The Latvian Economy - November 2015
Where to look for more tax revenues?
  • To meet its growing spending needs, the government will aim to collect more tax revenues as a percent of GDP
  • Extensive research suggests that a good tax system should strive to be neutral, progressive, and growth-friendly
  • A proposal for Latvia: replace reduced VAT rates with targeted welfare benefits and raise revenues through residential real estate tax

 To meet its growing spending needs, the government will aim to collect more tax revenues as a percent of GDP
The Latvian government’s spending ability is lagging behind its medium term spending needs. There is still the potential for more efficient government spending, which can free-up resources for more expenditure on defence, health, etc. But to considerably raise the spending ability, there is also a need to significantly increase tax revenues as a percent of GDP, which have been hovering around the 28% mark for more than a decade and are among the lowest in Europe.




Extensive research suggests that a good tax system should strive to be neutral, progressive, and growth-friendly

Extensive research on international practices and theory in tax design suggest that a good tax system should strive to be neutral and progressive. It should be neutral in a way that distorts the behaviour of individuals as little as possible by taxing similar activities similarly. It should be progressive in a way that it helps to redistribute wealth efficiently, i.e., benefiting the less wealthy while minimizing the loss in work incentives of the more wealthy. A tax system should also harm economic growth as little as possible. Importantly, a tax system should be viewed as a whole rather than just a set of individual taxes. It is the overall effect of a tax system that is important – e.g., not all taxes need to be progressive as long as the overall system is. Generally, it is more efficient to rely on direct income taxes to raise the overall tax progressivity.

A proposal for Latvia: replace reduced VAT rates with targeted welfare benefits and raise revenues through residential real estate tax
If aiming to reduce income inequality, it is sub-optimal to rely on differentiated consumption taxation. Replacing the reduced value-added tax (VAT) rates, e.g., for medicine and heating with direct welfare benefits is both more effective in providing targeted support to the less wealthy and potentially expenditure saving and/or tax revenue enhancing. To increase the progressivity of the tax system, the focus of Latvian policy makers has been placed on wage income, typically leaving out from discussions other types of incomes that are currently subject to much lighter tax burdens. The tax burden on wage income is by far the heaviest between all income types, and also heavier than in Estonia and Lithuania as well as the European average. Increasing the tax burden on wage income further would hurt competitiveness. The tax burden on corporate income and income from capital – the types of incomes more often received by the wealthier – is considerably milder than on wage income. Crucially, this does not by itself mean that taxes on these incomes should be raised. For instance, increasing the tax burden on corporate income is relatively more harmful to economic growth, while increasing the tax burden on capital income might encourage capital flight and thus lower tax revenues. A possible way of collecting more taxes from such incomes is to increase revenues through residential real estate tax. This can both satisfy the calls from society for higher progressivity of the overall tax system and minimise the harm to economic growth. Crucially, such a policy choice would also make tax evasion more difficult – while incomes are possible to hide, it is impossible to hide real estate.

PDF The Latvian Economy - November 2015


For more information please contact Mr. Mārtiņš Kazāks, +371 6744 5859, martins.kazaks@swedbank.lv

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