 2022[60]). This needs to be complemented with expanding targeted training to public employees in the use of digital technologies and the design of digital services, which has been introduced in 2023 as one EU recovery fund project. Fostering peer-learning across the public sector through workshops and online courses and the certification of successfully digitalised government services would also help (OECD, 2021[59]).
Source: The World Bank Group, Enterprise Surveys, www.enterprisesurveys.org; and OECD (2018), Product Market Regulation Database.
Despite progress in digitalising public services, there is room to improve digital tools for ex-ante as well as ex-post evaluations of laws, regulations and policy programmes (Figure 1.20). Ex-ante impact assessment of laws and regulations helps to prevent that legislation is changed too frequently, as it raises regulatory quality and ensures ex-ante that legal action meets the expected policy objectives, while reducing economic, social and environmental costs (Brenner and Fazekas, 2021[62]). This contributes to legal certainty, which is key for raising long-term investments of households and firms. Ex-post evaluations allow monitoring the effects of regulations and policy programmes and adjusting them if policy objectives are not met. Both types of impact assessment require a good quality of data and analytical capacities and close cooperation with relevant stakeholders. Since 2021, regulatory impact assessment is mandatory when developing new primary laws and subordinate regulations. However, there is room for improving analytical methodologies and knowledge on cost-benefit analysis and the quality, exchange and analysis of data across the public sector (Figure 1.20) (OECD, 2021[58]). Implementing the planned single electronic identifier for firms and natural persons is key for linking and analysing data and reducing the administrative burden within the government. The oversight and quality control for ex-post evaluations of regulations should be improved and reviews of regulatory stock, which mostly focus on reducing the administrative burden, should be expanded to also analyse the effects of regulation on competition (see Chapter 2).
OECD Indicators of Regulatory Policy and Governance (iREG, higher value indicating better performance), 2021
Source: OECD (2021), OECD Indicators of Regulatory Policy and Governance (iREG).
Better impact assessment of policies through better data and digital tools would also help prioritising expenditures and raising spending efficiency. Latvia has introduced medium-term and performance budgeting based on spending reviews, but weak impact assessment capacities complicate their successful implementation. Many performance indicators for budget programmes exist and are published in the annual state budget law. However, they have little consequences in budget negotiations for the allocation of resources across programmes (OECD, 2016[63]). Incentives for public bodies to conduct critical evaluations to identify fiscal space and to strengthen impact assessment capacities should be improved. This is a particular problem at the municipality level, where impact assessment capacities are weaker than in the central government administration. Improving these capacities and allowing for accessing, linking and analysing administrative data across levels of government, including by implementing the planned single electronic identifier for firms and individuals, would enhance peer learning opportunities, facilitate evidence-based policy making, reduce the administrative burden and raise spending efficiency. Better impact assessment would also help to improve the targeting of policy measures to particular groups. For example, the energy price support measures could not be targeted at vulnerable households or particularly affected firms, as the necessary data infrastructure to identify these households and firms remains to be established.
Improving public procurement and investment planning
Latvia has considerably improved procurement procedures and their transparency by introducing an electronic procurement platform, the use of which is mandatory for all levels of government for tenders with a value above EUR 10 000 for supply and service contracts and EUR 20 000 for public works. This reduces information asymmetries and lowers barriers to bidder participation, particularly for smaller and younger firms, fostering competition and reducing costs (Fazekas and Blum, 2021[64]). It also facilitates joint procurement across the public sector to take advantage of economies of scale and gains from specialisation (Allain-Dupré, Hulbert and Vincent, 2017[65]). Centralised procurement has been found to significantly reduce costs compared to local procurement, for example in Italy by 60% in pharmaceuticals (Fazekas and Blum, 2021[64]; Baldi and Vannoni, 2015[66]). However, in Latvia, the procurement of many standardised goods and services that could gain from centralised purchase is still conducted at the municipal level, for example ICT and software services or drugs and medical equipment. Within the central government, joint procurement across Ministries, public agencies and SOEs is also rather the exception than the norm. Despite the legal requirement to purchase standardised goods and services centrally, the weak capacity of existing central or cross-municipal purchasing bodies and legal exemptions for cases where requested products and services are not offered by the central purchasing body hinder centralised procurement. Spending efficiency should be improved by consolidating existing purchasing bodies, improving their IT and staff capacity and reducing legal exemptions that allow to opt out of mandatory centralised procurement.
Data from the e-procurement platform should be better used to identify risks for bidder collusion and raise spending efficiency. So far, the existing red flag system is hampered by the limited availability of information, such as the lack of bidding prices of other bidders than the final contractor. Collecting and including data on public tenders below the threshold for mandatory e-procurement in the red flag system would allow to investigate strategic splitting of procurement projects to avoid mandatory e-procurement and could help to raise transparency and fight corruption. In addition, the threshold for mandatory e-procurement should be lowered, while reducing the administrative burden for setting up tenders and publishing documents and data in the system. Moreover, the three stages of procurement, bid design, bid evaluation and contract execution, should not be conducted by the same person to reduce corruption risks. Fostering e-procurement and improving the red flag system to reduce the scope for corruption can significantly reduce costs (Veljanov and Fazekas, 2023[67]; Abdou et al., 2022[68]).
Municipalities are responsible for a high share of public investment (Figure 1.21). As there will be a significant inflow of EU funds during the next years, it is crucial to improve investment planning capacities at the local level to ensure effective and cost-efficient implementation of infrastructure projects (IMF, 2023[4]; Becker, Egger and von Ehrlich, 2013[53]). The recent territorial reform has consolidated municipalities leading to potentially larger investment and procurement projects, which reinforces the need to up-skill public employees in local planning and procurement agencies. Improving ex-ante cost-benefit analysis, risk assessment and analysis of market capacity for contracting decisions is key to raise spending efficiency, as exemplified by the OECD Support Tool for Effective Procurement Strategies (STEPS) (OECD, 2021[22]). Implementing STEPS to improve public procurement procedures related to infrastructure projects across all levels of government has been found to yield spending efficiency gains of more than 1% of GDP in Germany (Makovšek and Bridge, 2021[21]). Better cooperation across municipalities in infrastructure planning, including joint procurement, can also significantly reduce costs and improve effectiveness of implementation (Allain-Dupré, Hulbert and Vincent, 2017[65]).
