## cr18266 - 9.5 percent, the current account swung into a moderate deficit of 0.8 percent of GDP. Real GDP

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### Recent economic performance and key indicators
- Real GDP growth projected to moderate to 3.7 percent in 2018, driven by continued strong domestic demand.
- Real GDP (Percentage change): 2013: 2.4; 2014: 1.9; 2015: 3.0; 2016: 2.2; 2017: 4.5; 2018: 3.7; 2019: 3.3.
- Nominal GDP (billions of euros): 2013: 22.8; 2014: 23.6; 2015: 24.3; 2016: 24.9; 2017: 26.9; 2018: 28.9; 2019: 30.6.
- GDP per capita (thousands of euros): 2013: 11.3; 2014: 11.8; 2015: 12.2; 2016: 12.7; 2017: 13.8; 2018: 14.9; 2019: 15.8.
- HICP Inflation (Period average): 2013: 0.0; 2014: 0.7; 2015: 0.2; 2016: 0.1; 2017: 2.9; 2018: 2.7; 2019: 2.4.
- Current account balance (Percent of GDP): 2013: -2.7; 2014: -1.7; 2015: -0.5; 2016: 1.4; 2017: -0.8; 2018: -2.4; 2019: -2.6.
- Gross external debt: 2013: 133.9; 2014: 144.1; 2015: 143.6; 2016: 148.8; 2017: 140.8; 2018: 136.6; 2019: 136.8.
- Net external debt: 2013: 36.6; 2014: 33.7; 2015: 29.3; 2016: 28.8; 2017: 24.4; 2018: 30.1; 2019: 31.6.

### Growth drivers and composition
- 2017 growth strong and broad-based, driven by:
  - Domestic demand which tripled from 2.5 percent in 2016 to 7.5 percent in 2017.
  - Private consumption: 2017 growth 5.1 percent; projections 2018: 4.3 percent; 2019: 3.5 percent.
  - Investment recovery on accelerated absorption of EU funds and private sector projects.
  - Sectoral notes: construction growth peaked to over 19 percent in 2017; financial and insurance services declined by 17 percent in the same period; manufacturing and retail trade growth picked up.
- EU structural funds allocation for 2014–20: €5.63 billion (including €1.16 billion for infrastructure, €782 million for environment protection, €764 million in support of SMEs).

### Fiscal developments and stance
- 2017 general government outcomes:
  - Budget deficit: 0.5 percent of GDP (cash basis).
  - General government structural balance (ESA definition): deficit of 0.8 percent of GDP.
  - Structural deficit produced a positive fiscal impulse, rendering fiscal policy procyclical.
- Consolidated general government (Percent of GDP):
  - Total revenue: 2017: 35.8; 2018: 36.6; 2019: 36.0.
  - Total expenditure: 2017: 36.7; 2018: 37.8; 2019: 37.0.
  - Basic fiscal balance: 2017: -0.8; 2018: -1.2; 2019: -1.0.
  - ESA balance: 2017: -0.5; 2018: -0.9; 2019: -1.0.
  - General government gross debt: 2017: 36.3; 2018: 35.0; 2019: 34.2.
- Staff view and fiscal recommendations:
  - Fiscal policy has become procyclical due to accelerated EU investment fund inflows and tax reform.
  - Authorities should use favorable conditions to mitigate overheating risks and build fiscal buffers.
  - Increase revenue mobilization to mitigate upfront cost of tax reform.
  - Reallocate spending toward better targeted social protection programs and productive investments.

### Labor market, wages, and inflation
- Labor market:
  - Unemployment rate (LFS; period average, percent): 2017: 8.7; 2018: 8.2; 2019: 8.1.
  - Employment flat since crisis; labor force participation rate increased to an all-time high.
  - Job vacancy rate approaching pre-crisis peak; labor shortages increasing in industry, construction, and service sectors.
  - Demographic headwinds: shrinking labor force and emigration.
- Wages:
  - Nominal gross wages rose by 7.8 percent in 2017.
  - Private sector wages grew at 8.3 percent in 2017; about 1 percentage point higher than public sector wage growth.
- Inflation:
  - Average headline inflation reached 2.9 percent in 2017.
  - Energy and food price inflation contributed about 0.6 and 0.5 percentage points respectively to 2017 inflation.
  - Average core inflation has approached 2 percent as wages pressured service prices.
  - Minimum wage increase: 13 percent; inflation expected to peak at over 3 percent in mid-2018 and remain above 2 percent over the medium term.

### External sector and competitiveness
- Trade and current account:
  - Imports of goods and services growth: 2017: 9.5 percent; projections 2018: 7.1 percent; 2019: 4.5 percent.
  - Exports of goods and services growth: 2017: 4.8 percent; 2018: 3.2 percent; 2019: 3.1 percent.
  - Trade balance (Percent of GDP): 2017: -9.7; 2018: -10.9; 2019: -11.1.
  - Current account swung into a moderate deficit of 0.8 percent of GDP in 2017.
- Competitiveness:
  - Wage growth drove unit labor costs (ULCs) to pre-crisis highs; export shares in neighboring markets have started weakening.
  - Goods and services export volumes expanded by 4.8 percent in 2017; world export shares edged up.
  - External sector position assessed stronger than implied by medium-term fundamentals; EU fund inflows and improved terms of trade contributed about 0.4 percentage points to the lower current account deficit.
  - Latvia’s policy gap is about 1.5 percent, reflecting the average accommodative fiscal stance of the rest of the world.

### Financial sector stability and risks
- Banking soundness and the ABLV episode:
  - In February 2018, US Treasury financial intelligence unit proposed blacklisting ABLV Bank.
  - As ABLV’s liquidity deteriorated, the ECB determined the bank was failing or likely to fail.
  - Suspension of ABLV’s activities put pressure on non-resident deposits, which declined by more than a third.
  - Banking system resilience at end-March 2018:
    - Capital-to-risk-weighted assets: 22.4 percent.
    - Liquid assets exceeding 80 percent of short-term liabilities.
- Credit and deleveraging:
  - Deleveraging continued for households and NFCs.
  - Household debt to income now at half of its pre-crisis levels.
  - Corporate debt to GDP down by more than a quarter from its peak in 2010.
  - Credit to private sector (annual percentage change): 2017: 1.2 percent; earlier years: -6.6 (2013), -7.4 (2014), -2.3 (2015), 3.5 (2016).
- Reputational and AML/CFT risks:
  - Money laundering allegations involving banks servicing foreign clients (BSFCs) have damaged credibility.
  - Of 21 banks operating at end-2017, about half are actively engaged in domestic activity; the rest tailored toward non-resident business.
  - 50 percent outflow of non-resident deposits since end-2015; BSFCs have not sufficiently refocused business models.
  - Corruption allegations against the Bank of Latvia’s governor and his suspension raised concerns about central bank independence.
- Staff and Directors’ concerns and recommendations:
  - Strengthen enforcement of AML/CFT regulations, mitigate risks from non-resident deposits and opaque companies.
  - Improve regulatory tools to liquidate banks deemed to be failing or likely to fail.
  - Over the medium term, make the financial system more supportive of investment and address insolvency framework and shadow economy risks.

