I think I've had enough of this place. Seriously. What's the point of being a professional economist in a country where the government appears to have just drafted 500 million LVL worth of legislation in JUST A FEW DAYS??!

The crown jewel of the ‘new’ initiative is that the bulk of it is not about reducing budget expenditure but about increasing taxes. In particular, the government plans increased the VAT to 23% and introducing the progressive income tax where the top rate (40%) will be levied on income exceeding 800 LVL a month (bruto). Moreover, the tax rate for income less than 200 LVL a month remains 23%. Thus, we’re talking about a pure increase in the tax burden for anybody who (officially) makes more than 200 LVL a month. Ironically, I am generally a supporter of progressive taxation, which makes me seriously pissed that the New Era has defiled the word “progressive tax” for years to come.

First of all, the scale is just too steep. For example, in the United States, that “bastion of capitalism”, the top tax rate of 35%(!) is only levied on monthly income in excess of 31 thousands USD. Tax rate for income that is approximately between 347 and 1414 LVL per month is only 15%. Or, compare to a more socialistic Sweden (courtesy of Janis Skrastins). Take bruto salary of 973 LVL, which is roughly what is paid to a decent professional. Before the reform, the after-tax income is 702 LVL. After the reform – 621 LVL. In Sweden, the same bruto salary would leave you with an after-tax wage of 757 LVL.

Second, I have serious doubts that this tax reform will produce the 35 million LVL in tax revenue that Mr. Repse hopes for. The key word is “tax evasion”. Hasn’t anyone noticed how widespread envelope wages in Latvia are? Has anyone given any thought as to why this is the case? Quite simply, 23% personal income tax combined with 33% social payroll tax create a tax wedge (the share of labor cost paid in these taxes) that is more than 40% of the labor cost to the employer. That is one of the highest tax wedges in the world. The tax wedge is what creates an incentive to pay wages in envelopes – to the mutual benefit of both the employee and the employer. An effective increase in the personal income tax will create an even bigger incentive for envelope wages and is likely to result in massive shift of businesses underground. Moreover, I think the sad truth is that there are not many people these days who feel a moral obligation to pay taxes to the government. And it should be easy enough with the State Revenue Service only working four days a week now.

Third, and a corollary to my second point, is that the tax reform will have disastrous effect for the economy in the long run. Think of what envelope wages mean. They reduce labor costs of employers who pay wages in envelopes, as compared to those who pay them officially. First, this cost advantage will drive out all the firms that pay taxes, because they will find it hard to compete with those who do not. So envelope wages would tend to spread quickly. Second, envelope wages are likely to be more widespread among small firms, rather than large firms. The reason is that the tax authorities usually find it hard to monitor the (many) small firms, but find it easier to monitor large firms. Thus, a small firm would realize that becoming a large firm means losing the cost advantage granted by envelope wages. Small firms will have less incentive to grow and that would mean poor growth prospects for the economy. I have written about this elsewhere. Quite simply, we will end up living in the economy where people would spend time evading the tax authority, rather than producing economic value.

Fourth, the budget deficit is a public sector problem. With the GDP contracting at the (likely) rate of 18% a year, it is obvious that tax revenues would fall as well. Thus, it is simply a question of the public sector living within its means. The public sector MUST cut its spending. Instead, what the government does is shifting the burden to the private sector by increasing the taxes. As if the private sector didn’t have enough problems already.

To sum up, the new measures are unlikely to achieve their objectives (larger revenue) in the short run, and will probably have disastrous effects on the economy in the long run. Moreover, they are morally wrong, as the government appears incapable of reducing the spending of the public sector, in spite of all the tough talk of Mr. Repse.