EUROPEAN COMMISSION Brussels, 26.2.2020 SWD(2020) 513 final COMMISSION STAFF WORKING DOCUMENT Country Report Latvia 2020 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2020 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2020) 150 final}



Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Reform priorities 3.1.Public finances and taxation 3.2.Financial sector 3.3.Labour market, education and social policies 3.4.Competitiveness reforms and investment 3.5.Environmental sustainability A.Overview Table B.DSA statistical annex C.Standard Tables D.Investment Guidance on Just Transition Fund 2021-2027 for Latvia E.Progress towards the Sustainable Development Goals (SDGs) References LIST OF Tables 1.1.Key economic and financial indicators - Latvia 2.1.Summary table of 2019 CSR assessment

C.1.Financial market indicators C.2.Headline Social Scoreboard indicators C.3.Labour market and education indicators C.4.Social inclusion and health indicators C.5.Product market performance and policy indicators C.6.Green growth LIST OF Graphs 1.1.GDP growth and contribution of components 1.2.Investment growth and contributions, % 1.3.HICP inflation and contributions, % 12-month average year-on-year change 1.4.Selected labour market indicators 1.5.Wages, productivity and unit labour costs, index 2000=100 1.6.Selected social inclusion indicators, % of population 1.7.Current account and its components, % of GDP 2.1.Overall multiannual implementation of 2012-2019 CSRs to date 3.1.1.The fiscal stance and the economic cycle 3.1.2.Expenditure growth and the discretionary fiscal effort 3.1.3.Estimated tax wedge on labour in 2020, compared to relatively high and relatively low levels in other EU countries 3.1.4.Effect on income distribution of the increase in the basic allowance presented in the budget for 2020

3.2.1.House prices / wages ratio, index, 2006=100 3.3.1.Unemployment rate by education attainment 3.3.2.At-risk-of-poverty rate by age groups 3.3.3.Density of practising doctors across regions of Latvia 3.4.1.Labour productivity growth, annual % change 3.4.2.Average productivity growth 2013 - 2018, % 3.4.3.Unit labour cost growth and its components, % 3.4.4.Average real investment growth 2013 - 2018, % 3.4.5.Control of Corruption indicator 3.5.1.Greenhouse gas emissions, index, 1990=100 3.5.2.Greenhouse gas emissions by sector, million tonnes of CO2 equivalent 3.5.3.Energy consumption by sector, million tonnes of oil equivalent LIST OF Boxes 2.1.EU funds and programmes to address structural challenges and to foster growth and competitiveness in Latvia 3.3.1.Monitoring performance in light of the European Pillar of Social Rights 3.4.1.Administrative & territorial reform in Latvia 3.4.2.Investment challenges and reforms in Latvia

Economic activity remains robust despite slowing investment. Key reforms are progressing well, but ensuring that growth benefits all parts of society remains a challenge. While investment is set to slow, Latvia’s growth is expected to remain robust on the back of a strong labour market, which will support private consumption growth. From a longer-term perspective, Latvia is among the frontrunners of EU convergence; however, as the country becomes richer, its income growth will increasingly depend on investments in human capital and innovation, whose performance has been limited. Public finances have remained broadly sound with government debt decreasing. However, growth has not been fully inclusive, as inequality has remained high and peripheral regions have lagged behind the Riga region. Catching up with the EU average, decarbonising its economy and spreading the growth benefits more broadly while coping with a falling population will be Latvia’s main challenges over the coming decades. GDP growth is moderating as investment slows down and exports face headwinds from a deteriorating external environment. GDP growth reached 2.1% in 2019, marking the end of the EU-fund fuelled investment boom, which had pushed GDP growth to above 4% over the previous two years. While investment growth declined from double-digits in 2017 and 2018 to around 4% in 2019, private consumption remained steady, supported by strong labour market and high wage growth. Declining financial and transport services weighed on export growth on the one hand, while a good harvest gave a boost to grain exports, on the other. Overall, though, slowing foreign demand reflected in Latvia’s export growth, which in 2019 was 2.7%, down from 4.0% the year before. Looking forward, growth is set to remain stable at around 2½ % over 2020 and 2021. Labour market performance is strong. The employment rate continued its upward trend (76.8% in 2018), on the back of a declining labour force. The unemployment rate declined to 6.4% in 2019 from 7.4% in 2018. The long-term unemployed and young people also continue to benefit from the steady improvement in the labour market, but regional and skills level disparities persist. Unemployment is forecast to fall further over the coming years, mainly because the labour supply is expected to continue shrinking due to population decline. Declining labour supply is driving rapid increase in labour cost, but risks remain limited. Over the past six years Latvia has had some of the highest increase in labour cost among the EU countries. They are primarily a result of declining labour supply stemming from population ageing and emigration. The growth in labour costs has far outpaced productivity growth in recent years, raising concern about Latvia’s cost competitiveness. Yet, so far Latvia has managed to expand its export market shares and with the current account broadly balanced and low credit growth, the risk of overheating is contained. On the positive side, the rising incomes may help stem the emigration, which has been the major driver of the population decline in the first place. Latvia’s main economic objective remains steady income convergence with the EU average. Latvia’s income per capita has increased by 22% over the past five years with productivity growth being the main driver. Yet, in 2018 it stood at only 69% of EU average and income difference with the EU remains a powerful driver of emigration. Therefore, continued convergence remains Latvia’s key challenge both in terms of improving its population’s living standard and of halting emigration. Productivity growth has been solid throughout the post crisis period. However, concerns about sustained convergence with the EU average persist due to Latvia’s rising infrastructure costs resulting from declining population, poor innovation performance and underinvestment in human capital. Inequality in income and opportunities remains significant. The income distribution is more unequal in Latvia than in the EU on average, and the situation worsened in 2018. The redistribution through taxes and social transfers has a lower impact on income inequality than in other Member States, due to the limited adequacy of social protection system and the limited progressivity of tax system. Notably, the elderly and people with disabilities experience high poverty rates. Moreover, access to healthcare is more difficult for low-income groups, and the quality of education remains unequal between larger urban and smaller rural schools. Furthermore, there are large regional disparities in income levels, with the poorest regions enjoying only around half of the income level enjoyed in Riga. Skills shortages and mismatches are among the main obstacles to business investment and limit productivity growth. Limited labour supply has led to shortages of skilled workers. At the same time, low-skilled workers are less in demand and face higher unemployment. Strong growth in the construction sector absorbs some of the low and medium-skilled workforce, while upskilling and adult learning had little impact in reducing skills mismatches. The low level of digital skills among the labour force limits the use of digital technologies by businesses and the potential for innovation. Moreover, job opportunities are concentrated in urban centres while labour mobility from less dynamic areas is hampered by the availability of affordable housing and poor transport connections. Public expenditure growth is being restrained following the recently enacted tax cuts. The labour and corporate tax cuts over 2018-2020 have only been partly compensated by revenue-increasing measures. As a result, both government revenue and expenditure shares in GDP are expected to decline between 2018 and 2020. The size of the shadow economy has declined, but remains large relative to other EU countries. The large informal economy reduces government’s revenue and its spending capacity, as well as distorts competition and resource allocation. Firms involved in informal activity stay small and ready to close down once detected. Banks are reluctant to lend to such firms. While their share is decreasing, many employees are still partially or fully undeclared, facing lower social protection. Latvia can boost its long-term growth potential by focusing private and public investments on innovation, human capital and regional development. Latvia remains a catching-up economy and its main national development focus is on increasing its GDP per capita. As evidenced by falling productivity growth rates, the easy gains of the early catch-up stage have been exhausted. This means that productivity growth will have to increasingly rely on knowledge-intensive activities. Latvia’s weakest point has been innovation, which requires investments in research and development, in developing people’s knowledge and skills, and in other intangible assets. Latvia would also benefit from boosting the economic potential of its peripheral regions - increasing their accessibility, and promoting energy efficiency, employment and investment opportunities. Finally, investments in social inclusion and healthcare are needed in order to tackle high inequality and uneven access to employment and public services. Additionally, identifying investment needs in green technologies, sustainable solutions, and securing adequate funding will be key to deliver on the climate and energy objectives and shape a new growth model. Latvia has made some progress in addressing the 2019 country-specific recommendations. Substantial progress has been made in strengthening the anti-money laundering system. There has been some progress in the following areas: · The tax wedge on labour has been reduced and is closer to the EU average. · Taking steps to address social exclusion by improving the guaranteed minimum income, minimum pensions and income support for persons with disabilities in 2020. The adequacy of benefits, however, remains low. · Improving the accountability and the efficiency of public administration. Latvia has launched a reform of territorial administration aiming to improve to the governance of municipalities. · Efforts to improve accessibility, quality and cost-effectiveness of the health system continue. However, public financing for health is set to decline as a share of GDP in 2020. · Measures to consolidate resources for education, including the large school network, while improving quality and efficiency have been delayed. Reforms to improve vocational education and training are ongoing, but their attractiveness remains low. There are no new measures to improve provision of adult learning. Plans to develop a comprehensive skills strategy are ongoing. Latvia's performance on the indicators of the Social Scoreboard supporting the European Pillar of Social Rights point to a number of employment and social challenges, but also some positive outcomes. Latvia’s labour market performance has been solid in recent years. Employment levels have reached historic highs and the gender employment gap is among the lowest in the EU. Nevertheless, disparities in employment across regions and skills levels persist. In addition, growth has not been fully inclusive, as inequality remains high. The risk of poverty or social exclusion has slightly increased as the situation continues to worsen for people with disabilities, older people and the unemployed. Access to affordable healthcare is a challenge and, although self-reported unmet needs for medical care are decreasing, they remain high.