### Policy challenges, outlook, and risks
- Short-term challenges:
  - Prevent further inflationary pressures and competitiveness risks due to rapid wage growth and EU investment fund flows.
  - Address risks related to banks servicing nonresidents and AML/CFT enforcement gaps.
- Medium- and long-term challenges:
  - Demographic headwinds and weak credit growth constrain investment, productivity, and long-term income convergence.
  - Need to revive domestic credit to support investment and tackle supply and demand constraints (insolvency regime, shadow economy).
- Outlook:
  - Growth momentum expected to moderate: Real GDP 2018 projection 3.7 percent; 2019 projection 3.3 percent.
  - Positive output gap: 1.2 percent of GDP.
  - Medium-term convergence to potential rate: 3 percent.
  - Risks tilted to the downside, especially domestically.
  - Downsizing of BSFC activity projected to weigh on growth by about ½ percentage point of GDP in 2018.
- Risk highlights (from RAM):
  - Retreat from cross-border integration: Likelihood Medium; Impact High.
  - Structurally weak growth in key advanced and emerging economies: Likelihood High; Impact High.
  - Tighter global financial conditions and retreat in Nordic mortgage market: Likelihood High/Medium; Impact Medium.
  - AML enforcement delays and BSFC sector adjustments: Likelihood High/Medium; Impact High/Medium.
  - Failure to advance structural reforms and fiscal pro-cyclicality: Likelihood Medium; Impact High.

### Staff and Executive Board recommendations (macro, fiscal, financial)
- Macro-structural policies:
  - Ease labor market constraints and improve productivity: support labor market participation, reduce structural unemployment, raise labor productivity.
  - Skill-matching and skill-building policies, better access to housing, revisit minimum wage structure, improve labor participation of targeted groups, encourage appropriate labor immigration.
- Fiscal policy:
  - Undertake upfront consolidation to offset current procyclicality of fiscal policy.
  - Use favorable macroeconomic conditions to mitigate overheating risks and build fiscal buffers.
  - Increase revenue mobilization to mitigate the upfront cost of ongoing tax reform.
  - Reallocate spending toward better targeted social protection programs and productive investments.
- Financial sector and AML/CFT:
  - Strengthen enforcement of AML/CFT regulations and enhance regulatory tools.
  - Swiftly refocus the business model of banks servicing nonresidents to minimize financial sector stability risks.
  - Address insolvency framework and shadow economy constraints to support credit growth and investment.

### Tax reform: expected effects and scenarios
- PIT and CIT changes:
  - PIT: move from flat to progressive PIT schedule; gradually increase—and make more progressive—the non-taxable income threshold; increase child allowances; increase social security contribution (SSC) rates by 1 percent (to be used to increase financing for the healthcare reform).
  - CIT: change from gross to distributed profit taxation; increase the tax rate from 15 to 20 percent.
- PIT specifics:
  - New PIT rates: up to €20,004 per year taxed at 20 percent; incomes up to €55,000 taxed at 23 percent; higher incomes taxed at 31.5 percent.
  - Estimated post-reform tax wedge declines to below 40 percent.
  - Distributional note: largest impact expected for low-wage earners, especially those with families; workers who already have very low wages and do not pay income taxes will be worse off due to the SSC rate increase.
- Staff simulations and growth impact:
  - Under a favorable scenario where corporates fully invest additional income from the CIT reform, combined PIT and CIT reforms could increase real GDP by about 1.5 percent over the medium term.
  - Financing modality matters: deficit financing yields a large positive upfront impact that dissipates quickly; a budget-neutral option delivers the largest long-term benefits.
- Fiscal cost:
  - PIT could be permanently lower by up to 1 percent of GDP on average.
  - CIT revenues will have an even larger impact—by about half for the first two years of implementation and gradually converge to below pre-reform levels.
- Policy implication:
  - Without further reforms to identify stable revenue sources, the government tax revenue ratio will be permanently lower.
  - Revenue-balancing measures recommended to prevent further constraining fiscal space.

### Reallocating spending to improve growth and equality
- Investment:
  - Staff estimate: a permanent increase in capital expenditure of 0.5 percent of GDP per year—upon the deceleration of EU-funded investment—financed by a reduction in government consumption, could gradually add about 0.7 percentage points to cumulative real GDP growth over the medium term.
- Health and education:
  - Streamline institutions with high teacher-student ratios and reallocate resources to fewer institutions to improve education quality.
- Social protection:
  - Rely more on properly designed means-tested (MT) programs; strengthen the guaranteed minimum income and social housing programs.
  - Latvia spends significantly less than other EU countries on social protection, especially on MT programs.

### Revenues, tax administration, and fiscal space
- Growth-friendly revenue options:
  - Raise property revenues; Latvia has low intake from property taxes compared to EU peers.
  - Reduce VAT tax expenditures by simplifying the VAT rate structure.
  - Reduce VAT noncompliance by strengthening the tax administration.
- Authorities committed to strengthening revenue administration and reforming the property tax.

### Restoring credit growth and financial intermediation
- Credit constraints:
  - Supply side: tight lending standards, weak borrower collateral and equity, lengthy insolvency procedures, shadow economy.
  - Demand side: nearly three-quarters of SMEs report no need for credit.
- Non-bank financing:
  - NBFS assets in 2016: 42 percent of GDP (euro area average: 367 percent).
  - Ratio of non-bank loans to bank loans rose to 20 percent (2013: 10 percent).
  - Non-bank credit to households rose sharply after 2016 regulatory changes but remains at only 2 percent of GDP.
- Recommended reforms:
  - Complete insolvency regime reform to shorten procedures and improve recovery rates.
  - Encourage formalization of the economy and voluntary disclosure by improving trust in institutions and strengthening tax administration, FIU, and the Corruption Prevention and Combating Bureau.
  - Roll out instruments to support credit (financial and non-financial support for startups) and pursue regional cooperation to develop capital markets.

### Shadow economy and credit access
- Size and implications:
  - Shadow economy estimated at more than 20 percent of GDP.
  - Underreported wages ("envelope" wages) and underreported corporate profits widespread.
  - Informal activity linked to low trust in government.
  - Policy implication: boosting credit growth requires reforms to encourage formalization.

### Public and external debt, and fiscal position (selected figures)
- Nominal gross public debt (in percent of GDP) as of April 07, 2017 — 2016: 30.5; 2017: 37.4; 2018: 36.3; 2019: 35.1; 2020: 34.1; 2021: 32.9; 2022: 31.9; 2023: 30.9; 2023 (final listed): 29.9.
- Public gross financing needs (in percent of GDP): 2016: 3.1; 2017: 0.5; 2018: 5.7; 2019: 5.6; 2020: 5.4; 2021: 3.8; 2022: 2.8; 2023: 1.6.
- Real GDP growth (in percent) projections (selection): 2016: 0.6; 2017: 2.2; 2018: 4.5; 2019: 3.7; 2020: 3.3; 2021: 3.1; 2022: 3.0; 2023: 3.0.
- Inflation (GDP deflator, in percent) projections (selection): 2016: 3.9; 2017: 0.3; 2018: 3.0; 2019: 3.5; 2020: 2.7; 2021: 2.5; 2022: 2.4; 2023: 2.2.
- Effective interest rate (in percent): 2016: 4.8; 2017: 3.6; 2018: 3.2; 2019: 2.8; 2020: 2.8; 2021: 3.0; 2022: 2.9; 2023: 2.8.
- Cumulative change in gross public sector debt (2016–2023): -6.4 (percent of GDP).

