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Euro Countries (and the IMF) Can Learn from Latvia's Economic Success



The International Monetary Fund (IMF) has just published a public information note about its preliminary findings from the annual review of the Latvian economy. It is rare for the IMF to write anything as positive as it did in its first summary paragraph:

Latvia's economy continues to recover strongly. Following real GDP growth of 5.5 percent in 2011, growth is expected to exceed 5 percent again this year despite recession in the euro area. Labor market conditions are improving. The unemployment rate fell from 16.3 percent at the beginning of the year to 13.5 percent at the end of the third quarter, despite an increase in participation rates. Real wage growth remains restrained. Consumer price inflation has declined sharply, easing to 1.6 percent at end-October after peaking at 4¾ percent in mid-2011. Robust export growth is expected to keep the current account deficit at about 2 percent despite recovering import demand.

In the midst of the euro crisis, the going does not get much better than this. Latvia will have the highest growth rate and one of the smallest budget deficits in Europe this year, probably 5.3 percent, along with low inflation and wonderful export expansion. The only shortcoming is the still high unemployment rate, but unemployment is a lagging indicator and it is falling sharply.

Remember that in 2008–09, Latvia lost 24 percent of its GDP. It was heading toward a budget deficit of 19 percent of GDP in 2009 without a program of radical austerity. But the Latvian government did undertake austerity, and the last two years' success shows the merits of that policy.

The troubled countries in the euro area have much to learn from Latvia. While Latvia returned to growth after two years of severe crisis, Greece has suffered five years of recession and two more are expected.

A new Latvian government came to power in March 2009, when GDP was in free fall. It told people how bad the situation was, and the various social partners responded by signing up to a truly radical austerity program. One-third of the civil servants were laid off; half the state agencies were closed, which prompted deregulation; the average public wage was cut by 26 percent in one year. But this was a socially considerate program. Top officials were hit more, with 35 percent in wage cuts, while in the end pensions were not cut. In particular, public servants were no longer allowed to sit on state corporate boards and earn more than from their salaries, a malpractice that is still common in many European countries. The government exposed high-level corruption. Yet, many schools and most of the hospitals were closed.

This was a truly front-loaded program. Of a total fiscal adjustment of 17 percent of GDP, 9.5 percent of GDP was carried out in 2009. Two-thirds of the adjustment was expenditure cuts that are more easily executed in a crisis, and only one-third revenue increases, mainly through consumption taxes. The low corporate profit tax of 15 percent was maintained to stimulate business. Latvia needed international financial support, and fortunately the IMF, the European Union, and neighboring countries did both commit and deliver on time.

From the outset, it was clear that this program could resolve the crisis within three years if carried out properly, and confidence was restored by June 2009, as reflected in swiftly falling market interest rates and rising international currency reserves. For Greece, no viable stabilization program has been presented as yet, so no confidence has been restored, and growth—which normally reappears after a couple of years—is not in sight.

Despite all these huge sacrifices, the center-right coalition government of Prime Minister Valdis Dombrovskis, who took his country through this arduous crisis, was reelected twice in parliamentary elections in 2010 and 2011. The big losers were the oligarchic parties that had ruled Latvia on the way into the crisis and ignored massive overheating. The Latvians understood that the crisis was severe and that there was hardly any better way out than the one Dombrovskis presented.

At the outset of the crisis, the IMF favored devaluation, but the Latvians resisted firmly with strong popular support. As it turned out, no devaluation was needed, and none of the EU countries with pegged exchange rate have devalued. (The others are Denmark, Estonia, Lithuania, and Bulgaria.) In 2011, Estonia adopted the euro. Latvia intends to do so in 2014, and it appears to be fully ready.

Throughout the crisis, the Latvian government has insisted on maintaining its flat personal income tax, as most other East European countries have. The IMF, which no longer can dictate Latvia's economic policy, nonetheless advocates the introduction of a progressive income tax: “The planned cumulative PIT cuts of 5 percentage points over 2013–15 should be reconsidered, at least for 2014 and beyond: Better options could include a two-tier system or an increase in the minimum non-taxable allowance." The issue of whether to adopt a flat or a progressive income tax is an ideological matter that should remain beyond the mandate of the IMF. There is no macroeconomic justification for such a demand. It is a political statement. Latvia, with a reasonably even income distribution, can and does ignore it.

Many countries from Switzerland on down attract wealthy people through tax incentives. Latvia cannot afford to lose out in the intense tax competition that prevails in Eastern Europe, where most countries have flat personal income taxes. The flat personal income tax in Latvia is actually rather high at 21 percent, compared with 15 percent in neighboring Lithuania or 10 percent in Bulgaria. Latvia cannot afford to impose higher taxes than its competition, which the IMF should realize.

The IMF should stick to macroeconomic and prudential financial policies. On the other hand, it ought to push for lower public expenditures as a share of GDP. Usually it claims innocence when it comes to spending versus taxes, only showing concern about the budget deficit. But enough research has been done to show that high public expenditures impede economic growth, rendering this a macroeconomic issue. In crisis-ridden Greece public expenditures stayed constantly high at 50 percent of GDP in 2010 and 2011. By contrast, Latvia has slashed that level from 44 percent of GDP in 2009 to probably 36 percent of GDP in 2012.

The IMF is right in praising Latvia's achievement, but it should push for a lower level of public expenditures, instead of arguing for progressive income taxes.

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