EUROPEAN COMMISSION Brussels,7.3.2018 SWD(2018) 212 final COMMISSION STAFF WORKING DOCUMENT Country Report Latvia 2018 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2018 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(2018) 120 final}





Contents 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. Investment 3.5. Sectoral policies 3.6. Public administration Annex A Overview Table Annex B Macroeconomic Imbalance Procedure Scoreboard Annex C Standard Tables References LIST OF Tables Table 1.1:Key economic, financial and social indicators Table 2.1:Summary table on 2017 CSR assessment

Table 3.2.1:Financial soundness indicators Table B.1:Macroeconomic imbalances scoreboard Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: GDP growth and components' contributions Graph 1.2: Investment by type of asset, % of GDP Graph 1.3: 12 month average HICP inflation, % change Graph 1.4: Labour market trends in Latvia Graph 1.5: Poverty indicators Graph 1.6: Distribution of income and net wealth Graph 1.7: Net international investment position by sector Graph 1.8: Credit growth Graph 1.9: Real house price index, 2010=100 Graph 2.1: Multiannual implementation of 2012-2017 country-specific recommendations to date

Graph 3.1.1: Government expenditure growth plans Graph 3.1.2: Cumulative fiscal effect of the tax measures Graph 3.1.3: Tax wedge on labour, single earners Graph 3.2.1: Private sector credit growth 22 Graph 3.2.2: Funding of non-financial corporations Graph 3.2.3: House price benchmarks Graph 3.3.1: Employment by sector, year-on-year changes Graph 3.3.2: Job vacancies and labour shortage indicators Graph 3.3.3: At-risk-of-poverty or social exclusion rate by age groups Graph 3.3.4: Relationship between healthcare spending and health outcomes, 2014 Graph 3.3.5: Health risk factors in Latvia relative to other EU countries, 2013-2014 Graph 3.4.1: Investment as a share of GDP Graph 3.4.2: Investment by type of asset, % of GDP vs EU average Graph 3.4.3: Annual average productivity growth, % Graph 3.4.4: Value added per person employed, index 2000=100 Graph 3.4.5: Productivity and real wages, index=1995 Graph 3.4.6: Average unit labour cost and productivity growth, 2001- 2016 Graph 3.4.7: Changes in real effective exchange rate in Latvia and euro area Graph 3.4.8: Employment, labour force and the unemployment rate Graph 3.5.1: Electricity prices for industrial consumers, 2016

LIST OF Boxes Box 2.1: Tangible results delivered through EU support to structural change in Latvia Box 3.1.2: Distributional effect of the tax reform Box 3.2.3: Policy highlights: Altum – single development financing institution Box 3.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 3.4.5: Investment challenges and reforms in Latvia Executive summary Latvia currently enjoys strong economic growth and it has undertaken a number of reforms in key areas. Latvia's economy is on overall strong footing with solid productivity growth, but rapid wage growth carries some risks. Latvia has implemented a major tax reform and is pursuing reforms in other key areas like healthcare, education and public administration. While these reforms aim to address some of the key challenges identified in this report, their effectiveness varies. At the same time, the rapidly shrinking population is weighing heavily on labour supply and the efficiency of public services. Moreover, the high inequality and a number of social challenges reflect the weak social protection in Latvia (). An improving external outlook coupled with recovering investment has pushed Latvia’s real GDP growth above 4% in 2017. Real GDP growth is forecast to have reached 4.5 %, double the 2016 figure and the highest GDP growth since 2011 thanks to the recovery of investments, the more favourable external outlook and continued strong private consumption growth. Growth is expected to ease off to 3.5% in 2018 and 3.2% in 2019 once the initial boost from the investment recovery has passed. Exports and private consumption are expected to continue their strong performance, although these will be increasingly held back by accelerating inflation and labour shortages. While unemployment is steadily decreasing, employment growth is becoming constrained by the falling labour supply. Driven by the shrinking labour force and, to some extent, economic growth, the unemployment rate continued to decline to 8.7 % in 2017. A rapidly rising number of vacancies, reported labour shortages and a strong increase in wages signal a tightening of the labour market. Employment remained practically unchanged while wage growth continued to increase further, reaching nearly 10% in the first three quarters of 2017, also partly due to an increase in the minimum wage. Wage growth has been more or less uniform across skill levels, but large regional differences and skill-level gaps in employment opportunities exist. The large difference between the net income of low-wage earners and the total cost for employers (‘the high tax wedge’) is dampening labour supply while the lack of affordable housing makes it hard for people to move to find work. The population decline increasingly weighs on the efficiency of several areas of the economy and social policy. Latvia’s population has been falling since the early 1990s, caused by a negative natural change and sizeable emigration. Over the past decade, however, the pace of decline has intensified due to a further increase in emigration. Besides weighing on the supply of labour, the falling population is putting a strain on public resources for social and health services. The negative effect of this dynamic is also becoming apparent in education and public utilities as fewer users of the existing infrastructure make their use more expensive. Productivity growth in Latvia has been solid since the crisis, but the easy gains of catching up are over. Since 2010 annual productivity growth in Latvia has been 2.4% on average, among the highest in the EU. However, it has more than halved compared to what it was during the fast catching-up process before the crisis. The structurally lower investment rate suggests that there is no low hanging fruit left and that the country’s growth model will need to change by shifting the focus to climbing the global value chains. However, weak innovation performance, average education outcomes and a diminishing talent pool due to emigration raise concerns about the economy’s ability to expand its share of knowledge-intensive activities. Despite some recent improvements, persistently high inequality and poverty reflect the weakness of the social safety net and the design of the tax and benefit system. While progressivity of labour taxation has been recently improved, its impact on reducing inequality is expected to remain negligible. Poverty and inequality remain high, notably due to the low spending on social protection which is directly linked to low tax revenue as a share of GDP. Although poverty among children has decreased considerably over the past 5 years, poverty risk for the elderly has worsened, largely because pensions have not kept pace with economic growth. Future pension adequacy is also a concern due to a rapidly rising old-age dependency ratio. A major tax reform leaves little room for discretionary spending in other areas. While the cost of the tax reform is expected to weigh on the fiscal position in 2018-2019, the government deficit is set to remain at around 1% of GDP. At the same time, the intention to stick to the current tax policy for the coming three years will limit the available public resources for crucial needs in healthcare and social assistance. Latvia has made some progress in addressing the 2017 country-specific recommendations. Some progress was recorded on reducing the tax wedge on low-income earners and on improving tax compliance. Some progress was also made as a result of setting efficiency targets for central government, by increasing the provision of public healthcare services and by updating vocational education curriculum. However, progress has been limited on preventing conflict of interest in public administration and on improving the adequacy of the social safety net. As for progress in reaching the national targets under the Europe 2020 strategy, Latvia has attained its employment rate target, early school leaving, tertiary education attainment and poverty reduction targets in 2016 and is performing well on renewable energy, energy efficiency, reducing greenhouse gas emissions. More effort is needed on R&D investment. Latvia faces challenges with regard to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. High economic growth has translated into improved employment outcomes. However, income inequality and poverty remain relatively high, in part due to the weaknesses in the social protection system. Access to healthcare and decent housing is limited and social housing is scarce. Participation in active labour market policies remains low. On the positive side, the gender employment gap is very low and gross disposable household income per capita is increasing. The main findings of the analysis contained in this report, and the related policy challenges, are as follows:

·Tax cuts are expected to provide employment and investment incentives, but restrict resources for public services. Labour taxation is being made more progressive by reducing the tax wedge on low wages, although a gap with the EU average remains. Changes to the taxation of capital give entrepreneurs an incentive to retain the profits and the government expects this will boost investment. However, the tax cuts are only partly compensated by increases in excise duties and improving the tax administration, thereby reducing the tax revenue as a share of GDP. As a result, resources for public services remain restricted, in particular for pressing needs in healthcare and social assistance. At the same time, the revenue potential of property taxation remains underused. ·The education system faces a challenge to consolidate resources while improving quality and efficiency. Access to quality education remains dependent on the place of residence and type of school. The decline in student numbers calls for fewer schools and teachers, which would allow for higher teacher salaries and specialisation. At the same time, a competences-based general education curriculum is set to be rolled out from 2018. This is intended to align skills with future labour market needs. The target for vocational education is to increase its share of students by offering them better work opportunities and gradually updating the curriculum. At the moment, participation in vocational education and adult learning is relatively low. ·Facilitating labour market inclusion of the long-term unemployed remains difficult, notably in rural areas. Active labour market policies rely on EU funding and are expected to increase, but their coverage is still lagging behind other EU countries. Regional mobility, particularly to Riga, is impeded by limited availability of quality rental accommodations and because Riga is excluded from the mobility-benefit scheme. There has been