### Annex I. External Sector Assessment — key diagnostics
- NIIP: around -56 percent of GDP by end 2017 (end-2016: -58 percent); projected to decline to about -48 percent of GDP over the medium term.
- Gross assets: 133 percent of GDP in 2017.
- Gross liabilities: 189 percent of GDP in 2017.
- Debt securities comprised 24 percent of liabilities.
- Net external debt: 24 percent of GDP at end-2017.
- EBA-lite CA model results:
  - CA-Actual: -0.8%
  - CA-Norm: -3.3%
  - CA-Gap: 2.5%
  - o/w Policy gap: 1.5%
  - Elasticity: -0.45
  - Implied REER Gap: -5.6%
  - CA-Fitted: -1.9%
  - Residual: 1.1%
  - ln(REER)-Actual: 4.61
  - ln(REER)-Norm: 4.62
  - REER-Gap: -0.8%
  - o/w policy gap: -0.8%
- REER appreciated by about 0.8 percent between 2016 and 2017.
- FDI inflows: 3.7 percent of GDP in 2017.
- Overall assessment: external position in 2017 assessed stronger than implied by medium-term fundamentals and desirable policies; current account expected to widen from 2018 onwards.

### Staff appraisal: macro outlook and policy guidance
- Binding constraints: shrinking labor force, labor market tightness, rising wages eroding competitiveness, labor force aging likely to dampen productivity, weak credit growth limiting investment.
- Policy mix recommendations:
  - Calibrate policies to mitigate overheating and keep economy on sustainable growth path.
  - Reforms to ease labor market constraints and encourage labor immigration where appropriate.
  - Productivity-enhancing reforms critical to face demographic headwinds.
  - Reverse procyclical fiscal policies, build fiscal buffers, implement upfront consolidation.
  - Reallocate government spending toward productive investment as EU structural funds decelerate.
  - Improve efficiency of health and education spending and better-target social protection.
  - Reform insolvency framework and reduce the shadow economy.
  - Restore reputation of financial system via effective AML/CFT enforcement, changes in banking legislation, EU harmonization for liquidation tools, and more vigilant fit-and-proper rules.

*International Monetary Fund (IMF) staff report for the 2018 Article IV consultation on the Republic of Latvia.*

### 9.5 percent, the current account swung into a moderate deficit of 0.8 percent of GDP. Real GDP

### cr18266 - 9.5 percent, the current account swung into a moderate deficit of 0.8 percent of GDP. Real GDP

### Recent economic performance and key indicators
- Real GDP growth is projected to moderate to 3.7 percent in 2018, driven by continued strong domestic demand.
- Real GDP (Percentage change): 2013: 2.4; 2014: 1.9; 2015: 3.0; 2016: 2.2; 2017: 4.5; 2018: 3.7; 2019: 3.3.
- Nominal GDP (billions of euros): 2013: 22.8; 2014: 23.6; 2015: 24.3; 2016: 24.9; 2017: 26.9; 2018: 28.9; 2019: 30.6.
- GDP per capita (thousands of euros): 2013: 11.3; 2014: 11.8; 2015: 12.2; 2016: 12.7; 2017: 13.8; 2018: 14.9; 2019: 15.8.
- HICP Inflation (Period average): 2013: 0.0; 2014: 0.7; 2015: 0.2; 2016: 0.1; 2017: 2.9; 2018: 2.7; 2019: 2.4.
- Current account balance (Percent of GDP): 2013: -2.7; 2014: -1.7; 2015: -0.5; 2016: 1.4; 2017: -0.8; 2018: -2.4; 2019: -2.6.
- Gross external debt: 2013: 133.9; 2014: 144.1; 2015: 143.6; 2016: 148.8; 2017: 140.8; 2018: 136.6; 2019: 136.8.
- Net external debt: 2013: 36.6; 2014: 33.7; 2015: 29.3; 2016: 28.8; 2017: 24.4; 2018: 30.1; 2019: 31.6.

### Growth drivers and composition
- 2017 growth was strong and broad-based, driven by:
  - Domestic demand which tripled from 2.5 percent in 2016 to 7.5 percent in 2017.
  - Private consumption: 2017 growth 5.1 percent; projections 2018: 4.3 percent; 2019: 3.5 percent.
  - Investment recovery on accelerated absorption of EU funds and private sector projects.
  - Sectoral notes: construction growth peaked to over 19 percent in 2017; financial and insurance services declined by 17 percent in the same period; manufacturing and retail trade growth picked up.
- EU structural funds allocation for 2014–20: €5.63 billion (including €1.16 billion for infrastructure, €782 million for environment protection, €764 million in support of SMEs).

### Fiscal developments and stance
- Government revenues overperformed in 2017, buoyed by strong economic activity and wage growth.
- 2017 general government outcomes:
  - Budget deficit: 0.5 percent of GDP (cash basis).
  - General government structural balance (ESA definition): deficit of 0.8 percent of GDP.
  - The structural deficit resulted in a positive fiscal impulse, rendering fiscal policy procyclical.
- Consolidated general government (Percent of GDP):
  - Total revenue: 2017: 35.8; 2018: 36.6; 2019: 36.0.
  - Total expenditure: 2017: 36.7; 2018: 37.8; 2019: 37.0.
  - Basic fiscal balance: 2017: -0.8; 2018: -1.2; 2019: -1.0.
  - ESA balance: 2017: -0.5; 2018: -0.9; 2019: -1.0.
  - General government gross debt: 2017: 36.3; 2018: 35.0; 2019: 34.2.
- Staff view: fiscal policy has become procyclical due to accelerated EU investment fund inflows and tax reform; authorities should use favorable conditions to mitigate overheating risks and build fiscal buffers, increase revenue mobilization to mitigate upfront cost of tax reform, and reallocate spending toward better targeted social protection programs and productive investments.

### Labor market, wages, and inflation
- Labor market:
  - Unemployment rate (LFS; period average, percent): 2017: 8.7; 2018: 8.2; 2019: 8.1.
  - Employment has remained flat since the crisis; labor force participation rate increased to an all-time high.
  - Job vacancy rate approaching pre-crisis peak; labor shortages increasing in industry, construction, and service sectors.
  - Demographic headwinds: shrinking labor force and emigration.
- Wages:
  - Nominal gross wages rose by 7.8 percent in 2017.
  - Private sector wages grew at 8.3 percent in 2017; about 1 percentage point higher than public sector wage growth.
- Inflation:
  - Average headline inflation reached 2.9 percent in 2017.
  - Energy and food price inflation contributed about 0.6 and 0.5 percentage points respectively to 2017 inflation.
  - Average core inflation has approached 2 percent as wages pressured service prices.