· Latvia is likely to meet most of its 2020 targets except investment in research and development. Regarding progress towards its national targets under the Europe 2020 strategy, Latvia has attained its employment rate target and renewable energy target. It met its targets on preventing early school leaving, tertiary education attainment in 2016, and is progressing well containing its greenhouse gas emission growth. At the same time, with its energy consumption continuing to increase, it is at moderate risk to miss its energy efficiency target. However, it is far from its public research and development investment target, which are unlikely to be met by 2020. Moreover, due to an increase in relative poverty, Latvia has moved away from its poverty target. Latvia is progressing well on most United Nations’ Sustainable Development goals with slower progress in health, innovation and reducing inequalities ( ). The main findings of the analysis in this report, and the related policy challenges, are as follows: · Latvia’s tax revenue share in GDP has been reduced by tax cutting measures. The main sources of revenue are labour and consumption taxes, while the share of capital taxes is low and has been further reduced by the corporate tax reform. Property taxation remains based on outdated values, which reduces revenue from recurrent property taxation over time. The low government revenue share in GDP limits the capacity to finance public spending on social protection and healthcare, which are lower than in other Member States. · While mortgage lending is boosted by state support, overall, credit growth remains low. While total credit growth has picked up over the past year or so, it follows a long period of negative growth. Measured over medium term, it has remained substantially below nominal GDP growth rate. State support for home buying to families has boosted the mortgage lending somewhat but it remains substantially below the mortgage growth in the other Baltics. Credit growth is constrained by the prevalence of the shadow economy and the legacy of the 2009 financial crisis, which damaged many households’ credit history. At the same time, Latvia’s banking sector remains financially sound. · Latvia has reduced the flow of risky money through its banks and overhauled its anti-money laundering system. Latvia has taken a number of major steps to ensure its financial system is not used for money laundering and terrorist financing. By banning the servicing of non-resident shell companies, Latvia has substantially reduced the flow of risky money through its banks. Furthermore, it has amended a number of laws to improve the governance and clarify responsibilities of main stakeholders. Finally, it has strengthened the capacity of key supervisory, financial intelligence and law enforcement institutions. ·Latvia's labour market performance is positive overall, but upskilling of the labour force is weak. While overall unemployment is low, less skilled, older workers, ethnic minorities and those living in rural areas still face higher unemployment. Their participation in adult learning and in measures that facilitate return to employment is low. Digital skills are also below the EU average. Sectoral level bargaining is strengthened, but overall capacity of social partners remains limited. ·Latvia’s education system performs well in terms of basic skills proficiency, but improving efficiency and ensuring quality for all remains a challenge. Student outcomes are above the EU average, however, urban schools on average outperform rural schools. The government faces the twin challenges of streamlining the large and inefficient school network, and to renew the teaching workforce by improving the attractiveness of the teaching profession. Reforms in these areas have not yet brought about the desired improvements. The government has taken steps to consolidate and improve higher education, but the system remains fragmented and not sufficiently competitive at international level. While the tertiary education attainment rate is high, the proportion of science, technology, engineering and mathematics graduates is low. Vocational education and training are being modernised, but the share of students in this type of education is below the EU average. · Measures to address the high risk of poverty or social exclusion are limited. Poverty is prevalent among the elderly, people with disabilities, and the unemployed. Tax and benefit policy changes over the period 2008-2018 have had made little difference. The minimum income level, minimum pensions and support for persons with disabilities have increased from 2020, but less than initially expected. Meanwhile, unemployment benefits have been reduced. Moreover, there are gaps in social protection for self-employed and non-standard workers. Low-income groups have poor housing conditions and access to social housing is limited. · Low public spending for healthcare and unhealthy lifestyle choices constitute the main reasons for the population’s poor health. Reforms to boost efficiency and quality in healthcare have been initiated, but remain at early stages. Health workforce shortages, especially in regions outside Riga and in the nursing sector in general, hinder access to health services and pose risks to the implementation of health reforms. An increase in public financing in recent years has improved the availability of health services and reduced the waiting times. However, public spending for health is set to remain well below the EU average in the coming years. Investments would be needed in order to ameliorate access to and quality of healthcare, improve the geographical availability of health services and implement the planned reforms. · Reducing energy consumption in transport and housing are Latvia’s key climate policy challenges. Latvia’s greenhouse gas emissions per capita are among the lowest in the EU. This is because its energy consumption per capita is lower than the EU average and the share of renewable energy is among the highest in the EU. However, in order to meet its 2030 target for greenhouse gas emissions, it will need to break the current trend of increasing energy consumption in transport and housing. Moreover, it will need to continue increasing the share of renewables, which it has successfully done in heating and power generation sectors, but has struggled to do in transport. In addition, it will need to boost its circular economy performance and improve the sustainability of its agricultural and forestry practices. The Commission’s proposal for a Just Transition Mechanism under the next multi-annual financial framework for the period 2021-2027, includes a Just Transition Fund, a dedicated just transition scheme under InvestEU, and a new public sector loan facility with the EIB. It is designed to ensure that the transition towards EU climate neutrality is fair by helping the most affected regions in Latvia to address the social and economic consequences. Key priorities for support by the Just Transition Fund, set up as part of the Just Transition Mechanism, are identified in Annex D, building on the analysis of the transition challenges outlined in this report. · Latvia invests little in research and innovation and faces a shortage of researchers. In 2018, Latvia invested 0.64% of GDP in research and innovation, which was among the lowest in the EU. Moreover, the investment is highly dependent on EU funding and has not noticeably increased for more than a decade. The serious underfunding of the system hinders its effectiveness and its attractiveness to researchers, especially young researchers. Moreover, the system suffers from governance fragmentation. On the positive side, Latvia has a vibrant start-up community, which boosts its innovation output somewhat against a backdrop of rather weak performance on other fronts. · Latvia is undertaking a major administrative territorial reform aiming to improve the functioning of municipalities. Latvia has begun work to consolidate its 119 municipalities to less than 40. The reform aims to increase the municipalities’ capacity to foster development and provide better quality services. The larger municipalities, however, will need to make infrastructure investments to ensure quality public services are accessible to citizens living further away from the centres of the new municipalities. A participatory approach with involvement and commitment of all stakeholders is important to ensure the sustainability and swift implementation of the reform. · Latvia is taking steps to improve the effectiveness of its justice system and the fight against corruption. However, improving the quality of public procurement remains a challenge. The quality of the justice system is being improved, particularly by introducing a unified complaints portal and evening out workload. It is also progressing well on fighting corruption as evidenced by gradually improving corruption perception figures and a reinforced capacity to investigate corruption, including high profile cases. However, in European comparison corruption perception remains high. Shortcomings remain as regards the oversight of implementation of anti-corruption actions. Transparency in public procurement could be improved, considering that the negative perception among business of the fairness of procurement process remains high. This in turn could enhance competition. GDP growth In 2019, growth slowed as the investment cycle matured and external demand weakened. At the same time, continuously strong private consumption helped sustain a healthy growth rate. GDP growth is expected to have reached 2.1% in 2019. The growth rate of all components slowed compared to 2018, with investment seeing the sharpest decline. The slowdown of investment and construction, in particular, led to lower employment growth, which in turn had a knock-on effect on household consumption. While weakening external demand weighed on exports, they maintained solid growth thanks to dynamic services export. The falling labour supply ensured that the unemployment rate continued to decline despite less buoyant growth in employment. Inflation accelerated somewhat compared to 2018, notably due to an increase in food and utilities price growth. Graph 1.1: GDP growth and contribution of components Source: European Commission The Commission's Winter Forecast projects growth to remain broadly constant in 2020 and 2021 as slightly stronger domestic demand is expected to compensate for falling export growth. Private consumption is set to benefit from rapid wage growth and slowing inflation, thus being the main growth driver. Investment growth meanwhile is expected to decelerate further in 2020 before recovering somewhat in 2021. Export growth in 2020 is set to benefit slightly from the good harvest of 2019. However, this will not be enough to compensate for the drag on growth coming from weakening external demand. Overall, growth is forecast to reach 2.3% in 2020 and increase slightly to 2.4% in 2021. Consumption