a greater effort to reach young people neither in employment, education or training and to help the long-term unemployed get jobs, but this remains a complex task. ·Adequacy of social benefits remains low and results in a high proportion of people at risk of poverty and still high income inequalities. The social safety net is insufficient to provide for the basic subsistence needs. The large number of low-wage earners and widespread underreporting of wages mean that a sizable part of the population has only minimal social coverage. Ambitious government plans to raise the minimum income level have not been implemented due to a lack of funding. Instead, the guaranteed minimum income has been increased marginally. Also, despite some increases in the lowest pensions, ensuring their adequacy remains a challenge. Moreover, the social protection of people with disabilities remains very weak. ·The increase in healthcare financing is expected to satisfy some of the critical needs but newly adopted access restrictions risk worsening health outcomes. The country's poor health outcomes are linked to the low public financing of healthcare and lower efficiency than in other countries. Prioritising resources for health in 2018 and 2019 is expected to expand access to services. However, public spending plans for 2020 remain well below the EU average and reforms to boost efficiency have only just started. State-funded health services are set to be linked to the payment of social contributions from 2019. Population groups excluded from the full access to public services can opt-in by making voluntary health contributions. As a result, part of population stand to lose access to the full basket of healthcare services. ·Rapidly rising labour costs raise some concerns about Latvia’s price competitiveness. Despite rapid wage growth, Latvia has continued to gain export market shares. Crucially, unlike during the period leading up to the 2009 economic crisis, the current account has, on average, remained close to balance. The falling labour supply appears to be the main driver of wage growth, which in turn may have a positive effect by containing emigration. While the risks are limited so far, they highlight the importance of policy measures to increase labour supply. ·Latvia's productivity growth has been solid, but its innovation performance is average. A favourable macroeconomic environment and pressures from the falling working-age population have helped productivity growth in Latvia. However, the low investments in R&D, the overall weak innovation performance and average education outcomes undermine Latvia’s pursuit of higher productivity through specialisation in knowledge-intensive activities. ·Latvia has taken steps to reduce the burden of energy subsidies on electricity consumers but challenges remain. In response to the high and rising costs of energy subsidies, Latvia phased-out the support paid to the state-owned energy company which accounted for around half of the entire subsidy cost. Moreover, it has also sought to increase the competitiveness of large industrial consumers by lowering their electricity price, which is among the highest in EU. However, challenges remain over the efficiency of the electricity network (partly due to the population decline) and achieving better cost effectiveness in renewable energy support. ·Latvia's business environment is generally favourable, although the judicial system and public procurement continue to pose challenges. Overall, Latvia scores high on international business environment rankings, standing out for its well-developed IT infrastructure, online services and access to credit. It does less well in insolvency process and public procurement. While the specific weaknesses of the insolvency framework that allowed for major abuses of the process have been addressed, trust in the judiciary remains relatively low. Furthermore, there are challenges with respect to competitiveness and transparency of the public procurement process. ·The upcoming public administration reform aims at increasing the quality and efficiency of the central administration. This is expected to be achieved by centralising administrative support functions and cutting back administrative procedures and regulations. However, local authorities and state owned-enterprises are outside the scope of the reform, limiting its overall effectiveness. ·Corruption remains a challenge for the business environment, but strengthening functional independence of the anti-corruption office is a positive step. Based on the surveys, corruption is still considered to be more widespread than in some other EU countries, but the share of businesses pointing to it being an obstacle for doing business is decreasing. The in-fighting in the anti-corruption office in the previous years weakened its efficiency, which is expected to be resolved by recent organisational changes. Nevertheless, the delay in legislating on whistle-blower protection is detrimental to improving the accountability and efficiency of public administration. 1. Economic situation and outlook GDP growth GDP growth reached 4.5% in 2017 on the back of strong investment recovery and improved external demand. Investment and exports led the way in an all-around acceleration of growth. While private consumption continued its steady climb supported by increasing wage growth, the recovery of investments was the main determinant of the pick-up in activity in Latvia. Both factors are expected to extend their impact into 2018, but the growth is expected to return to about its post crisis average by 2019. Graph 1.1:GDP growth and components' contributions Source: European Commission According to the Commission's Winter forecast, growth is expected to slow down to 3.5% in 2018 and to 3.2% in 2019. Once the initial boost of the recovery of EU-fund disbursements wanes, growth is expected to slow down but remain solidly above 3%. Robust growth of the EU's economy coupled with strong wage increases and a stimulus provided by the tax cuts should drive the economy in 2018. On the other hand, growing inflation and limited labour supply are projected to be constraining factors. Consumption Private consumption grew at a high pace in 2017 but it is expected to decelerate. Private consumption is believed to have increased by more than 4% in 2017 up from 3.3% in 2016, mainly due to rising wages. Above average consumer confidence also contributed to the acceleration in consumption growth. It is, however, expected to decelerate in line with the developments of real disposable income, whose growth is set to slow down on account of falling employment and increasing inflation. Investment EU-funded projects set to drive the investment cycle. Investments moved in line with the flow of EU funds, returning to their 2015 level 2017 following a dip in 2016. Looking ahead, the stimulus provided by the EU funds are expected to last until early 2019 by which time the disbursements should have reached their normal levels. A major investment in equipment by the national airline and credit growth turning slightly positive gave an additional boost to investment in 2017.

Graph 1.2:Investment by type of asset, % of GDP Source: European Commission Trade Increased global trade provides only a limited boost to Latvia's exports. Exports of goods and services are forecast to have increased by some 4% in 2017, largely the same as in 2016. Export growth to the EU held steady and goods exports to Russia resumed growth for the first time in three years. At the same time, growth of services export slowed in 2017 as a result of a continued decline in rail transit services to Russia and financial services to non-residents. According to the Commission's Autumn forecast, export growth is set to remain in the vicinity of 4% in both 2018 and 2019. Import growth, on the other hand, is set to loosely follow the investment cycle, gradually decreasing in both 2018 and 2019 as investment growth slows down. Inflation Increasing wage pressures are set to keep inflation elevated in the foreseeable future. Recovering energy prices and a surge in food prices pushed HICP inflation in Latvia to 2.9% in 2017. While the impact of these developments is expected to be short-lived, wage growth and a considerable increase in excise taxes are set to keep inflation close to 3% in both 2018 and 2019. Graph 1.3:12 month average HICP inflation, % change Source: European Commission Labour market The shrinking of the labour force drives the unemployment rate down and wage growth up. While the number of people in employment remained stable, the unemployment rate continued to fall on the account of shrinking labour force, whose impact has been mitigated by increasing activity rate (Graph 1.4). In 2017, the unemployment rate in Latvia was 8.7% (seasonally adjusted), but there were large regional differences ranging from 4.8% in Riga to 15.8% in the eastern region, Latgale. The share of long-term unemployed decreased, yet the average duration of the unemployment spell increased. The unemployment rate is expected to decrease further on the back of the continuing decline in the working age population, which on average has decreased by around 1.5% annually since 2010. Graph 1.4:Labour market trends in Latvia Source: European Commission Wage growth nears 10% as competition for the falling number of jobseekers intensifies. The nominal wage growth picked-up to 8.7% in the first three quarters of 2017, from 6.8% in 2016. The pick-up in GDP growth, in particular the upswing in investment growth, were the main drivers of the acceleration in wage increase. Wage growth is broadly similar across industries, regions and skill levels, with a slightly higher increase to the pay of the low-skilled. Wages are expected to continue rising at a high rate in 2018 and 2019 in line with the solid GDP growth and partly due to an approximately 13% increase in the minimum wage (from EUR 380 in 2017 to EUR 430 in 2018). Notably, real wage growth has exceeded productivity growth for a number of years now and therefore raises potential concern about the country's price competitiveness. This issue is covered in more detail in section 3.4.4. The challenges stemming from the demographic decline are becoming more pronounced. The rate of decline of Latvia's working age population has increased from 0.8% annually over the 2003 to 2007 period to almost 2% over the 2008-2016 period, primarily on the account of increased emigration. Emigration is linked to higher pay and better employment opportunities in the richer EU countries. The rapidly rising wages can help stem this trend and therefore present a positive development from this perspective. The population decline carries important policy challenges in a number of areas – fiscal sustainability (see Section 3.1.4), labour supply (see Section 3.3.1), healthcare (see Section 3.3.3), education (see Section 3.3.4), productivity (see Section 3.4.3), energy (see Section 3.5.1) and public administration (see Section 3.6.1). Social developments Despite some improvements, the risk of poverty or social exclusion remains high. The