Also, land planning and construction licensing procedures for private investments need to be improved at the local level. Improving digital tools for spatial development planning would support decision-making processes and increase their transparency. In some regions, the share of firms complaining about issues related to land access, business licenses and corruption, particularly related to construction permits, is higher than in other regions and more than double the share than in other Baltic countries (World Bank, 2019[69]; OECD, forthcoming[70]). In some cases, conflict of interests might play a role, if local businessmen get elected for public office or participate in procurement committees without sufficiently separating private from public interests. To reduce barriers for competition and investment as well as scope for corruption, it is key to improve internal control and audit systems and increase transparency at the local level. Conflict of interest situations should be managed by better enforcing existing regulation on transparency of income and assets and external activities of public officials. For example, as members of procurement committees are not always appropriately declared as public officials by their heads of institutions to the State Revenue Service, the regulation is not always effectively enforced for all persons involved in public procurement and spending decisions. This is also the case for some public agencies and SOEs at the national level, for example related to decisions on the allocation of EU funds. Ensuring that the existing strict transparency regulation for public officials is enforced for all persons involved in procurement and spending decisions is key for raising transparency and reducing the scope for corruption.
Source: OECD National Accounts database.
Improving the governance of state-owned enterprises
In Latvia, state-owned enterprises (SOEs) play a larger role in the economy than in other OECD countries (OECD, 2022[1]). About 7% of the workforce is employed in SOEs, which is triple the OECD average (Figure 1.17). Seven of the largest 20 companies in Latvia are state-owned with 42% of total assets of the largest 20 companies (Figure 1.22). Profits (measured as EBITDA) of the seven biggest SOEs amount to 2.8% of GDP in 2022, significantly contributing to the central government budget through dividend payments. The sectoral scope of SOEs is relatively broad compared to other OECD countries, indicating room for reducing the presence of SOEs in commercial activities (Box 1.2).
Although Latvia follows OECD best practices and assesses the rationale of state-ownership every five years, the ownership structure of SOEs has not changed much since 2015 despite the broad scope of SOEs. According to the law, SOEs that do not correct market imperfections or serve strategic and national security purposes should be divested, but criteria for justifying state-ownership remain relatively vague (OECD, 2021[71]). Better defining assets, goods and services of strategic interest and conducting in-depth analysis on the presence of market failures and the consequences of state-ownership on competition is key for making decisions on the rationale for state-ownership more transparent and improving social welfare (IMF, 2019[72]; OECD, 2021[73]). The SOEs that so far have been excluded from the assessment, such as the post, railroad, airport, television, radio and theatre companies, should be included in future reviews. For those SOEs that remain public, ensuring that ownership is entirely separated from the state’s other roles as regulator or policy maker is key to ensure competitive neutrality and foster business dynamism and innovation.
Share in total asset value of 20 biggest companies (in %, 2023) and profit margins measured as earnings before interest, tax, depreciation and amortisation (EBITDA) as a share of total turnover (in %, 2022)
Source: Data portal on state ownership in Latvia: http://www.valstskapitals.gov.lv/lv/.
Overall, there are 65 fully owned and four majority owned SOEs managed by the central government, which are active in air, rail and road transport, telecommunications, logistics, energy generation and distribution, including electricity and natural gas, construction, forestry, real estate as well as consumer services, such as gambling or cultural activities (OECD, 2021[71]). Moreover, about 330 SOEs are owned by 43 municipalities, operating in areas such as utilities, public transport, construction but also in health services, sport, or cultural activities. Employment in local SOEs represents about 40% of total employment in SOEs (OECD, 2019[2]). Compared to other OECD countries, the share of SOE employment in transport and IT and telecommunication services, energy generation and distribution, real estate as well as other commercial activities, such as cultural activities, health services and media, is high in Latvia (Figure 1.23).
SOEs employees, % of total employees, 2015
Note: OECD average is an unweighted average of 33 OECD countries. “Other activities” for Latvia include healthcare, culture, education and sports, public media, environment and legal services sectors.
Source: (OECD, 2017[74])
The Competition Council should be further strengthened and play a central role in evaluating the presence of market failures and the consequences of state ownership on competition and market outcomes. As many SOEs act as an income source for the government, there is a potential conflict of interest between revenue generation and competition enforcement. Although there has been some improvement since 2018, Latvia still ranks below the OECD average in the competition assessment of regulation according to the 2023 OECD Product Market Regulation Indicator (Figure 1.24). At the same time, market entry barriers in services sectors, where SOE presence is high, are still among the highest across the OECD, reducing business dynamism, innovation and productivity (see Chapter 2). A 2020 law established the principle of competitive neutrality for SOEs. Legislation also requires the central government and municipalities to ask the Competition Council for an evaluation of their SOEs regarding justification of their ownership. However, not all SOEs have been evaluated so far, as many municipalities have not requested an assessment. Due to its advisory role, the Competition Council can only act upon request of a public body and cannot mandate any regulatory changes, but only provide advice. The same is true for the assessment of the effects of new and existing regulations on competition. The Competition Council should receive the power to start market investigations on the competition effects of regulation and state ownership rationale of SOEs to ensure competitive neutrality. In other OECD countries, such as Italy and Spain, or in Romania, the competition authority can also challenge administrative decisions and regulations issued by public bodies in case it finds that they hamper competition, which is not the case in Latvia (see Chapter 2) (OECD, 2016[75]) (Whish, 2020[76]) (Motta and Peitz, 2021[77]) (OECD, 2021[78]). Latvia is one of the few OECD countries that has not yet conducted an OECD review of the competition policy framework. Conducting such a review, including financial market regulation, could help to identify and implement the necessary policy changes to improve competition enforcement.
OECD Indicators of Product Market Regulation (PMR), index scale of 0-6 from least to most restrictive (higher values indicate worse performance)
Note: OECD average for 2023 includes all OECD countries, except Belgium, Hungary, Mexico, the Netherlands, and the United States for which data collection is still ongoing. PMR values for Estonia and Lithuania for 2023 will only be released in Summer 2024.
Source: OECD (2023), Product Market Regulation Database (forthcoming).
