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Taking a hit for the government

By Nathan Greenhalgh. 03.02.2009

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The Lithuanian and Latvian media and hotel sectors face steep VAT increases to cover government deficits. If you notice your favorite Baltic hotel's rates have gone up, don't blame the management – blame the government, and be happy the lodging's still in business. Likewise if your favorite Lithuanian and Latvian newspaper or magazine can't be found next time your around Riga or Vilnius, you can blame the same culprit.

As part of their anti-crisis plans, on January 1 both governments implemented steep value-added tax (VAT) increases on print publications and are strongly considering a VAT hike on hotel stays from five percent, the VAT subsidy rate, to as high as 21 percent in 2010.
The press in both countries is lashing out at the decision. In a press release, the Latvian Press Publishers Association said "this completely unexpected decision, which was approved by the Latvian government without consultations with our organization or any other representative of our sector, could seriously cripple the media sector at a time when it is already threatened by the deep economic downturn in our country. This economically unfair and legally dubious action presents a disturbing threat to freedom of the press and freedom of speech in Latvia."
Meanwhile the hotel industry is predicting doom if the sudden tax increase is passed.
"I don't believe there's many industries that could live with that kind of increase of 400 percent of taxes," Juris Zudovs, the president of the Latvian Association of Hotels and Restaurants, said. "What we've heard from our members is there will be a large percentage of our members out of business."

Revenue recovery
Given their current difficulties, it seems hard to fathom that the Lithuanian and Latvian governments are scrambling for every last cent when just a couple of years ago they were in the midst of the Baltic Tiger economic boom that yielded a doubling of average annual incomes from 1999 levels and the highest growth rates in Europe.
However, one of the negative consequences of this rapid growth that is now rearing its ugly head is a large external imbalance of trade, as Lithuania and Latvia were both importing more than exporting.
The elimination of the five percent VAT subsidy rate is part of both nations' anti-crisis plans created to avoid large budget deficits and lower credit ratings that would make loans, especially during the global credit crunch, much more difficult to get.
Unlike the United States, Lithuania and Latvia cannot take on enormous deficits to spend their way out of a recession because they don't receive the high credit ratings larger nations can enjoy.
"The United States is the largest economy in the world while Lithuania is a very small economy. The government of the United States, UK and Germany can borrow at very reasonable rates. Our credit rating has been lowered twice in the past year, now by S & P BBB which is seven steps lower than AAA rating enjoyed by major economies major markets, so financing a deficit is three times more expensive for Lithuania than those other ones," Nerijus Udrėnas, a senior economist for SEB Bank, said about Lithuania's national budget.
The need to avoid large deficits in Latvia is more profound. To fill the 2008 budget deficit the country was forced to go to the International Monetary Fund (IMF), an action usually reserved for Third World countries until last year's financial crisis. And the influx of 1.7 billion euros in IMF funds, 3.1 billion euros in European Union funds and hundreds of millions of euros from the World Bank and neighboring countries hasn't helped Latvia's credit rating.
On January 7 Moody's, which remains a Nationally Recognized Statistical Rating Organization despite their loss of reputation for giving perfect ratings to collateralized debt obligations full of toxic subprime mortgages, downgraded the foreign and local currency ratings of the Government of Latvia to Baa1 from A3.
"The Latvian economy was much more internally overheated and much more dependent on external financing and nonresident deposits. So this inflated the real estate market even more. Inflation was flirting with 20 percent inflation at one point. Since the overheating was more the slowdown is more painful," Udrėnas said.
"I use a comparison with the highway. If you're going very fast and suddenly there is a jam in front of you, you slam on the brakes. The faster you're going, the harder it is to put on the brakes. After an accident you may need to change wheels, just like in an economy you must take reforms, which can be difficult."
Vjačeslaus Dombrovsky, an assistant professor at the Stockholm School of Economics and Baltic International Center for Economic Policy Studies, blames the Latvian government's cash shortfall was caused by failing to anticipate an end to the country's high economic growth.
"The main reason for this, basically, is that after 2004, for several years in a row, especially 2006, 2007, 2008, Latvia enjoyed really high growth of above 10 percent and wages went up 30 percent. They were totally out of any fundamentals. This was fuelled by the unprecedented inflow of credit," Dombrovsky said.
"The Latvian economy got itself basically to the point where incomes were really high but they were illusory. The government made expenditure plans based on this going on in the future. Now they're at the point where they're almost bankrupt."
In order for Latvia to maintain its currency peg to the euro and continue on its path to entering the Eurozone, it has agreed to strong adjustment policies which are reflected in its anti-crisis plan and consist of budget cuts and tax increases to keep the government's deficit below five percent in 2009 and gradually decrease to 2.8 percent in 2011.
"There are basically two crowds of people. There's one crowd that believes the lat should not be devalued. If you believe they're right, then the best way to eliminate any doubts is to adopt the euro," Dombrovsky said.
"The other camp is those who think that the extent of the external imbalances is just too huge."
The alternative to maintaining the currency peg would be to allow the lat to devalue. Although that could potentially lead to stronger recovery in the long run, the immediate consequence of such a move would be harsh.
Eighty percent of all loans in Latvia are in euros, not lats, as Latvians have been expecting to switch to the euro for some time now. But Latvians are paid in lats, so these loans would become impossible to pay off, especially since the Latvian economy is now expected to shrink. This could also scare off the Scandinavian banks that were the primary source of credit during the Baltic Tiger years and are now very exposed in Latvia and Lithuania.
"You're talking about massive defaults on loans and big problems for the banking sector," Dombrovsky said. "Maybe the Scandinavians and others who own the Latvian banking sector will burn their fingers so bad they won't want to come back."
He added that if Latvia devalued its currency other Eastern European countries might be forced to follow suit.
"If Latvia devalues it's not just going to take Latvia down, it will take all of Eastern Europe with it," he said.
“Basically, all of Eastern Europe was subject to the same conditions. It would be what's called financial contagion – it could take everyone else with it. All the countries trade with each other."
Possible repercussions like these have put the government staunchly against even mentioning devaluation.