share of people at risk of poverty or social exclusion continued to decrease to 28.2% in 2017, but it remains above the EU average of 23.5% (2016) (). The decrease is thanks to a drop in the severe material deprivation rate and, to a lesser extent, to a decrease in the proportion of people living in low work intensity households (Graph 1.5). No significant improvements occurred for monetary poverty in 2017 (see section 3.3.2 for more details). In 2017, the at-risk-of-poverty rate remained at a high level for people with disabilities and for those living in (quasi-) jobless households, and the elderly. Graph 1.5:Poverty indicators Source: European Commission Both wealth and income inequality are high. In 2017, the share of income of the richest 20% of households was more than six times higher than that of the poorest 20% of households, placing Latvia among the EU countries with the highest income inequality. Despite having notably declined since 2006, Latvia's Gini coefficient () for household income after taxes and benefits remain among the highest in the EU (). While market incomes were only slightly more unequal than in other EU countries, the impact of taxes and benefits on reducing the inequality is significantly lower in Latvia than in other EU countries. This reflects the low social spending (see Section 3.3.2) and weak tax progressivity (see Section 3.1.3) in Latvia. In addition, wealth inequality is among the highest in the euro area. Around half of the wealth reflects ownership of the main residence and a quarter reflects ownership of other real estate, which is similar to the EA average (Graph 1.6). Graph 1.6:Distribution of income and net wealth Source: EU SILC (Eurostat, 2017) and HFCN (2016) Inequality of opportunities and unequal access to healthcare are also a cause for concern. While the link between educational outcomes and socio-economic background is relatively low, the poverty situation of the children of low-skilled parents (41.8% at risk of poverty) is considerably higher than that of the children of high-skilled parents (4.9%). This divide is also reflected in access to healthcare, with the gap between the poorest and the richest as regards self-reported unmet need for medical care being among the highest in the EU. External position The current account has reverted to a deficit on the back of recovering investment. The increase in EU funds flow and the corresponding increase in imports of investment goods is forecast to have put the current account back in deficit of 1.4% of GDP in 2017. It is expected to remain moderately negative over the forecast horizon. The net international investment position (NIIP) continued to improve mainly due to Latvian banks' declining need for external financing. At the end of 2017, Latvia's NIIP was above -60% of GDP compared to below -80% of GDP in 2009. Furthermore, it is mostly made up of foreign direct investment (FDI), limiting the risks of a sudden withdrawal. Graph 1.7:Net international investment position by sector Source: European Commission

Credit developments Credit growth has remained low in spite of the economic upswing. In 2017, credit to households has been recovering, but lending to firms decelerated (Graph 1.8). Only 25% of new house purchases were financed by banks. The rest was financed by buyers' own means or by alternative consumer credit providers. This latter market segment has been expanding. The alternative lenders have about 300 thousand clients across the country and by volume grant more consumer loans than banks. Non-financial companies are reluctant to invest, despite the current economic prosperity. Firms are making profits but do not intend to expand their productive capacities. Part of this is owed to a subdued economic confidence, but the weak judiciary system and unresolved problems in insolvency procedures are additional factors discouraging credit growth. Graph 1.8:Credit growth Source: European Central bank House prices House price growth has picked-up but the price level remains in line with the fundamentals. House price growth reached 9.3% in the first three quarters of 2017, however this follows a prolonged period of generally subdued price increase (Graph 1.9). Overall, the average house price growth since 2010 has been 5.1%, below the average growth rate of nominal GDP (5.8%). As a result, the current house price levels are around the long term average (Section 3.2.5). Graph 1.9:Real house price index, 2010=100 Source: European Commission Public finances With the general government deficit hovering at around 1% Latvia's public finances remain solid but the current expansion is pro-cyclical. The general government deficit was 0.9% of GDP in 2017 and it is expected to remain thereabout in both 2018 and 2019. Defence and healthcare spending are the main beneficiaries from the expenditure growth foreseen for 2018. A major tax cut aimed at stimulating economic activity is set to limit the revenue gains from the strong growth in the tax base. Given the above potential economic growth, the expansionary fiscal stance is pro-cyclical. The pro-cyclicality of the fiscal policy raises concern about the resilience of the public finances should the economic cycle turn. Table 1.1:Key economic, financial and social indicators Source: Eurostat and ECB as of 30 Jan 2018, where available; European Commission for forecast figures (Winter forecast 2018 for real GDP and HICP, Autumn forecast 2017 otherwise) 2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Latvia in 2017 has to be seen in a longer-term perspective since the introduction of the European Semester in 2011. Looking at the multi-annual assessment of the implementation of the country specific recommendations since these were first adopted, 85 % of all the recommendations addressed to Latvia have recorded at least ‘some progress’ (Graph 2.1). Substantial progress and full implementation have been observed by maintaining fiscal discipline, adopting the domestic fiscal framework and by improving the macro-prudential supervision of the banking sector. Latvia is fiscally prudent and has recently reduced the tax wedge () on low wages somewhat. Latvia corrected its excessive government deficit in 2012 and has complied with the fiscal requirements since then. A fiscal framework has been set up and implemented. Shifting taxation away from low wages in a growth-friendly manner has been recommended to Latvia since 2012. The 2017 tax reform partly addressed this recommendation, as the tax wedge on low wages has been reduced, but it remains above the EU average and above other Baltic countries. Moreover, the fiscal costs of the tax cut are only partly compensated by increases in excise duties and stricter VAT administration. Tax compliance has been gradually improving, helped by the tax administration's preventive measures and efforts to eradicate tax evasion. However, some policy measures are prone to abuse, like the micro-enterprise tax regime. Graph 2.1:Multiannual implementation of 2012-2017 country-specific recommendations to date Source: European Commission Social policies have seen little progress over time, but lately healthcare has gained the necessary attention. The social assistance system has not improved over the years. A major reform introducing a universal minimum income level was presented in 2014 and was planned to be introduced in 2017, but so far has not been advanced, primarily due to lack of funding. The adequacy of social benefits has been somewhat improved by more generous pension indexation rules and by increasing child benefits, in particular for large families, and a modest increase in the guaranteed minimum income. Updating vocational education in line with the labour market needs has been slow. Framework conditions for work-based learning were established in 2016, but uptake is still low. The healthcare sector has been prioritised in budget decisions, but supply of state-funded services still lags behind demand. Strategic decisions on consolidation and specialisation for greater resource efficiency are still to be implemented in practice. A reform proposal for increasing efficiency of the central public administration has been adopted. Public administration reforms have advanced little over the previous years, with several proposals presented, but few adopted. Ideas for increasing efficiency of public administration were tabled in 2016 and the revised proposal was adopted by the Government in 2017. The reform hinges on high-level targets for reducing staff numbers in central government allowing for wage increases, thus attracting talent to the public sector. However, these plans don’t include local government. The legislative proposal for a unified legal framework for all public-sector employees has not been passed by Parliament, despite being ready since 2014. The prevention of conflict of interest is hampered by an unclear division of competencies among the institutions charged with the verification of declarations of assets and interests, a process that is not carried out systematically. The delay in legislating on whistle-blower protection is detrimental to the accountability and the efficiency of public administration. Overall, Latvia has made some progress () in addressing the 2017 country-specific recommendations. It made some progress on reducing the tax wedge on low-income earners and on improving tax compliance, as well as on launching the reform of central government and on increasing provisions of public healthcare services. Only limited progress was made on improving adequacy of the social safety net and there is some progress in updating vocational education curricula, although fair amount of work is still needed to fully address the country-specific recommendation. Progress on preventing conflict of interest is assessed to be limited. Table 2.1:Summary table on 2017 CSR assessment Source: European Commission European Structural and Investment Funds (ESI Funds) are pivotal in addressing key challenges to inclusive growth and convergence in Latvia (Box 2.1). ESI Funds are notably used in promoting R&D in the private sector, strengthening links between research and industry, supporting national reforms directed at improving accessibility and quality of health care. ESI Funds also help improve the quality of vocational education and training, strengthen the employability and social inclusion of persons with disabilities, the elderly and other vulnerable groups. Member States can request from the Commission technical support to prepare, design, and implement growth-enhancing structural reforms. The Structural Reform Support Service (SRSS) provides, in cooperation with the relevant Commission services, tailor-made technical support, which does not require co-financing and is provided at a Member State's request. The support addresses priorities identified in the context of the EU economic governance process (i.e., implementation of country-specific recommendations), but the scope of the SRSS support is wider as it can also cover reforms linked to other Commission priorities, or reforms undertaken at the initiative of Member States.