There is also room to continue to improve the governance of SOEs (Figure 1.24). Currently, public ownership of SOEs is dispersed across 13 ministries, one public agency and one SOE functioning as a public asset manager. The Cabinet of Ministers sets strategic objectives for SOEs, while the capital-shareholding ministries and supervisory boards, which exist only for larger SOEs, set annual financial and non-financial objectives. Although the State Chancellery located under the prime minister’s office is tasked to coordinate policies related to SOEs and evaluate their performance, standards in terms of transparency, accountability and performance are not unified across SOEs (OECD, 2022[1]). Following the 2015 OECD Guidelines on Corporate Governance of SOEs and centralising all SOEs into a single holding entity could help clarify their objectives, unify transparency, accountability and performance standards and better monitor performance (OECD, 2015[79]).
There is no centralised performance evaluation for municipal SOEs, and transparency on financial statements, employment, wage payments and public subsidies remains relatively weak. A website exists, where most municipalities publish some information on their SOEs online, but comparability of the data is weak (Delna, 2021[80]). Many of these SOEs have a larger labour share and weaker productivity than private firms with similar turnover, contributing to factor misallocation and raising prices, and potentially reducing quality of inputs for private firms (IMF, 2019[72]) (see Chapter 2). Softer budget constraints of local SOEs, due to weak incentives for spending efficiency of local governments (see above), might distort competitive neutrality and present a fiscal risk (IMF, 2019[72]). This is particularly problematic as bond issuance of municipal SOEs is planned to be facilitated (Cabinet of Ministers, 2023[81]). A rigorous evaluation of the effects of SOE presence and fiscal and procurement relations with municipalities on competition and market outcomes is key and should be facilitated by improving data availability and transparency, including for external researchers, and making separate accounting for commercial and other activities of SOEs mandatory (see Chapter 2). Expanding the role of the State Chancellery to also set performance standards for local SOEs and monitor their performance would be an important step to improve their governance, as for example done in Lithuania (OECD, 2021[71]). Supervisory boards should be made mandatory for all commercially oriented SOEs and the nomination process coordinated by the State Chancellery. At least 50% of the board members should be independent according to the law, but “independent” should be better defined to reduce political influence (OECD, forthcoming[82]).
Listing minority shares of larger SOEs could also help improve governance, foster competition and attract foreign investors to domestic capital markets (see Chapter 2). The listing can improve data transparency and the separation of commercial activities and activities pursuing public policy goals, including those of statutory natural monopolies, thereby strengthening the enforcement of competitive neutrality (OECD, 2021[78]; OECD, 2019[83]). In OECD countries, 45% of all SOEs by equity value and 25% of all SOEs by employment are listed enterprises, while in Latvia there is so far no listed SOE (OECD, 2017[74]). Thus, there is scope for listing SOEs in Latvia, particularly larger SOEs in commercial activities, such as telecommunication and transport services, energy generation and distribution or real estate. However, to safeguard competitive markets, independent and well-resourced regulators and a well-functioning competition enforcement are key conditions for listing SOEs (OECD, 2019[83]).
Fighting tax evasion, corruption and money laundering
Further improving tax enforcement and reducing informality
Since 2011, Latvia has made impressive progress in reducing VAT evasion (Figure 1.25). This is related to a range of measures, such as the introduction of automatic exchange of information on sellers on digital platforms, cash payment restrictions in the construction sector, reverse charging procedures and the use of data and digital technologies to better target inspections. However, the size of the shadow economy has not decreased and is still above 20% of GDP in 2022 (Sauka and Putnins, 2023[27]; Schneider, 2022[28]). The most common form of informality is underreporting of hours worked and wages, whereby workers are formally employed at the minimum wage and the unreported wage income is paid out in cash through the so-called envelope wages (Gavoille and Zasova, 2023[84]). In 2022, the share of unreported wages in total wages was estimated at about 25% on average, with higher shares in construction, retail and other services sectors, strongly reducing revenue from personal income tax and social security contributions (Sauka and Putnins, 2023[27]). Around 11% of employees are estimated to be working without any contract and 16% of total business profits to be unreported.
VAT gap, % of VAT Total Tax Liability (VTTL)
Note: The VAT gap is the overall difference between the expected VAT revenue and the amount actually collected.
Source: European Commission, Directorate-General for Taxation and Customs Union, VAT gap in the EU : report 2021, Study to quantify and analyse the VAT gap in the EU-27 Member States : report 2013.
The reasons for informality and tax evasion are manyfold and addressing them requires a cross-cutting strategy, but strengthening enforcement should play a key role. First, high effective marginal tax rates reduce incentives to raise formal labour supply, particularly for low-income earners, which should be addressed by a comprehensive reform of the tax and transfer system (see above). Second, low trust in institutions and weak quality of public services also contribute to low tax morale and informality (Putniņš and Sauka, 2015[85]; Sauka and Putnins, 2023[27]). This should be addressed by improving the capacity of the public sector to deliver high quality public services, continue the fight against corruption and better inform citizens about the benefits of the social security system and public services (see below). However, this needs to be combined with strengthening enforcement efforts, as the detection probability and the level of negative sanctions significantly affect tax compliance (Putniņš and Sauka, 2015[85]).
To reduce tax evasion, it is key to make electronic payment of wages and filing of an income tax declaration mandatory and better enforce strict economy-wide limits for cash payments. So far, the State Revenue Service (SRS) only disposes of a limited amount of information on taxpayers to guide its inspections, as not all of them are required to file an income tax declaration. Implementing existing plans for the mandatory filing of an electronic tax declaration for all taxpayers, while continuing to reduce the administrative burden by pre-filling declarations with information from previous years, should be a key priority. The abolishment of a labour law provision that allows for paying wages in cash should be combined with better enforcing economy-wide maximum thresholds for cash payments, while at the same time fostering financial inclusion in remote regions (see Chapter 2). Introducing withholding taxes on payments to sub-contractors would help to reduce tax evasion in sectors where sub-contracting is widespread (World Bank, 2017[30]). As for a high share of minimum wage earners wage income is underreported, raising minimum wages can also reduce informality, although there are some negative effects on compliant firms and workers that slightly earn above the minimum wage (Gavoille and Zasova, 2023[86]).
