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Language: en
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# 52012SC0320

**COMMISSION STAFF WORKING DOCUMENT Assessment of the 2012 national reform programme and convergence programme for LATVIA Accompanying the document Recommendation for a COUNCIL RECOMMENDATION on Latvia's 2012 national reform programme and delivering a Council opinion on Latvia's updated convergence programme, 2012-2015 /\* SWD/2012/0320 final \*/**

  

CONTENTS

1. Introduction.. 4

2. Economic
developments and challenges. 4

2.1.Recent economic
developments and outlook. 4

2.2. Challenges. 5

3. Assessment of the
policy agenda.. 7

3.1. Fiscal policy
and taxation. 7

3.2. Financial
sector 11

3.3. Labour market,
education and social policies. 12

3.4. Structural
measures promoting growth and competitiveness. 15

3.5. Modernisation
of public administration. 20

4. Overview table. 23

Annex.. 26

EXECUTIVE
SUMMARY

After a strong rebound in 2011, Latvia's GDP growth is expected to
decelerate to 2.2% in 2012. The rate of unemployment dropped substantially in
2011 and is expected to decrease further to 14.8% in 2012 but youth and
long-term unemployment rates remain high.

The government has ensured financial stability and fiscal
consolidation by over-achieving its fiscal targets. In 2012, the general
government deficit is expected to decrease to 2.1% of GDP. In other areas,
however, reform efforts have been limited, particularly as regards the public
administration and the unified wage grid, management of state owned assets,
strengthening of the competition framework, setting up of the Development Bank
and outlining proposals for managing the EU funds in the new financing period.

Latvia continues to face important policy
challenges: building on the significant progress made regarding public
finances, further fiscal consolidation is necessary to meet the medium-term
objective to maintain market confidence. Latvia has one of the highest
long-term and youth unemployment rates in the EU. There is a relatively high
tax wedge on low-wage earners and a high level of undeclared work. A high share
of the population is at risk of poverty or social exclusion. The coverage of
unemployment benefits is low and the impact of social transfers on poverty
reduction is small. Inefficiencies in the civil justice system have a negative
impact on the business environment. The education and training systems are not
adapted to labour market needs and not geared to improving Latvia’s innovation performance. Improving energy efficiency, in particular of the building stock,
would contribute to growth and jobs, while reducing energy dependence.

1. Introduction

Procedural aspects

In July 2011 the Council of the European Union adopted only one
country-specific recommendation for Latvia: implement the balance of payments
programme conditions.

In November 2011 the Annual Growth Survey for 2012 (AGS 2012)
presented the basis for building the necessary common understanding about the
priorities for action at national and EU levels in 2012. It focused on five
priorities — ensuring growth-friendly fiscal consolidation, restoring normal
lending to the economy, promoting growth and competitiveness, tackling
unemployment and social consequences of the crisis, and modernising public
administration — and encouraged Member States to implement them in the 2012
European Semester.

Against this background, Latvia presented its national reform
programme and convergence programme in April 2012. The documents outline the
fiscal consolidation efforts in a consistent manner, based on medium-term
macroeconomic projections and key structural reforms. The national reform
programme evaluates the progress made towards meeting the national targets for
employment, R&D, education, energy and climate change, and poverty
reduction for 2020. It also describes the measures Latvia plans to take under
the Euro Plus Pact.

This Staff Working Document assesses the state of implementation of
the balance of payments programme condition, as expressed in the latest
Supplemental Memorandum of Understanding, identifies current policy challenges
and, in this light, examines the country’s latest policy plans.

Overall assessment

Overall, the policy plans submitted by Latvia are adequate, but in some areas they lack the ambition to address the challenges in
a comprehensive way. The most pressing challenges facing Latvia are to continue growth-friendly fiscal consolidation and implement wide-ranging structural
reforms to achieve sustainable growth and catch up with other EU countries. In
particular, strong implementation of the conditions outlined in the latest
Supplemental Memorandum of Understanding will be important, inter alia in the
fields of energy markets and energy efficiency, higher education and vocational
training, management of state-owned enterprises, public administration and the
judicial system, competition and public procurement policies, restructuring and
sales of state-owned banks and management of EU funds.

