Presentation by Gabriele Giudice, Ingrid Toming, Francesco Di Comite and Julia Lendvai (DG ECFIN) at Country workshop: "EU Balance-of-Payments assistance for Latvia: Foundations of Success" organized by the European Commission, Directorate General for Economic and Financial Affairs, and the Bank of Latvia. Brussels, March 1, 2012

1. EU Balance-of-Payments assistance
for Latvia: Foundations of Success
Fiscal consolidation in the midst
of the crisis: lessons from Latvia
Gabriele Giudice
Ingrid Toming
Francesco Di Comite
Julia Lendvai
DG 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 a
particularly striking example of that:
2009 2010 2011
Change in cyclically-adjusted primary balance, European
0.6 1.0 3.3
Commission 2011 Autumn Forecast, % of GDP
Change in structural primary balance, European Commission
1.1 1.7 1.8
2011 Autumn Forecast, % of GDP
Consolidation measures as reported by the government
9.5 4.0 2.6
(Convergence Programme April 2011), % of GDP
European Commission estimate of discretionary measures
8.9 4.9 2.2
(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)
Impact
Cyclical adjustment underestimating fall in indirect taxes 1.4 – 2.3 pps
Cyclical adjustment underestimating fall in labour taxes 1.2 pps
Cyclical adjustment not capturing behavioural changes in social benefits outlays Ca 0.5 pps
Policy action approach "missing" expansionary elements Up to 3.0 pps
TOTAL Up to 7 pps
+ uncertainties related to real time estimates of output gap, differences in
…
measurement methodologies etc

5. Composition of consolidation in Latvia in 2009-2012
Frontloaded 9%
consolidation: overall 8%
around 17% of GDP, 7%
Other measures
o.w. ½ in the first year 6%
Consumption taxes
More than half on the 5%
Labour taxes
expenditure side, in Government consumption
4%
particular government
consumption 3%
Tax increases: overall by 2%
ca 6% of GDP (ex-ante 1%
estimate), mostly 0%
consumption and -1%
2009 2010 2011 2012
property taxes % of GDP Source: Commission Services

6. Consolidation in the Baltics: overall comparable
LATVIA LITHUANIA ESTONIA
9 9 9
8 Revenue Revenue 8 Revenue
8
7 Expenditure 7 Expenditure 7 Expenditure
6 6 6
5 5 5
4 4 4
3 3 3
2 2 2
1 1 1
0 0 0
2009 2010 2011 2009 2010 2011 2009 2010 2011
-1 -1 -1

7. Latvian specific factors - revenue
VAT compliance in the Baltics
100%
Tax compliance seems to have 90%
80%
fallen most in Latvia during 70%
60%
the crisis 50%
40%
Possible reason: 30% LAT VIA EST ONIA LIT HUANIA
20%
- weakening of the State 10%
0%
Revenue Service 2005 2006 2007 2008 2009 2010 2011 9m
- higher level of dissatisfaction 41%
Implicit tax rate on labour
of entrepreneurs 39%
37%
Lessons: tax offices to be 35%
spared from cuts, keeping 33%
31%
firms out of “grey area” easier 29%
27% L AT V IA E S T O NIA L IT HUANIA
then bringing them back to 25%
“white” 2005 2006 2007 2008 2009 2010 2011f

8. Latvian specific factors - expenditure
Government consumption index 2000=100, values
Cuts in government consumption 350
clearly visible in ex-post statistics 300 ESTONIA
only in Latvia (albeit from higher LATVIA
level) 250
LITHUANIA
Particularly sizeable savings in 200
healthcare and education 150
Possible reason: plans were ready for
100
reforms in these sectors (but lack of
00
01
02
03
04
05
06
07
08
09
20 0
(f)
will to implement them before the
1
11
20
20
20
20
20
20
20
20
20
20
20
crisis), administrative reform
Lessons: cuts “across-the-board” give Change in nominal expenditure between 2008 and 2010, %
Estonia Latvia Lithuania
limited and temporary results, but General public services -3.8 -8.6 1.2
sizeable expenditure restraint can Defence -9.7 -47.3 -28.3
Public order -3.4 -8.5 1.4
be achieved through a structural Health -9.6 -26.7 -6.8
reform strategy Education -10.1 -25.8 -10.3
Social protection 10.8 13.4 0.1

9. Overall successful consolidation:
better deficit outcomes and smaller debt accumulation
than feared at the depth of the crisis
Latvia: general government deficit, Latvia: general government debt
projections in summer 2009 and outcome projections in summer 2009 and outcome
24 100
21 90
IMF July 2009
18 Initial 80
IMF July 2009
(IMF Jan. 2009) 70
15
% of GDP
12 60
% of GDP
COM June 2009
COM June 2009 50 Forecasts
9
Outcome 40 Outcome
6
30
3 Forecasts
20 Initial
0 (IMF Jan. 2009)
10
-3
2008 2009 2010 2011 2012 2013 2014 0
2008 2009 2010 2011 2012 2013 2014

10. To summarise
• Measuring consolidation can be a daunting task in quickly
changing environment;
• Revenue collection rates will likely fall and behaviour of agents
likely change in the crisis – special attention needed to keep
taxpayers out of "grey area";
• Frontloaded consolidation is better as it allows to bear the
fruits of fiscal discipline sooner
BUT
• Expenditure cuts should be based on comprehensive reform
strategy and that takes time (Latvia was lucky to have structural
reform plans ready beforehand)

11. Have government cuts depressed the economy?
Many like to depict the
correction in GDP from
peak to trough (-24%) as a
major social cost
But one should not loose
sight of how much GDP
has increased over the
past decade (5.1% p.a.) or
even still since 2004
(+2.5% p.a.)
The graphs shows
remarkably well how the
economy turned around as
the consolidation took off.

12. The impact on the economy, depends on composition of consolidation
Country-specific fiscal multipliers for Latvia (QUEST model): Impact of 1 pp of GDP consolidation on GDP
2 2
Employment (rigid LM)
Consumption taxes
1.5 1.5 Gov. consumption
Property tax
1
Transfers
1
Labour taxes Employment (flexible LM)
0.5 Capital Income tax 0.5 Government investment
0 0
-0.5 -0.5
-1 -1
-1.5 -1.5
0 1 2 3 4 5 6 7 8 9 10 50 0 1 2 3 4 5 6 7 8 9 10 50
• Most of the consolidation in Latvia was implemented through measures with
more limited negative impact on growth in the short term, but positive in the
longer term, notably consumption taxes and cuts in government
consumption. (But social fairness of these measures could be an issue)

13. Non-keynesian effects ? Decisive action
is key to affect
expectations
Channels proposed in the literature:
• DEMAND: Consumer and investors gain in confidence,
consuming and investing more because of lower future
uncertainty and taxes;
• SUPPLY: wage reductions and relocation of employment
to more productive sectors foster productivity and
competitiveness.
Composition of the adjustment is key,
together with flexibility and openness

14. A confidence effect likely took place
From mid-2009, as
the fiscal Consolidation kicked-off
consolidation kicks in,
investments and
consumption recover
quickly.
At the same time,
bonds' yield decrease
and surveys of
consumer confidence
increase.

15. The initial increase in investment and consumption
was hardly driven by higher wages, profits or
employment…

16. But real wage decreases have progressively
helped stimulate the industrial recovery.

17. Public employment cuts and tax policy helped reallocation
The flexibility of Latvian economy allowed resources to be quickly reallocated
to manufacturing after the crisis.

18. Confidence now – Competitiveness then
• Non-Keynesian demand effects of fiscal consolidation
showed 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 the
foundations for the recovery.