Moreover, it is key to make e-invoicing mandatory and better enforce the recently introduced obligation to use electronic cash registers to fight underreporting of income and revenue by firms and further reduce VAT evasion. The annual turnover threshold below which self-employed workers and firms do not have to pay the VAT will be raised to EUR 50 000 in 2024, which is relatively high compared to other OECD countries. This should be carefully evaluated to ensure efficient use of public resources.
These measures should be combined with further strengthening the capacity of the SRS through raising its budget resources and improving human resource policies and the IT infrastructure. Better cooperation and data exchange with other law enforcement agencies and public bodies are key to improve the risk-based approaches to guide inspections, which would also strengthen the fight against money laundering (Figure 1.26). For example, introducing the mandatory electronic registration of workers on construction sites has been an important step, but enforcement has suffered from an insufficient number of inspectors and the inability to link registered workers and wage payments with firm revenue, tax, social security, bank account and planned construction cost data to detect inconsistencies and successfully guide inspections. Moreover, as recommended by the previous OECD Economic Survey of Latvia, heavy penalties for tax evasion should be effectively enforced to deter criminal behaviour. Improving whistleblowing procedures would also help. This should be combined with continued efforts to raise tax morale by providing advisory services to taxpayers and rewarding compliance (World Bank, 2017[30]). The SRS has recently introduced a public scoring system based on the compliance history of taxpayers to guide procurement decisions and reward compliance through reputation effects. Providing advisory services is particularly important for new firms, for which the likelihood that non-compliance is related to a lack of knowledge is higher.
Note: Panel A summarises the overall assessment on the exchange of information in practice from peer reviews by the Global Forum on Transparency and Exchange of Information for Tax Purposes. Peer reviews assess member jurisdictions' ability to ensure the transparency of their legal entities and arrangements and to co-operate with other tax administrations in accordance with the internationally agreed standard. The figure shows results from the ongoing second round when available, otherwise first round results are displayed. Panel B shows ratings from the FATF peer reviews of each member to assess levels of implementation of the FATF Recommendations. The ratings reflect the extent to which a country's measures are effective against 11 immediate outcomes. "Investigation and prosecution¹" refers to money laundering. "Investigation and prosecution²" refers to terrorist financing. Data for Latvia is based on Moneyval’s 5th-round evaluation report on Latvia published in 2018 and does not reflect institutional changes since 2018.
Source: Panel A: OECD Secretariat’s own calculation based on the materials from the Global Forum on Transparency and Exchange of Information for Tax Purposes. Panel B: OECD, Financial Action Task Force (FATF).
Continuing the fight against corruption and money laundering
Since 2017, Latvia has significantly stepped up the fight against corruption and money laundering (Figure 1.27). Several cases of large-scale money laundering through banks and corruption cases have strongly reduced trust in political institutions, raising awareness among policy makers and leading to the effective implementation of a wide range of measures (Figure 1.28). Resources for the anti-corruption agency (KNAB) have been increased and coordination with other law enforcement agencies improved. Public disclosure of the financial situation of public officials has been made mandatory and a two-year cooling-off period applies to higher officials leaving the public sector. The implementation of a comprehensive transparency registry of beneficial ownership has greatly facilitated financial intelligence related to money laundering and tax crimes as well as asset recovery. Moreover, amendments to the law on party financing created a transparent mechanism of resource allocation to parties and established strict limits for donations and their immediate public disclosure (Figure 1.28). Anti-money laundering regulation has been implemented successfully, strongly reducing deposits held by foreigners, although there is scope to reduce the administrative burden for firms and households (see Chapter 2).
However, there is still a long way to go to bring back trust in institutions to the OECD average (Figure 1.27, Figure 1.28). A recent opinion survey of the KNAB found that better enforcing the existing heavy penalties against corruption and economic crimes, as recommended by the previous OECD Economic Survey of Latvia, would be the most effective way to combat corruption and raise trust in institutions (KNAB, 2022[87]). Lengthy court proceedings, particularly in complex cases against top public officials, and many verdicts not fully applying penalties foreseen by law cause dissatisfaction with the judiciary (OECD, 2022[1]). To address this issue, recent amendments to the criminal law broaden the definition of corruption and lower the burden of proof for conviction by expanding the definition of harmed interests related to the criminal offense. To shorten procedures, the recent establishment of the Economic Court, which is a specialised court for complex cases related to corruption, money laundering and economic crimes, has improved efficiency and quality of judicial procedures and its remit should be expanded (see Chapter 2).
Note: Panel B shows the point estimate and the margin of error. Panel D shows sector-based subcomponents of the “Control of Corruption” indicator by the Varieties of Democracy Project.
Source: Panel A: Transparency International; Panels B & C: World Bank, Worldwide Governance Indicators; Panel D: Varieties of Democracy Project, V-Dem Dataset v12.
OECD Public Integrity Indicators (OECD PII), 2022
Note: Higher indicator values indicate better performance. Data for the indicator “Legislative stability” was not yet available for Latvia at the time of publication of this report.
Source: OECD Public Integrity Indicators, https://oecd-public-integrity-indicators.org/.
To raise transparency and integrity in lobbying and reduce undue influence of special interest groups it is key to implement and enforce the planned lobbying register as a comprehensive and centralised transparency register with a legislative and regulatory footprint (Figure 1.28). Latvia has yet to create a publicly available lobbying register, which already exists in more than half of OECD countries (OECD, 2023[88]). Including all contacts with public bodies in a centralised register, including at the municipal level, is key for effectively raising transparency, as for example done in Ireland (OECD, 2020[89]). Municipalities are responsible for around 30% of public spending and the share of firms reporting issues with corruption is much higher in some of the more remote regions compared to the national average (OECD, forthcoming[70]). The legislative footprint, which links lobbying activities to their legislative outcomes, should be complemented with a regulatory footprint to include lobbying to influence the drafting of regulation. For the register to be effective, an independent supervisory body with sufficient resources and investigative powers should be responsible for its enforcement and sanctions should be applied for non-compliance. Regulations related to party financing as well as asset and income disclosure of public officials are strong, but more could be done to ensure that all political parties submit their required financial statements on time and the KNAB should employ the services of certified auditors to verify the content of these financial statements (OECD, forthcoming[90]) (Delna, 2021[80]). Better enforcing compliance with access to information regulation and facilitating data linkage and analysis for external researchers would raise transparency and compliance. In addition, side activities of public officials should be made transparent more quickly to prevent conflicts of interest, particularly at the municipal level.