2. Economic
developments and challenges
2.1.Recent
economic developments and outlook

Recent developments

After a severe economic contraction in 2008-09, the Latvian economy
started to grow again towards the end of 2010 and switched to a rapid recovery
in 2011. The economy expanded by 5.5 % in 2011 driven mainly by exports
and investments and was quite resilient to the adverse external demand shocks
in the second half of the year. At the beginning of 2012, industrial
production, retail trade and transport services were also performing relatively
well, indicating some decoupling from the weak performance in many EU Member
States. The economic sentiment indicator rebounded to a four-year high at the
beginning of 2012 with improvements recorded in both the household and
corporate sectors. Unemployment remains among the highest in the EU after
deteriorating to about 20 % at the beginning of 2010 from 6-7 % in
the pre-crisis period. However, the unemployment rate dropped substantially to
16.1 % in 2011 and 15.0 % in the last quarter of the year. The
harmonised index of consumer prices (HICP) inflation was in line with
expectations at 4.2 % in 2011, including a large contribution from the
increase in VAT rates. The constant-tax price index is estimated at 2.7 %
in 2011.

The current account balance turned to a deficit of 1.2 % of GDP
in 2011 after surpluses in 2009 and 2010. The country remained in a net lender
position, however, as the net inflows in the capital account reached 2.1 %
of GDP. The rebalancing of the economy towards tradable sectors continued at a
fast pace as the share of exports in GDP expanded to 59 % in 2011 from 54 %
in 2010. The net inflows of foreign direct investments rebounded substantially
in 2011 while the share of external debt to GDP decreased further.

Outlook

The Commission spring forecast projects that Latvia’s growth rate
will slow down to 2.2 % in 2012 due to weakening external demand in the
first half of the year combined with some downward correction of the
consumption propensity of households as a result of global economic
uncertainties. However, in line with the expected improvement in external
demand, growth is set to regain momentum in the second half of 2012 and to
accelerate to 3.6 % in 2013. Unemployment is expected to decrease further
in 2012-13 though at a relatively weak pace set by slower economic growth.
Inflation is projected to decelerate to 2.6 % in 2012 and 2.1 % in
2013 as the impact of the tax increases in 2011 weakens substantially.
Uncertainties about prices of primary energy resources pose a significant risk
to the inflation forecast, as the country depends heavily on energy imports.

Both the national reform programme and the convergence programme
share the same economic outlook, but neither of them gives any figures on the
impact of the proposed structural reforms on growth. The economic growth
outlook for 2012-13 is broadly in line with the most recent Commission
forecast. In 2014-15, the annual growth rate is expected to accelerate to 4 %,
which is seen as the medium-term potential growth in the country. This rate
remains unchanged from the projections presented in the 2011 programmes but
could be subject to slight downside risks as the results of the 2011 census
show a faster decline in the population than previously estimated.

2.2. Challenges

Although growth has resumed after the financial crisis, Latvia should speed up its reforms to improve growth potential. In particular, Latvia has amongst the highest long-term and youth unemployment rates in the EU. This,
along with the relatively high tax wedge on low wage earners and the high level
of undeclared work, indicates a need for appropriate labour market policies, a
review of the tax and benefit system and greater efforts to tackle the grey
economy (e.g. without effective activation and support measures, the marginal
tax rate for low-earners will remain discouragingly high, increasing both
unemployment and poverty). The high share of the population at risk of poverty
or social exclusion is also a cause for concern: families with children and the
unemployed are particularly affected. The coverage of unemployment benefits is
low and the impact of social transfers on poverty reduction is small. Ensuring
an effective system of social assistance to protect the most vulnerable while
maintaining incentives to work remains a challenge.

