Latvia’s Ministry of Finance requestedthe World Bank to collaborate on a review of the country’stax system as input for the design a medium-term taxstrategy. The motivation behind the tax review is to findoptions to increase tax revenues by three percentage pointsof GDP to reach a target tax-to-GDP ratio of 33 percent inthe medium term.1 In Latvia, tax revenues are lower thanpredicted for its income level and institutionaldevelopment. Latvia’s tax policy needs to be restructured tosupport economic development and raise living standards. Thespeed of convergence in Latvia to average income levels inthe European Union (EU) was impressive until the 2008-2009crisis, but since then output recovery has been fast but notrapid enough for real GDP to return to pre-crisis level. Acritical challenge then is to boost productivity growth inthe economy: the level of productivity is low relative toOECD economies and its growth has slowed notably since thecrisis. Increasing labor productivity is particularlyimportant if overall productivity is to rise: informalityand inactivity reduce both labor activity and productivity.Increased investment in skills and good health are animportant part of the labor productivity and participationstory—particularly as Latvia rapidly ages. But reducing thereliance of the tax system on low-skilled labor is also akey policy challenge. Latvia’s tax system puts substantiallymore of a burden on labor compared to capital orconsumption. This is all the more concerning given thatwages for much of the population are low and so the currentflat income tax structure has implications for socialinclusion and poverty. Inequality of (after-tax) disposableincome in Latvia is one of the highest in the EU, with onlyBulgaria, Romania and Lithuania having higher inequality.The tax system entails distributional choices and one of theobjectives of the review is to look at options to improvethe 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 similarsituations, are of importance. Governments are inevitablyconfronted with an equity-efficiency trade-off: higher taxeson the richer parts of the population, to raise revenue andto finance benefits for poorer groups, can distort theeconomic incentives for work, entrepreneurship, saving andrisk-taking of middle- and higher-income individuals. At thesame time, redistribution to low-income individuals, throughtax credits or benefits, could weaken labor supplyincentives. On the other hand, fairness, or equity is animportant consideration for widespread acceptance andsustainability of the tax system.
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