Latvia has requested technical support from the SRSS to help implement reforms in various areas such as: public administration, growth and business environment, public financial management, health and the financial sector. In particular, the SRSS provides support for improving tax administration, increasing the cost-effectiveness and access to healthcare, developing Latvian capital markets, and providing anti-money laundering training. Box 2.1: Tangible results delivered through EU support to structural change in Latvia Latvia is a beneficiary of significant European Structural and Investment Funds (ESI Funds) support and can receive up to EUR 5.6 billion until 2020. This represents around 3 % of GDP annually over the period 2014-2018 and 65 % of public investment ( I ). By 31 December 2017, an estimated EUR 3.1 billion (55% of the total) was allocated to projects on the ground. This has paved the way for supporting around 84 000 additional households with broadband access of at least 30 Mbps; 1 145 restructured or modernised farm holdings; 57 000 people received European Social Fund support of whom 16 000 of long-term unemployed. Latvia has also received support from the Youth Employment Initiative to combat youth unemployment and 23 000 young people have benefited from it. Out of the EU financing, EUR 126 million is to be delivered via financial instruments. ESI Funds help address structural policy challenges and implement country-specific recommendations. Examples include promoting R&D in the private sector; strengthening links between R&D, innovation and industry; in healthcare the setting up of a national strategic policy framework and preparing a healthcare infrastructure mapping to increase the efficiency of healthcare investments; improving the effectiveness of the justice system; in education improving the quality of vocational education and training through consolidating the school network, updating the curricula and expanding the work-based learning components; strengthening activation and social inclusion measures to improve employability of persons with disabilities, elderly and long-term unemployed, and strengthening the capacity of social work. Various reforms were undertaken already as precondition for ESI Funds support. ( II ) Smart Specialisation Strategy for research and innovation was developed to focus efforts on product specialisation with strong market potential. This has also helped to improve cooperation between enterprises and public research institutions. The consolidation of research institutions by linking financing to performance and in higher education by better focussing education to the needs of the economy was also done in line with the priorities set in the Smart Specialisation Strategy; improving access and quality of healthcare by developing healthcare infrastructure focusing on priority healthcare areas; in education by developing evidence-based early school leaving prevention strategy. These reforms have prepared the ground for better implementation of public investment projects in general, including those financed from national sources and from the other EU instruments. Latvia is advancing the take up of the European Fund for Strategic Investments (EFSI). As of December 2017, overall financing volume of operations approved under the EFSI amounted to EUR 182 million, which is expected to trigger total private and public investment of EUR 615 million. More specifically, 6 projects involving Latvia have been approved so far under the Infrastructure and Innovation Window (including 3 multi-country projects), amounting to EUR 164 million in EIB financing under the EFSI. This is expected to trigger about EUR 370 million in investments. Under the SME Window, 6 agreements with financial intermediaries have been approved so far. European Investment Fund financing enabled by the EFSI amounts to EUR 19 million, which is expected to mobilise approximatively EUR 245 million in total investment. Over 4 200 smaller companies or start-ups will benefit from this support. Transport ranks first in terms of operations and volume approved, followed by SMEs. Funding under Horizon 2020, the Connecting Europe Facility and other directly managed EU funds is additional to the ESI Funds. By the end of 2017, Latvia has signed agreements for EUR 267 million for projects under the Connecting Europe Facility. 3. Reform priorities 3.1. Public finances and taxation 3.1.1.Budgetary plans Latvia’s fiscal position remains benign. The government deficit is estimated at 0.9 % of GDP in 2017. The government deficit target for 2018 has been adjusted to 1.0 % of GDP, as compared to 1.6 % of GDP under the Latvia’s stability programme. This is largely achieved by modifying the plans of a major tax reform between the announcement in the stability programme in April 2017 and the adoption in July 2017, in particular spreading out the costs of the corporate tax changes over the coming years. The medium-term budgetary plans are mainly determined by the tax reform. The labour and corporate tax cutting measures are only partly balanced by revenue increasing measures, thus overall restricting the fiscal space over the medium term. The tax revenue share remains well below the medium-term national target of one third of GDP, limiting the room for financing structural reforms and the redistributive function of the budget, in particular towards the most vulnerable groups. The 2018 budget expands spending on defence, healthcare and family support, but the discretionary effort is not sustained in 2019-2020 (Graph 3.1.1). As a result of the tax reform, little room is left for discretionary expenditure in 2019-2020. Latvia has few automatic expenditure indexation rules. In general, the expenditure is assumed to remain unchanged in nominal terms, as a baseline for the national budgetary plans. The policy areas with well-anchored funding rules or which are receiving EU financing have a certainty over their budgetary plans, while policy areas which rely on discretionary budgetary decisions face difficulties to secure financing. The budgetary plans for 2019-2020 demonstrate that the contribution-based social spending and financing envelopes for local authorities and defence account for a stable and large share of the total expenditure increase (Graph 3.1.1). A pick-up in other expenditure in 2020 is linked to a surge in the implementation of EU financed projects. However, the discretionary increase in financing for healthcare in 2018 and 2019 is not continued in 2020 (Section 3.3.3). Other costly policy initiatives such as the minimum income level reform (Section 3.3.2) also get side-lined in the absence of the space for discretionary spending. Graph 3.1.1:Government expenditure growth plans Source: The medium term budgetary plans for 2018-2020 3.1.2.Fiscal framework and expenditure review The fiscal framework is followed in broad terms when setting out fiscal policy, but adherence to the fiscal rules is not always rigorous. 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, which also endorses the macroeconomic forecasts used for budgetary planning. The authorities’ adherence to the national fiscal rules is somewhat weakened by the planned suspension of the ‘fiscal security reserve’ in 2019. Moreover, the Fiscal Discipline Council () has issued seven irregularity reports on specific issues in 2017, indicating occasions when decisions by the budgetary authorities (e.g. on re-allocation of budgetary resources) appeared to be in conflict with the Law on fiscal discipline. An expenditure review across the central government took place in 2017, with limited funds re-allocated. The 2017 expenditure review identified expenditure in the magnitude of 0.3 % of GDP available for re-allocation in 2018. The review followed up on the implementation of the recommendations issued in 2016, including improvements in the budget preparation and reporting processes. The review also included pilot projects for ‘zero-based’ budgeting () for reimbursable pharmaceuticals and for public libraries. Both projects had to be completed in 2017. No follow-up is planned for the reimbursable pharmaceuticals project, due to data limitations. The public libraries project recognised advantages of reassessing processes and costs, as well as the need to cooperate across institutions and use a uniform methodology. The project is set to be completed in 2018. 3.1.3.Taxation The tax revenue share in GDP remains well below the EU average. The tax revenue ratio to GDP stood at 31.2 % in 2016 (), below the EU average of 38.9 %. The tax system relies on consumption and labour taxes in terms of total revenue, while taxation of capital is limited. The tax burden on labour is relatively high especially for low-income earners without dependants or second earners. The tax revenue share in GDP is limited by tax non-compliance, given the large shadow economy. This limits funding available for government services, in particular social services. The tax system is being overhauled by a reform adopted in the summer of 2017. The tax reform aims at promoting the competitiveness of the Latvian economy, reducing income inequality and increasing the tax revenue to one third of GDP in the medium term. The key measures focus on the reduction of personal and corporate income taxes. The fiscal costs of the measures are partly compensated by higher excise duties and improvements in VAT collection (Graph 3.1.2). Most measures are effective from 2018, with some transitional provisions in place until 2020. Graph 3.1.2:Cumulative fiscal effect of the tax measures Source: European Commission The objectives of the tax reform are expected to be only partially achieved. The authorities assume that lower labour and capital taxation would strengthen investment and growth, and ultimately trickle down to better public services and work opportunities. Macroeconomic simulations from the Commission, however, point to a very limited positive effect of the reform on investment and GDP (European Commission, 2017a). Only a few measures are well targeted towards reduction of inequality, such as an increase in the basic allowance, and they account for a small share of the overall reform costs (Box 3.1.1). The target of the tax revenue share in GDP of one third is not expected to be reached. The World Bank's review of the Latvia's tax system and its recommendations were largely ignored. Following a request from Latvia, the World Bank provided a review of the Latvian tax system (World Bank, 2016). Its recommendations, however, have not or only to a limited extent been incorporated in the current tax reform. Moreover, the adoption of the tax reform prior to the discussion on the public expenditure needs illustrates a lack of a comprehensive budgetary strategy, including an integral assessment of the government revenue and expenditure priorities. The low tax progressivity contributes to income inequality. The small difference in tax wedge between the lower and higher incomes in 2016 points to a low progressivity, relative to the EU average (Graph 3.1.3).