Despite relatively good overall educational attainment, the quality
of tertiary and vocational education remains a cause for concern. There is
evidence of skills mismatches on the labour market, including an insufficient
number of graduates in science and technical subjects. There is also a low
degree of employment in knowledge-intensive activities. More efforts to
implement the necessary reforms in higher and vocational education (in line
with the commitment made in the Supplemental Memorandum of Understanding) would
help to adapt education and training systems further to labour market needs. Latvia’s poor innovation performance impairs its competitiveness and the country has no
systematic and effective research and innovation policy. There is little
R&D investment by domestic companies or large foreign affiliates to support
specialisation in knowledge-intensive and innovation-driven sectors.

Completing the restructuring and sales of the three state-owned
banks — Parex, Citadele and MLB — to comply with the Commission’s state aid
decisions is the most pressing issue in the field of financial stability.
Consistent implementation of the plans for these banks would further increase
confidence in the financial sector and allow the public sector to withdraw from
commercial activities. The 2011 Latvian
Competitiveness Report also highlights the underdeveloped financial markets as
one of the main weaknesses of the economy.

Regional economic disparities have widened, mostly due to the rapid
growth of the capital Riga. Regional problems are most acute in the eastern parts
of the country, which have particularly low levels of investment per capita,
relatively few enterprises and very high unemployment rates. Disparities are
widening due to an increasing urban/rural divide, triggered largely by
migration to Riga from rural areas and other cities.

The poor overall condition of transport infrastructure is
undermining the growth and competitiveness of the country. Significant
differences also exist in the development of ICT infrastructure and expansion
of broadband connections between urban and rural areas.

Isolation from the EU gas and electricity markets and low energy
efficiency are key challenges facing Latvia. One centrepiece could be to
improve significantly the energy efficiency of the building stock, thereby
contributing to growth and jobs, while reducing energy dependence. Low energy
efficiency is also a challenge for the transport sector.

Further environmental challenges lie in the water and wastewater
treatment sectors and waste management, with landfills remaining the main
option for disposal of municipal waste (around 90 %).

Progress with reforming management of both state-owned enterprises
and public real estate will require a sharp focus. The new state-owned
enterprises governance model is supposed to be in place by the end of March
2013, while action is still needed to adopt a special law on management of state-owned
enterprises, to transfer assets under the new state-owned enterprises
management authority and to give the centralised state-owned enterprises
manager appropriate capacity. Further centralisation of public real estate
management under the Finance Ministry and divestments of assets not used for
public needs are planned.

Progress is expected in the next few months on a number of key
conditions included in the latest Supplemental Memorandum of Understanding:
preparing a strategy for management of human resources, implementing
energy-related EU legislation, strengthening energy efficiency programmes,
making amendments to the Public Procurement Law, improving the quality
assurance system for roadbuilding, reviewing the port management and taxation
system, adopting a Construction Law, etc.

Given the notable impact of EU cohesion funds on the economy,
creating the conditions for effective support and reinforcing strategic
programming of funds for 2014-2020 will be important in order to deliver on the
Europe 2020 priorities.

Inefficiencies
in the civil justice system have a negative impact on business and the economic
environment, as they increase the risk and cost of doing business. There is a
large backlog of civil and commercial cases before the first- and
second-instance courts, together with excessively long procedures. There are
still weaknesses in the insolvency law. The professional performance and
accountability of judges are not always up to standard. Training of both judges
and prosecutors is not sufficient to ensure that they have the appropriate
qualifications.

3. Assessment of the policy agenda
3.1. Fiscal policy and taxation

The main goal of the medium-term budgetary strategy of the 2012
convergence programme is to secure correction of the excessive deficit
situation by the deadline recommended by the Council (2012) and subsequently to
approach the medium-term objective (MTO), which has been revised to a more
ambitious target of a structural deficit of 0.5 % of GDP. Under the convergence
programme strategy, the headline general government balance will reach a near-balanced
position in 2015. The adjustment is front-loaded, with greater improvement in
the structural deficit in 2012-2013 than in 2014-2015.

