How to achieve fiscal consolidation? 13

Anyone dares to argue 'budget consolidation' is not one of the main challenges for the next two years? According to the Memorandum of Understanding with the lender, the budget needs to be consolidated by 800-900 million LVL over the next two years, probably 400 million LVL for 2011. Yet 'consolidation' is a term dreaded by the politicians. So far, no political party has unveiled a clear plan of how to achieve more reasonable levels of budget deficit.

Politicians probably know what needs to be done, they just don't know whether they will be re-elected after they do this. Or, perhaps they think any unpopular decisions can be easily written off to "international financial occupation".

And yet, some pieces of 'consolidation' begin to emerge. Two measures look almost certain. First, tax increases, including abolition of reduced VAT rates, a sharp increase in real estate tax, and a tax on luxury cars. Second, terminating payments to the 2nd (funded) pillar of the pension system, and channeling them to the current pensioners. I think the first measure is a step in the right direction. The second measure, however, is not a "solution" of any kind, but a mere postponement of the problem. Worsening demographic situation and (likely) mass migration mean that the purely redistributive pension system is unsustainable in the long run. Without pension reform, those already in their 30s and 40s today will not be able to get the pensions they expect. The reason is there simply won't be enough young workers to pay these pensions by that time. That was the whole point of the pension reform and introduction of the funded pillar. Thus, terminating (and also reducing) payments to the second pillar 'solves' short-term problems by creating long term-problems. How is this different from simply selling a Latvenergo and using the proceeds to close the whole in a budget for a year or two? How is this different from Greece's numerous ploys to disguise the size of its budget deficit?

I'd like to stop here but there is a problem. I have a strong opinion that a criticism of someone's approach to consolidation entails an obligation to suggest an alternative. I just criticized, so here is what I think needs to be done.

Devising expenditure cuts on such a scale requires substantial investment in thinking how that needs to be done. At the moment, it does not seem like the government, or political opposition, has been either willing or capable of making such an intellectual investment. Thus, in all likelihood, all the fancy words like "structural reform", "optimization of public expenditure", etc are just this. Words. Hence, apart of planned tax increases, the only decent blueprint for consolidation is the World Bank's menu, which contains about 500 million LVL worth of measures on the expenditure side. About half of these are related to the social budget, including pensions. This means that consolidation would have to involve pension cuts, focusing on those who experienced the largest windfall gains (i.e. recent pensioners whose pensions were affected by the 'salary bubble').

Yes, I understand the implications of what I am suggesting. This is not an easy choice. I have grandparents, too, and their pensions are barely sufficient to survive. And yet, falling incomes, huge number of unemployed, and increased migration mean that there is simply no resources to keep pensions at their current levels. Pensioners have to take part in the consolidation, just like teachers, doctors, policemen, and everyone else. There are alternatives, but their long-term negative consequences could far exceed today's benefits to the pensioners. If the price of keeping the pensions is to ruin the lives of their children and grandchildren, would the pensioners themselves be willing to pay this price?

And yet, such a step inevitably brings the misery of pensioners into the spotlight. Pensions of many old people have been below subsistence also before the crisis. Why? There are many reasons. Some politicians have shamelessly used the social budget to plug the holes in the central government budget, and also to finance populist policies, such as overly generous maternity benefits. And yet, the main reason is widespread tax evasion, exemplified by infamous 'envelope wages'. I think that involving pensioners in budget consolidation implies a responsibility to address the issue of low pensions. Thus, I would combine reducing pensions today with a pledge to eliminate "envelope wages" in two years time, thereby achieving an increase in pensions for the (surviving) pensioners. A very clear and specific promise, the one that's easy to monitor.

I think this is possible. One year for researching the problem, planning, and preparations. One year for the measures to take effect. Broadly, the measures would consist of both a 'carrot' and a 'stick'. Here is a broad outline.