The adopted labour tax measures will reduce labour taxation and increase its progressivity. All income groups are estimated to gain from the reform with the largest gains in the second to fifth decile of the income distribution. A higher progressivity of the tax system has been achieved by increasing the basic (tax-free) allowance and the allowances for pensioners and dependents. The measure with the largest budgetary impact — the reduction of the standard personal income tax, however, is a regressive measure, benefitting more to those with higher incomes (Box 3.1.1). Overall, the labour tax measures are estimated to reduce the at-risk-of-poverty rate by 1.8 pps. and the Gini coefficient by 0.5 pp. The unused tax allowances and the low work intensity for low-income groups limit the effect of the measures on poverty and inequality reduction. Households with the lowest incomes include many unemployed, inactive individuals and pensioners with low pensions. They rely more on social benefits, in particular pensions, and contribute less to tax revenue. The increase in allowances for dependents and pensioners, which are intended to support families with children and the elderly, does not target the poorest groups well, as their personal income tax bill was fully or largely reduced by the tax allowances before the tax reform. For these groups social transfers are better suited. As a result, these measures are of a greater benefit for middle income groups and have a limited effect on inequality and the tax cuts have a lower effect on the first income decile (Box 3.1.1) The high tax wedge on low incomes has been reduced, but remains elevated. In 2016, the tax wedge for single workers earning 67 % of the average wage was 41.8 % (compared to 43.2% in 2010), which was still one of the highest in the EU (where the average is 36.8 %). Since the tax wedge affects labour demand and supply for this income group, lowering it can help boost employment. The tax reform is estimated to reduce the tax wedge on a single person earning 50% of average wage to 36.0 %, but still above the EU average of 32.5 % (Graph 3.1.3). The increase in the income-differentiated basic allowance is the most effective way of reducing the tax wedge for single earners among the adopted measures. However, the increase in social contributions adds directly to the tax wedge for all income groups (). Graph 3.1.3:Tax wedge on labour, single earners Source: European Commission Box 3.1.2: Distributional effect of the tax reform The adopted tax reform includes notable changes to labour taxation, reducing the overall tax burden on labour and increasing progressivity. The box assesses the effect of the selected measures across different income groups using the EUROMOD simulations ( III ). 1.A personal income tax Cut Personal income tax (PIT) rates are differentiated along three income brackets from 2018. The standard PIT rate is reduced from 23 % to 20 % for incomes up to 170 % of the average wage. A second tax rate of 23 % will be applied to incomes up to almost five times the average wage. For incomes exceeding this threshold, the rate is set at 31.4 %. The difference between the second and third bracket corresponds to the employee's share of the existing solidarity tax, implying that the effective marginal tax rate as of the second bracket remains stable for all income groups. All tax payers will benefit from the decrease of the standard rate and only part of the incomes of the richest 10 % will remain unaffected (Graph 1a). The changes in the PIT rates cost 0.8 % of GDP. Given that 60 % of the benefits go to the 30 % highest incomes, the measure increases income inequality. The measure is estimated to lower the poverty rate by 0.4 pp. 2.Income-differentiated basic allowance The tax reform increases the maximum income-differentiated basic tax allowance to EUR 3 000 per year by 2020. Currently the allowance ranges from EUR 1 380 for the lowest incomes to EUR 720 for the highest. The reform builds on the earlier plans by increasing generosity towards the lower incomes and by advancing implementation (Graph 1b). The increase in the basic tax allowance further increases the degree of progressivity in the personal income tax system. As it represents a larger share of net income for low-income earners, it also has a stronger impact on the tax wedge of low incomes than of high incomes. The measure comes at a small fiscal cost (0.1 % of GDP) and largely benefits the bottom half of the income distribution. The mean annual equivalised disposable income of households is positively impacted (+0.3 %). By contrast, disposable income for the top deciles is expected to be negatively impacted (Graph 1b), as the current minimum allowance is set to be withdrawn. This measure lowers income inequality (as measured by the Gini coefficient) and the relative poverty rate by 0.5 pp. and 0.8 pp., respectively. 3.allowance for pensioners and dependants The tax reform also raises the allowance for pensioners (from EUR 2820 to 3 600 annually) and dependents unable to work (from EUR 2 100 to 3 000 annually). The aim is to address child poverty and poverty among the elderly. The increase in the allowance for dependants benefits the middle-income groups relatively more. Households in the first decile of the income distribution are little impacted by the reform. This is linked to the fact that a large share of their taxable income is already covered by the allowances before the reform and by the fact that only 11 % of households in the first decile with dependent children stand to benefit from the reform (Pluta and Zasova, 2017). The reach of the measure increases towards the middle income groups, which gain the most relative to their disposable incomes. As a result, the measure only has a limited positive effect on income inequality, reducing the Gini coefficient by 0.1 pp. The reform of the pensioners' allowance has a marked impact on income in the second to fourth deciles (Graph 1a), as those are deciles with a large share of pension incomes. The impact of the measure on incomes in the first decile is limited, as already one third of pensions were below the allowance in 2016 and this share is set to increase. Nevertheless, the reform has a positive redistributive effect and should markedly bring down the risk of poverty rate for single elderly people, albeit to a level that remains more than three times as high as for the overall population. 4.healthcare-related social contribution The social contribution and the solidarity tax rates are raised by 1 pp. (shared equally among employers' and employees' contributions), with the ensuing additional revenues earmarked for healthcare financing. The additional social contribution rate to finance health should bring in 0.3 % of GDP in fiscal revenues. It directly adds to the tax wedge for all employees, but it will weigh on higher incomes slightly more than on lower ones (Graph 1a), given a lower share of employees in the bottom half of the income distribution. The impact on poverty and inequality is negligible. Taxes on capital are aligned at a 20% rate and the taxation of corporate income is deferred until the distribution of profits. The nominal tax rate on corporate profits and dividends of 23.5 % has been lowered, while the rates on interest and capital gains have been increased from 10 % and 15 % to 20% from 2018. At the same time, no tax is payable on undistributed profits. This is expected to carry a large fiscal cost in the first years following implementation (0.6 % of GDP in 2020, with tax-increasing measures covering less than 0.1 % of GDP, Graph 3.1.2). Revenue is expected to start increasing from 2020, but there is a risk of a large share of profits being retained due to the advantages provided by deferred taxation, thus affecting tax revenue over a longer period (). Macroeconomic and distributional effects of the reform will depend on the business decisions taken by companies, but are expected to stimulate investment. On the face of it, reducing the effective tax rate for corporations benefits the richest most, as the richest 20 % of households own around 80 % of financial wealth (Graph 1.6). Indirect tax revenue is set to expand due to rate increases and stricter administration. Excise duties on fuel, alcohol, tobacco and gambling are planned to be increased and stricter requirements under the VAT system are expected to improve tax compliance. These include a reduction of the VAT registration threshold for companies from EUR 50 000 to EUR 40 000 and a requirement to report VAT transactions in greater detail. Recurrent property taxation remains low. Recurrent tax on property accounts for 0.9 % of GDP in Latvia, as compared to 1.6 % of GDP in the EU on average. Increasing taxation of property is one of the suggested revenue sources for reducing the high tax wedge on low wages for Latvia, given its limited impact on economic growth (European Commission, 2015). Moreover, much of the property wealth is concentrated in the higher income groups which would lead to a progressive distribution of the tax burden (Household Finance and Consumption Survey, 2017). Property taxation is becoming gradually detached from market values. By design, the property values used for property tax should follow market values with a two year lag. The successive postponement of reassessing cadastral values amounts to a freeze at 2012/2013 property prices. The most recent update planned for 2018 has been postponed for 2 years. This sends undesirable signals to the property market, encouraging speculative behaviour and price increases. It also accounts for some 0.1 % of GDP in foregone revenues (Graph 3.1.2), due to the lower valuations used for taxes. Moreover, inconsistencies in the value of similar properties persist due to underreporting of the value upon registration and misidentifying the type of property usage (different property types are taxed at different rates). These issues serve as a pretext for postponing the update of cadastral values until a new methodology is devised by 2020. Uniform application of property tax is distorted by practices at local government level. Some local authorities provide property tax rebates which are more than compensated by income tax revenue, leading to tax competition at the local level. This is beneficial for local authorities as the equalisation fund adjusts only for divergences in property taxation, while the role of income tax is not considered (). At the same time, such practices erode the overall revenue of local authorities. While socially-motivated tax rebates exist, those are linked to property values and benefit more to valuable property owners. The option to use tax deferrals for vulnerable groups is not used by the local authorities. This option suits the needs of asset-rich but income-poor households better and ensures uniform treatment of properties. Although the shadow economy is shrinking, it is estimated to be larger than in the other Baltic countries. The shadow economy in Latvia was estimated at 20% of GDP in 2016, 1 percentage point (pp.) lower than in 2015, but still approximately 5 pps. higher than in Estonia and Lithuania. The level of envelope wages is similar in all three Baltic countries, while unreported business income in Latvia (42% of the shadow economy) explains the difference with the peers. The shadow economy is estimated to be the highest in the construction industry (40 %), followed by the retail industry (25 %), and the share of envelope wages in total wages are estimated at 18 % in 2016 (Sauka & Putnins, 2017). The high share for the shadow economy poses a challenge for tax collection and business environment. However, improving tax compliance takes time, as it involves a change in culture together with an attuned policy design. A variety of measures are being taken to improve tax compliance. The tax administration aims to improve the culture of tax compliance, through a more co-operative approach at sectoral level and with individual tax payers. Moreover, public pressure for tax compliance is expected to be generated by the public disclosure of employers paying salaries lower than the minimal wage and of those being late with tax returns from 2018 onwards. At the same time, an increasingly detailed electronic tax record will enable the tax administration to perform its task more efficiently. Despite a strengthening of the capacity of the State Revenue Service and the state police, lengthy court procedures and mild sentences continue to impede the fight against tax crime. The micro-enterprise tax regime poorly serves its purpose, being used as a tax optimisation tool for a wider set of business than intended. The micro-enterprise tax regime is intended to support start-ups and sectors with low wages. In recent years, however, it has been used as a tax optimisation tool by companies operating under the general tax regime (Ministry of Welfare, 2016; World Bank, 2016). It also limits social contributions and social protection for a large share of the workforce. The tax administration has been unable to eradicate abuse due to issues over the burden of proof and administrative costs. From 2018, the maximum annual turnover for the micro-enterprise tax regime has been decreased from EUR 100 000 to EUR 40 000, with the aim of shifting companies to the general tax regime. Nevertheless, the micro-enterprise tax regime with an effective tax wedge of 15 % to 27 % (depending on turnover and deductible expenditure), will continue to be more attractive than the general tax regime. 3.1.4.Long-term fiscal sustainability Due to low spending levels, health care, long-term care and pension expenditure do not pose a threat to long-term fiscal sustainability, based on the current policies. Despite an ageing population and rising dependency ratios, Latvia scores well for the long-term sustainability of public finances according to the Ageing Report 2018 projections. Public pension spending is projected to decline from 7.4 % of GDP in 2016 to [4.7% of GDP] in 2070 — among the lowest in the EU. Almost all this decline will be offset by rising mandatory private individual pensions, leading to total pension expenditure remaining broadly unchanged as a share of GDP by 2070. Moreover, a number of recent changes to the public pension and welfare system have somewhat increased in generosity, including changes in pension indexation mechanism, increases in minimum survivor pensions and broader eligibility criteria for the non-contributory minimum pension. These reforms are reflected in the fact that public pension expenditure in the latest Ageing Report 2018 projections are consistently higher than in the previous Ageing Report 2015 projections for the 2020-2060 period. Despite these reforms, the adequacy of current social policy and healthcare expenditure could potentially be further strengthened, as discussed in Sections 3.3.2 and 3.3.3. 3.2. Financial sector 3.2.1.credit developments Despite recently turning positive, credit growth in Latvia remains subdued as both businesses and households continued to decrease their debt levels. Credit growth returned at the end of 2016. However, its growth rate remains below that of the other Baltic countries and remains only barely positive (see Graph 3.2.1). This is largely attributed to the banks' higher cautiousness towards Latvia as the financial losses during the crisis were much higher in Latvia than in the other Baltics. The abuse of the insolvency process (see section 3.6.3) which also caused considerable losses to the banks, has also been cited as one of the reasons for banks perception of higher country-specific risk in the case of Latvia. The prolonged weak credit growth has resulted in a substantial decrease in total private sector debt, which has decreased from above 130% of GDP in 2010 to below 90% of GDP in 2016. On the one hand, this has led to a decrease in financial risks, on the other hand it has been among the main reasons for the low investment. Graph 3.2.1:Private sector credit growth Source: European central bank 3.2.2.Financial stability