Budgetary developments and debt dynamics

As a result of the ambitious front-loaded fiscal consolidation
implemented since 2009 and of the faster-than-expected recovery in growth,
Latvia’s general government position improved strongly in 2011, reaching a
deficit of 3.5 % of GDP, which is considerably better than both the
initial deficit target set under the balance-of-payments assistance programme
(deficit of no more than 6 % of GDP) and the target of a deficit of no
more than 4.5 % of GDP in the 2011 convergence programme. This was
achieved thanks to stronger-than-expected economic recovery and lower
exceptional costs related to the restructuring of the banking sector. Moreover,
while tax revenue as a share of GDP was broadly in line with expectations in
the previous programme, several expenditure categories not related to
absorption of EU funds (notably social benefits) were kept under tight control,
leading to a reduction in their share in GDP.

The programme expects the general government headline deficit to
decline further to 2.1 % of GDP in 2012, which is in line with the projections
in the Commission spring 2012 forecast and better than the target of a deficit
of 2.5 % of GDP in the previous programme. The macroeconomic scenario
underpinning these projections is broadly in line with Commission projections;
however, the most recent information (notably the estimate of economic growth
in the first quarter of 2012) indicates that this scenario can be considered as
cautious. According to estimates in the programme, measures in the 2012 budget
law to improve the budgetary position add up to 0.7 % of GDP (see
Box 1). The budget law was adopted by the Saema (Parliament) on 15
December 2011. The programme thus aims to bring the excessive deficit below the
3 % reference value — with sizeable leeway against adverse developments —
by the date recommended by the Council. Risks to fiscal projections for 2012
stemming from the macroeconomic scenario seem on the upside, taking into
account the most recent information. However, the programme acknowledges that
consideration is being given to reducing the VAT rate; the letter accompanying
the programme, along with recent public information, suggest that this will take
place in 2012 already (see also the section on the ‘Tax system’).
Nevertheless, the planned reduction in the VAT rate is unlikely to endanger
meeting the current target for 2012.

|| Box 1: Main budgetary measures ||

|| Revenue || Expenditure ||

|| 2011 ||

|| 1.6 % of GDP || -0.7 % of GDP ||

|| 2012 ||

|| Legislative measures to support the fight against the grey economy, including application of reversed VAT in some sectors, and changes in taxation of the gambling industry (0.25 % of GDP) Broadening the real estate tax base and abolishing the limits on increases in real estate tax (0.03 % of GDP) || Nominal wage freeze in the public sector and other measures to limit or reduce expenditure, notably cuts in subsidies to transport and road maintenance and review of the sickness benefit scheme (-0.4 % of GDP) ||

|| 2013 ||

|| Resuming contributions to the private mandatory funded pension scheme at 6 % of gross wages, compared with the current temporarily lowered contribution of 2 % (-0.6 % of GDP) || Reforming the system of family allowances and social safety net (impact not specified) Continue limiting maximum amounts of family and sickness benefits (impact not specified) ||

|| 2014 ||

|| n/a || n/a ||

|| 2015 ||

|| n/a || n/a ||

Note: The budgetary impact in this table is the impact reported in the programme, i.e. by the national authorities. A plus sign means that revenue/expenditure increases/decreases as a consequence of the measure.

For 2013, the authorities are aiming for a nominal budget deficit of
1.4 % of GDP, which is better than the target of a deficit of 1.9 %
of GDP in the previous programme. The macroeconomic projections in the
programme for 2013 are plausible. According to the programme scenario, the
reduction in the headline deficit will be achieved through continuous restraint
in compensation of employees (i.e. a nominal wage freeze in the public sector)
and through further cuts in intermediate consumption. These measures, however,
currently do not seem to be backed by any specific action and thus represent
risks to attainment of the target. While in the past the Latvian authorities
have demonstrated their ability to implement planned expenditure cuts, these
have often taken the form of ‘across-the-board’ expenditure reduction. Such a
strategy entails risks related to slippages in implementation, excessive cuts
in public employment being detrimental to efficiency, and uncompetitive wages
which could lead to better performing employees quitting the public sector, a
trend which is already visible in higher-level positions. It will thus be
important to identify targeted and sustainable measures in the 2013 budget to
support the planned expenditure restraint. At the same time, there are several
areas — notably social benefits — where expected savings in 2013 are already
backed by legislation. Another risk comes from the planned tax cuts that are
being considered but are not yet reflected in the programme scenario (see the
section on the ‘Tax system’).

