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Wednesday, July 22, 2009

Why Latvia Is In Such A Mess

Hat Tip to Aleks Tapinsh - "No wonder this country is in such a mess. Someone posted this video of a payday at the Elkor electronics chain in Latvia. The paycheck as you can see comes in an envelope, in cash. No one pays any taxes. And everyone happy. Or not".

Second example: Prime Minister Valdis Dombrovskis cited in a press conference in Riga yesterday the fact that some companies, including state-owned companies like Latvian Railways, had tried to cheat the social security system by significantly raising the wages of some of its employees (in his example from 1,000 lats a month to 12,000 lats a month), thus apparently raising their pay into the social security system. That way, if a person gets laid off, they'd get 70 percent of the new and improved wage.

Now two recent quotes from my blog interpreting yesterday's comment from the Economy Minister - (Viz: "Representatives sitting in Washington and educated at Yale do not fully understand what is going on in Latvia”)

"To provide with logic behind quote of the economics minister, I believe he thought that the EC and IMF does not realize the scope and importance of grey economy in the country. With that figure hard to estimate (ranging from 15%-40%). Any increase of Tax base will only push the economy on the gray side both for individuals (tax exemption on income earned) and for companies (unaccounted cash revenue, forgone taxes,etc). Thus resulting in even less tax revenue that initially had and larger budget deficit to balance. As for VAT tax, as a sign of protest, some of the local companies have publically annouced the full closure of their business if the VAT is raised to 23%."

"Yep, stupid comment when at the same time you are reaching out your hands to receive their money... That said, the IMF does not really fully understand if they think they can introduce e.g. a progressive income tax and raise more revenue. Very hard to do in a country that does not believe that higher taxes will benefit the population and where tax avoidance is an art mastered by most."


Anonymous said...

A problem,on the whole, in the former Eastern bloc very much is spread. To be honestly my workers in Russia I "must pay with an envelope, I do not make so I also get no good bricklayers.
To the Prime Minister of Latvia. Neither He nor the government have understood the crisis. The political élite is incapable, differently than in Estonia there was never a real good economic policy. The reaction of the Prime Minister has to be understood with the inferiority complex many Latvians carry inside . He feels be trated of the USA, the Latvian élites understood they not really a member of the European Union but not more than an EU protectorate with many privileges. A sort of Bosnia + (Shengen etc.). It hurts to understand they have to write reports again ..written to somebody who is the real boss. Already in the USSR times this has irritated the political élites. By own guilt in the foreign rule of the IMF and the EU. This hurts, by own stupidity and not by tanks

Anonymous said...

Dear Edward, please make sure that the facts you are implying here are true and verified.

Handing out salary in cash doesn't mean that the company isn't paying social and income tax for its employees. Cash is a completely valid form of payment and no one has yet confirmed that this video is a proof of something illegal.

At the same time, there is no doubt that there are a lot of companies avoiding the taxes because of the 45% cut from everything above 256 Euro (the minimum salary).

And with the recent policy changes you won't receive even a basic health protection for that social tax of 30,44% -- local hospitals are being closed down and the emergency services will have to drive more than 150km to get one to the closest hospital.

Edward Hugh said...

Hi anonymous,

In some senses I think this is a fair comment. I had been thinking about this all day. Not that the problem shown in the video isn't a real one. But maybe this is a spoof video. So let's just say, this is how it might happen in workplace after workplace all over Latvia, rather than suggesting that the people who appear are engaging in any form of illegal activity. Let's just pretend it is a soap opera, depicting how real life might be.

But you surely aren't trying to deny that this problem is very, very widespread. This is basically why the IMF have not been able to reach an agreement with the Latvian government.

Anonymous said...

Dear Edward,

The so called envelope wages are widespread in the former Soviet Union. But in Latvia the practice doesn't mean that you don't receive a legitimate salary as well.

In the recent years the trend was to pay a larger and larger part of one's salary in a completely lawful way. Many employers even gave a choice to employees -- you could either get a normal wage or choose to have 30% more income but with a minimum wage by contract. And many did chose to go 100% legit as the government provided good incentives.

With time, banks started to look at your contractual salary for income as well. That meant you had to have a decent amount to get a sizable loan. We also had a sophisticated pension system to encourage savings. There again, the government refunded a part of your investment in cash, provided your official salary was big enough. You could invest a EUR 100 every month for your pension and get EUR 300 back every year from government in cash. The official salary is also important for the size of your retirement pension and maternity leave among other things. Basically, nearly every part of the society had an incentive to go legit. And that's exactly what they gradually did.