### External sector and competitiveness
- Trade and current account:
  - Imports of goods and services growth: 2017: 9.5 percent; projections 2018: 7.1 percent; 2019: 4.5 percent.
  - Exports of goods and services growth: 2017: 4.8 percent; 2018: 3.2 percent; 2019: 3.1 percent.
  - Trade balance (Percent of GDP): 2017: -9.7; 2018: -10.9; 2019: -11.1.
  - Current account swung into a moderate deficit of 0.8 percent of GDP in 2017.
- Competitiveness:
  - Wage growth drove unit labor costs (ULCs) to pre-crisis highs; export shares in neighboring markets have started weakening.
  - Goods and services export volumes expanded by 4.8 percent in 2017; world export shares edged up.
  - The external sector position is assessed to be stronger than implied by medium-term fundamentals, with EU fund inflows and improved terms of trade contributing about 0.4 percentage points to the lower current account deficit.
  - Latvia’s policy gap is about 1.5 percent, reflecting the average accommodative fiscal stance of the rest of the world.

### Financial sector stability and risks
- Banking soundness:
  - Despite suspension of activities of Latvia’s third largest bank on money laundering concerns, the banking system remains well capitalized and liquid.
  - Capital-to-risk-weighted assets: 22.4 percent at end-March 2018.
  - Liquid assets exceeding 80 percent of short-term liabilities at end-March 2018.
- Credit and deleveraging:
  - Deleveraging continued for households and nonfinancial corporations (NFCs).
  - Household debt to income now at half of its pre-crisis levels.
  - Corporate debt to GDP down by more than a quarter from its peak in 2010.
  - Credit to private sector (annual percentage change): 2017: 1.2 percent; earlier years: -6.6 (2013), -7.4 (2014), -2.3 (2015), 3.5 (2016).
- Reputational and AML/CFT risks:
  - Money laundering allegations involving banks servicing foreign clients (BSFCs) have damaged credibility.
  - Of 21 banks operating at end-2017, about half are actively engaged in domestic activity; the rest are tailored toward non-resident business.
  - There has been a 50 percent outflow of non-resident deposits since end-2015; BSFCs have not sufficiently refocused business models.
  - Corruption allegations against the Bank of Latvia’s governor and his suspension raised concerns about central bank independence.
- Staff and Directors’ concerns:
  - Directors emphasized need to strengthen enforcement of AML/CFT regulations, mitigate risks from non-resident deposits and opaque companies, and improve regulatory tools to liquidate banks deemed to be failing or likely to fail.
  - Over the medium term, the financial system needs to become more supportive of investment; reforms should address risks from the insolvency framework and the shadow economy.

### Policy challenges, outlook, and risks
- Short-term challenges:
  - Prevent further inflationary pressures and risks to competitiveness due to rapid wage growth and EU investment fund flows.
  - Address risks related to banks servicing nonresidents and AML/CFT enforcement gaps.
- Medium- and long-term challenges:
  - Demographic headwinds and weak credit growth constrain investment, productivity, and long-term income convergence.
  - Need to revive domestic credit to support investment and tackle supply and demand constraints (insolvency regime, shadow economy).
- Outlook:
  - Growth momentum expected to moderate: Real GDP 2018 projection 3.7 percent; 2019 projection 3.3 percent.
  - Risks are tilted to the downside, especially on the domestic front.
  - Next Article IV consultation expected on the standard 12-month cycle.

### Staff and Executive Board recommendations
- Macro-structural policies:
  - Focus reforms on easing labor market constraints and improving productivity.
  - Support labor market participation, reduce structural unemployment, raise labor productivity.
  - Reform measures could include skill-matching and skill-building policies, better access to housing, revisiting minimum wage structure, improving labor participation of targeted groups, and encouraging appropriate labor immigration.
- Fiscal policy:
  - Undertake upfront consolidation to offset current procyclicality of fiscal policy.
  - Use favorable macroeconomic conditions to mitigate overheating risks and build fiscal buffers.
  - Increase revenue mobilization to mitigate the upfront cost of ongoing tax reform.
  - Improve growth-friendliness and inclusiveness of fiscal policy by reallocating spending toward better targeted social protection programs and productive investments.
- Financial sector and AML/CFT:
  - Strengthen enforcement of AML/CFT regulations and enhance regulatory tools.
  - Swiftly refocus the business model of banks servicing nonresidents to minimize financial sector stability risks.
  - Address insolvency framework and shadow economy constraints to support credit growth and investment.

_International Monetary Fund (IMF) staff report for the 2018 Article IV consultation on the Republic of Latvia._

### 10.      The financial system remained stable despite pressures from the suspension of

### 10.      The financial system remained stable despite pressures from the suspension of

### Financial stability and ABLV episode
- In February 2018, the US Treasury’s financial intelligence unit proposed blacklisting ABLV Bank—Latvia’s third largest bank—on money laundering concerns.
- As ABLV’s liquidity situation deteriorated rapidly, the ECB subsequently determined that the bank was failing or likely to fail (Annex II).
- The suspension of ABLV’s activities put pressure on non-resident deposits, which declined by more than a third.
- Banking system resilience at end-March, 2018:
  - Capital-to-risk-weighted assets: 22.4 percent
  - Liquid assets: exceeding 80 percent of short-term liabilities

### Credit, lending standards, and non-bank credit
- Deleveraging continued for households and nonfinancial corporations (NFCs):
  - Household debt to income: now at half of its pre-crisis levels
  - Corporate debt to GDP: down by more than a quarter from its peak in 2010
- Credit trends:
  - Decline in credit to households leveled off
  - Credit to NFCs expanded modestly in 2017
  - Lending standards remained tight as banks improve lending portfolio quality
  - Non-performing loans: 4 percent
  - Non-bank credit to households rose sharply after 2016 regulatory changes but remains at only 2 percent of GDP

### Public and external debt, and fiscal position
- Public and external debt have remained stable.
- Low spreads supported by Latvia’s investment-grade credit rating improved refinancing conditions (longer maturities, lower interest costs).
- 2018 budgeted fiscal position: expected deficit of 1 percent of GDP (as tax and healthcare reforms take effect and EU-funded investment peaks).
- Medium-term fiscal consolidation: about 0.6 percent of GDP gradual consolidation expected to ease domestic demand pressures and help close the output gap.
- Staff assessment: achieving the authorities’ ambitious fiscal targets will require frontloaded savings of ½–¾ percent of GDP and raising new permanent revenue of this amount while safeguarding growth-enhancing spending.