Large emigration and a falling working age population have weighed on potential growth and have exacerbated skilled labour shortages (Figure 1.29, Figure 1.2). Unemployment has steadily fallen since the global financial crisis and the number of unfilled job vacancies has strongly increased (Figure 1.30, Panel A). However, regional heterogeneity in labour market tightness is large (Figure 1.30, Panel B). Most vacancies are concentrated in the metropolitan area of Riga and Pieriga, where unemployment rates are low. In regions further away from Riga, unemployment rates are much higher and vacancy rates lower. Thus, raising regional labour mobility and expanding remote work opportunities is one key policy lever to reduce mismatch in the labour market. Improving transport infrastructure and digital connectivity in remote areas and providing mobility subsidies and affordable housing are key and have been discussed in earlier OECD Economic Surveys of Latvia (see Chapter 2) (OECD, 2019[2]; OECD, 2017[91]; OECD, 2022[1]). However, this must be combined with policies to reduce skills mismatches and improve human capital. It is key to raise the quality of education and training to equip current and future workers with the skills required in the labour market, improve health outcomes to enable experienced workers to work longer and facilitate skilled migration.
Source: United Nations (2022), World Population Prospects: The 2022 Revision, Online Edition; Central Statistical Bureau of Latvia.
Although major steps to consolidate the VET school network and improve the quality of VET have been made, important challenges remain. The accreditation of new courses or changes of existing curricula is centralised at the national level, which might hinder the timely adaptation of training content to skill needs in local labour markets. Although social partners participate in the centralised accreditation procedures through the sectoral expert council (SEC), more than half of all firms, and particularly smaller ones, are not organised in employer associations, reducing the responsiveness of the SEC to skill demands in local labour markets (OECD, 2022[92]). Giving regional VET institutes more power to coordinate the content of VET programmes with local employers and facilitating accreditation procedures, as foreseen by amendments to the VET law in 2022, is key to better adapt training content with skill needs in local labour markets (OECD, 2019[2]). This should be combined with improving coordination among firms of the same sector, for example by making membership in the business association mandatory, to increase incentives for firms to participate in VET design and implementation and provide on-the-job training (see Chapter 2).
Note: The vacancy rate in Panel B refers to the share of vacancies in the total number of jobs, which is the sum of occupied jobs and vacancies.
Source: Central Statistical Bureau of Latvia; and Eurostat.
Although active labour market policies have been improved with the help of EU structural funds, spending on active labour market policies remains weak, particularly given the relatively high unemployment rates in some regions (Figure 1.31, Figure 1.30). Better cooperation with VET institutes is needed to provide adult education and VET courses that help the unemployed acquire the skills that are needed in local labour markets, including digital and Latvian language skills. As recommended by the 2019 OECD Economic Survey of Latvia, the hiring of more counsellors and the expansion of successful training programmes should be financed by domestic resources to provide more continuity in public employment services, as the strong dependence on EU structural funds has complicated the continuity of successful programmes in the past (OECD, 2019[2]). Moreover, only about half of the unemployed receive unemployment benefits and duration of benefits is low, which reduces matching quality in the labour market and forces many unemployed to accept low-wage job offers (OECD, 2022[1]). Increasing the eligibility of unemployment benefits, as recommended by the previous OECD Economic Survey of Latvia, coupled with the provision of re- and up-skilling opportunities linked to skill needs in local labour markets would help to reduce skill mismatches (OECD, 2022[31]). Germany has recently expanded the eligibility conditions for unemployment benefits for unemployed persons enrolling in a VET programme (OECD, 2023[61]).
Improving health outcomes is key to enable experienced workers to work longer and raise domestic labour supply (Figure 1.32). About a third of the unemployed has been without a job for more than a year, which is mainly related to poor health conditions (OECD, 2022[1]). As discussed by the previous OECD Economic Survey of Latvia, access to health services is hampered by long waiting times, high out-of-pocket payments and low supply of primary and home care. The recently announced increases in health spending, which is currently much lower than the OECD average, are welcome and will help to raise wages of doctors and other medical staff and reduce skilled labour shortages. However, improving working conditions, for example by reducing the number of patients per nurse, shortening work shifts or improving career paths and broadening responsibilities for nurses, is also key to make these professions more attractive. Further consolidating the hospital network and fostering digitalisation and the provision of digital health services are also key to mitigate labour shortages (OECD, 2022[1]). Including all hospitals and primary care units in the centralised digital e-platform would help prevent duplication of check-ups and laboratory tests, the cost of which has strongly increased in latest years. High drug prices can be reduced through centralised procurement procedures (see above). Focusing on preventive measures, such as promoting sport activities and improving road safety to reduce accidents, and further raising taxes for alcohol and tobacco are also key to improve health outcomes (OECD, 2022[1]).
Public expenditure on active labour market policies, % of GDP, 2021
Note: Data exclude temporary employment maintenance.
Source: OECD Labour Force Statistics.
The average Latvian students performed slightly better than the OECD average in PISA 2022, notably in science and mathematics, and educational inequality is relatively low. However, the best performing students lag their peers in other countries (Figure 1.33). This can be a problem in the long term, as labour shortages in many high-skilled occupations such as STEM and ICT professionals are high in Latvia. The implementation of a comprehensive reform of learning standards and curricula in early-childhood, primary and secondary education is ongoing, focussing on transversal, digital and ICT skills as well as improving the quality of STEM and foreign language teaching. Additional nation-wide exams will be introduced in primary and lower secondary education to monitor the implementation of the new curricula, better target support to students with difficulties and evaluate school performance. Publishing these results is important to raise incentives for municipalities to improve teaching quality, as municipalities have received more responsibilities for allocating resources across schools. Further consolidating the school network and using fiscal savings to continue raising teacher wages and improving working conditions, for example by reducing the high share of teaching in total hours or hiring teacher assistants for classes with many disadvantaged students, is key to address teacher shortages and improve teaching quality. This would also facilitate teacher training, which is particularly important for implementing the objective of educating all children in Latvian from 2025, as many older teachers can still improve their Latvian language skills.
Healthy life years at birth, 2021 or latest available year
Source: Eurostat.