The financial sector is performing well overall, with no immediate concerns about financial stability. The average capital adequacy ratio is 20.5% (Table 3.2.1), which is well above the recovery (Graph 1.7) suppressed the activity in the housing market and the housing construction, which in Latvia has been significantly lower than in the other Baltic countries. So far, the house price developments have been in line with the domestic growth drivers, in particular income growth. The house required 8% and well above the EU average of 18.5%. The loan-to-deposit ratio remains stable at 109%. Some foreign-owned banks still hold substantial liabilities to their parent banks. In this respect, a potential downturn on the Swedish housing market is recognised as an external risk. The country is still suffering from the loss of confidence due to the financial crisis. As a result, both the demand and supply for loans are still negatively affected. Another legacy from the crisis is the relatively high level of non-performing loans: 10.9% for firms and 7.1% for households. This is above the EU averages of 9% and 4.4%, respectively. In this regard, a well-functioning insolvency process is particularly important (see section 3.6.3). The total share of NPLs, however, has decreased considerably since peaking at above 13% in 2010. At the same time, the coverage ratio is 34.8%, below the EU average of 44.4%. Table 3.2.1:Financial soundness indicators Source: European Central bank 3.2.3.Access to finance Access to finance for SMEs is improving. Latvia has been very active in improving the access to finance for SMEs over the last years. A range of financial instruments for SMEs have been made available, including mainly public loans, public guarantees and microfinance measures. The measures are provided either directly by the Single Financial Development Institution Altum, or indirectly through intermediary commercial banks. Starting in 2017, Altum's development of full operational capacity should further contribute to enhancing access to finance for SMEs. Local stakeholders suggested that Altum could expand the scope of its support. Moreover, the Latvian authorities are also actively promoting other alternative sources of financing, such as crowd investing. Graph 3.2.2:Funding of non-financial corporations Source: European Central bank Latvia has seen a steady increase in venture capital investment. The development of Latvia’s venture capital market is actively promoted by the government and a number of venture capital, pre-seed and seed capital funds have been established since 2010, to help young and innovative businesses throughout the different stages of growth. In 2017, additional financial products have been launched, including three acceleration funds; and in 2018, additional risk capital funds, including three acceleration funds, will start their operations. Compared with 2010, Latvia has the third highest increase in venture capital in the European Innovation Scoreboard. In absolute terms, however, such investments still remain relatively small and largely dependent on support from EU funds. Both equity and debt markets in Latvia lag behind the EU levels in terms of depth and liquidity. To address this challenge, the government is implementing the Financial Sector Development Plan for 2017-2019 (adopted in March 2017). In 2017, the government revised the legal framework for public pension funds to provide them with incentives for investment in local venture capital funds. Adjusted tax incentives were introduced for saving in private pension funds. The government also adopted an amendment on investment-saving accounts, aiming to attract retail investors to the capital market and prepared a draft law on crowdfunding platforms, to provide a legal framework for development of this market segment. A review of specific obstacles to capital market development in the commercial law is planned. In November 2017, the Ministers of Finance from Latvia, Estonia and Lithuania signed a Memorandum of Understanding on cooperation for regional capital market in the Baltics. The objective is to create common asset classes, market infrastructures and index labels. Some relevant support projects are already ongoing with support from the Commission and the EBRD, including the development of a legal and regulatory framework for covered bonds, securitisation and derivatives, as well as projects to raise the profile of the equity market and promote SME listing. 3.2.4.Anti-money laundering Anti-money laundering reforms are broadly implemented; continued efforts would be needed to achieve sustainable improvement. Following the financial fraud cases revealed in 2015 and the ensuing efforts to tighten the regulation and supervision, the key amendments to the financial fraud prevention framework are now in place. Strengthening of the FCMC Compliance Department in terms of staff, data processing and operating procedures is progressing. The Association of Latvian Commercial Banks issued summaries of enhancement in anti-money laundering compliance for all its member banks. It urged the employees of the Compliance Departments of banks to obtain international certification from ACAMS (Association of Certified Anti-Money Laundering Specialists). Banks whose primary business is serving non-residents are subject to higher solvency and liquidity requirements. Due to tightening anti-money laundering supervision, in last two years they have lost about 20 000 depositors, including the most risky clients. Some of the banks have been strongly hit by high sanctions (increased from the maximum 10% of the company's profit to 10% of the turnover). In general, the non-resident banks see their assets and profit margins shrinking. Many look out for a new business model, however, this will also help improve the reputation of the whole financial sector. 3.2.5.house prices Recent house price inflation has been accompanied by stagnant mortgage credit growth. House prices in Latvia increased by above 9% in the first three quarters of 2017, showing an upturn following a prolonged period of moderate growth after the burst of the housing bubble in 2008 (Graph 1.8). Initial household deleveraging and slow credit prices to income ratio (Graph 3.2.1) is still below the historical average (), suggesting no sign of overheating, at the moment. There are, however, some structural issues affecting the housing supply. Firstly, the planning and building permit approval process in Riga is particularly long () which increases the lead time for market reactions to prices. Secondly, current rental regulations discourage investment in rental housing. The government is drafting a new rental law with a view to stimulate more investment in rental housing. Demand for quality accommodation in urban areas with better job opportunities, notably in Riga, is reflected by the overcrowded housing and a shortage of adequately priced rental accommodation. This leads to problems of access to quality housing and housing exclusion (see Section 3.3.2.). The small rental market has contributed to reduced labour mobility (OECD survey of Latvia, 2017). Only 20% of households rent their home, which is low relative to other Member States, moreover more than half of the tenants pay rents that are considerably below the market price for their dwellings, a legacy of Soviet-era rental agreements (). Moreover, the current regulation does not foresee an out-of-court dispute resolution, thus the rental dispute resolution is time consuming and costly. This impedes an effective functioning of the rental market and has resulted in underinvestment in both existing and new housing. The government is now drafting a new rental law with the aim to shorten the dispute resolution times, to boost investment in rental housing and to improve tax collection from rental income. It is important, however, that a balanced view of the interests of landlords and tenants is maintained. Graph 3.2.3:House price benchmarks Source: European Commission Box 3.2.3: Policy highlights: Altum – single development financing institution Latvia has been very active in enhancing access to finance for SMEs. A range of financial instruments for SMEs have been made available (public loans, public guarantees and microfinance measures) and a number of venture capital, pre-seed and seed capital funds have been established since 2010, to help young and innovative businesses throughout the different stages of growth. Previously, the support instruments were managed by different entities, now a single public development institution is in charge. The new one-stop-shop for public financial support for businesses 'Altum' (the joint stock company Development Financing Institution Altum) was created in 2014 and merged with the other two existing institutions in 2015, completing the consolidation of the support activity in a single entity. At the end of 2015, Altum managed a portfolio of financial instruments of the total value of 1.5 % of GDP, made up of 8 900 projects, of which 90 % were loans and guarantees and 10 % venture capital funds. Altum provides financial and non-financial support, including counselling, training, mentoring, in various fields such as energy efficiency of buildings, agricultural business and even housing loan guarantees for families with children. Altum is also the contact point for the European Investment Bank and the European Investment Fund in Latvia. A substantial part of funding is provided for by European Structural and Investment Funds, with a 2014-2020 allocation from the European Regional Development Fund exceeding 0.6 % of GDP. ALTUM cooperates with all major banks in the country and it also operates as a fund of funds providing indirect financial support through acceleration, seed and start-up as well as expansion capital funds. ALTUM operations have only been recently rolled out, but stakeholders are appreciative of its work and of the design of the system, which has the potential to improve access to finance in Latvia. In September 2017 Altum has signed COSME agreement with EIF to improve access to finance in form of guarantees. 3.3. Labour market, education and social policies 3.3.1.Labour market Labour market conditions have improved on the back of economic growth, but the social protection system remains weak. Stronger economic growth has led to increasing employment opportunities for both men and women, decreasing unemployment and increasing wages and disposable household income. Latvia has a low gender employment gap and increasing gross household disposable income per capita. However, despite recent improvements, social safety nets in Latvia are still not effective at reducing high inequality, poverty and social exclusion. Moreover, low participation in active labour market policies, also by the young, may be hindering access to the labour market and equal opportunities for all. Graph 3.3.1:Employment by sector, year-on-year changes Source: European Commission (Eurostat) The labour force is set to decrease on the back of a shrinking working-age population. While the employment rate (75.2 % in Q3-2017) is 3 pps. above the EU average and continues to grow, the working-age population is declining quickly, as a result of negative natural growth and net emigration. This in combination of a temporary lower economic growth led to the decreasing number of people employed in 2016 (Section 1). As a stronger economic growth resumed in 2017, employment picked up in Q3-2017, in particular in construction and public sector (Graph 3.3.1).