### Outlook and risks
- Growth projections:
  - Real GDP growth projected to moderate to 3.7 percent in 2018
  - Positive output gap: 1.2 percent of GDP
  - Medium-term convergence to potential rate: 3 percent
- Sectoral and cyclical drivers:
  - Strong domestic demand supported by EU structural funds and rising wages
  - External demand has weakened
  - Investment growth projected to moderate in second half of 2018
  - Downsizing of BSFC activity projected to weigh on growth by about ½ percentage point of GDP in 2018
- Risks tilted to the downside:
  - Domestic: excessive labor market tightening, deepening fiscal pro-cyclicality, failure to advance structural reforms, failure to enforce AML/CFT regulations, or a failure of the BSFC sector to refocus could undermine confidence and financial stability (Annex II)
  - External: weaker growth in advanced economies, retreat from cross-border integration, abrupt reversal of risk appetite in Europe, tighter global financial conditions, or spillovers from a significant retreat in the Nordic mortgage market via parent bank funding
  - Upside risks: large stimulus to investment from CIT reform; faster-than-projected credit recovery

- Short-term inflation and labor pressures:
  - Minimum wage increase: 13 percent
  - Inflation expected to peak at over 3 percent in mid-2018
  - Inflation projected to remain above 2 percent over the medium term due to catch-up effects relative to the euro area

- Medium-term projection table excerpt (percent change):
  - GDP: 4.5 3.7 3.3 3.0
  - Consumption: 4.9 4.3 3.2 3.2
  - Gross investment: 17.5 13.4 6.5 5.0
  - Exports: 4.8 3.2 3.1 3.0
  - Imports: 9.5 7.1 4.5 4.0

### Labor market constraints and demographic challenges
- Emigration and population loss:
  - Since 1990 Latvia has lost about ¼ of its population, of which about 60 percent was caused by emigration
  - Latvia lost an estimated 1 percentage point of annual growth during 1999–2014 due to emigration and deterioration of skills
- Labor force and participation:
  - Labor force participation at a historical high but below neighbors; low participation for youth (15–24) and older workers
  - Skills mismatches and shortages among the highest in the EU
- Long-term demographic projections and impacts:
  - By 2050:
    - Population projected to decline by one quarter
    - Labor force projected to decline by about 20 percent
    - Share of workers aged 55 years or older rising from about 20 percent in 2015 to 30 percent in 2050
  - Demographic shifts could decrease long-run growth by 1–2 percentage points
  - Growth scenarios:
    - No-aging scenario long-run growth: 3 percent
    - Allowing projected natural population change (2020–50) and aging, but abstracting from projected migration: long-term growth could be lower by about 0.7 percentage points due to projected decline in labor
    - Projected net migration trends could cut an additional 0.3 percentage points
    - Diminishing productivity of the aging workforce could reduce growth through a negative impact on TFP to about 1.1 percent on average in 2020–50
  - Income convergence:
    - No-aging: per-capita income projected to reach almost 60 percent of the EA-19 average by 2050 (about 2.8 times higher than in 2015)
    - Including population decline and migration: income about 2.5 times higher by 2050
    - Including workforce aging impact on productivity: per-capita income about 1.8 times higher by 2050

### Policy discussions and recommended reforms
- Overarching objective: stem overheating risks, use cyclical recovery to deepen reforms addressing medium- and long-term growth risks; focus on labor supply, productivity, and growth-friendly fiscal policies.
- Macro-structural and labor-market policy options:
  - Increase participation in active labor market policies (ALMPs); current participation remains low and spending on ALMPs among the lowest in the EU
  - Continue reforming vocational education and training (VET) and encourage lifelong learning; improve links with employers and expand workplace-based learning
  - Improve access to housing; current rental regulations discourage investment in rental housing and rental dispute resolution is time consuming and costly
  - Employ more foreign workers; current barriers include lack of public health insurance coverage for non-EU workers and integration challenges for non-EU students
  - Revisit the minimum wage structure; consider age-specific and regional-specific minimum wage provisions to avoid pricing low-productivity workers out of formal employment
  - Increase participation rates of targeted groups by raising retirement age, linking it to life expectancy, limiting early retirement, and providing flexible work arrangements for older workers
- Structural reforms to boost TFP and long-term growth:
  - Improve quality of institutions (protection of property rights, legal system upgrades)
  - Increase access to financial services, especially for small productive firms
  - Reduce regulatory burden and red tape; improve corporate governance of state-owned enterprises
  - Foster greater technology diffusion, R&D, and education reforms
  - Fiscal structural reforms to improve tax-system efficiency and reduce resource misallocation
- Authorities’ positions:
  - Authorities broadly agreed with staff’s assessment of outlook and risks
  - Recognized strong positive impact of EU structural funds in 2018 and the dampening effect of BSFC downsizing
  - Expressed concerns about administrative complexity in minimum wage reforms, doubts about effectiveness of work-based training for small firms, skepticism that rental market policies hinder mobility, and political sensitivities to relaxing immigration for non-EU workers
  - Agreed on focus toward productivity-enhancing measures

*International Monetary Fund staff summary of chapter content.*

### 28.      The recently-adopted tax reform should help reduce inequality and enhance growth,

### 28.      The recently-adopted tax reform should help reduce inequality and enhance growth,

### Tax reform: expected effects and scenarios
- The change to the PIT structure is described as "an important initial step to reduce Latvia’s high labor tax wedge and income inequality."
- Changes to the CIT system "could improve corporate balance sheet transparency and investment incentives."
- Medium-term impact depends on success in boosting labor force participation and corporate investment.
- Staff simulations: in a scenario with the most favorable assumptions, in which corporates fully invest additional income provided by the CIT reform, the PIT and CIT reforms could increase real GDP by about 1.5 percent over the medium term.
- Tax revenues will be permanently lower as a result of the reform; the difference between the staff baseline and authorities' projections is due to the difference in assessment of the tax reform cost, which staff assesses as permanent.
- Revenue-balancing measures would prevent further constraining fiscal space (Annex VI).

### Fiscal space, constraints, and near-term priorities
- Room for policy maneuver is constrained by limited flexibility in the budget and lingering uncertainties about revenues.
- Latvia faces spending needs to:
  - advance income convergence with the euro area,
  - reduce existing high levels of poverty and inequality,
  - address spending pressures related to projected adverse demographic trends.
- Fiscal policy mix recommendation: combine more efficient and growth-friendly spending with better revenue mobilization.
- Near-term fiscal priorities: prevent accumulation of imbalances, reverse fiscal procyclicality, build fiscal buffers, and implement upfront consolidation to support authorities’ fiscal objectives.
- Greater revenue mobilization is recommended to mitigate costs of the recent tax reform.

### Reallocating spending to improve growth and equality
- Investment:
  - Latvia has a relatively low capital-output ratio compared with advanced economies; greater investment is needed to support long-term growth.
  - Staff estimate: a permanent increase in capital expenditure of 0.5 percent of GDP per year—upon the deceleration of EU-funded investment—financed by a reduction in government consumption, could gradually add about 0.7 percentage points to cumulative real GDP growth over the medium term.
- Health and education:
  - Efficient healthcare and education spending can directly reduce market income inequality and increase human capital and labor productivity.
  - Suggested savings: streamline institutions with high teacher-student ratios and reallocate resources to fewer institutions to improve education quality.
- Social protection:
  - Latvia spends significantly less than other EU countries on social protection, especially on means-tested (MT) programs.
  - Recommendation: rely more on properly designed MT programs; strengthen the guaranteed minimum income and social housing programs.
  - Further savings and efficiency gains: reduce the size of the wage bill, recalibrate existing safety nets, and improve administrative capacity in program implementation.

### Revenue mobilization and tax administration
- New and stable revenue sources are required to achieve the targeted fiscal path and development goals.
- Limited scope for spending efficiency gains because Latvia is close to the efficiency frontier in many areas.
- Growth-friendly revenue options:
  - Raise property revenues (Latvia has low intake from property taxes compared to EU peers).
  - Reduce VAT tax expenditures by simplifying the VAT rate structure.
  - Reduce VAT noncompliance by strengthening the tax administration.
- Authorities expressed commitment to:
  - strengthening the revenue administration,
  - reforming the property tax as a source of additional permanent revenue,
  - and emphasized structural reforms to boost productivity (healthcare and infrastructure).