Despite the slowdown in 2019, private consumption is set to remain strong on the back of robust growth in real disposable income. In 2019, household consumption is forecast to have grown by 3.2%, somewhat lower than the 4.2% growth in 2018. The slowdown was primarily due to lower employment growth and higher inflation which both restrained disposable income growth. However, with the labour market set to remain tight, robust wage growth combined with abating inflation are expected to ensure solid growth of real income and by extension – private consumption. Consumer confidence remains high, providing further support for private consumption. Investment Investment is set to gradually slow as inflows of EU funds approach their peak in 2020. However, the beginning of the Rail Baltica project is expected to boost investments in 2021. In 2019, investment is forecast to have grown by 4.5% - notably less than the double-digit growth rates seen in 2017 and 2018. Due to EU fund inflows levelling off, public investment growth declined significantly while the momentum in private investment held up better. In 2020, public investment is expected to decline slightly while moderate growth in private investment should put the total growth rate in low positive territory. The construction related to the Rail Baltica project (see Section 3.4) is expected to begin at the end of 2020 and should boost the investment growth rate in 2021. Graph 1.2: Investment growth and contributions, % Source: European Commission Trade Exports slow amid weakening external demand while decelerating investment curbs import growth. In 2019, exports are forecast to have grown by 2.7%, down from 4.0% in 2018. The slowdown is partly due to a drop in re-exports. However, there was also a slowdown in growth in exports of domestically produced merchandise, most notably wood products, after the boost from high timber prices of previous years. On the positive side, services export growth improved compared to 2018 thanks to the especially strong performance of business and IT services exports, which outweighed the languishing transport sector — Latvia’s biggest services export sector. Over the coming years, export growth is unlikely to improve significantly given the weakening demand from the country’s main export markets. Inflation Inflation reaches its peak in 2019 as food and utility prices drove it past the 3 per cent mark. HICP inflation reached 3.1% in 2019, up from 2.6% in 2018. The pick-up in inflation was due to hikes in the prices of several utilities at the beginning of the year, a pick-up in inflation for industrial goods and a spike in the growth of food prices, which was partly the result of the previous year’s poor harvest. Services price growth at the same time remained stable, hovering around 3 per cent. It is expected that the acceleration in utility and food prices will have been temporary and will therefore slow inflation this year and next. Inflation is forecast at 2.5% in 2020 and at 2.3% in 2021. Graph 1.3: HICP inflation and contributions, % 12-month average year-on-year change Source: European Commission Labour market At 6.4% in 2019, the unemployment rate edges closer to its record low as wage growth remains high. In 2019 the unemployment rate dropped to 6.4% from 7.4% in 2018. The unemployment rate continued falling despite a forecast 0.4% decline in employment — this was due to the declining active population. Employment was down in trade, while in construction it continued to grow. However, with investment growth projected to slow, employment demand from the construction sector should also fall. Nonetheless, a continued decline of the labour force is expected to keep the unemployment rate constant despite falling employment — it is forecast to remain at 6.4% in 2020 and 2021. The continued decline of the working age population is set to ensure a dwindling active population. Altogether, this will ensure the labour market remains tight over the forecast horizon, exerting upward pressure on wages. Graph 1.4: Selected labour market indicators Source: European Commission Labour supply is expected to continue falling and skills mismatches have emerged. The reduced labour supply – the outcome of natural population decline and emigration – has led to emerging labour shortages and a tightening labour market. In addition, skills mismatches prevail with large and increasing differences among the unemployment rates of different skills groups (Section 3.3.1). Wages and productivity Rapid wage growth drives unit labour cost appreciation. Nominal wages grew by 8.5% in 2019, up from 7.6% growth in 2018. Wages have been increasing at a brisk pace for some time now with the average wage growth over the past 5 years reaching 7.9%, substantially above the EU average of 1.6%. Productivity growth has also been fairly rapid with 3.0% growth in 2019, slightly higher than the 2.8% average growth rate over the past 5 years. Wage growth, however, has outpaced productivity growth by some margin, leading to a significant appreciation in unit labour costs, which grew by 5.3% in 2018 and the three-year growth of 14.7% is above the macroeconomic imbalance procedure threshold of 12%. In 2019, unit labour cost growth is expected to have slowed along with slowing wage growth. However, looking forward, the tight labour market is set to continue driving swift wage growth, which may lead to elevated unit labour cost growth. Graph 1.5: Wages, productivity and unit labour costs, index 2000=100 Source: European Commission Income level In 2018, Latvia’s GDP per capita stood at nearly 70% of the EU average. In 2018, Latvia’s GDP per capita increased by 5.4% — among the highest growth rates in the EU. It was driven in equal parts by productivity growth, which increased by 3.0% and by growth in the share of the employed population, which increased by 2.4%. In purchasing power parity terms, it was 69.3% of the EU average, more than 3 percentage points higher than the year before. However, there are significant regional differences in GDP per capita within the country — in 2016, in Riga it stood at 165% of the national average, while in the other regions it was below the national average with the poorest region — Latgale — producing only 51% of the national average. The differences in wage levels are smaller, with the Riga region’s wages being 113% compared with Latgale’s 69% of the national average. Social developments

While severe material deprivation has declined, relative poverty has worsened and both remain above the EU average. In line with the gradual improvement in labour market indicators, the share of people living in low-work intensity households has been falling for a number of years and reached 7.6 % in 2018, down from 10 % in 2013. This however, has not been sufficient to alleviate poverty, due to the presence of high in-work poverty in the low work intensity households. The at-risk-of-poverty rate, a measure of relative poverty, increased to 23.3 % in 2018 from 19.4 % in 2013, above the EU average of 17.1 %. Meanwhile, severe material deprivation showed a marked decline from 24% in 2013 to 9.5% in 2018, but remains somewhat above the EU average of 5.9% (see Graph 1.6). In 2018, the overall at-risk-of-poverty-or-social-exclusion rate of 28.4% also masked large differences between age groups, with the elderly (65+) facing a much higher risk compared to children or those of working age (49% as opposed to 22.5% and 23.5 % respectively) (Section 3.3.2). Graph 1.6: Selected social inclusion indicators, % of population Source: European Commission Income inequality remains well above the EU average. While reducing inequality is one of the main goals of Latvia’s national development plan, Latvia is unlikely to achieve its national target to bring inequality down to the EU average by 2020. Income inequality as measured by the S80/S20 has risen in the post-crisis period and is among the highest in the EU. In 2018, the ratio stood at 6.8 compared with the EU average of 5.2. While income inequality before taxes and benefits is below the EU average, inequality after taxes and benefits, remains high, due to its relatively small role in redistributing income. A key driver is the low income of elderly households whose median income level is less than three quarters of that of the general population. Unequal opportunities in access to education and healthcare persist. According to the OECD Programme for International Student Assessment (PISA), the education system is rather equitable, with socioeconomic background exerting a relatively limited influence on learning achievement in reading. At the same time, access to quality education remains dependent on the place of residence, and urban schools outperform rural ones (Section 3.3.4.). A similar urban-rural divide exists in access to healthcare. Moreover, low-income groups report significantly more unmet needs for medical services than high-income groups (Section 3.3.3.). External position The current account remains close to balance. In 2019, the current account is forecast to have recorded a deficit of 0.8% of GDP, similar to the previous year. The main forces at work in determining the current account balance are (i) EU fund inflows, which are partly spent on importing investment goods, and (ii) household savings growth in excess of domestic investments, which need to find an investment outlet outside of the country. Consequently, the net international investment position has continued to improve and stood at minus 50% of GDP at the end of 2018, from minus 83% of GDP in 2010. While still relatively high, the associated economic risks are limited, because this net investment position is mostly composed of foreign direct investment, while the investment position excluding equity was close to balance at the end of 2018. Graph 1.7: Current account and its components, % of GDP Source: European Commission Public finances The general government balance improved slightly in 2019. The general government deficit is forecast to have been 0.6% of GDP in 2019, slightly better than the 0.7% of GDP deficit in 2018. The government balance is set to remain broadly stable in 2020 and 2021, while the government debt is expected to continue falling to reach 32.9% of GDP in 2021. The Commission estimates that the output gap will remain positive but will be shrinking throughout 2019-2021. Key sustainability challenges Latvia progresses well on most United Nation’s Sustainable Development goals with slower progress in health, innovation and reducing inequalities. Latvia has among the highest shares of renewable energy among EU countries (SDG 7, see Section 3.5), it scores above EU average on most education and labour market indicators (SDGs 4 and 8, see Section 3.3.4). However, inequality in Latvia is high and has seen little progress over medium to long term (SDG10, see Section 3.3.3). This is also reflected in Latvia’s health outcomes (SDG 3, see Section 3.3.3) and social protection (SDG 1, see Section 3.3.2) remaining below EU average, as these sector have been significantly underfunded. Furthermore, breaking the trend of rapidly growing energy consumption and improving the recycling rates remain the key environmental sustainability challenges (SDG 12, see Section 3.5). Finally, while Latvia’s economic performance has overall been good, as its income per capita growth over the past decade has been remarkable (SDG 8, see Sections 1 and 3.4), its innovation performance is poor and has seen little progress in recent years (SDG 9, see Section 3.4). Table 1.1: Key economic and financial indicators - Latvia (1) NIIP excluding direct investment and portfolio equity shares.

(2) Domestic banking groups and stand-alone banks, EU and non-EU foreign-controlled subsidiaries and EU and non-EU foreign-controlled branches.

(3) The tax-to-GDP indicator includes imputed social contributions and hence differs from the tax-to-GDP indicator used in the section on taxation. Source: Source: Eurostat and ECB as of 9-1-2020, where available; European Commission for forecast figures (Autumn forecast 2019) Since the start of the European Semester in 2011, 95% of all country-specific recommendations addressed to Latvia have recorded at least ‘some progress’. In 2019, work advanced on some long-standing recommendations, with ‘some progress’ made in improving the adequacy of minimum social benefits and public administration reform has helped improve governance of municipalities. Moreover, the taxation of low wages (the tax wedge) has been notably reduced over the years past few, bringing it in line with the benchmark against other EU countries in 2020. However, this reduction in the tax on labour has been only partly compensated by other tax measures, showing ‘limited progress’ over time (Graph 2.1). Latvia has achieved ‘substantial progress’ and ‘full implementation’ in introducing a fiscal governance framework, reforming the pension system a few years ago and strengthening the anti-money laundering system more recently. Graph 2.1: Overall multiannual implementation of 2012-2019 CSRs to date (1) The overall assessment of the country-specific recommendations related toon fiscal policy exclude compliance with the Stability and Growth Pact.

