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Latvia-Tax-Review.Pdf Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Europe and Central Asia Region Asia andCentral Europe andInstitutions Finance, Equitable Growth, Acknowledgements The report summarizes a thorough research on the Latvia’s tax system that the World Bank has undertaken over the past year. The report was prepared by the team of World Bank experts from the Equitable Growth, Finance, and Institutions cluster, and Global Practices for: Poverty, Macroeconomics and Fiscal Management (MFM), and Governance. The core team was led by Emily Sinnott (World Bank) and Emilia Skrok (World Bank), consisting of Michael Engelschalk, Mihails Hazans (University of Latvia and IZA); John Fanning (former Irish Civil Service), William Dillinger (former World Bank) and Bas Jacobs (Erasmus University Rotterdam). The team is greatly indebted to Jan Gąska, Paulina Hołda (World Bank), Māris Jurušs (Riga Technical University), Palma Mosberger (Central European University), Anna Pluta (Baltic International Centre for Economic Policy Studies and University of Latvia), Olga Rastrigina (University of Essex) and Joanna Tyrowicz (GRAPE) for their invaluable contribution to the report. William Shaw and Anne Grant provided excellent editorial and production support. Special thanks are due to Olga Rastrigina (Institute for Social and Economic Research, University of Essex) for invaluable support in terms of getting access to EUROMOD software and EUROMOD-adjusted SILC data as well as Agnieszka Boratyńska, Aleksandra Ignaczak, Jason Victor and Indiana Taylor (all World Bank) for their excellent editorial support and research assistance. Many people contributed to the writing of the report. The main authors and contributors were: Introduction was written by Bas Jacobs, Emily Sinnott and Emilia Skrok Chapter 2 (Evolution of tax system and structure) was written by Emilia Skrok and Jan Gąska contribution from with Paulina Hołda. Chapter 3 (Personal Income Tax and Social Security Contributions) was written by Bas Jacobs, Mihails Hazans and Emily Sinnott with contributions from Palma Mosberger and Anna Pluta and guidance from Olga Rastrigina on the EUROMOD tax-benefit microsimulation model. Chapter 4 (Corporate Income Tax) was written by John Fanning and Emilia Skrok, with contribution from Bas Jacobs. Chapter 5 (Microenterprise Tax) was written by Mihails Hazans and Emily Sinnott. Chapter 6 (Value Added Tax) was written by Emilia Skrok with contribution from Jan Gąska. Chapter 7 (Excise Tax) was written by Emilia Skrok with contributions from Māris Jurušs. Chapter 8 (Residential Property taxation) was written by William Dillinger with contributions from Emilia Skrok. Chapter 9 (Tax compliance) was written by Michael Engelschalk. This work benefitted from the support, guidance and advice of Arup Banerjee (Regional Director for Operations, European Union), Ivailo Izvorski (former Practice Manager in the Macroeconomics and Fiscal Management Global Practice), Luis-Felipe Lopez-Calva (Practice Manager in the Poverty Global Practice), Lalita Moorty (Practice Manager in the Macroeconomics and Fiscal Management Global Practice), Carolina Sanchez-Paramo (Senior Director in the Poverty Global Practice), Carlos Pinerua (Country Manager for Poland and the Baltic Countries) and Marina Wes (former Country Manager for Poland and the Baltic Countries). We particularly thank our reviewers Alan Fuchs Tarlovsky (Senior Economist), Blanca Moreno-Dodson (Lead Economist), and Karlis Smits (Senior Economist) for their extensive and constructive suggestions. This report gained much also from workshops held in Riga in June, September and December 2016. Finally, the team wishes to thank senior officials from the Ministry of Finance and the State Revenue Service. The team is sincerely grateful for the preparation and sharing of data, contributions, comments and suggestions received from the counterparts in Latvia during preparation of the report. Latvia Tax Review – Executive Summary 1. Introduction Latvia’s Ministry of Finance requested the World Bank to collaborate on a review of the country’s tax system as input for the design a medium-term tax strategy. The motivation behind the tax review is to find options to increase tax revenues by three percentage points of GDP to reach a target tax- to-GDP ratio of 33 percent in the medium term.1 In Latvia, tax revenues are lower than predicted for its income level and institutional development. The additional revenues would be used to cover growing spending needs in the following areas: Defense spending. The Government aims to increase defense spending to the NATO guideline target of 2 percent of GDP by 2018 (from 1 percent of GDP in 2015 and an estimated 1.5 percent of GDP in 2016).2 Investment