### Restoring credit growth and deepening financial intermediation
- Credit growth has been slow due to supply and demand constraints:
  - Supply side: regulatory efforts to repair banks’ balance sheets and macroprudential policies to build capital cushions; tight lending standards due to weak borrower collateral and equity, lengthy insolvency procedures, and the shadow economy.
  - Demand side: nearly three quarters of SMEs report no need for credit; pickup in non-bank credit (mainly EU funds) has not been sufficient to revive overall credit growth.
- Healthy credit growth is needed to support investment given a shrinking labor force.
- Recommended reforms to support credit and investment:
  - Complete insolvency regime reform to shorten insolvency procedures and improve creditors’ recovery rates.
  - Bring more economic activity into the formal economy and encourage voluntary income and asset disclosure by improving public trust in institutions and strengthening tax administration, FIU, and the Corruption Prevention and Combating Bureau.
  - Roll out new instruments to support credit (financial and non-financial support for startups) and pursue regional cooperation to develop capital markets.

### Strengthening the AML/CFT framework and refocusing the BSFC sector
- The suspension of activities of Latvia’s third largest bank highlighted deficiencies in regulatory and supervisory frameworks across supervision of BSFCs.
- Identified problems:
  - Shortfalls in implementation of AML/CFT preventive measures in the BSFC sector.
  - Doubts about supervisors’ capacity to effectively identify and address AML/CFT compliance breaches.
  - Legal framework weaknesses that do not provide sufficient powers for compulsory liquidation where a bank is deemed “failing or likely to fail.”
  - Risk that ineffective AML/CFT controls in liquidation could lead to payouts without sufficient customer due diligence.
- Multi-pronged strategy recommended:
  - Strengthening AML/CFT enforcement and implementation:
    - Ensure financial institutions apply preventive measures (including verification of the beneficial owner), particularly for high-risk customers.
    - AML/CFT supervision should more stringently evaluate banks’ risk mitigation models, ensure customer due diligence requirements are followed, and apply corrective actions and sanctions when deficiencies are identified.
    - Improve information sharing among FCMC, FIU, tax administration, corporate registry, and law enforcement.
    - Swiftly implement actions recommended by the AML/CFT assessment adopted by Moneyval in July 2018.
    - Establish a regional AML/CFT supervisory arrangement to enhance convergence of supervisory practices and minimize regulatory arbitrage.
  - Refocusing the BSFC sector:
    - Reassess sustainability of business models involving opaque entities.
    - Apply legislation that prohibits banks from engaging with some narrowly-defined types of shell companies and take further measures to ensure transparency and identify beneficial owners.
    - FCMC should oversee ABLV’s voluntary liquidation, insured deposit payouts, and consolidation of the BSFC sector to mitigate risks of payments to entities associated with money laundering and impacts on confidence and financial stability.
    - Ensure new BSFC activities do not increase financial stability risks or contingent liabilities for the government.
  - Upgrading banking and insolvency framework:
    - Provide national authorities adequate legal tools to liquidate a bank deemed “failing or likely to fail.”
    - Strengthen integrity, accountability, and qualification requirements of insolvency administrators.
    - Harmonize within the EU to include clear requirements for the FCMC to impose compulsory liquidation upon a bank determined as “failing or likely to fail” by the ECB but not resolved by the SRB.
    - Continue vigilant application of fit-and-proper rules, including strengthening assessment of the reputation of bank owners and senior managers.

### Staff appraisal: macroeconomic outlook and policy guidance
- Economic progress and constraints:
  - Latvia’s economy continued to recover since the crisis; growth peaked in 2017 and strong growth is projected for 2018.
  - External sector position is stronger than implied by medium-term fundamentals.
  - Binding constraints: shrinking labor force, labor market tightness, rising wages eroding competitiveness, labor force aging likely to dampen productivity, and weak credit growth limiting investment.
- Policy mix recommendations:
  - Calibrate policies to mitigate overheating risks and keep the economy on a sustainable long-term growth path.
  - Reforms to ease labor market constraints: encourage greater labor force participation, reduce structural unemployment, use skill-matching and skill-building policies, improve access to housing, revisit minimum wage structure, improve labor participation of targeted groups, and encourage labor immigration.
  - Productivity-enhancing reforms are critical to face demographic headwinds.
- Fiscal and financial system recommendations:
  - Reverse procyclical fiscal policies, build fiscal buffers, and implement upfront consolidation to support fiscal objectives.
  - Reallocate government spending toward productive investment as EU structural funds decelerate.
  - Improve efficiency of health and education spending and better-target social protection programs to build human capital and address high poverty and inequality.
  - Reform insolvency framework and reduce the shadow economy to make the financial system more supportive of investment.
  - Steadfast actions to restore the reputation of Latvia’s financial system via effective AML/CFT enforcement, changes in banking legislation, EU harmonization for liquidation tools, and more vigilant application of fit-and-proper rules.

*Source: IMF staff report excerpt (Republic of Latvia).*

### Box 1. Risk Assessment Matrix

### Box 1. Risk Assessment Matrix

### Overview and likelihood definitions
- The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).
- The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline:
  - “low” is meant to indicate a probability below 10 percent,
  - “medium” a probability between 10 and 30 percent,
  - and “high” a probability between 30 and 50 percent.
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

### Risk: Retreat from cross-border integration
- Likelihood: Medium
- Impact if realized: High
  - Fraying consensus about the benefits of globalization leads to protectionism and economic isolationism, resulting in reduced global and regional policy and regulatory collaboration with negative consequences for trade, capital and labor flows, sentiment, and growth.
  - As a small open economy, Latvia could be significantly impacted mainly through trade and confidence channels.
- Policy recommendations / Mitigation:
  - Pursue structural policies that enhance productivity.
  - Continue to diversify product and export markets.
  - Participate in coordinated policy response at the European level.

### Risk: Structurally weak growth in key advanced and emerging economies
- Likelihood: High
- Impact if realized: High
  - Low productivity growth (U.S., euro area and Japan), high debt, and failure to fully address crisis legacies by undertaking structural reforms amidst persistently low inflation (euro area and Japan) undermine medium-term growth.
  - The euro area remains Latvia’s single largest trade partner. A protracted slowdown would have a direct impact on exports while also eroding business and consumer confidence.
- Policy recommendations / Mitigation:
  - Participate in coordinated policy response at the European level.
  - Allow automatic stabilizers to operate.
  - If the shock is of sufficient magnitude, discretionary fiscal action could be considered.

### Risk: Tighter global financial conditions and retreat in Nordic mortgage market
- Likelihood: High/Medium
  - Tighter global financial conditions (High): Continued monetary policy normalization and increasingly stretched valuations across asset classes, an abrupt change in global risk appetite, could lead to sudden, sharp increases in interest rates and associated tightening of financial conditions.
  - Significant retreat in the Nordic mortgage market (Medium).
- Impact if realized: Medium
  - Could raise the public cost of debt financing. Domestically, sharp increases to interest rate could further hinder credit growth.
  - Could lower funding for Nordic banks reliant on wholesale funding, raising cost of financing and hindering credit growth.
- Policy recommendations / Mitigation:
  - Perception of Latvia as a safe asset and the issuance of long-term sovereign debt are mitigating factors.
  - Continue implementing prudent debt management and macroprudential policies and build fiscal buffers.
  - High bank capitalization and liquidity are mitigating factors.