(2) The multiannual CSR assessment of the country-specific recommendations looks at their implementation since from the CSRs time they were first adopted until the February 2020 Country report. Source: European Commission Latvia is committed to fiscal discipline and the tax wedge for low wages has been reduced. Latvia corrected its excessive government deficit in 2012 and since then has strived to maintain government borrowing within the limits set by the well-established fiscal governance framework. The increase in the income-dependent basic allowance in 2020 should reduce the tax wedge for low wages, thus showing a substantial progress in this respect. However, Latvia has not ensured revenue neutrality of the recent tax changes with the tax revenue from capital and property declining, contrary to what has been recommended. This limits its capacity to address the social reforms recommended to Latvia. Tax compliance is gradually improving, but more could still be done by closing tax policy loopholes, like the micro-enterprise tax regime, and by tackling more decisively shadow activity in several sectors of the economy. Some progress has been made in carrying out social policy reforms, but their implementation is limited by the low level of public funding. Ambitious government plans to raise the minimum income level announced in 2014 have been shelved up to now due to a lack of funding. In 2020, the minimum social assistance benefits have been somewhat increased, but less than planned for 2020-2021, due to funding constraints. The adequacy of the minimum social benefit remains low and more effort is needed. The low level of public financing for health has limited people’s access to quality and timely care for years. Healthcare financing increased in 2017-2019, reaching an estimated 3.8% of GDP, but it is set to decline in 2020, as funding commitments are only partly satisfied. Efforts to increase the efficiency and quality of the health system continue, while major reforms of the hospital and primary care networks are still at an early stage, despite being on the reform agenda for some years now. Education reforms have shown ‘some progress’ since 2012, but a greater effort could be done in order to improve the quality and efficiency of the education system, while expanding adult learning. Latvia made some progress in developing a quality-rewarding financing model for higher education and setting up an external quality assurance agency for higher education over 2012-2015. However, the amount of performance-based funding remains limited, and the higher education system remains fragmented, with too many study programmes and education institutions. The intentions of streamlining the school network, given the declining number of students, has not proceeded as planned in recent years, thus delaying gains in quality and efficiency in general education. Reforms to improve vocational education and training are ongoing, but the share of students in this type of education remains low. Participation in adult learning is low, especially for the low-skilled, due to personal reasons and insufficient non-financial and financial incentives for employers to invest and support adult learning for their employees. Despite low national financing, ‘some progress’ has been achieved in investing in innovation, transport and digital infrastructure, while housing and environmentally minded policies have not yet been established. Since 2012, Latvia has been recommended to expand its investments in R&D, but funding plans have not materialised. Nevertheless, consolidation of the research institutions has been achieved and establishing a unified governance body planned. Transport and digital infrastructure have been developed with the EU’s support, but broadband coverage in rural areas remains low. Plans to develop an environmentally sustainable energy and transportation network have not yet been devised. However, the development of Rail Baltica should support the shift to transport that is less carbon intensive. Investments in housing are hampered by lengthy and cumbersome planning processes, as well as outdated rental laws, with no progress on proposed changes since 2018. Public governance reforms, one of the reform priorities since 2012, have shown ‘some progress’ in recent years. The reduction in the length of court proceedings in general has been achieved, while the role of the Council for the Judiciary has been strengthened. Public oversight of insolvency administrators has been established. Public administration reform for the central government is being implemented over the period 2017-2020 and reform of local governments is set to be rolled out from 2021. Moreover, corporate governance of state and municipal companies already started to improve before the country’s accession to the OECD in 2016 and has continued to improve since then. ‘Some progress’ has been made in preventing conflict of interests over time, but certain shortcomings remain.

Latvia has made ‘some progress’ in addressing the 2019 country-specific recommendations (see Table 2.1). ‘Substantial progress’ has been made in strengthening the anti-money laundering system and reducing the flow of risky money through Latvia. The shifting of the tax burden from labour to other less detrimental tax sources has been partly achieved, as the measures were not revenue neutral. Social and healthcare plans for 2020 have had their financing restricted, resulting in ‘some progress’. Environmentally sustainable investment policies are still being designed. Public administration reforms have advanced, while the system to prevent conflict of interest showed mixed developments.

Upon request from a Member State, the Commission can provide tailor-made expertise via the Structural Reform Support Programme to help design and implement growth-enhancing reforms. Since 2017, Latvia has received support for a total of 32 projects. In 2019, several projects were implemented, including the development of a framework for assessing performance of the healthcare system and the provision of a methodology for innovative public service reform projects. Moreover, the Commission has supported the authorities in implementing the mid-term tax strategy by, among other things, supporting the development of VAT gap analysis methods and a compliance-risk management strategy. In 2019, work started on reviewing system for assessing disabilities and on enhancing the integration of people with disabilities in the labour market. Table 2.1: Summary table of 2019 CSR assessment * (1) The assessment of CSR1 does not include an assessment of compliance with the Stability and Growth Pact. Source: European Commission * The assessment of CSR3 does not take into account the contribution of the EU 2021-2027 cohesion policy funds. The regulatory framework underpinning the programming of the 2021-2027 EU cohesion policy funds has not yet been adopted by the co-legislators, pending inter alia an agreement on the multiannual financial framework (MFF)”.

(Continued on the next page) Box (continued) 3.1.Public finances and taxation 3.1.1.Fiscal policy Latvia’s fiscal stance is estimated to have tightened in 2019 and 2020. Latvia ran a fiscal expansion in 2017 and 2018 during a cyclical upturn in the economy. This was marked by an increase in government borrowing and annual expenditure growth rates of around 10%. It is projected that in 2019 and 2020, the structural deficit will be reduced in parallel with a slowdown in economic growth and a narrowing positive output gap (Graph 3.1.1). The expansionary revenue effort resulting from tax-cutting measures being implemented as of 2018 has been offset by a contractionary expenditure effort, as nominal expenditure growth is restrained at around 3.5% on average in 2019 and 2020 (Graph 3.1.2). Graph 3.1.1: The fiscal stance and the economic cycle Source: European Commission – Autumn 2019 forecast The government revenue and expenditure share in GDP has declined due to tax-cutting measures. The cuts in effective tax on labour and corporate profits and dividends adopted in 2017 and being implemented from 2018 have only been partly compensated by revenue-increasing measures. It is estimated that the ratio of government revenue to GDP will decline by 1 percentage point of GDP between 2018 and 2020. This will lead to a contraction of the government expenditure ratio, while the government is committed to reducing government borrowing. Current expenditure is planned to decrease by 1 percentage point of GDP (mostly government purchases and transfers) and capital expenditure by 0.5 percentage points of GDP between 2018 and 2020. At the same time the government sector wage bill and social payments are expected to expand, in view of discretionary increases and indexation to wage and price developments in the economy. Graph 3.1.2: Expenditure growth and the discretionary

fiscal effort (1) Discretionary fiscal effort (DFE) consists of revenue and expenditure effort. (1)=(2)+(3)

(2) Revenue effort represents discretionary revenue measures. In this graph, positive revenue effort means expansionary fiscal stance (deficit-increasing).

(3) Expenditure effort shows the gap between the growth of public spending and smoothed potential growth over 10 years.

(4) Expenditure benchmark growth follows the notion of the expenditure benchmark in the EU fiscal framework (nominal smoothed potential growth adjusted for discretionary revenue effort). For further details on the methodology see Carnot, N. and F. de Castro (2015). ‘The Discretionary Fiscal Effort: an Assessment of Fiscal Policy and its Output Effect’. European Commission, Economic Papers 543, February. Source: European Commission – 2019 Autumn Forecast 3.1.2. FISCAL FRAMEWORK AND EXPENDITURE REVIEW The fiscal framework guides the fiscal targets with a margin of interpretation. Budgetary targets are set on the basis of the fiscal rules established in the Law on fiscal discipline and are monitored by the independent Fiscal Discipline Council. However, the Latvian budgetary authorities exercise interpretation when setting the targets, frequently resulting in higher structural balances than what is allowed by the national fiscal framework, as noted in the Surveillance Report by the Fiscal Discipline Council (2019). In particular, the authorities treat part of the tax reform costs as one-off measures, relaxing the structural balance requirement under the national fiscal framework, which is contested by the Fiscal Discipline Council. The Commission also does not recognise such one-off measures, and the authorities take that into account for compliance with the Stability and Growth Pact. The expenditure review in 2019 analyses health and education expenditure, but does not re-evaluate spending priorities across government sectors. The review brought forward improvements in budget preparation, analysed spending on education and health and presented some savings for reallocation. However, the expenditure review does not assess the relevance of existing spending amounts. Any savings in one government sector are expected to be used in the same sector first, while reallocations among government functions are limited. Sectors with historically larger budgets and established indexation mechanisms are in a stronger negotiation position in the government discussions (defence, social protection). However, sectors relying on discretionary decisions need political support from other ministers to be agreed. For example, the baseline budgetary plans for the healthcare sector do not account for the underlying demographic and cost pressures, undermining its starting positon in the budget negotiations. 3.1.3. TAXATION Latvia’s tax revenue share in GDP has been reduced by tax-cutting measures. The ratio of tax revenue to GDP is set to decline from 31½% in 2017 to 30½% in 2020, which is well below the EU average of 39%. The main sources of revenue are labour and consumption taxes. The share of capital taxes was already low compared to other Member States and has been further reduced by the corporate tax reform. The transition to the new corporate income tax regime, where only dividend withdrawals are taxed, resulted in higher temporary costs in 2019 and lower revenue in the medium-term, as companies appear to be retaining profits more than initially planned. Moreover, the decision to postpone the property value update for property tax from 2020 to 2022 limits revenue the potential of taxes on capital. Latvia has moved towards a greener tax system and of all Member States now has one of the highest shares of environmental taxes. Taxes on energy, transport, pollution and use of resources amounted to 3.4% of GDP in 2018 (EU average 2.4%). Nevertheless, some tax exemption remain, decreasing tax effectiveness in changing environmentally harmful consumption patterns. Reduced VAT and excise duty rates on energy (heating and fuel used in agriculture) accounted for 0.3% of GDP in tax expenditure in 2017 (Ministry of Finance, 2018). Moreover, VAT deductibility for the purchase price and operating costs of company cars subsidises the private use of company cars. Latvia’s draft energy and climate plan intends to review and to reduce tax subsidies on fossil fuels, aligning taxation based on CO2 emissions, while household investments in energy efficiency could be incentivised by temporary VAT or property tax reliefs. Increasing environmental taxes can help in achieving environmental objectives. At the same time distributional effects and respective compensatory measures for the most vulnerable households should be taken into account (European Commission, 2019c). The taxation of low wages has been brought in line with other Member States. The budget for 2020 further increased the monthly income-dependent basic allowance to EUR 300 and its minimum threshold to EUR 500, exceeding the previously adopted plans. As a result, the tax wedge for wages at 50% of average wage would decrease to 35% in 2020 — broadly in line with levels in other Member States (Graph 3.1.3). While the measure is targeted at low wage earners, it is estimated to benefit more middle income groups in the population-wide income distribution (Graph 3.1.4). This is explained by a low work intensity of lower income groups and already existing allowances that partly or fully exempt low wages from personal income tax. Social transfers generally considered to be better suited to reaching the poorest households (see Section 3.2.3). At a cost similar to the 2017 tax reform, a reform of the minimum income level, with a tapered transition to labour income, could close the gap with the EU average in terms of poverty and inequality while improving incentives to work (Ivaškaitė-Tamošiūnė et al., 2018).