in human capital. Health, education and social protection are additional areas that the Government has identified as requiring further investments. In particular, public health spending is low and health outcomes are lagging compared with much of the European Union (EU). Latvia’s tax policy needs to be restructured to support economic development and raise living standards. The speed of convergence in Latvia to average income levels in the European Union (EU) was impressive until the 2008-2009 crisis, but since then output recovery has been fast but not rapid enough for real GDP to return to pre-crisis level. A critical challenge then is to boost productivity growth in the economy: the level of productivity is low relative to OECD economies and its growth has slowed notably since the crisis. Increasing labor productivity is particularly important if overall productivity is to rise: informality and inactivity reduce both labor activity and productivity. Increased investment in skills and good health are an important part of the labor productivity and participation story—particularly as Latvia rapidly ages. But reducing the reliance of the tax system on low-skilled labor is also a key policy challenge. Latvia’s tax system puts substantially more of a burden on labor compared to capital or consumption. This is all the more concerning given that wages for much of the population are low and so the current flat income tax structure has implications for social inclusion and poverty. Inequality of (after-tax) disposable income in Latvia is one of the highest in the EU, with only Bulgaria, Romania and Lithuania having higher inequality.3 There are multiple dimensions to be taken into account in examining tax reform options apart from increased revenue generation. Tax systems as a whole should be efficiently designed to meet revenue targets and distributional goals with the lowest possible distortions on economic activity. Taxes entail economic costs by affecting people’s and firm’s behaviors: decisions on working, saving/consuming, investing and employing workers. A tax system that relies too heavily on inefficient taxes, uncompetitive tax rates and poorly targeted or ineffective concessions will impose 1 See Declaration of the Intended Activities of the Cabinet of Ministers Headed by Māris Kučinskis, February 2016, Riga http://www.mk.gov.lv/sites/default/files/editor/deklaracija_en.pdf 2 Defense expenditure as a share of GDP for 2015 and 2016 is sourced from NATO (2016). 3 Based on Eurostat data for the Gini coefficient in 2015 (latest available as of May 2017). 1 significant economic costs on the economy. This “excess burden” of taxation is the economic cost of taxation. Such economic distortions entail costs over and above the income that individuals and firms pay in taxation. It is also important who actually bears the economic costs of taxation—commonly referred to as the ‘incidence’ of a tax. Here it is important to look at tax neutrality—the degree to which taxes favor one type of economic activity over another and the distribution of the economic incidence. The tax system entails distributional choices and one of the objectives of the review is to look at options to improve the equity of the system. Here both vertical equity, i.e. taxing less those of lower income, and horizontal equity, i.e. taxing the same those in economically similar situations, are of importance. Governments are inevitably confronted with an equity-efficiency trade-off: higher taxes on the richer parts of the population—to raise revenue and to finance benefits for poorer groups—can distort the economic incentives for work, entrepreneurship, saving and risk-taking of middle- and higher-income individuals. At the same time, redistribution to low-income individuals, through tax credits or benefits, could weaken labor supply incentives. On the other hand, fairness, or equity is an important consideration for widespread acceptance and sustainability of the tax system. To reduce economic distortions created by the current tax system, increase equity and meet increased revenue goals, the following features of the current tax system of Latvia are important to address in a medium-term tax strategy: Restore tax neutrality across firm types and economic activity. The most pressing need is to rebalance tax treatment across enterprises. There are large incentives for firms to remain small in terms of turnover and the number of employees due to the microenterprise taxation regime. Depending on their legal form, size or production mix, firms face different possibilities to benefit from tax relief, allowances, exemptions and deductions. The lack of neutrality contributes to economic efficiency losses (e.g. small firms in Latvia have
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