RIGA - Prime Minister Aigars Kalvitis was forced to weigh in on a Finance Ministry idea to raise Latvia's VAT rate from 18 to 20 percent, saying it was a rash idea that would only further fuel the country's runaway inflation. News that the government was contemplating raising the value-added tax by two percentage points hit the business and financial community like a bomb. Almost unanimously, analysts said any such move would spark more inflationary troubles for the Baltic state, which already has one of the highest levels of inflation in the European Union.
"My opinion about raising VAT is very negative, since it would not be right to push the high inflation further by increasing taxes," Kalvitis said in an interview.
He said that the government must consider all options, but for now the Cabinet of Ministers has not included any tax increases in the 2008 budget. "It is only an idea that the Finance Ministry is assessing, and it is only normal that such debates are taking place while the budget is being planned," he said.
Still, Finance Ministry officials seemed to be inspired by Germany, which at the beginning of the year increased its VAT rate from 16 to 19 percent so that the government could decrease taxes in other areas that would stimulate economic growth, such as labor costs. Though it is far too early to assess results, the 3 percent hike has so far stifled consumer confidence in Europe's largest economy.
Latvian Finance Ministry officials said any increase in VAT would be accompanied by a reduction in VAT on certain goods, such as basic foodstuffs 's e.g., bread, potatoes, milk and eggs. This would be welcome news for many low-income families who find it increasingly difficult to keep up with rising food prices in Latvia.
Finance Minister Oskars Spurdzins, citing the German model, said that an increase in VAT would in the long-term curb inflation while in the short-term satisfy ministries' "insatiable" appetite for budget funds.
Still, the proposal raises profound questions about the government's priorities at a time when inflation 's which was 8.5 percent year-on-year at the end of March 's is taking its toll on Latvia's economy, the fastest growing in the EU.
Also, blindly adopting the German experiment before the results are clear is also a dubious approach to macroeconomic policy.
Latvia's economy underwent an enormous psychological attack in March when international analysts and traders voiced concern about the stability of the national currency 's the lat 's in an environment of high inflation, a massive current account deficit and a yawning labor deficit. The word "devaluation" echoed throughout Europe, and Latvian ministers and central bank officials had to scramble to downplay the fears. The Bank of Latvia was forced to intervene on the forex market more often than usual.
Any rise in the VAT will immediately impact inflation, analysts said, and that, in turn, will continue to put pressure on the lat, which is currently pegged to the euro. If the government doesn't tackle inflation, the lat will continue to be vulnerable and the temptation to devalue the currency may become too great to resist.
"Raising budget revenues by increasing VAT, which means an increase in consumer prices, is absolutely wrong," Henrik Danusevics, head of the Latvian Traders' Association, told the Bizness & Baltija paper. "If the government has large expenditures that it can't cope with, then it should limit its costs and not increase the tax burden on the population."
Danusevics said that a 2-percent increase in VAT could result in as much as a half-percentage point in the level of inflation.
But Latvian ministers, under great pressure to balance the budget as part of its inflation-busting plan, may still support the VAT-hike. On May 2 the government approved a mid-term budget plan for 2008 - 2010, according to which there will be a 0.3 percent surplus in 2010, or 59.5 million lats (84.7 million euros).
Next year budget revenues will reach 5 billion lats, or 19 percent more than 2007, while expenditures will decline 2 percent to 4.3 billion lats. In all, 2008 revenues are expected to comprise 32.5 percent of GDP.
In May 2004, Latvia introduced a reduced VAT of 5 percent on so-called socially sensitive items such as medicine, books, newspapers, hotel service and public transportation.
Previously, former Economy Minister Krisjanis Karins proposed reducing VAT on most foodstuffs to 5 percent since prices of food have been outpacing inflation in recent years by several percentage points and therefore playing a large part in contributing to Latvia's rapid inflation.
However, Prime Minister Kalvitis did not support the measure at the time.