Top performers in science, mathematics and reading, % of 15 year-old students
Note: Top performers in science, mathematics and reading are students who achieved the highest level of proficiency (i.e. Levels 5 and 6) on the OECD’s PISA assessment.
Source: OECD (2020), PISA 2018 Results (Volume I); OECD (2023), PISA 2022 Results (Volume I).
Encouraging more women to participate more intensively in the labour market would help to address labour shortages. In 2022, the female employment rate was 2.5 percentage points higher and the difference to the male rate 10.1 percentage points smaller than in the average OECD country. However, the gender pay gap for formal full-time employees is very high compared to other OECD countries (Figure 1.34). This partly reflects a misallocation of female talent into occupations and economic sectors with on average lower wages (Figure 1.35). Although more women than men attain tertiary education, the share of women graduating in STEM and other study fields with high labour market returns is much lower. Promoting role models can help tackle gender stereotypes and encourage young women to enter high-skilled occupations which are in short supply. Better informing lower secondary students about labour market trends could also help.
Gender wage gap, % of men's wage, 2022 or latest available year
Note: Figures report the difference between men and women’s median gross earnings as a share of men’s median gross earnings for full-time dependent employees; OECD refers to the simple average of 38 Member countries.
Source: OECD Employment and Labour Market Statistics database.
The gender wage gap is particularly high for workers between 25 and 44 years, which is related to the motherhood penalty (Latvian Statistics Institute, 2023[93]). Labour market participation rates for women in this age group are significantly lower than for men due to child caring activities. The higher engagement of women in childcare may be related to cultural reasons but is also strongly linked to incentives in the social transfer system. Before 2023, paid parental leave did not include any restrictions on who takes the leave, resulting in an average of 49 weeks for women and 1 week for men according to the OECD family database. From 2023, 2 months of the available paid parental leave duration have to be taken by the second parent or will be deducted from the total duration. This is a welcome step in the right direction, but a further increase in the compulsory sharing of parental leave among parents should be combined with limiting the parallel parental leave time to incentivise fathers to engage more in child caring activities.
Improving access to childcare is also key for improving labour market outcomes of women. About 36% of all families with children are single-mother families, who particularly suffer from weak access to childcare services. Costs for childcare are very low in international comparison, but weak infrastructure and high labour shortages complicate access to childcare, which is a core function of municipalities (see above). Continuing to provide funding to municipalities to raise investments in childcare facilities and addressing labour shortages through expanding training and flexible work arrangements is key for securing a sufficient supply of high-quality childcare services and reducing long waiting lists. Since 2020, state budget grants are provided to municipalities to raise investments in childcare facilities, and EU funds will further support these efforts during the next years. Continuing to improve access to childcare and further raising other child-related benefits could also help increase the low birth rate (OECD, 2023[94]). However, the design of child-related benefits should be closely coordinated with other features of the tax and transfer system to ensure sufficient incentives for parents to increase labour supply (see above).
Relatively high gender wage gaps in economic sectors where women form a large part of the workforce, indicate that discrimination also plays a large role in explaining why men in Latvia earn more than women (Figure 1.35) (Ciminelli, Schwellnus and Stadler, 2021[95]). According to labour force data in 2022, only 31% of higher management positions were filled by women, despite 56% of all mid-level managers being women. Only 23% of board members in Latvia’s largest companies are women (EIGE, 2023[96]). To increase the share of women in top management positions, the introduction of a gender quota for the composition of managing and supervisory boards of companies could be introduced like in Germany, where this measure has led to an increase in the share of female top managers (Kirsch, Sondergeld and Wrohlich Katharina, 2023[97]). Moreover, making pay transparency mandatory in the private sector could help reduce wage discrimination, as increasing public attention and peer pressure at the firm level could improve the negotiation power of women (OECD, 2021[98]). Conducting gender pay audits and closer monitoring of pay levels by gender could also help to reduce the gender wage gap. Since 2018, public employers are required to report monthly on their pay levels by gender, but no such obligation exists for private employers.
Source: Central Statistical Office.
Besides raising the domestic labour supply potential, further facilitating skilled migration is key to address skilled labour shortages in the short run. This is particularly important for preventing further increases in construction costs and ensuring the timely implementation of important infrastructure and green investment projects. Although application procedures for work permits and visa have been facilitated and digitalised, specific requirements for exercising occupations related to education and competences, including language proficiency, as well as wage thresholds still act as a barrier for raising migration. The share of occupations, including for managers, professionals and technicians, that can be exercised in English is among the lowest across OECD countries (Marconi, Vergolini and Borgonovi, 2023[99]). To facilitate skilled migration, it is key to foster the use of English and other languages of the European Union at work and lower occupation specific restrictions for migrants upon entry, while requiring attendance and successful completion of Latvian language courses after a certain time period. Moreover, as wages differ significantly across sectors, minimum wage thresholds for receiving work permits, which are set at the national average wage, have acted as a barrier to raise migration. A recent tri-partite agreement has introduced wage thresholds that are differentiated according to sectoral average wage levels, which will help facilitate labour migration. To improve enforcement, a unique electronic identifier for work permit and visa holders should be established and data exchange should be improved across all public bodies. So far, information on employment and wages is missing for many work visa holders as they are not registered at the State Labour Inspectorate and data exchange with the visa authorities is insufficient. This facilitates posting of workers and wage dumping in other EU countries.
Further raising diaspora remigration can help reduce skill shortages and foster entrepreneurship, investment and innovation. Although more than 50 000 people have remigrated to Latvia in the last nine years, the diaspora remains large with a population of more than 370 000. In 2021, only a quarter of those returning to Latvia held a tertiary degree and around half of remigrants returned to the Riga region. Within the Plan for Work with Diaspora, the State Employment Agency manages programmes to raise awareness and provide information to members of the diaspora about work opportunities and living conditions in Latvia, as well as the administrative steps involved in remigration. LIAA’s regional business incubators and support units of LIAA have also been opened to expatriates to help them set up new businesses. Coupling these measures with temporary wage subsidies for highly skilled returnees in regions where there is a shortage of such workers and promoting support programmes for remigrants to transfer their businesses to Latvia would help to raise remigration.
