The possibility of avoiding tax raises

Budget consolidation has been on the government's agenda for quite some time as it has been seeking to find a balance between spending and the actual incoming cash flow into the Treasury. Both politicians and the people are fatigued from the protracted restructuring of the budget; nevertheless, it is clear that the process could not be accomplished in a day or a year and there were objective reasons behind the restructuring. The reasons, similar to those in most troubled countries throughout Europe and the world, included both the lack of fiscal discipline and the swelling national debt as well as the consequences of the global financial crisis. The main factor at work in Latvia could be the need to cut the expenditure base created by significant inflation of spending in the pre-crisis years on account of a short-lived increase in budgetary revenue. 

The very reason behind this financial problem already points to the necessary remedy. Would it really be reasonable to multiply expenditure items and try to cover the financing gap by additional tax collections? As previously stated, spending was increased on account of windfall revenue caused by unexpectedly high economic growth that boosted the cash flow into the Treasury. 

It must be recognised that much has been accomplished in Latvia to cut the expenditure, yet unfortunately, throughout the restructuring, the weight of consolidation has been shifting towards tax increase. Confronted with a crisis, the government had to act swiftly, and in 2009 it managed to find most of the required amount by reducing the current expenditure and investment. However, in the following two years after obvious expenditure cutting options dried up, the weight of consolidation was shifted towards revenue, mainly via tax raises. 

We have seen the value added tax grow from 18% to 22%, social insurance tax contributions increase from 33.09% to 35.09%, several excise tax rates were raised, the tax base was expanded as well (e.g. several personal income tax exemptions were reduced). 

Despite a slight decrease in the personal income tax rate from the beginning of this year, since the end of 2008 this rate as well as the overall burden of labour taxes, including higher employee social insurance contributions applicable from the beginning of the year, has grown. It has to be reiterated again that a heavier burden of labour taxes is detrimental to economic growth[1]. Raising labour income taxes compresses labour supply and gives incentives to both businesses and population to choose a country with a friendlier taxation regime, especially considering that the burden of labour taxes was above the European Union average already as it was. Tax raises implemented in the recent years have determined that the so-called tax wedge or the ratio between the aggregate labour tax paid and aggregate labour costs in Latvia is one of the largest in Europe. Taxes paid on the average wage in Latvia are also higher than in other Baltic states. 

A higher value added tax means more expensive goods and services; consequently, it reduces private consumption and dampens the recovery of economic activity. Raising the rate also does not help to achieve a recently alleged government priority of combating the grey economy and improving tax administration.

People spend less also when they become cautious and uncertain about the financial prospects of their families. Some signs of recovery in private consumption became evident in the second half of 2010; nevertheless, towards the end of the year, seeing the indecisiveness regarding fiscal consolidation which threatened to result (and eventually resulted) in further tax raises, precautionary sentiment increased again putting an end to the meagre recovery of consumption. It was reasonable for the population to become concerned about their future income which is, inter alia, adversely affected by tax raises and the associated inflation expectations. It has to be taken into account that the current situation with income and access to borrowing leaves households with practically no room for financial manoeuvre; consequently, any reduction of this income is particularly painful.

Government's actions are followed by foreign observers and investors as well. Although the overall result of the budget consolidation is of an utmost importance, the means of achievement are no less significant. Financial market confidence in a country grows when prudent management is evident and serious steps by the government to rein in spending are undertaken, instead of attempts to fund current expenditure by additional collections from people and businesses whose ability to pay is limited. To see prudent government policies is particularly important, considering that currently the investors' eye is on the sustainability of public finances and the level of public debt. Businesses contemplating entry into Latvia also factor in the budget position and the risk of any further increases in tax rates should the expenditure linger and solutions be sought on the revenue side. By contrast, one of Latvia's neighbours is a potential investment target country, where a balanced budget signals a significantly lower probability that the government could resort to raising taxes in order to finance spending that is incommensurate with revenue. 

Tax-raising is the easiest road in budgetary consolidation, at least in terms of forecasts and plans, although no one can be quite sure if they will be fulfilled. Spending is easier to control, yet the political decisions to curb it are more difficult to take. The short-term effect of expenditure cuts on the economic development is less harmful than that of a tax raise, whereas the efficiency gains provided by reduced spending even support growth in the long-term. 

International debate about dividing the weight of consolidation between the expenditure and revenue sides is held in both the academic circles and well as among institutions. Research presents evidence that consolidation measures on the expenditure side have a much more beneficial effect on economic growth than raising taxes. In the OECD (2008) working paper on the impact of tax structures on economic growth, Arnold finds that the biggest losses to the economy are sustained by raising the rates of direct taxes, particularly those of labour income taxes and corporate income taxes[2]. The European Central Bank researcher Coenen and co-authors (2007) in a working paper on the impact of taxes on the labour market indicate that an increase in the taxes (personal income tax and social insurance contributions) forming the tax wedge is particularly detrimental to growth, distorting the labour market and reducing labour supply[3]. Government spending cuts, in turn, have a positive effect in the long-run, reducing distortions in the allocation of resources and facilitating the concentration of labour in value adding economic sectors. 

Regaining trust and establishing a predictable tax policy is not a fast process, yet it has to be started one day, if the government wants to see successful business development, investment and new jobs. It is clear that the situation with the government budget will remain tight and further budgetary consolidation will be required in 2012 as well. The people and businesses will definitely view it also as an opportunity for the government to come up with a stable taxation policy.

The article was published by Delfi on 24 May 2011.