Will it work?
These are far from the only industries affected by the VAT increase – others include meat and fish producers and pharmaceuticals. Both governments are increasing excise taxes on alcohol, cigarettes and gasoline, too.
Economists and policy analysts are split as to whether the plan will work. Instead of bringing in additional revenue the increased taxes on commerce combined with the economic slowdown could reduce consumer spending and consequently bring less money in.
Udrėnas is confident that this will not happen and that the Lithuanian government will achieve its goal.
"The general budget revenue is very dependent on VAT intake and that increase of VAT by one percentage point brings in additional revenues. Of course purchasing is slowing down and that affects revenue but I don't think the slowdown will be as bad as people think," he said.
"I'm pretty confident that the government will be able to meet its targets and if things really get worse they have the option to review the situation in late summer or early autumn."
Dombrovsky is cautiously optimistic as well that the Latvian government will achieve its goals with the anti-crisis plan.
"Most likely it will. The only unknown here is by how much tax revenue will fall," he said.
Some would argue that increasing taxes during an economic slowdown creates nothing but trouble.
"They do not comply with the laws that are acting in the economy," Rūta Vainienė, president of the economic liberal think-tank Lithuanian Free Market Institute, said. "They simply deny those laws. One of these is the Laffer law – if you increase tax rates, spending will decrease. They expect to raise revenue – that will do the opposite. They won't generate as much simply adding the expected amount."
Mantas Dubauskas, economics editor of the Lithuanian newspaper Lietuvos Rytas, was similarly skeptical.
"Consumer spending will decrease because of excise duties on gasoline, alcohol and cigarettes. I'm not sure the government will get the revenues they need after increasing the excise tax."
Both Dubauskas and Vainienė predict that the VAT and excise tax increases will push people toward the black market and predict increased smuggling along Lithuania's borders.
"I think the consumer will buy less legal alcohol and less legal fuel. In Kaliningrad, alcohol costs two or three times cheaper. Cigarettes are also cheaper. At the moment fuel prices in Latvia are much lower, so I think people in northern Lithuania will go to Latvia to buy fuel and the Latvian petrol stations will pay more to the Latvian budget," Dubauskas said, noting that with the cessation of Schengen border controls any Lithuanian can take the relatively short drive to Latvia, fill up and return home.
Vainienė bitterly points out that these "pro-Keynesian" measures are being passed by conservatives, and alleges that the tax increases will be catastrophic for the Lithuanian economy.
"The first quarter will show how much they collect in tax revenue. When they notice that they aren't getting the revenues they want they will have to rescind. Or they will increase that tax poison. If they raise the tax rates again, it will result in a collapse in the market," she said.
Dombrovsky mentioned that despite his hopes the economic adjustments Latvia will be forced to undergo could trigger a cycle of bankruptcies and layoffs that will last for years.
"What deflation may mean is a wave of bankruptcies if they lay off their labor, and that may induce another number of bankruptcies. Well, that's going to be the biggest danger, that it's going to become this cycle like in the US in the Great Depression. As they go out of business they fire their labor force, and this reduces the number of aggregate demand. That's the most pessimistic scenario out there," he said.
"The real adjustments mean that prices and wages will have to adjust downward. They will have to fall through bankruptcies and unemployment. This is a pretty tricky process. I don't think anyone in this country has the experience of going through this process."


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