Latvia is among the OECD countries that have reduced greenhouse gas emissions the most compared to 1990 (-59% by 2021, excluding land use, land-use change and forestry, LULUCF). Nonetheless, almost all of the reduction happened in the early 1990s due to a decline of GDP by about 50% during the country's transition to a market economy (Zvidrins, 1998[100]). Since the early 2000s, Latvia has succeeded in decoupling GHG emission growth from GDP growth, but total GHG emissions have remained broadly constant, against the trend in the EU and mainly due to high emissions in transport, agriculture and residential buildings (Figure 1.36). In addition, there is a long-term increase in emissions in the LULUCF sector related to the conversion of forest land into settlements, cropland and grassland.
High costs due to climate change emphasise the need to accelerate emissions reductions. The number and frequency of extreme weather events have increased, and the share of built-up areas exposed to river flooding is the highest in Europe (OECD, 2023[101]). Estimated at EUR 164 million in the last decade for the forestry sector alone, Latvia’s climate-related damages are already significant. Adaptation policies, therefore, should be mainstreamed in all government activities (IMF, 2023[4]). In 2019, the government adopted the Climate Change Adaptation Plan 2030, which outlined multiple adaptation strategies to reduce social, economic, and biological risks. A monitoring website was created aiming to improve coordination between climate adaptation projects and track adaptation activities. Hydrologic, temperature, precipitation and drought statistics are available at national and sub-national levels. Going forward, changes in the intensity and frequency of floods from the Daugava River should be closely monitored, and national and sub-national climate risk assessment should be updated to quantify climate change effects on key sectors and better target the EU funds allocated to municipalities. Other OECD countries, such as Chile and Greece, could serve as examples in the development of climate risk maps (OECD, 2023[102]). Forward-looking land use policies and interventions could help reduce costs due to rising sea levels (IMF, 2023[4]).
Note: In Panel B: CO2 emissions from fuel combustion in Latvia. GDP per capita refers to GDP USD PPP at 2015 prices divided per population, energy intensity refers to total energy supply per unit of GDP (USD PPP at 2015 prices), and CO2 intensity of the energy mix refers to CO2 emissions per unit of total energy supply.
Source: IEA Greenhouse gas emissions from energy database; OECD (2023), Green Growth Indicators, OECD Environment Statistics (database); IEA (2023), IEA World Energy Statistics and Balances (database); OECD (2022), Pricing Greenhouse Gas Emissions: Turning Climate Targets into Climate Action, OECD Series on Carbon Pricing and Energy Taxation, OECD Publishing, Paris, https://doi.org/10.1787/e9778969-en.
Carbon pricing should be strengthened to reduce emissions
Carbon prices in transport, buildings and agricultural sectors should increase to lower emissions. The EU Emissions Trading System (ETS) maintains strong incentives to reduce emissions and invest in clean technologies in the electricity and industrial processes sectors, which account for about a quarter of overall emissions in Latvia, a lower share than in most OECD countries (Figure 1.36, Panel C). However, more measures are needed to reduce emissions in the effort-sharing sectors, which the EU-ETS does not cover. Current policies are projected to reduce emissions in the effort-sharing sectors by 10% relative to 2005 levels in 2030, which is 7 percentage points lower than the required reduction according to the EU Fit-for-55 objective. Currently, effective carbon prices in the road traffic, buildings and agricultural sectors are considerably lower than the EU average (Figure 1.36, Panel D). The planned emission trading system at the EU level for road transport and buildings (from 2027) and the increase in green investment planned as part of Latvia’s Recovery and Resilience plan would help to reduce emissions. Until the European trading system for road transport and buildings starts operating, a carbon price for all sectors not covered by the EU ETS should be introduced. As poorer households suffer more from higher carbon prices, because emission intensive goods account for a higher share of their consumption expenditures, additional revenues from carbon pricing should be partially recycled back to lower-income households as a lump-sum transfer (OECD, 2023[61]).
The Latvian tax system is fairly green, with environmental taxes at 3% of GDP in 2021, compared to only 1.4% in the OECD average, even though they deteriorated by ¾ percentage point of GDP from their peak in 2016. Nonetheless, the effectiveness of environmental taxes in reducing emissions is hindered by fossil fuel and other environmentally harmful tax expenditures and subsidies in many economic sectors (European Commission, 2023[103]). Examples include the excise duty reliefs on diesel used for agriculture and aquaculture, and the excise tax exemption and tax relief for natural gas for industrial consumers. The government should systematically screen all existing subsidies, tax exemptions and reduced rates for fossil fuels and gradually phase them out.
Accelerating emission reductions will also require significant investments to lower abatement costs and to reduce the social costs of the green transition. Public investment will need to increase to help crowding in private investment, which has been week for many years (see Chapter 2). Latvia plans to spend 42% of the EU RRF fund to support climate objectives. For example, the plan supports the green transition with investments to overhaul the Riga Metropolitan area transport system and incentivises clean transport and sustainable mobility (EUR 295 million). Likewise, EUR 472 million are dedicated to improving energy efficiency in private, public and commercial buildings.
The attractiveness of public transport needs to improve
Greater reduction of emissions in the transport sector is a main priority. Transport is the largest source of emissions in Latvia; 30% of GHG emissions emanate directly from transport, for example, when burning fuel to run an internal combustion engine car. The car fleet renews only slowly, likely reflecting the limited financial resources of households and businesses to purchase cars, and buying used cars run by diesel is common. As a result, Latvia has one of the oldest car fleets among OECD countries. The average age of passenger cars is 14.3 years, with 75% of cars in the fleet being older than 10 years (ACEA, 2022[104]). In addition, the share of battery-electric vehicles (4.6% in 2022) is much lower than the EU average (12%) (European Commission, 2023[103]). Moreover, the trend towards low-density development in the suburbs and the concentration of high-wage jobs in Riga city contribute to high emissions due to increased commuting (OECD, 2019[2]). This is exacerbated by the prioritisation of cars in urban planning, underdeveloped public transport infrastructures and cooperation issues in the Riga metropolitan area, leading to a decline in the use of public transport and an increase in private car use (Figure 1.37). This has also raised pollution and congestion, exacerbating mismatches in the labour market (OECD, 2022[1]).