The emigration of skilled labour remains a challenge. Between 2009 and 2016, the outflow of people with higher education accounted for 40% of net outward migration. This is equivalent to 17.4 % of the high-educated working-age population in Latvia (European Centre of Expertise, 2018). A shortage of qualified labour to some extent caused by emigration is perceived as a serious challenge for Latvia’s competitiveness and economic growth in the long run. Graph 3.3.2:Job vacancies and labour shortage indicators Source: European Commission (Eurostat, Economic Sentiment Indicator) Recent data point to labour shortages, albeit to a lower extent than before the crisis. Labour shortages as a factor limiting production in industry and construction increased to 16 % and 13 % respectively in 2017, but remain well below the 2007 peak (Graph 3.3.2). The number of registered vacancies also increased in 2017, but stayed well below the pre-crisis levels. The survey-based ratio of vacancies to jobs in 2017 reached the level of 2008, but remained lower than the EU average and well below that observed in the main destination countries of Latvian emigrants. More than 80 % of vacancies were registered in the Riga region where also 70 % of existing jobs are located. Unemployment is strongly linked to the level of skills. The variation in labour market outcomes by education level is somewhat wider in Latvia than in many other EU countries (European Commission, 2017b). In 2016, unemployment among the low-educated was 20.6 % (EU average: 16.1 %), while it remained limited to 4.3 % among the highly educated (EU average: 5.1 %). Older workers have a lower employment rate, but few seek to change careers or update their skills. The employment rate of older workers (55-64) is growing. However, they earn less than younger workers and face depreciation of their skills. Adult participation in learning, although increasing (7.3 % in 2016), remains below the EU average of 10.8 % and significantly below the national target of 15 % for 2020. Moreover, only 4 % of older workers participated in adult learning in 2016 (the EU average is 6.1 %). Latvia’s 2016-2020 adult education governance model implementation plan aims to be more targeted towards skill needs and to reduce fragmentation of training programmes. In the context of the Upskilling Pathways Council Recommendation (), an EU-funded programme for employed adults was started in 2017 with special focus on workers in high-risk groups, such as those over 45 or the low-skilled. In 2017, training started in four priority sectors (construction, ICT, metalwork and woodwork), which were identified together with the social partners through the sectoral expert councils and are set to expand in 2018 to eight additional sectors. Around 36 000 adults are expected to take part in training financed through this project, of which 13 000 are expected to be low-qualified adults. The training will be provided mostly at VET schools. Youth unemployment has declined as labour demand picked up. The youth unemployment rate and the rate of young people not in employment, education or training (NEET) increased in 2016. Limited outreach has resulted in a relatively low number of young people registered in the Youth Guarantee scheme (), despite some progress since the launch of the scheme in 2014. The economic upturn of 2017 led to a decrease in youth unemployment rate (by 1 pp.) to 16.2%. Employment opportunities vary significant from region to region. The dispersion of employment rates among ethnic groups and regions are larger than before the crisis (European Centre of Expertise, 2018), suggesting that a substantial amount of labour is not utilised. According to national data, the lowest registered unemployment rate (4.3 % in the Riga region) was less than one third of the highest regional rate (15.8 % in the Latgale region) in December 2017. Moreover, 54 % of the unemployed in Latgale had been without a job for more than a year, while in Riga this figure was only 10 %. This reflects on the difficulty in bringing the long-term unemployed back to the labour market and regional labour mobility problems, exacerbated by the limited supply of affordable rental accommodation in the cities (Section 4). Box 3.3.1: Monitoring performance in light of the European Pillar of Social Rights The European Pillar of Social Rights, proclaimed on 17 November 2017 by the European Parliament, the Council and the European Commission, sets out 20 principles and rights to benefit citizens in the EU. In light of the legacy of the crisis and changes in our societies driven by population ageing, digitalisation and new ways of working, the Pillar serves as a compass for a renewed process of convergence towards better working and living conditions. Latvia faces challenges with regard to a number of indicators of the Social Scoreboard IV supporting the European Pillar of Social Rights. Income inequality is high. Although the risk of poverty or social exclusion has been decreasing, it still remains high, especially for people with disabilities and the elderly. Self-reported unmet needs for medical care are also elevated. On the positive side, gender employment gap is low and gross disposable household income per capita is increasing. Pensions do not effectively protect against poverty in Latvia. In 2017, 43.9% of people above the age of 65 faced risks of poverty or social exclusion. Moreover, the trend has been continuously deteriorating for the past 6 years, resulting in nearly 11 pps. increase. Poverty particularly affects women, which can partly be explained by their longer life expectancy. The absence of survivor pension for spouses also contributes to this situation. The gender employment gap is relatively low. The overall difference between the cumulated earnings of all men and all women is 28.8 %. This is not only due to the low gender employment gap, but mainly because of a relatively low share of women employed part-time in Latvia. Very high tertiary educational attainment of women and relatively low fiscal disincentives for second earners also contribute to low employment and earnings gaps. Active labour market policies are being upgraded with EU funds but participation remains low. In 2016, involvement in active labour market policies (ALMPs) stood at 5.8 participants per 100 people wanting to work (on average, at any given moment). Nevertheless, all registered unemployed people undergo profiling and have job integration agreements. In 2017, ALMPs saw an increase in funding and an expansion of support measures for the long-term disadvantaged unemployed as implementation of EU-funded projects picked-up pace. Almost one third (29.3 % in 2016) of the registered long-term unemployed with job integration agreements regained employment, more than double the EU average. Mobility support (transport and rent costs subsidy) for moving to work in Riga is expected to be made available, facilitating the regional mobility of the unemployed. So far, local authorities in the rural areas have blocked this option, given the greater job opportunities in Riga and declining population in the rural areas. An increase in the minimum wage affects a large share of population, in particular in rural areas. In 2017, the national minimum wage of around 42 % of the average wage was in line with the EU average ratio. One fifth of employees received the minimum wage or lower; this share stood at one-third in the region of Latgale. In 2018, the minimum wage has been increased by 13 % to EUR 430, somewhat exceeding the projected wage growth of around 9 % in the economy as a whole. While this increase broadly corresponds to wage developments in general, it may affect access to employment in less developed regions. The institutional set-up for tripartite social dialogue is adequate, but there is scope to improve its quality. The National Tripartite Cooperation Council (NTSP), which brings together employers' organisations, trade unions and the Government, focused on taxation, education and healthcare reforms in 2017, and social partners consider their involvement satisfactory. However, social partners note that social dialogue can be further enhanced by ensuring their timely involvement in the dialogue and by further expanding their capacity. Limitations in social partners’ capacity hamper social dialogue. The capacity of social partners and bipartite social dialogue is currently being strengthened under the EU-funded project, although low membership remains an issue. In 2014, just 10.9 % of workers were organised in trade union, which is among the lowest in the EU. Trade union membership is concentrated in the public sector, but it is low in the private sector. Members of the employers' organisation employ 30 % of all workers (Eurofound, 2015), with smaller companies being weakly represented. 3.3.2.Social policies Despite recent improvement, high levels of poverty and income inequality remain a serious challenge. In 2017, the income of the richest 20 % of the population was 6.3 times higher than the poorest 20 %. It is still one of the highest in the EU. While the proportion of people at risk of poverty or social exclusion has been steadily reducing, it remains above the EU average (Section 1). Looking ahead, the tax reform is expected to only have a limited effect on the reduction of inequality and poverty (Box 3.1.1). Low adequacy of benefits contributes to high poverty and inequality. Latvia spends little on social protection as a percentage of GDP compared to other EU Member States. In spite of a recent improvement, social transfers, including the minimum income scheme, are among the least effective in reducing poverty in the EU (). From 2018, the guaranteed minimum income tops up income to EUR 53 (some municipalities voluntary provide higher benefits), while the at-risk-of-poverty threshold reached EUR 330 per month in 2016. The coverage of guaranteed minimum income decreased by more than 50 % between 2013 and 2016, from 64 408 to 27 769 persons. According to the Ministry of Welfare, the modest increase in the adequacy of benefits would increase the coverage to 29 553 recipients in 2018. The concept paper adopted in 2014 envisaging a significant increase in benefit adequacy has not been implemented, and the most recent plan to improve the minimum income support system for 2018-2020 has not been adopted by the Government (submitted in March 2017). As concerns unemployment benefits, Latvia ranks close to EU average for indicators related to adequacy and coverage, while maximum duration (for a 1-year work record) is comparatively high (). The social protection system provides partial coverage for the self-employed. Some 8 % of Latvian workers are self-employed without employees, which is below the EU average of 10 %. However, these workers cannot opt-in to the statutory unemployment assistance regime. As a result, the proportion of Latvian self-employed with social protection coverage is lower than the EU average. Moreover, following the healthcare reform, seasonal agricultural workers, people employed under the micro-enterprise tax regime, patent-fee payers and certain types of self-employed will have access only to the minimum basket of healthcare services. To obtain access the full basket they may voluntary join the new social contribution's based scheme as of 2018 (Section 3.3.3.). Pensions are not keeping pace with economic growth, which leads to increasing poverty in old-age. The at-risk-of-poverty or social exclusion rate for the elderly continues to deteriorate (Graph 3.3.3) and is above the EU average of 18.2 % in 2016. Moreover, the poverty gap, which measures the intensity of poverty (i.e. how poor the poor are), is among the highest in Europe. This is mainly because pension indexation lags behind the growth in labour incomes while there are no adequate safety nets for the elderly. The minimum pension varies from EUR 70.43 to EUR 108.85 per month depending on the length of the pension contribution period. These amounts are below the income threshold of a person in need, which is defined as having a monthly income below EUR 128 — amount not revised since 2009. Latvia has taken some steps to address pension adequacy in the short term, although in the medium to long run this remains a challenge. To address the conversion of the pre-reform service record into post-reform pension benefits, in 2018, pensions will be increased for people with careers spanning 30 years or more and the process of compensating the pensioners who retired in 2010-2015 for the losses in their pension capital in crisis years is on-going (European Commission, 2017b). Moreover, as of 2018, most recipients of medium and higher pensions will benefit from the tax reform due to an increased tax allowance and progressive taxation (Box 3.1.1). However, according to analysis carried out for the upcoming Pension Adequacy Report, the aggregate replacement ratio in Latvia is among the lowest and theoretical replacement rates 40 years from today are also projected to remain among the lowest in the EU. About one third of employees make social insurance contributions from incomes that are below or equal to the minimum wage, which gives cause for concern about the adequacy of future pensions. This also affects employees falling under the micro-enterprise tax regime (Section 3.1.1). Graph 3.3.3:At-risk-of-poverty or social exclusion rate by age groups Source: European Commission (Eurostat)