Stage 1: Remove the 'carrot'

Why are there 'envelope wages'? One of the main reasons is exorbitant taxation of wages. A combination of personal income tax and a social tax imply a tax wedge of about 45% - one of the world's highest. In other words, after all taxes are paid, an employee gets slightly more than half of what he costs to the employer. This creates an incentive for an 'envelope wage': an employee is paid more than his after-tax wage, and costs less than a wage-with-taxes. All at the expense of the taxes, of course. Moreover, both employer and the employee benefit, so none has an incentive to report the crime. This is what makes 'envelope wages' very hard to detect. The tax on income - a combined burden of personal income tax and social tax - is what constitutes a carrot. Thus, incentive for 'envelope wages' need to be reduced by transferring the tax burden from taxation of income to taxing assets, such as the real estate. This is the main reason I've been advocating a reduction of social tax rate and an increase in the tax on real estate. For example, reduce the social tax rate to a total of 20% (about 33% now) and make it payable half by employee and half by the employer (even though this statutory incidence does not really matter). Increase taxation of real estate so that a family with average income pays the same amount of taxes, i.e. it pays less in social taxes, but more for the real estate.

Of course, this also requires work with the real estate tax: abolishing real estate stamp duty (2% on sales price) to remove incentive to underreport transaction prices, review cadastral values, sort out tax liabilities of the unemployed, pensioners, etc. The devil is in the detail, of course. But it can be done.

Stage 2: The surge of 'sticks'

Reducing the incentive for envelope wages will have some effect, but is unlikely to be sufficient as long as sufficient sanctions are in place. I do not have a full understanding of the underpinning of 'envelope wages' in this country - one needs a thorough research of this. However, my intuition and the bits and pieces of evidence tells me the following. First, it's concentrated in the small business sector. Large businesses are likely to find it hard to practice this as they're on the tax authorities' radar, and there is too much at stake. Second, it's probably near universal. That is, 'honest' businesses are likely an exception, than the rule. Third, 'envelope wages' and, probably, also VAT evasion, bestow a competitive advantage. This is what explains why tax evasion is so universal. It is this last feature that is likely to be key to how to fight it. In short, I think small businesses are all in a massive 'prisoner's dilemma' as concerns tax evasion.

Let me explain. Consider a auto repair shop business, with many small firms in fierce competition. These firms have an option to evade taxes, e.g. VAT and income taxes, which allows charging a lower price. Suppose every business pays all the taxes and, as a result, there is some prevailing price in the market. At this price, all firms earn just about 'normal' profits. Then, any business that starts paying 'envelope wages' receives the benefit of lower labor costs and, therefore, can afford to charge a slightly lower price and, therefore, compete away the customers from other repair shops. The other firms face a choice: mimic behavior of the tax evader, or lose their customers and go bankrupt. Thus, tax evasion is likely to spread very quickly. Once everyone is engaged in tax evasion, for any one firm to start paying taxes is equivalent to suicide. The reasoning is the same. Paying all taxes implies higher costs and, therefore, higher prices. If prices are higher compared to the competitors, the result is losing customers and going out of business. Thus, it might be in the collective interest of all firms to pay taxes, but it is in private interests of any individual firm not to pay any taxes.

The implication is that piecemeal measures will not work. An increase in tax inspections by 10, 20, or 30 percent will not work. Whatever the fines, the firms will not start paying taxes as long as other firms don't pay. Market discipline is a far better policeman than the tax authorities are. If some firms faces a fine that is 'too large', it would make more sense to shut down the firm and open a new one. The implication is clear. What we need is a "surge" (a parallel to U.S. tactic in Afghanistan and Iraq) of 'sticks'. I am talking about a massive, coordinated, and simultaneous attack on tax evasion by a fully revamped State Revenue Service (SRS). I am talking about potentially doubling (if necessary - tripling) the budget of SRS so it could have better people, more of them, and the best technology out there. I don't have the detailed blueprint, of course, but I know it can be done. There are many countries out there who are very good at collecting taxes. There is no reason why Latvia can't become one of them.

To sum up, I think politicians should spend more time thinking about what's the right thing to do, and then spend even more time explaining the voters why that is the right thing to do. In contrast, what we see is massive cowardice across the political spectrum. Our problem is that there are too many 'politicians'. We badly need statesmen, individuals who have the guts to do what they think is right, regardless of what the voters think about it.


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Niloy Nahid

I would love to read more about this <a href="">personal statement example latvia</a>
as it has added a lot to my knowledge. Kindly keep posting such information so that people like me can enhance our knowledge like you

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JW 08.09.2010 22:43
It would be interesting to see you turn in the same effort in analysing the conjuring tricks of the financial sector.