Nowadays, however, the portion of your social security tax going into the main part of your pension fund has been dramatically reduced. Because of that, everyone knows that their social security taxes (24.09%) don't add much to the pension.

You can feel how every enticement to go legitimate has been dismantled. The system never worked with coercion. You won't get this thing under control even if the IMF stipulated a death penalty for tax evasion. It will only get worse, i.e. return to what it was before the boom years. And the more people are pushed against the wall, the harder they'll push back. Feedback from increasing taxes is probably negative already. And it's just negative for lowering them too.

Anonymous said...

It is entirely possible, right now, to have every transaction done under the table from rents and wages to purchases made in shops, even high end merchandise that will still require servicing and a guarantee. There is not a single day that goes by where I am not presented with this option!

As mentioned in the above post, when things get tough everything goes underground into a hidden economy and a sizable portion of the people managing this country like that just fine as they have their fingers in many pies.

The fish always stinks from the head downwards.

Anonymous said...

Not related to this post...

Just slightly different point of view on issues in Baltics ...

For those following Latvia case it might be especially interesting ...


Edward Hugh said...

Hello another anonymous,

You raise some really interesting issues.

"With time, banks started to look at your contractual salary for income as well. That meant you had to have a decent amount to get a sizable loan."

Interesting if you look at the IMF staff documents and reports of the spring of 2007 (onsite IMF) you will find they insisted on this at the time, and this was the reason this happened. So the IMF have been battling over this for some time. It's just that it has all now gotten completely out of control. Indeed, in the latvian case at least, you can trace the bursting of the bubble directly to this change, since the rate of loan increases slumped, just because the banks asked for documentation, which means that all these people at SEB and Swedebank who lost all that money for the Swedish taxpayers knew the reality behind the loans (all the grey money) all the time. Perhaps some of them should be explaining this on Swedish TV.

"Basically, nearly every part of the society had an incentive to go legit. And that's exactly what they gradually did."

Interestingly there are very interesting comparisons between the Catalonia (Spain) where I live and your situation, if we think about the post Franco years. Spain was not that different to Latvia. 25% of the economy is still underground, and at the start of the 1990s almost all the leading Catalan employers were arraigned in a major trial that hoit all the headlines for systematic social security evasion.

The problem was resolved in Spain by Economy Minister Solchaga (who curiously went to Argentina to advise at the end of the 1990s (same problem there). What Solchaga did was entice everyone into declaring their full wages by creating an unemployment system which gave very high benefits for up to 2 years, but only as a proportion of declared earnings.

This worked while the economy boomed, but it is one of the main items which will be reformed when the IMF get their hands on Spain (as I am sure they will do), and then people will essentially go back underground again, in the way you are describing.

The conclusion to all this is pretty depressing. Basically nearly all these societies will enter virtual permanent bankruptcy as the inversion in the population pyramid raises and raises the cost of health and pension provision on an ever reducing tax base. Look at Italy, if you want to see the future. I've seen it, and it doesn't work.

Anonymous said...

"[...] will enter virtual permanent bankruptcy as the inversion in the population pyramid raises [...]"

I'm not sure that will be the case with Latvia. We have a substantial and well educated expat base all over the world. I'm not saying they're supposed to repair the pyramid, no, that's the job of migrants from other former Soviet countries. We're in the EU and that means we will always boom higher than them. Immigrants is what will stabilize our economy in the future. The expats will be the educated enterpreneurs and perhaps specialists to drive SME development and draw investment into our country. You know very well that Latvia hit the brick wall of massive wage inflation due to scarcity of labor. Resulting inflation stopped a lot of long term investment.

I'm not too optimistic, however. There seems to be great reluctance to form progressive immigration policy and tap into foreign labor sources. All that despite half of our capital being non Latvians. And Russia isn't helping these days. Because of the stupid and irresponsible actions of the Kremlin government many countries of the larger former Soviet block want to stop the use of Russian language in official matters and limit economic ties. That discourages immigrants from Russia itself, never mind Russian businesses. Historically, all of Latvian infrastructure was built to support massive manufacturing and transit. We were built as the center of Soviet industry, education, culture and holiday making.

All that we've been the last several years, however, is a bedroom community for the Irish, British and the American economies. We produce labor and specialists at no cost to whoever wants take them. We also manufacture debt to whoever is willing to make a bubble out of our economy.

Other than that I'm optimistic.