Better coordination between Riga and municipalities in the Pieriga region and improved urban planning, which focuses on densification, is needed to make public transport and shared mobility more attractive and cost-effective. Currently, each municipality is responsible for its own transportation system, causing inefficient public transport connections, schedules, and ticketing systems. As recommended in previous OECD Economic Surveys of Latvia, establishing a metropolitan transit authority could help to prioritise investments and facilitate coordination. Subsidising loans for purchasing low-emission cars, as done in several OECD countries, could address financial constraints by overcoming the high upfront costs of electric vehicles with moderate fiscal costs compared to direct purchase subsidies. Although price gaps between electric and combustion engine cars have declined, used combustion engine cars are likely to remain cheaper in the next years. At the same time, expanding charging points should be prioritised, as this is key for expanding the use of electric vehicles. The administrative burden for installing charging stations in older multi-apartment buildings is high, as the land is usually not owned by apartment owners as a result of the privatisation process in the 1990s (Zelmenis, 2023[105]). Facilitating planning and approval procedures for installing charging stations where land and buildings are in shared ownership is key to accelerate the expansion of the charging infrastructure. Likewise, Latvia should modify how it taxes benefits arising from personal use of company cars so that it discourages excessive use of private vehicles and long-distance commuting (OECD, 2019[106]). It should also increase taxation on diesel, which is lower than gasoline, even though the CO2 emissions per litre of diesel are higher (OECD, 2022[107]). To reach the government’s goal of increasing rail electrification from the current 13.4% to 24.2% by 2027, a substantial rise in investment in rail is needed. Investment in rail declined in the last decade, and no progress has been made in improving electrification in the last five years.
Ratio between the number of passengers using public transport (bus, train, metro, tram) and the total number of road and rail passengers, %
Source: Odyssee-Mure database.
Emission reduction in the building sector needs to accelerate
About 15% of Latvia’s GHG emissions are from the residential sector, driven by outdated heating systems and poor insulation (Figure 1.36). Modernising the housing stock is challenging as the share of households owning their apartment is among the highest across the OECD, and many homeowners are reluctant or are not able to undertake costly renovations. Housing investment has been low for many years and even declined in recent years despite increases in real estate value (Figure 1.38) (OECD, 2023[108]). About 90% of residential buildings are older than 20 years, and 96% of apartment buildings are older than 30 years (European Commission, 2020[109]). Co-owned apartment buildings are common and concentrated in the capital and other large cities. The energy efficiency of multi-apartment residential housing is often poor, with the average heating consumption in 2019 being 125 kWh per square meter, while the new National Construction Standard ceiling for new buildings and renovated ones has been set at 40-60 kWh/m2 and 90-100 kWh/m2, respectively. Coordination problems between apartment owners hamper renovations of these buildings. Latvia’s Long-term Strategy for Renovation of Buildings aims for 8 100 residential apartment buildings to be renovated by 2040, yet only 627 multi-apartment building renovation projects have been undertaken between 2016 and 2023 with government co-financing (ALTUM, 2023[110]).
Higher energy prices due to the war in Ukraine are strengthening incentives for renovation and shifting to lower-emission heating systems. However, a large backlog in housing investment, the difficult financial situation of many homeowners and high construction costs complicate an acceleration of emission reductions. As part of the EU RRF funds, ALTUM provides grants and loan guarantees with a budget of EUR 57.2 million to cover up to 49% of the cost of renovating around 170 buildings. In the past, funding from similar programmes was often not fully allocated, as a high administrative burden and uncertainty due to frequent changes in funding conditions acted as a burden for the house owner. In addition, coordination issues among owners in multi-apartment buildings and a lack of awareness of the need for renovation have added to low demand for these programmes. Simplifying procedures for receiving support for renovation and providing higher certainty regarding support conditions, also by making funding less dependent on EU funds, could help raise energy-efficiency investments. The standardisation of technical documentation for renovating similar multi-owner buildings could facilitate coordination among apartment owners and help reduce construction costs by limiting the scope for contractors to introduce more expensive solutions. The government could also consider increasing financial support targeted towards vulnerable households and for heat pump purchases, but this should be considered against tools to reduce emissions in other sectors that might be more cost-effective to reach overall emission targets.
Investment in dwellings, % of total gross fixed capital formation
Source: OECD National Accounts database.
Expanding wind and solar is key for greening the energy mix and raising energy security
The electricity generation sector accounts for 13% of GHG emissions, mainly from natural gas, which, along with hydropower, is responsible for almost all electricity generation in Latvia. Shifting to rely more on wind and solar could lower emissions in the building and transport sectors through electrification. It would also help reduce dependency on fossil fuel imports and improve energy security and the trade balance. Expanding wind power should be the priority due to Latvia’s comparative advantage in wind (IMF, 2023[4]) (Child, Bogdanov and Breyer, 2018[111]). However, expanding solar energy is also important as together with decentralised storage it can help to stabilise demand and supply, particularly in the context of changing weather conditions. Due to reduction in regulatory burden and fiscal support measures, solar energy supply has significantly increased in recent years.
However, wind park development in Latvia is lagging behind that of other Baltic countries. In 2022, the government approved a joint venture of two state-owned enterprises (Latvian Wind Parks) to develop high-capacity wind farms of up to 800 MW each, which is a step in the right direction. However, regulatory and administrative barriers are hampering private investments. Data on maritime spatial planning and cooperation and cost-sharing mechanisms between municipalities are lacking, and land planning and licensing procedures need to become faster and more transparent. Consolidating and simplifying the existing regulation for wind farm developments could help reduce these barriers and create a level playing field. Awareness campaigns should be extended and tax revenues from wind power generation could be shared with municipalities to lessen local resistance. Facilitating leasing of land owned by the state could help to attract private investors to expand wind power generation.
A rapid expansion of wind and solar energy and higher electricity demand because of electrification will pose challenges for the transmission network. An Estonian-Latvian off-shore wind farm project has been announced for 2030 and is currently in the impact study phase, with procurement process initiation expected by 2026. Projects for investment in electricity transmission systems are in place, supported by the EU Resilience and Recovery Funds, where EUR 510 million will be deployed to connect Latvia with the EU energy system until 2033. A swifter connection of wind and solar projects to the grid and a better balance of supply to variations in demand are needed, for example by expanding the roll-out of smart meters, introducing time-variable grid charges and developing storage solutions (OECD, 2023[102]). A faster integration into the European electricity grid would facilitate the pooling of renewable energy from a large geographical area.
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