### Risk: AML enforcement delays and BSFC sector adjustments
- Likelihood: High/Medium
  - Delays in the enforcement of AML standards (High).
  - Failure to refocus the business model of the BSFC sector and/or fast consolidation of the BSFC sector, including due to intensification of sanctions on Russia (Medium).
- Impact if realized: High/Medium
  - Could result in further actions taken by foreign regulators, affecting financial sector stability and growth.
  - Rapid downsizing of deposits could undermine confidence and have a larger-than-expected impact on growth.
- Policy recommendations / Mitigation:
  - Maintain strict AML/CFT regulations and improve their enforcement.
  - Reassess the sustainability of a business model involving opaque entities.
  - Closely monitor and manage the withdrawal of nonresident deposits to minimize spillovers and costs.

### Risk: Failure to advance structural reforms and fiscal pro-cyclicality
- Likelihood: Medium
  - Failure to advance structural reforms, including those that ease the labor market and pose risks of overheating (Medium).
  - Deepening of fiscal pro-cyclicality (Medium).
- Impact if realized: High
  - Could lead to overheating labor market, harming competitiveness.
  - Delay in other reforms could undermine productivity growth and the business environment.
  - Could trigger an accumulation of imbalances and overheating pressures.
- Policy recommendations / Mitigation:
  - Focus on improving the labor market, business environment, infrastructure, and human capital.
  - Reduce the structural balance faster to avoid procyclicality.

*Source: Box 1. Risk Assessment Matrix, as presented in the IMF staff report for the Republic of Latvia.*

### Annex I. External Sector Assessment

### Annex I. External Sector Assessment

### Foreign assets and liabilities
- NIIP stood at around -56 percent of GDP by end 2017, compared to -58 percent at end-2016; projected to continue declining to about -48 percent of GDP over the medium term.
- Gross assets: 133 percent of GDP in 2017.
- Gross liabilities: 189 percent of GDP in 2017.
- Debt securities comprised only 24 percent of these liabilities.
- Net external debt: 24 percent of GDP at the end of 2017.

### Current account
- Current account moved to a deficit of 0.8 percent of GDP in 2017, driven by a notable uptick in goods imports as investment and consumption growth accelerated.
- Current account projected to further deteriorate in 2018 and 2019 as investment and consumption continue to be strong.
- EBA-lite CA model results:
  - CA gap of around 2.5 percent of GDP in 2017.
  - About 1.5 percentage points of the CA gap can be attributed to the policy gap.
  - Remainder of the CA gap unexplained by the model and may represent other distortions including exchange rate misalignment.
- Overall assessment: the current account position is assessed stronger than implied by fundamentals and desirable policies.

### Real exchange rate
- REER appreciated by about 0.8 percent between 2016 and 2017.
- EBA-lite CA model suggests an undervaluation of 5.6 percent using standard trade elasticities.
- As a catching-up economy, continued strong investment and consumption should bring down the balance without the need for an exchange rate adjustment.
- EBA-lite Index REER model finds a small undervaluation.

### Capital and financial accounts
- Capital account dominated by EU structural fund inflows, which slowed in 2017 as funds are primarily aimed at supporting current expenditure on structural measures.
- FDI inflows: 3.7 percent of GDP in 2017 (rebounded to their highest level since the GFC).
- Portfolio and other investment flows remain the main drivers of the financial account.
- High foreign holdings of government bonds and cross-border linkages of the banking sector in the region indicate potential vulnerabilities.

### FX intervention and reserves level
- The Euro has the status of a global reserve currency; reserves held by euro area economies are typically low to standard metrics, and the currency is free floating.

### Overall external position (2017) — model summary and diagnostics
- External position in 2017 assessed stronger than implied by medium-term fundamentals and desirable policies.
- Expectation: widening of the current account deficit from 2018 onwards due to a pick-up in investment and unwinding of terms-of-trade gains.

EBA-lite CA model / diagnostic values (as reported)
- CA-Actual: -0.8%
- CA-Norm: -3.3%
- CA-Gap: 2.5%
- o/w Policy gap: 1.5%
- Elasticity: -0.45
- Implied REER Gap: -5.6%
- CA-Fitted: -1.9%
- Residual: 1.1%
- ln(REER)-Actual: 4.61
- ln(REER)-Norm: 4.62
- REER-Gap: -0.8%
- o/w policy gap: -0.8%

*Source: Annex I. External Sector Assessment, cr18266 - Annex I. External Sector Assessment*

### 8.      Many would-be borrowers cannot get credit because their official income is

### cr18266 - 8.      Many would-be borrowers cannot get credit because their official income is

### Shadow economy and credit access
- The size of Latvia’s shadow economy is estimated at more than 20 percent of GDP.
- Underreported or “envelope” wages (formally registered workers receiving part of their income informally) are widespread.
- Underreported corporate profits represent a sizeable share of actual corporate profits.
- Informal activity is strongly related to low trust in government and flourishes despite a relatively favorable business environment.
- Policy implication: Boosting credit growth will require reforms to encourage workers and firms to move from the shadow economy into the formal sector.

### Demand-side factors for bank credit
- Euro area bank lending survey (Bank of Latvia and ECB): demand for bank credit has increased since 2015 for households, SMEs, and large enterprises; some decrease in demand from large enterprises was observed in 2017 due to use of internal financing.
- Bank of Latvia 2016 SME survey: nearly three-quarters of SMEs responded that they had no need for credit (no immediate investment plans or resources to self-finance); over a third cited risk aversion as a reason for reluctance to borrow from banks in the future.
- Business confidence has remained subdued throughout the economic recovery, which could help explain why many firms do not have plans to expand.

### Rise of non-bank financing
- The non-bank financial sector (NBFS) in Latvia is small by European standards: in 2016, the assets of the NBFS and other financial intermediaries represented 42 percent of GDP compared to a euro area average of 367 percent.
- The NBFS is growing; non-bank lending to both households and NFCs largely outpaced bank lending in recent years.
- The ratio of non-bank loans to bank loans has risen to 20 percent compared to 10 percent in 2013.
- The bulk of non-bank lending consists of financial leasing loans to NFCs.
- Non-bank lending to households is smaller but growing rapidly: in 2017, only a quarter of new house purchases were financed by banks; the rest were financed by non-bank lenders or by the buyers’ own means.