Graph 3.1.3: Estimated tax wedge on labour in 2020, compared to relatively high and relatively low levels in other EU countries Source: European Commission Graph 3.1.4: Effect on income distribution of the increase in the basic allowance presented in the budget for 2020 Source: European Commission (Euromod) Despite increased labour tax progressivity, the tax system could do more to reduce inequalities. Since 2018, Latvia has adopted a progressive tax schedule and has increased the income-dependent basic allowance, making personal income taxation more progressive. Nevertheless, tax progressivity in Latvia remains lower than in other EU Member States. Moreover, a strong reliance on consumption tax revenue, which typically contributes little to redistribution, and low capital taxation limit the distributional effect of the tax-benefit system and its effectiveness in reducing income inequalities. Property taxation remains based on outdated values. Latvia has a potential to increase revenue from property taxation. Recurrent property tax accounted for 0.7% of GDP in 2019, below the EU average of 1.6% of GDP in 2017. While real estate cadastral values which are used to calculate property tax are meant to follow the market values, the Latvian government has consecutively postponed updating the cadastral values. The planned update in 2020 has been postponed to 2022, as increasing property taxation is highly unpopular. This postponement is estimated to cost around 0.1% of GDP on top of around 0.3% of GDP forgone in revenue due to the previous postponements of valuation updates. Proposed changes to property taxation would narrow the tax base. The draft cadastral methodology presented in 2019 envisages to standardise site areas used for buildings and to cut a number of building classification types, thus addressing the valuation difficulties and sources of inconsistencies. However, the planned introduction of special values for taxation of individual housing sites would make their taxation more detached from the market values. Furthermore, a proposal to tax only primary residences valued more than EUR 100 000 would exempt a majority of households from paying the tax and would cost some 0.2% of GDP in tax revenue. The share of the shadow economy still appears to be high. Based on surveys of company managers, Latvia’s shadow economy was estimated at 24% of GDP in 2018, exceeding estimates for Estonia (17%) and Lithuania (19%) (Sauka & Putnins, 2019). The under-reported business income in Latvia (35% of the shadow economy) and ‘envelope’ wages (22%) account for most of the difference with other Baltic states. Among sectors, construction (36%) and retail (25%) had the highest share of shadow activity in 2016-2018 on average. The VAT gap ( ) in Latvia is estimated at 15% in 2017 exceeding the EU average of 11% (CASE, 2019). The State Revenue Service of Latvia shares similar VAT gap estimates and expects the gap have narrowed in 2018. However, VAT fraud remains widespread. The World Bank has prepared several recommendations on this to the Latvian authorities and organised training for the staff of the State Revenue Service in order to improve VAT collection ( ). Tax compliance has gradually improved through variety of measures. In 2019, the authorities continued expanding use of data-driven risk assessments, increasing communication with the taxpayers through the electronic declaration system and implementing sector specific measures. In the construction sector, the implementation of the collective agreement (see Section 3.3.1) and tightening of electronic employee registration on large construction sites are expected to reduce the high share of shadow activity in the sector. Illegal online gambling has been restricted by more efficient blocking of access to unlicensed gambling sites and by involving payment service providers in policing unlicensed activities. The State Revenue Service is also improving its analytical capacity in using large data sets and in identifying suspicious operations. Tax revenue gains from these measures can be expected in the medium term, but it requires a continuous effort to monitor tax compliance and to react to the signs of evasion. 3.1.4. DEBT SUSTAINABILITY ANALYSIS AND FISCAL RISKS The risk to Latvia’s fiscal sustainability is assessed to be low in the medium and long term, assuming current policies continue. The low risks to fiscal sustainability are assessed on the basis of the low initial debt level and on the assumption that the costs related to the ageing population will be contained (see Annex B). Under the baseline scenario of the 2018 Ageing Report (European Commission, 2018a), total ageing-related expenditure is projected to decline by 1.3 percentage points of GDP between 2018 and 2070, assuming a fall in pension spending and a limited increase in healthcare spending. The average public pension benefit is projected to decline relative to the average wage, though this would be partly compensated by the increasing size of the mandatory private pension schemes. The health expenditure-to-GDP ratio is expected to increase from 3.7% in 2016 to 4.3% in 2070, in view of the projected demographic changes. This would still be one of the lowest in the EU. These assumptions might be politically and socially unsustainable, thought, in view of the currently low adequacy of pensions (see Section 3.3.2) and underfunding of public healthcare (see Section 3.3.3). If Latvia converges with the EU average indicators for pension adequacy and health spending, risks to fiscal sustainability appear higher. Assuming that healthcare costs converge with the EU average, Latvia’s healthcare and long-term care spending is projected to increase by some 3% of GDP by 2070. Maintaining the current levels of the pension benefit ratio up to 2070 would cost around 2% of GDP annually. Moreover, raising the pension benefit ratio to the EU average would cost 10% of GDP. Such assumptions would lead to higher risks to fiscal sustainability in the medium and long run than current policies suggest. Financial stability The Latvian banking sector remains profitable, well-capitalised and overall sound despite the decline of the non-resident segment. Average profitability has remained relatively stable despite the shrinking of non-resident banks’ operations. Return on equity increased slightly to 10.1% in the first half of 2019 while the return on assets was 1.1% at the end of the first half of 2019. As a result, banks are on average well capitalised with a total capital ratio of 22.6, which is well above the EU average and the prudential minimum set by the regulator. According to a stress test done by the Bank of Latvia, the shock absorption capacity at a systemic level is good. Local deposits are still outpacing credit growth, contributing to a falling loan-to-deposit ratio, which reached 74% at the end of Q2 of 2019. The liquidity risk of credit institutions is limited, as liquid assets make up a large share of total assets (30%). Table 3.2.1: Financial soundness indicators (1) * ECB aggregated balance sheet: loans excluding to government and monetary financial institutions / deposits excluding from government and MFI

** For comparability only annual values are presented Source: European Central Bank CBD2 The banks formerly servicing non-resident clients are in the process of finding a viable alternative for their former business model. Non-resident banks ( ) have substantially downsized their operations on the back of tightened anti-money laundering rules (see below) and transformed their business models. As a result, their business volumes and deposits shrunk notably. A part of the credit institutions servicing foreign customers has started to offer new financial products and collect household deposits via web platforms. While this improves the maturity composition of their financing, it may pose refinancing and liquidity risks in the medium term, given the likely outflow at maturity. Other credit institutions have seen the quality of their foreign loan portfolio deteriorate, a large part of which consists of unlikely-to-pay loans (NPL) not past due. The average non-performing loan ratio for households and non-financial corporations amounted to 7.5% in Q2 2019, but trends in the NPL-ratio of credit institutions servicing domestic customers and foreign customers considerably differ (4.2% and 31.4% respectively). The main risks to financial stability are associated with housing market developments in the Nordic countries and anti-money laundering in Latvia. Although, the significance of Nordic parent bank funding for their subsidiaries in Latvia has shrunk considerably, risks related to the housing market in Sweden could impact Latvia via trade and confidence channels. Moreover, following the transformation of Luminor Bank from a subsidiary into a branch of the Estonian entity, the transmission of shocks coming from other Baltic states to Latvia could be accelerated. While measures have already been put in place to mitigate the risks of money laundering and terrorist financing, potential ramifications in the financial sector could be wide and uncertain in case of adverse events. Anti-money laundering

