I have not written in a while. Hence, apologies are due to those who find it worth their time to read this blog. My other commitments over the last two months (especially teaching) made it quite difficult to contribute. The budget discussions are nearly history now, and in any case, the government didn't seem very interested in what economists had to say about this. And yet, I think a short summary is due.
Budgets and taxes 3
So, this round of budget 'cuts' has also been about tax increases, which, of course, upset lots of people. So lets start with a very general question of whether it was a good idea to increase taxes. It all, of course, depends on alternatives. And the next alternative - if we rule out things like default and non-Euclidian math - is to cut public spending. Naturally, just saying that they [the government] should have further "reduced bureaucracy" is empty talk unless one is ready to suggest specific solutions or to points to some very specific people whose employment in the public sector is a waste of taxpayers' money. And yet, perhaps I summarize the opinion of many when I say that I don't believe that all the options for this were exhausted. There is likely a fall of GDP of about 18% this year. The cuts should have been commensurate with this fall in the taxpayers' ability to pay taxes. They didn’t. On numerous occasions I raised the need to have a hard look at whether public procurement has been adjusted for deflation. I've never seen any evidence that is was. And then one hears reports of e.g. Latvian Radio and TV Centre (LVRTC), a public agency that rented posh cars for its top officials, paid hefty bonuses to their employees, and even paid for their employees families to have vacations in places like Egypt - all of this in 2009 (!!!) - one really wonders. Is the government really in charge?
And yet, tax increases are unavoidable, even if a more competent government were to cut public expenditure to the levels of 2006, 2005, or whatever. The reason is simple - it's the 7.5 billion loan, which needs to be paid back. Moreover, IMF, European Commission and Co are probably not in the business of long-term lending, which means that in just a few years time the loan would have to be refinanced by the private financial markets. Assuming a 4 percent annual interest rate (which is about what the donors charge), the costs of servicing this debt is 300 million euros per year. And we're not yet talking about repaying the principal amount of the loan - just interest payments. The interest rate charged by financial markets would depend on Latvia's credit rating. At the moment, Latvian government might need to offer at least eight percent yields to lure investors. So the debt servicing costs comes to 600 million euros per annum plus repayment of the debt itself (the principal). Also, there is probably little point hoping for a V-shaped recovery of the economy. Recoveries following financial crises are notoriously slow since many households and firms are highly leveraged. The bottom line is: when the public sector borrows about one third of GDP to finance current spending (not investment), it needs to increase taxes in the future to pay the loan back.
The next issue I'd like to turn to is which taxes need to be raised. This is the question of what is the optimal tax mix for raising a given amount of revenue. The answer to this questions depends on the trade-off between efficiency costs of different taxes and their distributional effects on various groups of population. Unfortunately, the tax package agreed on by the government has about zero economics in it. It was all about distribution.
A short economic assessment of the tax options available, in my opinion, would look something like this. Personal income tax and social tax create one of the highest tax wedges (the difference between employer's labor cost and employee's after tax income) in the world and is one of the main factors responsible for widely spread "envelope wages", i.e. tax evasion. "Envelope wages" have some really nasty distortionary effects, possibly standing in the way of economic development. Capital incomes taxes should be introduced but the revenue from such taxes is probably small and highly uncertain. The supply and demand of capital is very elastic, which makes it hard to tax in general and very counterproductive to have tax rates that are too high. VAT is a great tax, but a small country can't have a tax rate that's too high compared with its neighbors. Otherwise RIMI and others would have to close all their stores in Valka and other border regions and re-open them on the other side of the border. Taxes on intermediate goods (e.g. natural gas) is just bad economics. This leaves us with the real estate tax. Compared with other taxes, real estate tax is a great tax. It's easy to collect (tax evasion is near-impossible). It's also a very just tax, in the sense that tax liability is proportional to people's ability-to-pay, i.e. income. Its efficiency costs are very low because supply of real estate is fairly inelastic, once its there.
However, the real estate tax that was introduced is simply laughable. 0.1-0.3% on cadastral values that are completely of touch with reality? Of course, it meant that other taxes had to be increased, like personal income tax, and natural gas tax, and a higher 'car tax', and so on. Why did this happen? It is well known that People's Party was the major obstacle to the real estate tax. For purely distributional reasons, I think. Some people must have amassed quite some amounts of land and real estate. Just opposite my office on Strelnieku St. is a building that has been empty for years. There are quite a few other such buildings in Riga. Some people own those buildings. These people would face a much higher tax bill if proper real estate tax was passed. I can only presume that these are the "People" whose interests "People's Party" is so good at defending. In contrast, the tax increases that were passed would largely be paid by the middle class and the poor. A 'car tax', for example, is REGRESSIVE for car owners. For somebody who owns old Volkswagen Golf the tax increase would constitute a much smaller share of income than for an owner of Bentley. It's really not that different from reducing tax-exempt minimum for personal income tax. Not so for the real estate tax. A Bentley owner would pay much more in absolute terms since he also probably has a nice villa in Jurmala. All in all, I find this to be one of the most despicable episodes of the whole budget saga. I can only hope that voters will remember this when the election day comes.