### Public debt sustainability (selected baseline figures and projections)
- As of April 07, 2017 — Nominal gross public debt (in percent of GDP): 2016: 30.5; 2017: 37.4; 2018: 36.3; 2019: 35.1; 2020: 34.1; 2021: 32.9; 2022: 31.9; 2023: 30.9; 2023 (final listed): 29.9.
- Public gross financing needs (in percent of GDP): 2016: 3.1; 2017: 0.5; 2018: 5.7; 2019: 5.6; 2020: 5.4; 2021: 3.8; 2022: 2.8; 2023: 1.6; (other projection entries shown).
- Real GDP growth (in percent) projections: 2016: 0.6; 2017: 2.2; 2018: 4.5; 2019: 3.7; 2020: 3.3; 2021: 3.1; 2022: 3.0; 2023: 3.0.
- Inflation (GDP deflator, in percent) projections: 2016: 3.9; 2017: 0.3; 2018: 3.0; 2019: 3.5; 2020: 2.7; 2021: 2.5; 2022: 2.4; 2023: 2.2.
- Effective interest rate (in percent): 2016: 4.8; 2017: 3.6; 2018: 3.2; 2019: 2.8; 2020: 2.8; 2021: 3.0; 2022: 2.9; 2023: 2.8.
- Cumulative change in gross public sector debt (2016–2023): -6.4 (percent of GDP).
- Identified debt-creating flows (cumulative): -5.9 (percent of GDP).
- Automatic debt dynamics (cumulative): -5.7 (percent of GDP).
- Residual, including asset changes (cumulative): -0.5 (percent of GDP).
- Underlying assumption examples (baseline): Real GDP growth 2018–2023: 3.7, 3.3, 3.1, 3.0, 3.0, 3.0; Inflation 2018–2023: 3.5, 2.7, 2.5, 2.4, 2.2, 2.2; Primary Balance baseline 2018–2023: -0.3, -0.3, 0.2, 0.2, 0.2, 0.2.

### External debt sustainability (selected baseline figures and projections)
- Baseline external debt (in percent of GDP): 2013: 133.9; 2014: 144.1; 2015: 143.6; 2016: 148.8; 2017: 140.9; 2018: 137.0; 2019: 135.2; 2020: 132.2; 2021: 126.3; 2022: 126.9; 2023: 126.9.
- Change in external debt (2013–2023 selected): 2013: -4.3; 2014: 10.2; 2015: -0.5; 2016: 5.2; 2017: -7.9; 2018: -3.9; 2019: -1.7; 2020: -3.1; 2021: -5.9; 2022: 0.6; 2023: 0.0.
- Current account deficit, excluding interest payments (in percent of GDP): 2013: -0.6; 2014: -1.5; 2015: -2.2; 2016: -3.7; 2017: -1.3; 2018: 0.8; 2019: 1.1; 2020: 0.9; 2021: 1.3; 2022: 1.8; 2023: 1.9.
- Net non-debt creating capital inflows (negative) (in percent of GDP): 2013: -1.8; 2014: -1.4; 2015: -3.0; 2016: 0.1; 2017: -2.1; 2018: -0.8; 2019: -0.7; 2020: -1.2; 2021: -0.8; 2022: -0.7; 2023: -0.8.
- Gross external financing need (in billions of US dollars): 2013: 22.3; 2014: 22.3; 2015: 22.6; 2016: 20.0; 2017: 22.3; 2018: 26.0; 2019: 29.3; 2020: 32.2; 2021: 34.7; 2022: 35.2; 2023: 37.3.
- Gross external financing need (in percent of GDP): 2013: 73.6; 2014: 71.1; 2015: 83.7; 2016: 72.5; 2017: 73.5; 2018–2023: values presented in charts (e.g., 72.7, 76.6, 78.6, 79.8, 76.3, 76.5).
- Stress-test and bound test summaries: baseline external debt-to-GDP around 127 (average projection box), with stress scenarios showing higher peaks (examples: interest rate shock 134; historical scenario 152; combined shock 147; real depreciation shock 153; CA shock 139; growth shock 147). (Charts illustrate scenario outcomes and gross financing need under baseline.)

### Assessing the impact of the 2018 tax reform
- Reform components (selected):
  - PIT: move from flat to progressive PIT schedule; gradually increase—and make more progressive—the non-taxable income threshold; increase child allowances; increase social security contribution (SSC) rates by 1 percent (to be used to increase financing for the healthcare reform).
  - CIT: change from gross to distributed profit taxation; increase the tax rate from 15 to 20 percent.
  - Compensating measures: gradual increase of excise rates over the next three years; VAT administrative measures to reduce informality and improve revenue collection.
- PIT specifics:
  - New PIT rates: up to €20,004 per year taxed at 20 percent; incomes up to €55,000 taxed at 23 percent; higher incomes taxed at 31.5 percent.
  - Estimated post-reform tax wedge declines to below 40 percent.
  - Distributional note: largest impact expected for low-wage earners, especially those with families; workers who already have very low wages and do not pay income taxes will be worse off due to the SSC rate increase.
- CIT specifics:
  - Change aims to stimulate investment growth via distributed profit taxation, improve companies’ balance sheets (particularly small firms), and improve balance sheet transparency and access to bank financing.
  - Experience in Estonia shows improvement in firms’ capital and liquidity; impact on investment and productivity is positive but difficult to quantify ex-ante.
- Growth impact simulations (IMF GIMF):
  - Scenario calibrated to authorities’ estimates and to simulate similar corporate behavioral dynamics as observed in Estonia.
  - Under a scenario where corporates’ tax relief gradually translates into productive investment, the combined PIT and CIT reforms could result in higher real GDP over the medium term by almost 1.5 percent.
  - Financing modality matters: deficit financing yields a large positive upfront impact on growth that dissipates quickly; over the long term, a budget-neutral option delivers the largest benefits, especially one that focuses on revenue rebalancing.

*Source: cr18266 - 8.      Many would-be borrowers cannot get credit because their official income is*

### 5.      The tax reform will be costly. With the new introduction of a progressive system, PIT could

### 5.      The tax reform will be costly. With the new introduction of a progressive system, PIT could

### Fiscal impact of the tax reform
- PIT could be permanently lower by up to 1 percent of GDP on average.
- CIT revenues will have an even larger impact—by about half for the first two years of implementation and gradually converge to below pre-reform levels.
- The shortfall compares staff’s current baseline assumptions against PIT revenues pre-reform taking the most recent observable year as a reference point, adjusted for macroeconomic and wage dynamics.
- Source: Staff estimates.

### Macroeconomic effects and multipliers
- Multipliers range between 0.4–0.6, based on multipliers found in the literature for advanced economies, using the methodology explained in “Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections,” IMF, 2014.
- While the positive effect on net income of individuals and corporates will likely support consumption and investment, absent any further reforms to find stable revenue sources, the government tax revenue ratio will be permanently lower.

### Dynamic paths and scenarios (illustrative timing)
- Time horizon referenced: t-1, tt+1, tt+2, tt+3, tt+4, tt+5.
- Variables highlighted relative to pre-reform:
  - Real GDP: % difference to pre-reform (plotted over tt+1 to tt+5).
  - Real GDP Growth: % difference to pre-reform.
  - Real Investment: (% Difference to pre-reform).
  - Real GDP Growth (% Difference to pre-reform) under:
    - Budget neutral scenario.
    - Debt financed scenario.
- Revenue balancing versus debt financing are contrasted as approaches to addressing the fiscal shortfall.

### Policy implications and considerations
- Without further reforms to identify stable revenue sources, the tax reform will likely lead to a permanently lower government tax revenue ratio.
- The short-term boost to consumption and investment from higher net incomes may not offset the permanent revenue loss unless offsetting measures are adopted (revenue balancing or alternative financing).
- Choice between budget neutrality and debt financing has distinct medium-term effects on real GDP growth and investment trajectories (as depicted in the scenarios).

*Source: Staff estimates.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18266.pdf_