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K.O. 03.09.2010 14:22
What is Your opinion about proposition of Jānis Ošlejs - LVL devalvation + conversion of EUR credits to lats? Is this plan realistic?

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G.D. 02.09.2010 14:34
I am not saying corruption is not a problem. It certainly is. My point is that:
1) there are many other motives behind Latvian problems. Some, like insiders' wish to keep their jobs and conflict-avoidance everywhere are, I would say, more important.
2) even the problem of corruption can be addressed in two ways. One way is KNAB etc. but the other is experts systematically pointing towards politician's irrationality and proposing alternative, better solutions. An example. PPP (public private partnership). I, for example, see not a single rational motive for those schemes in a country like Latvia in 2010. Except corruption. But I am not an expert. The problem is that I have not heard anything from experts/economists about costs & benefits of PPP, neither positive or negative.

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... 02.09.2010 14:30
lots of interesting ideas from the author and comments. but I guess key is in the research.
for example "overly generous maternity benefits". most people will agree that it was an incentive to receive much bigger part of wage officially. It should be possible to measure increase of % official wages vs. increased expenses. only when such research is done one has a right to tell if the benefit was "overly generous" or created substantial tax incomes...and not to mention the change of public attitude - if I pay taxes, whenever something happens I'll receive benefits. now lots of employees do not have such incentives. they are willing to pay as little taxes as possible to save for a bad day (or just to make ends meet)
and another thing - VID alsmost never deal with individuals, only companies. so there is no pressure to empoyer to pay taxes from empoyess, there in now incentives to pay taxes for different kinds of small things (like renting out you flat). of course no tax authority could (or even should) check every individual, but there are some good moves in that direction - like need to present info on official income (payed taxes) when you are willing to take morgage loan. the same should be envisage for other kind of of events for amounts also smaller than now envisaged 100 minimal wages - like registration of car, or ragistration of real estate.

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Arzemnieks 02.09.2010 11:34
GD - some good points in your post.

However, just one comment. My references above to corruption, are not based on rumour, hearsay and second hand information. They are based on the 4 years I have spent in real estate, and my direct specific experience of the openess to corruption from municipalities, the land book, the land service, ministries etc etc.

As you say, solutions are needed, certainly not my whining. However, I will leave that to the experts, such as Vjacheslav.

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G.D. 02.09.2010 02:39
I agree that "surge of sticks" is the right thing to do. One of Latvia's problems is that nobody takes law seriously. The recent example when a parliamentarian forgot to declare a multi thousand loan is an illustrative example. And officials said: “yes, bad, but there is nothing we can do”. Compare with the US or any other Western country! It is obvious that a complete overhaul is needed but, as rightly mentioned in comments above, that could only be a medium term goal. In the meantime, however, we can do a lot of things to improve the efficiency of revenue collection: an enterprise has in mind a simple equation of costs and benefits: [benefits (gains from avoiding tax)] – [costs (losses in case if you are caught) X (probability of being caught)]. It is impossible to increase the probability of being caught in the short term, it is also difficult to decrease benefits (cutting taxes) during a crisis, but it is possible to increase losses from being caught, as we all know from driving-under-influence laws. They had a strong impact with little additional administrative burden! There are hundreds of ways how to increase the costs of being caught: criminal charges, huge fines, some element of personal responsibility, e.g. constraints to start a new enterprise etc.. Just check any other country’s legislation and you will find them all. Another thing which can be done immediately is to create career incentives at the SRS linked to the importance of a fraud case in terms of revenues not-collected. Do we lose much revenues because of a forgotten stamp or a missing signature? I guess not.

Some things to add:

1) I disagree with the widespread argument that we should somehow persuade the nation to voluntary pay taxes with providing something in return. I find the idea a complete nonsense. How can you persuade a construction worker who received 1500 LVL in 2007 and now survives on 300 LVL “in envelope” to be happy with the Latvian tax system? That is not how it works. Nobody wants to pay taxes! Nowhere! Coercion is the only answer.