Latvia has reaffirmed its commitment to fighting money laundering and terrorism financing as key to preserve trust and stability of its financial system. Following the ABLV case ( ), Latvia took immediate steps to reduce the flow of risky assets through its financial system (European Commission, 2019a) In July 2018, Moneyval concluded that the effectiveness of Latvia’s anti-money laundering (AML) system was only moderate and put it under enhanced monitoring by the Financial Action Task Force ( ) (FATF). The FATF will assess the progress made by Latvia at its next plenary meeting in February 2020. Following Moneyval’s report, Latvia has declared shoring up its AML system a priority and has worked on many fronts to strengthen its anti-money laundering system. In January 2020, Moneyval has taken stock of Latvia’s progress and improved the country’s ratings on 11 recommendations, and Latvia is now “compliant” or “largely compliant” with all FATF’s recommendations. Measures to improve the fight against money laundering would contribute to advancing towards SDG 16. Latvia has updated its anti-money laundering legal framework and strengthened the supervisory and law enforcement institutions. Latvia updated its anti-money laundering law, the law on credit institutions and the law governing Latvia’s financial supervisory agency – the Financial and Capital Markets commission (FCMC). The list of authorities with competence to enforce sanctions was also expanded. Implementation of international sanctions is among the FCMC’s top priorities for the coming years. As of 29 June 2019, the Financial Intelligence Unit (FIU) is the chief authority responsible for AML/CFT issues. Its staff was increased and its independence and autonomy were bolstered. The extent to which the Financial Intelligence Unit (FIU) of Latvia can effectively execute and leverage its new powers will be essential given its central role in AML/CFT framework. Latvia has increased the financial supervisor’s staff and invested in its analytical capacity. The number of staff dealing with AML supervision increased markedly. FCMC developed new tools to better identify beneficial owner groups and transaction connections. The FCMC also increased the number of on-site inspections and strengthened its supervision of money services providers, which have emerged in the wake of shell companies closing down. Over 2019, the FCMC has imposed enforcement actions (monetary and other) on four banks and four administrative investigations are ongoing. A new supervisors’ coordination platform allows a common understanding of money laundering and terrorist financing risks and is used to share knowledge and supervisory practices. All supervisors have now developed sectoral risk assessments and guidelines for risk-based supervision. However, Latvia should continue its efforts to implement risk based supervision in practice. De-risking and rebuilding the reputation of Latvia’s financial sector has been a critical part of Latvia’s anti-money laundering strategy. One of the FCMC's main objectives is to closely monitor the change of business model of the banks (formerly) servicing foreign clients. Due to de-risking measures taken by banks, amplified by the ban on servicing particular type of shell companies, the share of non-EU deposits has decreased from 35.6% in 2015 to 6.6% in September 2019. The value of non-resident deposits has shrunk from €8.1 bn in 2017 to €3.2 bn in September 2019 (39.7% to 19.5% in total deposits). De-risking actions taken in respect of other high-risk areas (e.g. foreign-owned companies) include improved transparency of legal persons ( ). Nevertheless, Latvia should increase its understanding of underlying risks of money laundering and terrorist financing, in particular in relation to accountants, lawyers, tax advisors and other professionals involved in company formation. The government has also strengthened the dialogue between the financial sector, the supervisor and the law enforcement bodies. In 2018 a coordination group led by the FIU was set up and helped improved the stakeholders’ understanding of money laundering risks. Moreover, thanks to the feedback by the Financial Intelligence Unit to obliged entities, the quality of suspicious transaction reports has improved and its quantity reduced, although it remains rather high. Cross-border dissemination of suspicious transaction reports has improved. Latvia should continue its efforts on the cross border dissemination of suspicious transaction reports. The law enforcement authorities’ capacity to handle money laundering cases still needs to be strengthened. Guidelines on investigation have been updated and training has been provided to all judicial stakeholders to improve the quality and effectiveness of prosecuting money laundering cases. Data show that the number of prosecutions and criminal proceedings has increased and that assets are being confiscated ( ). However, efforts could continue to ensure that money laundering investigations are prioritised and effective and dissuasive sanctions for persons convicted of money laundering. Credit growth Mortgage lending has been boosted by a state support programme, but credit growth remains sluggish overall. After prolonged deleveraging, the annual growth rate of mortgage loans turned positive in 2018, reaching 1.9% (year-on-year) in August 2019. The growth in mortgages is underpinned by an improvement in the financial situation of households, low interest rates and the state programme to support house purchases. The increase in lending to non-financial corporations (3.5% growth year-on-year in the first half of 2019) is to a large extent linked to a few large long-term loans. At the end of 2018 bank lending to the domestic non-financial sector stood at 34% of GDP, remaining among the lowest in the EU. At the same time, the role of non-bank financial institutions in domestic lending continues to strengthen. At the same time, the role of non-bank financial institutions ( ) in domestic lending continues to grow. At the end of 2019, non-bank lenders accounted for 17% of all loans granted to households and non-financial corporations. The growth in household leasing provided by the non-bank financial sector, in particular, accelerated from 5.9% in 2018 to 8.2% in Q2-2019. By contrast, growth in leases to non-financial companies decreased from 10% in Q4-2018 to 3.2% in Q2-2019. This can be explained by the deferral of corporate income tax tax for reinvested profits, which was introduced from 2018. Slow credit growth is due to both demand and supply factors. Banks’ standards for lending to small and medium-sized enterprises remain tight. High credit risk (bad track records, weak borrower collateral and equity), shortcomings in the legal framework, and the shadow economy are important supply-side constraints to corporate lending. On the demand side, the share of finance-constrained firms appears to be higher in Latvia than in other Member States (EIB Investment Survey 2019). Rejected loan application rates remain high — according to SAFE survey data, the percentage of rejected loan applications by small and medium-sized enterprises (SMEs) has further increased, reaching the fourth highest share in the EU. At the same time, the availability of bank loans for large corporates with sound financial indicators is good. However, their demand is low and volatile. Smaller investments are often financed with internal resources. Additional macro-prudential measures aimed at limiting the growth of loan-to-value ratios are under way. Bank of Latvia has expressed concern about the loan-to-value ratios which are rising because of the state guarantee programme helping families buy their first property by guaranteeing part of their down-payment. About half of all mortgages are granted under the state support programme. In the first half of 2019, new loans with a loan-to-value ratio exceeding 90% accounted for one third of all new mortgages. Besides the lower down payment, a discount on stamp duties for loans granted through the state support programme provides an additional incentive to apply for support. Bank of Latvia wishes to make the 90% ceiling on the loan-to-value ratio, which is already effective for banks, also binding for non-bank lenders. Alternative financing There has been a steady increase in the availability of venture capital in recent years and this trend is expected to continue. Access to finance is supported by the national development institution Altum, which plays a major role by supplementing bank and other market-based financing to mainly small and medium-sized enterprises. It provides loan guarantees to established companies and direct funding to start-ups for seed, acceleration and expansion phases. The sectoral distribution of venture capital investments is diversified, but ICT and manufacturing stand out. There is a strong concentration of venture capital in the Riga region, where most high-growth enterprises are located. According to the start-up ecosystem mapping completed in 2019, between 2012 and 2018 the amount of venture capital attracted by 178 Latvian start-ups totalled €122.2 million. Venture capital constitutes the main form of financing for start-ups or 46%. Other investors like banks and financial institutions represent 23% of the total investment, with financing also coming from business angels (6%), enterprises (5%) and crowdfunding (1%). Despite increasingly positive trends, the venture capital market in Latvia is still developing relatively slowly. It is focused on the rather early stages of financing and remains dependent on public co-funding (European Commission, 2019e). In August, the continuation of the Baltic Innovation Fund initiative was ensured with the signature of the Baltic Innovation Fund 2 Agreement by the European Investment Fund and the three Baltic states. Over the next 5 years, the Baltic Innovation Fund 2 (€156 million) will invest in private equity and venture capital funds that focus on the Baltic states, with the goal of further developing equity investments in SMEs to boost growth in the region. Housing market The growth in residential real estate prices does not pose systemic risks to financial stability. Nominal house prices have grown on average by 8-9% annually in recent years. The increase in house prices has been supported by the steady wage growth of recent years and the state support programme for house purchase that was introduced at the beginning of 2015 and expanded in 2018. Since the burst of the housing bubble in 2009 when house prices fell by 45%, their recovery has not exceeded wage growth. In fact, since 2010 when house prices were at their most depressed level, wage growth has exceeded house price growth by some 10 percentage points, as evidenced in the continuously declining house price wage ratio (see Graph 3.2.1). A housing affordability index compiled by one of the Baltics’ leading commercial banks shows that, of the three Baltic capitals, house prices remain most affordable in Riga (Swedbank, 2019). The volatility of construction demand has fuelled rapidly rising labour costs. Moreover, lengthy and cumbersome processes for obtaining planning and building permits have also contributed to the high cost of construction. As a result, the market for new dwellings is concentrated mainly in Riga and the surrounding area, because lower purchasing power in places further away makes new housing commercially unviable (European Commission, 2019a). Streamlining building regulations is essential to remove a range of supply-side factors that impede the ability of the construction sector to respond to a growing demand for affordable housing. Graph 3.2.1: House prices / wages ratio, index, 2006=100 Source: European Commission Shortages of skilled workers are a major bottleneck in the construction sector. There is a particular need for construction managers, water and wastewater engineers and roofers. Latvia adopted a construction industry development strategy for 2017-2024 to address industry issues, which include ensuring a qualified workforce; increasing productivity; reducing administrative barriers; and improving the quality of construction services. In addition, the volatility of investment demand exacerbates the capacity constraints and price pressures in the construction sector (European Construction Observatory 2019). 3.3.1. Labour market Labour market performance is overall positive; however, labour shortages and skills mismatches have emerged. The employment rate continues its upward trend (77.4% in Q3-2019; 76.8% in 2018), on the back of declining unemployment (6.2% in Q3-2019; 7.4% in 2018) and a growing activity rate (77.7% in 2018). The long-term unemployed and young people also continue to benefit from the steady improvement in the labour market. Nonetheless, unemployment rates continue to differ depending on the region and level of skills, highlighting the need for significant investment. Unemployment is forecast to fall further over the coming years, mainly because the labour supply is expected to continue falling due to a natural decline in the population and emigration (see Section 1). Between 2000 and 2016, Latvia lost about 287 000 people (12.1% of the initial population) to net migration, with skilled labour accounting for more than two thirds of this loss (Hazans M., 2018). The limited labour supply has led to emerging labour shortages and exposed skills mismatches. In Q2-2019, vacancies reached a historic peak of 30 500, with an increase of almost 24% compared to the same period in 2018 (CSB, 2019). Compared to other Member States, Latvia still faces relatively low labour shortages with 15.5% of the firms facing difficulties finding suitable workers (EU-BCS, 2019). However, the indicator has increased substantially since 2013 (by around 7.7 pps). Conditions are improving with return migration and immigration from other non-EU countries on the rise. In 2018, international long-term net migration was still negative at 4.9 thousand people. However, this is the lowest level recorded in the past 20 years. The ongoing income convergence and moderate labour shortages provide positive conditions for return migration. Coupled with more flexible immigration regulations, they have also led to an increase in immigration from non-EU countries. In 2018, about 4 000 work permits were issued, mostly for workers from Ukraine and the Commonwealth of Independent States (CIS), which is comparable with the number of return migrants (Krasnopjorovs, 2019). Nevertheless, assessing the full extent of non-EU workers in the Latvian labour market remains a challenge due to the multiple entry channels, absence of proper monitoring tools and fragmented oversight. While increasing, the limited size of return migration and immigration cannot compensate for the shortage of skilled labour caused by emigration over the past years (Hazans M., 2018). It could, however, alleviate some short-term labour market pressures.

