Tax changes and motivating banks to increase lending amounts will improve Latvia's competitiveness on foreign markets - Valainis

RIGA - Tax changes and motivating banks to increase their lending amounts will improve Latvia's competitiveness on foreign markets, according to a statement by Economics Minister Viktors Valainis (Greens/Farmers), posted on the ministry's website.

The minister points out that political discussions on next year's state budget and potential tax changes are under way and, as usual, a political struggle is expected over financing of many different state budget programs.

"However, as an economics minister, I would like to show you the overall picture based on Latvia's economic competitiveness," says Valainis.

The Economics Ministry has developed an ambitious economic growth strategy for Latvia, which aims to double the country's economy by 2035. This requires an annual gross domestic product growth of 4 percent to 5 percent.

Valainis points out that the state budget and taxes are the main instruments at the disposal of the government and the parliament to accelerate economic development. Experts believe that an increase in investment and exports will be of key importance in this process.

To achieve this, there are two main options in the context of tax changes: reducing the tax burden on labor and increasing the availability of financing for the development of the Latvian economy. At the same time, there are a number of other important objectives - programs co-financed by the EU, attracting foreign investment, development of human capital, cutting red tape.

The minister points out that several studies, including those carried out by the OECD and the European Commission, show that Latvia has a relatively high tax burden on labor, especially when compared to our closest EU neighbors, and especially in the low- and medium-wage segment. This creates two major problems: Latvian companies are less competitive than companies in Lithuania and Estonia, and Latvian employees receive lower net wages. This further affects availability of quality professionals, productivity and exports.

For Latvian society as a whole, the current situation means higher inequality and lower incomes as small and medium-wage earners have to carry a proportionally heavier tax burden, says Valainis.

He points out that around 80 percent of employees in Latvia receive a gross salary of up to EUR 2,000 per month, and it is in this wage segment that Latvia has proportionately much higher labor taxes as compared to Lithuania and Estonia. For example, the labor tax burden on net income of EUR 1,000 per month is 41 percent in Latvia, 36 percent in Lithuania and 33 percent in Estonia.

Therefore it is necessary to think of ways to reduce the labor tax burden and bring Latvia closer to the level of net wages in Estonia and Lithuania, explains Valainis.

This would benefit Latvian exporters, whose competitiveness on foreign markets would increase. Export growth is the most important element in the country's ability to achieve its economic growth targets. Reducing labor taxes would also be an important step toward reducing the informal economy, says Valainis.

"There may be different ways to achieve this - discussions are still ongoing, but it is clear that reducing the tax burden should be assessed in the context of next year's state budget," says Valainis.

According to the minister, by introducing various compensatory mechanisms, it is also possible to ensure that the state budget does not suffer from the reduction in labor taxes, and the fiscal impact of lower labor taxes would even be positive.

One of these potential compensatory mechanisms could theoretically be a tax on extraordinary profits earned by commercial banks, believes the minister.

Valainis stresses that the aim in this case is to get banks more involved in lending to the economy, rather than to increase the Treasury's revenue.

The current policies of the banks do not contribute to economic growth. Latvia has the lowest level of lending in the Baltic countries. Valainis points out that in 2014, the total amount of outstanding loans issued in Latvia was EUR 14.62 billion, and in 2023 - EUR 14.76 billion. In Estonia, the lending amount rose from EUR 15 billion to EUR 27.33 billion, and in Lithuania from EUR 15.16 billion to EUR 27.87 billion.

Despite the low lending activity, bank profitability in Latvia has been the highest in the euro area. Last year, commercial banks in Latvia earned a total of EUR 570.5 million.

"It is clear that the European Central Bank's high interest rate policy has helped banks make unusually high profits in recent years," says Valainis.

At the same time, there are stark differences between Latvia and the other Baltic countries in terms of housing loans. At the end of last year, Latvia had outstanding loans of EUR 5.77 billion, Estonia - EUR 12.17 billion and Lithuania - EUR 14.4 billion, with around half of Latvia's housing loans underwritten by the state.

"We have been in negotiations with representatives of Latvian commercial banks for a long time on their voluntary participation in a significantly more active lending to the economy and the population," says the minister.

He points out that profits of commercial banks in the first six months of this year were still very high at EUR 286 million, while outstanding loans issued to residents increased by only 3.7 percent compared to the first six months of last year.

This rate of growth is far too low. Valainis argues that commercial banks need to find incentive mechanisms to shift from the current safe profits model, based on the European Central Bank's high interest rate policy, to a slightly riskier model that involves more active involvement in financing the Latvian economy.

According to the Economics Ministry, the amount of outstanding loans of commercial banks should grow by at least 8 percent to 10 percent annually. "And we are ready to introduce an individual approach - if the volume of loans issued by a particular commercial bank grows by a certain percentage, it would not have to pay the super-profit tax (the rate of which would still have to be determined)," says Valainis.

The minister says that tax changes and more active lending to the Latvian economy and population are just two sets of measures to boost the country's economic growth, and they are to be implemented in the near future - within the framework of next year's state budget and draft laws.

"The details of the pending measures may still change in the course of the discussions, but I will stand up for these proposals with all my strength," emphasizes Valainis.