2) I also think that this obsession with corruption has become somewhat unhealthy and distracts attention from many problems which could and should be solved. Expatriates in particular have this problem to trace any problem to corruption, therefore, ending in some kind of a fatalistic dead end. We waste a lot of time wailing about corruption and not giving real proposals and solutions to real problems. This article is a refreshing digression from this tradition (praise to the author). Sure, corruption is one of the most important problems here. However, my thinking is that most of the Latvian problems come from a much more boring motives, like insiders wish to keep their job, incompetence, the conflict-avoidance attitude and the lack of political courage to change anything.

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Veiko Spolitis 01.09.2010 10:14
Very good overview Slava! And AN ADDITION to sticks SHOULD BE introduction of the universal property and tax declaration system! It must be implemented prior the rewamped SRS would be able to start their work of SURGING THE STICKS.

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Mareks 01.09.2010 09:48
I mostly agree with this line of the arguments but the "surge of sticks" tactic is unlikely to work. Even I, a law abiding tax payer, have to admit some clerks at the revenue service are imcompetent and corrupt, and they are no help to carry out the surge.

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Arzemnieks 01.09.2010 09:42
Vjacheslav – thanks for the article, very thoughtful and insightful. As Bubulis says above, I hope the politicians are reading it. However, I suspect they won’t, and one of Latvia’s problems is that the smart economists, such as yourself, are writing blogs such as these, not making the actual decisions. Latvia is not short of smart economists (or smart anything else), they just usually aren’t in the decision making positions.

Regarding VID, it would be great to have the kind of tax authority you are talking about here. However, as a foreigner who has lived in LV for 9 years, working in finance (and as such having a lot of exposure to VID), the kind of changes you are expecting from them would take a good 5 years to implement. They are not just structural changes, but changes that need to take place in the hearts of all the people who work there.

As Juris mentions above, VID is currently set up so as to find and penalise companies and people who break minor rules (a signature missing from this document, or a stamp missing from that document), because that is far easier than catching someone who has intentionally avoided paying taxes.

To find the right people to work in such a tax authority would also take a lot of time and money, and quite possibly, Latvia doesn’t currently have enough people with the right skills. So I agree that a super-VID is required, but it will take a lot longer than you anticipate. Unlike Juris though, I believe it will happen with time.

Two final point:

1/ Regarding maternity benefits, my girlfriend worked very hard in a law firm in Riga for 12 years before having our daughter. During that period of work she partly worked for the maternity benefits that were promised by the state. Luckily (for us), our daughter was born soon enough to narrowly avoid the cuts in maternity pay. If that had not been the case however, would it have been fair is she hadn’t received what she was promised for 12 years? Surely that would be constitutionally unacceptable?

2/ Corruption – the measures you have outlined above would not change the fact that Latvia is corrupt to the core. At the highest and lowest levels of government (from municipalities to ministries) many government employees are “for sale”. This leaches the blood out of Latvia’s respiratory system. Where corruption flourishes, the majority of a countries inhabitants will suffer as a result. Russia is the perfect example. With its tiny population and vast reserves of natural resources, it should have a higher average standard of living than Norway. Only one reason why it doesn’t – corruption. And without tackling corruption, your measures above will not be sufficient. So, fingers crossed that KNAB continues its good work (and that you keep writing your excellent blogs!).

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Juris Kaža 01.09.2010 08:35
I think the problem is intractable. Look at what is happening in terms of "return on taxation" the way you would calculate "return on investment". With another 900 million LVL in tax cuts coming, it is pretty clear that citizens will get diminishing, poor public services (education, police, health) for their taxes. So what is the incentive to pay (beside the competitive disadvantages described)? It looks like the only way to get tax revenues back up is through some form of " state revenue service police state". The SRS has a bad enough reputation for persecuting TAX PAYERS for trivial mistakes without bringing in a Tax Gestapo that people will resist simply on principle. Latvians are very inventive in this respect,

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bubulis 31.08.2010 17:42
I hope politicans read this blog :D

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Azeroth 31.08.2010 15:35
Although the intentions of the "overly generous maternity benefits" were most likely populistic as you correctly state, the unintentional consequences of this made it look like possibly the best decision from government in the bubble years. We have HUGE demographic problem (as you stated yourself) and the maternity benefits fixed both that and the "envelope wages". Maybe it's just my age group but I saw it everywhere - people were choosing to receive official taxed salary mostly to receive the maternity benefits in case incidental or accidental reproduction occurs to them :)

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