A large share of the unemployed are low-skilled, while there is a shortage of high-skilled labour. In the short term, the strong growth in the construction sector absorbs low and medium-skilled workers, with little effort for upskilling and adult learning ( ). Nevertheless, unemployment rates continue to differ by skill level: the unemployment rates of high, medium and low-skilled workers stood at 3.7%, 8.5% and 16.5%, respectively (2018) (Graph 3.3.1). Labour market shortages have emerged for high-skilled labour in particular. At the same time, the supply of low-skilled workers exceeds their declining demand, leading to a high unemployment rate for this group, with the gap expected to continue widening over the medium and long term (Ministry of Economics, 2019a). Increasing training of low-skilled and unemployed could help to progress on European Pillar of Social Rights principle 1, thereby also contributing to advancing towards the United Nations’ Sustainable Development Goal 4 and 8. Graph 3.3.1: Unemployment rate by education attainment Source: European Commission Low-skilled, older workers and ethnic minorities have limited access to the labour market. While youth unemployment has decreased, unemployed young people often lack work experience and basic skills, and youth employment (33.1% for young people aged 15-24) is lower than the EU average (35.4%, 2018). As many as half of the registered unemployed aged 15-29 are low skilled, which reflects the overall high unemployment of the low-skilled in the country (Graph 3.3.1). Unemployment among older workers (aged 55-74) is decreasing at a slower rate than for other age groups, which can be linked to their poor health and low participation in adult learning (3% in 2018) (CSB, 2019). The employment rate for ethnic minorities is some 12 pps lower than for the ethnic majority, and unemployment among non-EU nationals is consistently higher than among nationals in every age group. This is partly linked to the insufficient public supply of general and professionally oriented Latvian language courses for the adult population (OECD, 2019a). Improving labour market access for these groups and unlocking the internal labour market reserves, could ease some of the tensions in the labour market. Employment conditions differ across regions and internal mobility remains a challenge. The unemployment rate, youth unemployment rate and share of long-term unemployed vary considerably across regions. While densely populated Riga and the surrounding Pieriga region exhibits the lowest levels of unemployment (6.7% and 4.7% in 2018 respectively), Latgale has both the highest unemployment rate (11.8% in 2018) and lowest activity rate among Latvia's NUTS-3 regions (CSB, 2019). A regional mobility support scheme reimbursing transport or housing costs for 4 months (capped at EUR 600) is having a positive effect on job uptake and has the potential to be scaled up in a targeted way (OECD, 2019b). However, rental costs relative to incomes are high in Riga and the surrounding region of Pieriga, thus discouraging regional mobility. The absence of a national housing policy also limits the provision of housing to more vulnerable groups (see Section 3.3.2.). Spending on and participation in active labour market policies remain low, limiting the activation of those furthest away from the labour market. While Latvia has low public spending 0.6% in 2017 on active labour market policies, the list of such policies has expanded and diversified in recent years. Training for the unemployed has had a positive effect on labour market outcomes; effectiveness has been further boosted when combined with other measures, such as support for regional mobility. However, the role of these measures is limited by the low registration of jobseekers with the public employment service, with only around half of all unemployed registered, and relatively low participation rates (6.8 per 100 persons wanting to work, 2017). Many unemployed persons therefore cannot be reached to help them search for a job or participate in activation measures (OECD, 2019b). Cooperation between public employment services, social services and educational institutions is insufficient, resulting in poor monitoring of school-to-work transitions and limited integration in the labour market. While the employment rate of women is high, imbalances in the labour market persist. Latvia has one of the lowest gender employment gaps (4.2 pps in Latvia, 11.6 pps EU average, 2018) and a gender pay gap around EU average (15.7% versus 16.0% in the EU, 2017). While women have higher educational attainment (see Section 3.3.4), they are also more likely to study social sciences and humanities and work in sectors with lower wages, such as healthcare, social care, education and tourism. Around 21.8% of women and 19.4% of men earn minimum wages or lower (CSB, 2019). Access to flexible working arrangements is lower in Latvia than in the EU as a whole and around two thirds of women (68%) and men (63%) are unable to change their working time arrangements (EIGE, 2019). Latvia is taking steps to progress on European Pillar of Social Rights principle 2, thereby also contributing to advancing towards the Sustainable Development Goal 5, to achieve gender equality also through national planning documents, such as the Plan for Stimulating Equal Rights and Opportunities for Women and Men 2018-2020. The prevalence of completely or partially informal employment is high. While the share of undeclared earnings is slowly decreasing, estimated 41% of all employees had an undeclared earning share of at least 10% in 2016. More than 4% of employees were working entirely in the informal economy, with the highest incidence among skilled agricultural and manual workers as well as the low-skilled. Moreover, a typical ‘envelope’ wage receiver had low or middle income and faced difficulties in making ends meet (estimates based on EU-SILC microdata). According to a special Eurobarometer survey carried out in September 2019, 36% of Latvians know someone who worked without declaring all or part of their income. One in five Latvians also said they have purchased goods or services that could involve undeclared work in the past year. The high prevalence of the informal economy has adverse effects on the social protection of the affected workers. It further contributes to the under-reporting of accidents at work and heightens occupational risks (European Commission, 2019b). Several measures are being implemented to improve the compliance (see Section 3.1.3.); at the same time the capacity of the State Labour Inspectorate to tackle undeclared work remains limited, due to the high staff turnover and unfilled vacancies, especially in Riga (State Labour Inspectorate, 2019). Wages are catching up with the EU average, but the share of low-wage earners remains high. The average monthly wage (reflected in nominal compensation per employee) grew by 6.2% in 2019 (8.4% in 2018), reaching 67% of the EU average (in purchasing power standards). At the same time, some 27% of employees earned wages up to two thirds of the median wage in 2018, which is a higher share than in other Member States. The national monthly minimum wage stood at EUR 430 in 2019 — at 47% of the median wage. When comparing the net disposable household income of minimum wage earners to the at-risk-of-poverty threshold in 2018, the minimum wage did not provide sufficient income to be out of poverty for a single worker working full-time, for single parents with a child, nor for dual-earners couple with two children (all earning the minimum wage). The net earnings in purchasing power standards for a single person are among the lowest in the EU and reported as ‘weak but improving’ in the Social Scoreboard (Box 3.3.1). Furthermore, Latvia faces a risk of in-work poverty, at 8.1% in 2018 (7.6% for men and 8.5% for women). This risk is particularly high for older workers (aged 55+) with 10.5% at risk of in-work poverty in 2018 and significantly higher for temporary and part-time workers (30.9% and 22.7% in 2018, respectively). While sectoral collective bargaining has been strengthened, the social partners’ limited capacity restricts their role in social dialogue. As of November 2019, the collective agreement in the construction sector entered into force, setting a minimum wage for the sector at EUR 780 and reducing a surcharge for overtime work to 50%. This agreement is a novelty for Latvian industrial relations and a step towards strengthening sectoral collective bargaining, which is currently weak. While EU funds provide financial support to extend sectoral bargaining, collective bargaining coverage remains low and it takes place mainly at company level (Müller T. et al., 2019). The national setting for involving social partners in reforms and policy formation is well established; however, the social partners’ limited capacity restricts their meaningful and timely involvement. 3.3.2. Social policies Poverty remains high and is increasing, while spending on social protection is low. The risk of poverty and social exclusion slightly increased (28.4%, 2018), driven by an increase in monetary poverty (23.3%, 2018), and is reported as ‘critical’ in the Social Scoreboard (Box 3.3.1). Elderly people and people with disabilities are particularly affected (Graph 3.3.2). The share of people who are currently poor and were poor during two out of the three previous years is high and increasing. This indicates that people live with a low income for long periods, as opposed to people who face transitory poverty. In 2018, 1 in 5 Latvians experienced material and social deprivation. In 2018, Latvia spent 11.6% of GDP on social payments, well below the EU average of 20.4%. The budget for 2020 targets an increase in social expenditure to 11.7% of GDP ( ). This mostly reflects the annual indexation of pensions, as well as discretionary increases in minimum social benefits. However, significant investment needs remain to address Sustainable Development Goal 1 to end poverty and foster the active inclusion and social integration of vulnerable groups, which includes providing these groups with supporting social services. Graph 3.3.2: At-risk-of-poverty rate by age groups (1) The at-risk-of-poverty rate is the share of people with an equivalised disposable income below the at-risk-of-poverty threshold, which is set at 60% of the national median equivalised disposable income. Source: European Commission Poverty rates are markedly different among age groups, and tax and benefit policies have not changed significantly the situation of the poorest households. In 2018, the overall at-risk-of–poverty-or-social-exclusion rate of 28.4% masked large differences between different age groups, with older people (aged 65+) facing a more than double risk compared to children or those of working age (49% versus 23%, respectively). According to EUROMOD estimates, the tax and benefit policy changes between 2008 and 2018 increased, on average, disposable income and reduced income inequality (the Gini coefficient fell by about 1%) (European Commission, 2019b). Middle-income groups and the poorest 10% are estimated to have benefited the most. However, the overall poverty rate has remained broadly unchanged, as the poverty line of 60% of median income has increased, covering a similar share of people as before. Policy changes have been more targeted at reducing child poverty (by 2.9 pps), while the poverty rate for older people has increased (by 4.1 pps). The adequacy of social assistance benefits slightly improved, but remains low and contributes little to alleviating poverty. The adequacy and the coverage of the minimum income scheme are very low ( ). From 2020, the guaranteed minimum income tops up monthly income to EUR 64 (from EUR 53 in 2019). The amount of the benefit is still well below the costs of living and the poverty threshold, which stood at EUR 409 in 2018. In 2018, around 1% of the population (20 878 persons) were guaranteed minimum income recipients, out of which 20% were children, 16% people with disabilities and 14% older people. The increase will result in less than 5 000 additional people eligible for the benefit. The effect of the guaranteed minimum income on poverty reduction is very small (1 pp in 2017), and the effect of the housing benefits is equally low, underlining the poor adequacy of Latvia’s social safety nets (European Commission, 2019b). Minimum pensions have been slightly increased, but the adequacy of pensions remains low. In 2018, the aggregate replacement ratio for pensions in Latvia stood at only 40 %, among the lowest in the EU. In 2018, 11.5 % of newly allocated pensions were minimum pensions at an average amount of EUR 83 per month. The average monthly pension stood at around EUR 360 in 2019, which is below the poverty threshold. The gap between pensions and wages in the economy has widened. The average inflation-adjusted gross wage increased by 33% between 2014 and 2019, while, the average inflation-adjusted old-age pension increased only by 15%over the same period. To improve the situation for pensioners, the income tax allowance was increased in 2019 and more favourable indexation rules have been applied to cover inflation and for those with longer service periods. On 1 January 2020, the government also raised the minimum pension base rate from EUR 64 to EUR 80 with higher rates applied for more years worked. Those who have worked less than 15 years will not benefit from the increase, as they are only entitled to a state social security old-age allowance that has remained unchanged at EUR 64 since 2006. Consequently, the adequacy improvements are limited and a large proportion of older people (46%, 2018, EU-SILC) remains below the poverty threshold. The unemployed are at high risk of poverty, in particular when the duration of unemployment increases. The at-risk-of-poverty rate of unemployed persons is high, at 60% (2018), and rising. Despite this, as of 2020, unemployment benefits are paid only for the first 8 months of unemployment (previously 9 months) and are gradually reduced during these months. This change is expected to have a limited impact on the incentive to seek work, as there is already low benefit dependency and about half of the recipients exited the benefit scheme within 6 months (OECD, 2019b). Moreover, low social insurance contributions result in low unemployment benefits. As there is no minimum level of unemployment benefits, vulnerable groups may require social assistance. Therefore cooperation between public employment and social services could be enhanced. The average unemployment benefit stood at EUR 356 per month (September 2019, national data), below the poverty threshold of EUR 409 (2018). Moreover, seasonal workers and the self-employed are not covered by insurance against unemployment and have limited social protection coverage. Measures are being taken to improve the weak social protection for persons with disabilities. The share of persons with disabilities at risk of poverty or social exclusion in Latvia is 43.6 %, one of the highest in the EU (EU average 28.7 %; 2018). In 2018, Latvia had one of the highest gaps in the EU between the at-risk-of poverty–and-social-exclusion rate for persons with and without disabilities (22.4 pps vs. the EU average of 9.5 pps). On 1 January 2020, the state social security benefit, which serves as a basis for calculating the invalidity pension, was raised from EUR 64 to 80 EUR. But for persons with a disability since childhood, the amount has been increased from EUR 106.72 to EUR 122.69 and will be further indexed depending on the severity of the disability. Furthermore, the special care allowance for children and adults with severe disability since childhood was increased on 1 July 2019, by EUR 100, amounting to EUR 313.43 per month. While the measure increases the disposable income of this group, the amounts are still below the poverty threshold, and more could be achieved by providing community-based services. The transition from institutional to community-based care has started, but only covers a part of overall needs. Despite improvements, Latvia still has a high number of people living in institutional settings (5 010 in 2019). With a delay of 2 years, the transition from institutional to community-based care started in 2018 for three priority groups: adults with mental disorders, children with functional disorders and children in out-of-family care. As a result, the number of children in institutions is decreasing. Prejudices towards adults with mental disabilities remain a challenge though, and continuous communication efforts are needed. The EU funds support community-based care services as well as infrastructure, such as day care centres and group apartments, but these funds succeed in covering only a part of the overall needs. The capacity of municipalities to develop community-based services has been strengthened, but shortages of social workers pose a risk to the successful implementation and sustainability of the programme. In 2018, 36% of the country’s municipal social services did not comply with the minimum requirement set by law to provide one social work specialist per 1 000 inhabitants.

