Latvia fears losing investors

RIGA - As Latvian leaders worry about a growing budget deficit and the government wrestles with controversial pension reform, Estonia has given its southern neighbor yet another reason to fear for its economic well-being.

A decision by the government in Tallinn to abolish corporate income tax has some in Latvia worrying that future investors in the Baltic region will automatically set up shop in the north in order to reap the benefits that come with lower costs.

Doing away with the 26 percent corporate income tax in Estonia was one of the ruling coalition's pre-election promises. Prime Minister Mart Laar pushed ahead with the plan in hopes that it would inject new life into what has become a stagnant Estonian economy.

A similar decision was made by the government in the Czech Republic in 1997, when corporate income tax was abolished for companies who had invested more than $10 million into the local economy.

The relative merits and drawbacks of the move are still being debated in Tallinn, but in Latvia, the impact could be a continual decline in foreign investment.

"We have to assume that if an investor looks at Latvia and looks at Estonia, he's going to choose Estonia," said Haralds Burkovskis, a spokesman for Unibanka, Latvia's largest bank. "I don't know any investor who would choose to pay higher taxes."

Latvia's corporate income tax rate is 25 percent. So far, there's little evidence that this has dissuaded foreign investors from entering the Latvian market. Though the Economic Affairs Ministry reported that direct foreign investment declined in 1998, this was largely attributed to lingering effects of the Russian financial crisis and less investor confidence in Eastern markets in the wake of last summer's ruble devaluation.

The major investments in 1998 were made in Latvia's financial sector, with two Scandinavian banks - Skandinaviska Enskilda Banken and Merita Nordbanken - buying large stakes in Unibanka and the Latvian Investment Bank respectively.

But until now, investing in Estonia or Latvia was essentially a toss up; both had corporate income tax and, if anything, Latvia had the edge on its northern neighbor in terms of geographical location, ports and access to Russia, said Andris Liepins, director of the investment department at the Latvian Development Agency.

Now, the playing field is no longer level. J.C. Cole, president of the American Chamber of Commerce in Latvia, called Estonia's decision "a brilliant move that will make Estonia much more attractive to the foreign investor.

"This sends a clear message to investors that Estonia is a place for investment," Cole said. "It's time for Latvia to stop arguing with itself and make a place for foreign investors. If I had to pick one of the three Baltic states to invest in, Estonia is the first place I would go and look."

Of course, following in Estonia's footsteps is an unlikely route for Latvia to take at this point. The International Monetary Fund has already admonished the country for its fiscal budget deficit, which at 3.5 percent of GDP, is well above the 1 percent maximum the IMF recommends. Losing corporate income tax revenue would further complicate a budget that is already overextended; the government trimmed 64.4 million lats ($111 million) in August. Even in Estonia, there is no consensus yet on how the gap left by the loss of tax revenue will be filled.

"There are discussions going on [about corporate income tax], but on the other side, you have the budget deficit," said Henriks Silenieks, director of economic policy for the Latvian Chamber of Commerce.

Not everyone is convinced that Latvia will now play second fiddle to its northern neighbor. Liepins, of the Latvian Development Agency, said the government should worry less about corporate income tax and more about decreasing the operating costs of investors and eliminating bureaucratic barriers: border crossings should be simplified, business and residential visas should be easier to obtain, other taxes - specifically the real estate tax - should be reduced.

The LDA, he said, is focusing its efforts on what he calls "packages for investors."

"We're arguing that the government should provide programs that improve the infrastructure, train potential employees," Liepins said.

Investors tend to agree. If there is no corporate income tax relief, Cole said the government should nonetheless start sending clear messages to its investors by at least taking aim at the real estate tax.

"Right now, if I invest 2 million lats, I pay a 2 percent property tax, which is already quite high," Cole said. "If I invest 4 million lats, I may pay 4 percent.

"It's the choice of the Latvians. If they want to be competitive and attract direct foreign investment, they'll do something about the tax structure."

Added Burkovskis, of Unibanka, "I hope that we can start looking at long term development, not just at the problems in the budget right now. Estonia's doing that. They may lose in the budget now, but there will be more investment in the long term."