Social protection for persons with disabilities is very weak. While the employment and activity rates for persons with disabilities in Latvia are higher than the EU average, their poverty or social exclusion rate is among the highest in the EU at 38.9 % (EU SILC 2016). Also, the difference in poverty rates between people with and without disabilities is higher than the EU (20.1 pps. vs. the EU average of 10.1 pps.). In addition, Latvia has one of the largest tertiary education attainment gap between people with and without disabilities in the EU (20 pps. vs. the EU average of 13.7 pps. in 2015 - EU SILC 2016), indicating inequalities of opportunity. The coverage for children under the age of three in childcare facilities is lower than the EU average. This is linked to the long parental leave, which is paid until the child is 18 months old. In 2016, 28.3 % of all 0-3 year olds were enrolled in formal childcare (EU SILC), which is below the Barcelona targets of 33 % and below the EU average of 32.9 %. Due to the limited number of places in municipality kindergartens, children can receive pre-school education in private establishments with municipalities covering costs up to the average cost the municipality's kindergarten. The municipality contributions vary and are lower than private tuitions fees leading to unequal access to the service which can hamper employment at low wages. Child poverty has decreased substantially in recent years. In 2017, the at-risk-of-poverty or social exclusion rate for children stood at 23.9 %, below the EU average of 26.9 % and 20 pps. less than 6 years ago. To reduce the share of children living in child care institutions, measures to support foster families will be implemented in 2018, including improving their social protection. Large proportion of Latvian population is facing severe housing deprivation. In 2016, 15.5 % of Latvians lived housing that was overcrowded and showed at least one measure of deprivation (). This contrasts with the EU average of 4.9 %. One in five children (under 18) faced severe housing deprivation. Among the population at risk of poverty or social exclusion, 23.4 % lived in overcrowded, poor quality housing (), with children living in poverty being particularly vulnerable. In 2017 overcrowding rates were high, both for those at risk of poverty (47 %) and for the general population (41.9 % in 2017). Social housing is scarce and hard to access. Social housing represents only 0.4% of total housing stock, compared to the EU average of 8% (Housing Europe, 2017). As a result there are long waiting lists, especially in Riga. Housing benefits for low-income households cover in part the rent and utility bills (5 % of population in 2016). However, the cover is limited and the amounts vary considerably between municipalities ().In 2016 an estimated 0.33 % of the Latvian population sought shelter on account of homelessness (). 3.3.3.healthcare Health outcomes remain poor despite the substantial improvement over the past decade. Latvia has one of the lowest life expectancy among all EU countries. Despite a nearly five-years increase in 2000-2015, life expectancy is still nearly 6 years lower than the EU average (74.8 years vs. 80.6 years). Heart disease and strokes are the biggest causes of deaths, which remains among the highest in the EU. The poor health outcomes are linked to the low public expenditure, while other EU countries with similarly modest spending per capita have better results (Graph 3.3.4). This underlines the need to both expand public health services and increase their efficiency. Prevalence of lifestyle choices bad for health questions effectiveness of prevention policies. Latvia has been investing in the promotion of health and disease prevention activities by implementing a number of legislative measures, such as smoking restrictions and food regulations. The share of adult smokers has decreased over the past years, although lung cancer continues to be the main cause of cancer deaths. Obesity, low physical activity and rising alcohol consumption are major public health risks (Graph 3.3.5). Graph 3.3.4:Relationship between healthcare spending and health outcomes, 2014 Source: European Commission (Eurostat), OECD health statistics Graph 3.3.5:Health risk factors in Latvia relative to other EU countries, 2013-2014 Source: OECD/European Observatory on Health Systems and Policies (2017) Access to healthcare is a concern. The main barrier to access to healthcare is the annual ‘quota’ system and high out of the pocket payments, () which constituted 42 % of health spending in 2015, among the highest in the EU and nearly three times the EU average of 15 %. Over 8 % of Latvians report unmet medical care needs, which is less than in previous years, but still one of the highest shares among all EU countries (Box 3.3.1). There is significant disparity in unmet needs between the highest income quintile (2.5 %) and the lowest one (17.1 %) highlighting unequal access to services for vulnerable groups. As a result, less than half of Latvians report being in good health (46 % in 2015) and there are significant disparities between the income groups for people reporting that they are in good health (31.5 % of the low-income group vs. 68 % of the high-income group). Healthcare reforms to improve the system’s efficiency and effectiveness are progressing. In July 2017, the Government approved a healthcare reform package, including the Law on healthcare financing adopted in December 2017. The law makes healthcare part of the state social insurance system, with 1 % of social contributions directed to healthcare financing. Revenues from increased social contribution constitute less than 10 % of total healthcare expenditure in 2018, the rest remains financed from the general tax revenue. The Law on health insurance will follow. The publicly-funded basket of health care services has been restricted for a certain population group. The legislation provides for dividing healthcare services into a 'full basket' and a 'minimum basket'. The full basket will be available to all children and pensioners; however, for other groups the access to services will depend on them paying social security contributions, with an opt-in possibility for those not obliged to pay them. The minimum basket of services available to all provides for an access to the general practitioners, emergency services, childbirth care and curing diseases endangering public health. The access to hospital care in non-emergency situations will not be provided for the minimum basket. This financing model is a departure from an earlier Government decision to maintain universal access to full basket of healthcare services. While the intention is to motivate people to pay taxes, a share of the population risks losing their current level of access to healthcare. This is likely to lead to an even lower health status of the affected population, delayed treatment and an increase in the use of emergency services. The healthcare system suffers from inefficiencies and underfunding, however a substantial increase in financing is expected from 2018 onwards. Spending on health in Latvia is among the lowest in the EU (less than 40 % of the EU average). However, under the health reform goals, additional funding was made available in 2017 and a further increase in healthcare budget has been envisaged through budget reallocation and increased compulsory social contributions. Public spending on health is set to increase from 3.0 % of GDP in 2017 to around 3.5 % in 2018 and 2019, according to the medium-term budgetary plans. The target of government expenditure on healthcare of 4% of GDP in 2020 is adopted, but it includes private payments for services in public health institutions. The net public spending for the healthcare is estimated at 3.2% of GDP in 2020 or 10.5% of total government expenditure — still well below the EU average. Streamlining the hospital sector will allow for improvements to be made on efficiency and quality. The overall number of hospital beds per head in Latvia has declined by more than one third since 2000 (from 8.8 per 1 000 inhabitants in 2000 to 5.7 in 2015). However, the number of people who use hospital care remains slightly above the EU average. Plans for regional consolidation and specialisation of in-patient health care providers have been announced, in order to further rationalise the use of human resources and infrastructure resources. Moreover, the concentration of resources and flow of patients in specialised hospitals will contribute to the quality of the service. Shortage of healthcare workforce hampers delivery of public healthcare. Latvia faces labour shortages in the healthcare sector. This is reflected in a low number of doctors (3.2 per 1 000 population, compared to 3.6 for the EU average) and one of the lowest number of nurses among EU countries (4.7 per 1 000 population). It is difficult to recruit and retain a sufficient number of skilled health workers, mainly due to low salaries. The budget for 2018 provides financing for an increase in remuneration of medical staff and for compensation the extended working time of medical personnel. The implementation of the workforce plans is still contingent on planning and operational decisions at all levels of the healthcare system, as well as provision of the necessary financing both at central and local government level. The medium-term budgetary plans for 2018-2020 have not provided the healthcare financing to the level envisaged in the most recent healthcare reform plans presented in 2017. Introduction of e-health services has proceeded despite drawbacks. Following several postponement since 2016, the use of the first e-health services is mandatory from 2018. Medical and IT professionals have criticised the services currently provided for cumbersome use, system errors and over concerns of patient data security. The e-health system is still far from fully functional electronic medical health records, which could contribute to improving efficiency and quality of the healthcare. 3.3.4.education

The decline in student numbers poses a challenge to reduce capacity and improve quality of the education system. The remuneration of teachers is linked to a number of students and as this number decreases, especially in rural areas, schools become under-resourced and over-staffed. The low teacher salaries contribute to making teaching unattractive, which is one of the factors affecting the quality of education in the small schools and results in relatively few young people entering the profession (Krasnopjorovs, 2017). Improving the quality of education is crucial for enhancing human capital and its productivity. Access to quality education remains dependent on the place of residence and type of school. In terms of basic skills, 15-year-olds’ performance as measured by the 2015 OECD Programme for International Student Assessment (PISA) appears to have levelled off although it remains well above the EU average (OECD, 2016). The proportion of low achievers in mathematics (21 %) and in science (17 %) worsened compared to PISA 2012, but continues to be better than the EU average. However, the disparity between rural and urban schools is large and growing. In terms of basic skills, students in upper general education perform better than those in vocational education and training and special needs education (European Commission, 2016). Moreover, there is also a significant gender gap in education with women outperforming men significantly both in terms of qualifications and basic skill proficiency (). Consolidation of schools based on the minimum number of students has been delayed. While the Government’s requirements for the minimum number of students per class in the secondary education from 2018 were overruled in the court, legislative changes now allow for the Government to define qualitative and quantitative criteria in the secondary education by September 2018. The independent study on an optimal network of general education institutions will from a basis for the discussion on the criteria on minimum number of students per school and on the distribution of general education institutions. Streamlining the secondary school network would concentrate resources from state and municipalities budgets in fewer schools with better infrastructure and higher salaries for teachers, thus improving the quality and efficiency of the general education. A new competence-based curriculum is being gradually rolled out with the support of the European Social Fund. The new curriculum covers all levels of education from pre-primary to upper secondary, and is based on a framework of seven key competences and four transversal competences. It aims to introduce a student-centred approach to learning and to promote the competences and skills needed for ind