Access to childcare facilities is low and the provision of services and support measures is unequal. In 2018, 27% of all 0-3-year-olds were enrolled in formal childcare, which is below the Barcelona targets of 33% and below the EU average of 35% (EU-SILC). While Latvia guarantees a free public early education and care place for every child from as early as one and a half years, around 17% of women and men in Latvia report unmet needs for formal childcare services. Lone mothers are more likely to report higher unmet needs for formal childcare services (24%), compared to couples with children (17%) (EIGE, 2019). The number of public and private care facilities has increased mainly in Riga and the surrounding area, but decreased in other regions. Nevertheless, the availability of the legally entitled place in a public pre-school is a challenge in Riga and other larger cities. Available support measures, eligibility criteria as well as the amount of co-financing for children in private pre-schools due to the absence of publicly funded places varies among the municipalities, thus increasing the inequalities in access to early childhood education and care. Access to adequate housing, particularly for low-income groups, is a challenge, and homelessness is not addressed at national level. In 2018, 14.9% of the population and every fifth person at risk of poverty experienced severe housing deprivation, significantly above the EU average of 3.9% and 9.4% respectively. The proportion of people who found it difficult to adequately warm their homes decreased to 7.5% (2018), while the proportion of those with arrears in utility bills remains high (11.6%, 2018) (see Section 3.5). The lack of a common approach for providing housing benefits in municipalities creates unequal access to the service. The social housing stock is low and often not fit for living, while the waiting period can reach up to 25 years (BISS, 2019). Between 2009 and 2017, the number of homeless people using shelter/night shelter services in Latvia increased almost fourfold reaching 6 877 persons, of whom 80% are men. The service provision for the homeless remains underdeveloped and differs across various municipalities (Lāce T., 2019). Moreover, there is no national strategy in Latvia to address homelessness and housing exclusion specifically nor has any social housing policy been developed in general. The social economy is still a new concept with a potential for growth. There were 75 registered social enterprises by the end of 2019 (MoW data, 2019 ( )). However, it is estimated that up to 200 social enterprises operate in Latvia. Most are relatively new and usually do not employ more than 10 people. While there is a Law on Social Enterprises (2018) and a grant programme, limited recognition by the market and society, as well as poor entrepreneurial skills constrain the creation and growth of the social economy in Latvia. (European Commission, 2018b). Furthermore, while civil society organisations have many opportunities for participation in policy making, their impact is moderate due to their limited capacity. 3.3.3. Healthcare Unhealthy lifestyles constitute one of the main reasons for poor health outcomes. The rate of preventable mortality in Latvia was the second highest in the EU in 2017. Lifestyle-related risk factors (including tobacco smoking, dietary habits, alcohol consumption and low levels of physical activity) are responsible for around 51% of all deaths in Latvia, far above the EU average of 39%. The authorities are putting increasing emphasis on promoting health and a series of measures have been taken in recent years. Nonetheless, the spending on public health and prevention in Latvia remained at 2.4% of the health budget in 2017, below the EU average of 3.1% (OECD/European Observatory on Health Systems and Policies, 2019). Low public financing for health limits access to quality and timely care, negatively affecting health outcomes. Health coverage is nominally universal, but coverage gaps exist. Restricted access to state-paid health services leads to long waiting times, high unmet needs for care with significant disparities between income groups (12.8% for the poorest 20% of the population versus 1.7% for the richest 20% of the population), high levels of out-of-pocket payments for health services (41.8% of the total health spending in 2017) and financial hardship for vulnerable groups such as pensioners and low-income households (European Commission, 2019a). In 2017, the rate of treatable mortality in Latvia was the third highest in the EU, pointing to a need and scope to invest in improving access to and the quality of healthcare. Public financing for healthcare increased from 3.4% of GDP in 2017 to around 3.8% in 2019 ( ). This increased the availability of some health services and innovative medicines and reduced the waiting times in some areas. Moreover, the rise in health spending is expected to have a positive effect on GDP and public finances in the long run by increasing the size of the working age population. Nevertheless, spending on health in Latvia remains among the lowest in the EU. Health expenditure in Latvia, both in terms of per capita and as a proportion of GDP, remains well below the EU average (OECD/European Observatory on Health Systems and Policies, 2019). Latvia's public spending on health stood at 3.4% of GDP in 2017, well below the EU average of 7.8%. The spending share increased in 2018 and 2019, but is estimated to decline to 3.5% of GDP in 2020, as discretionary spending increases lag behind GDP growth (see Section 3.1.2). Significant investments are required in a number of specific areas in order to enhance the quality of healthcare and improve access in the context of Pillar principle 10 and Sustainable Development Goal 3.8: for the implementation of the planned reforms, improvement of the geographical availability of health services, disease prevention, strengthening of primary care, eHealth, integration of care, and for the health workforce. A new health insurance system will replace the two-basket system, which posed risks for access to healthcare for part of the population. The government decided to postpone until 2021 the introduction of the two-basket health insurance system, which was