1. EU Balance-of-Payments assistance for Latvia: Foundations of SuccessFiscal consolidation in the midstof the crisis: lessons from LatviaGabriele GiudiceIngrid TomingFrancesco Di ComiteJulia LendvaiDG ECFIN, 1 March 2012

2. Fiscal consolidation in Latvia: How big has it really been? What was the composition of consolidation? What was its impact on the economy? What can be learned from the experience of Latvia? 3. Measuring fiscal consolidation Two main approaches to measuring fiscal consolidation: Change in cyclically-adjusted (primary) balance or structural (primary) balance Policy action approach Results between two approaches can be quite different; Latvia in 2009 is aparticularly striking example of that: 2009 2010 2011 Change in cyclically-adjusted primary balance, European 0.61.03.3 Commission 2011 Autumn Forecast, % of GDP Change in structural primary balance, European Commission 1.11.71.8 2011 Autumn Forecast, % of GDP Consolidation measures as reported by the government 9.54.02.6 (Convergence Programme April 2011), % of GDP European Commission estimate of discretionary measures 8.94.92.2 (excluding exceptional restructuring costs) Difference between SPB and government estimate-8.4 -2.3 -0.8 4. Possible reasons for the difference between two approaches (on example of 2009)ImpactCyclical adjustment underestimating fall in indirect taxes 1.4 2.3 ppsCyclical adjustment underestimating fall in labour taxes1.2 ppsCyclical adjustment not capturing behavioural changes in social benefits outlaysCa 0.5 ppsPolicy action approach "missing" expansionary elements Up to 3.0 ppsTOTALUp to 7 pps+ uncertainties related to real time estimates of output gap, differences inmeasurement methodologies etc 5. Composition of consolidation in Latvia in 2009-2012Frontloaded 9% consolidation: overall 8% around 17% of GDP, 7% Other measures o.w. in the first year 6% Consumption taxesMore than half on the 5% Labour taxes expenditure side, inGovernment consumption4% particular government consumption3%Tax increases: overall by 2% ca 6% of GDP (ex-ante1% estimate), mostly0% consumption and-1% 2009 20102011 2012 property taxes % of GDP Source: Commission Services 6. Consolidation in the Baltics: overall comparableLATVIALITHUANIA ESTONIA9 9 98 Revenue Revenue 8 Revenue87 Expenditure 7 Expenditure 7 Expenditure6 6 65 5 54 4 43 3 32 2 21 1 10 0 0 2009201020112009 2010 2011200920102011-1-1-1 7. Latvian specific factors - revenueVAT compliance in the Baltics100%Tax compliance seems to have90%80%fallen most in Latvia during70%60%the crisis50%40%Possible reason:30% LAT VIAEST ONIA LIT HUANIA20%- weakening of the State10% 0%Revenue Service20052006 2007 20082009 2010 2011 9m- higher level of dissatisfaction41%Implicit tax rate on labourof entrepreneurs 39% 37%Lessons: tax offices to be 35%spared from cuts, keeping33% 31%firms out of grey area easier29% 27%L AT V IAE S T O NIAL IT HUANIAthen bringing them back to 25%white20052006 2007 20082009 20102011f 8. Latvian specific factors - expenditure Government consumption index 2000=100, valuesCuts in government consumption 350 clearly visible in ex-post statistics 300ESTONIA only in Latvia (albeit from higher LATVIA level)250LITHUANIAParticularly sizeable savings in 200 healthcare and education150Possible reason: plans were ready for 100 reforms in these sectors (but lack of00 0102 0304 0506 0708 0920 0 (f) will to implement them before the11120 2020 2020 2020 2020 2020 crisis), administrative reformLessons: cuts across-the-board giveChange in nominal expenditure between 2008 and 2010, % EstoniaLatviaLithuania limited and temporary results, butGeneral public services -3.8-8.6 1.2 sizeable expenditure restraint canDefence -9.7 -47.3 -28.3 Public order-3.4-8.5 1.4 be achieved through a structuralHealth-9.6 -26.7 -6.8 reform strategy Education-10.1 -25.8-10.3 Social protection10.8 13.4 0.1 9. Overall successful consolidation:better deficit outcomes and smaller debt accumulationthan feared at the depth of the crisis Latvia: general government deficit,Latvia: general government debtprojections in summer 2009 and outcomeprojections in summer 2009 and outcome 24100 2190IMF July 2009 18Initial 80IMF July 2009(IMF Jan. 2009)70 15% of GDP 1260% of GDPCOM June 2009 COM June 2009 50 Forecasts9 Outcome 40Outcome6 303 Forecasts 20 Initial0(IMF Jan. 2009) 10 -32008 200920102011 2012 20132014 0 2008200920102011 2012 20132014 10. To summarise Measuring consolidation can be a daunting task in quicklychanging environment; Revenue collection rates will likely fall and behaviour of agentslikely change in the crisis special attention needed to keeptaxpayers out of "grey area"; Frontloaded consolidation is better as it allows to bear thefruits of fiscal discipline soonerBUT Expenditure cuts should be based on comprehensive reformstrategy and that takes time (Latvia was lucky to have structuralreform plans ready beforehand) 11. Have government cuts depressed the economy?Many like to depict thecorrection in GDP frompeak to trough (-24%) as amajor social costBut one should not loosesight of how much GDPhas increased over thepast decade (5.1% p.a.) oreven still since 2004(+2.5% p.a.)The graphs showsremarkably well how theeconomy turned around asthe consolidation took off. 12. The impact on the economy, depends on composition of consolidationCountry-specific fiscal multipliers for Latvia (QUEST model): Impact of 1 pp of GDP consolidation on GDP2 2 Employment (rigid LM) Consumption taxes1.5 1.5Gov. consumption Property tax1 Transfers1 Labour taxesEmployment (flexible LM)0.5Capital Income tax 0.5Government investment0 0-0.5-0.5 -1-1-1.5-1.5 0 1 2 3 4 5 67 8 9 10 500 1 23 4 5 6 7 8 9 10 50 Most of the consolidation in Latvia was implemented through measures withmore limited negative impact on growth in the short term, but positive in thelonger term, notably consumption taxes and cuts in governmentconsumption. (But social fairness of these measures could be an issue) 13. Non-keynesian effects ?Decisive actionis key to affect expectationsChannels proposed in the literature: DEMAND: Consumer and investors gain in confidence,consuming and investing more because of lower futureuncertainty and taxes; SUPPLY: wage reductions and relocation of employmentto more productive sectors foster productivity andcompetitiveness. Composition of the adjustment is key, together with flexibility and openness 14. A confidence effect likely took placeFrom mid-2009, asthe fiscal Consolidation kicked-offconsolidation kicks in,investments andconsumption recoverquickly.At the same time,bonds yield decreaseand surveys ofconsumer confidenceincrease. 15. The initial increase in investment and consumptionwas hardly driven by higher wages, profits oremployment 16. But real wage decreases have progressivelyhelped stimulate the industrial recovery. 17. Public employment cuts and tax policy helped reallocationThe flexibility of Latvian economy allowed resources to be quickly reallocatedto manufacturing after the crisis. 18. Confidence now Competitiveness then Non-Keynesian demand effects of fiscal consolidationshowed up as soon as confidence was restored Supply-side effects kicked in after some quarters The way consolidation was brought about (decisive,frontloaded and well balanced in terms of composition)probably made the difference, laying down thefoundations for the recovery.