The structural balance[1] is expected to improve by ¼% of GDP in 2013 (compared with an
improvement of ½% based on estimates in the Commission spring 2012 forecast), taking
the structural deficit to below 1 % of GDP, according to the information
in the programme.[2] These projections take into
account the negative impact on both the nominal and (recalculated) structural
balance of restoring contributions to the mandatory funded private pension
scheme to 6 % of gross wages from 2013, compared with the current reduced
level of 2 %. In the Commission estimates, the current lower level of
contributions is treated as a temporary measure excluded from the structural
balance. Thus its reversal in 2013 will affect only the nominal but not the structural
balance. The impact of this reversal on the 2013 nominal balance is, however,
assessed to be higher in the Commission’s projections than in the programme’s
estimates, posing another risk to attainment of the target.

Latvia’s medium-term budgetary objective has been
revised in the 2012 convergence programme. The new medium-term objective of a
structural deficit of 0.5 % of GDP is higher than the previous figure and
adequately reflects the requirements of the Stability and Growth Pact. The
revision of the medium-term objective is linked to a major reform of fiscal
governance in Latvia which is discussed in more detail below.

In 2014 and 2015, the programme aims for a continuous improvement in
the nominal balance, reaching a near-balanced position in 2015. The targeted
improvement comes from continuing restraint in government consumption. Thus
risks applicable in 2013 will remain relevant. Planned tax cuts pose another
risk. According to the programme, the structural deficit will approach the
medium-term objective by the end of the programme period in 2015.

Based on the information provided in Tables 2a, 2b and 2c in the
Annex to the programme, the expenditure benchmark is set to be met in all the years
following correction of the excessive deficit (i.e. 2013-2015). However, taking
into account the discretionary impact on revenue of restoring contributions to
the mandatory funded pillar to 6 % of gross wages (included in Table 7.8
of the programme, but not reflected in Table 2b), the expenditure benchmark
would be missed, albeit only narrowly, in 2013. Taking the Commission estimate
of the discretionary impact, the deviation in 2013 would be somewhat higher. However,
in both cases the average deviation in 2012 and 2013 would remain negative,
given the substantial front-loaded expenditure restraint in 2012. In the outer
years of the programme the planned expenditure restraint would ensure that
expenditure growth remains significantly negative, and hence in line with the
expenditure benchmark in the Stability and Growth Pact.

In the programme scenario the general government debt is projected
to increase from 42.6 % of GDP in 2011 to 46.7 % in 2014, falling
thereafter rapidly to 38.9 % of GDP in 2015. This profile reflects
accumulation of financial assets in anticipation of large repayments of loans
under the financial assistance programme (as evidenced by high stock-flow
adjustment in 2012-2014) and the subsequent repayment of a large share of these
loans in 2014-2015. In June 2011, the authorities successfully returned to
international financial markets and a second major international bond issue
took place in February 2012. All major credit-rating agencies have revised Latvia’s sovereign ratings to the investment grade. The latest upgrade took place in May
2012.

Long-term sustainability

Assuming no policy change, debt would stand at 42.7 % of GDP by
2020. Ensuring continued sufficient primary surpluses over the medium term, as
planned in the programme, would further improve the sustainability of public
finances.

Fiscal framework

The current fiscal framework in Latvia lacks an effective mechanism
to limit expenditure growth in good economic times. In particular, there are no
fiscal rules at central government level that could impose a binding constraint
on the annual budgetary process. Recognising the need to develop a multi-annual
and rules-based budgetary framework that would minimise the risk of
pro-cyclical fiscal loosening in the new growth phase, in November 2011 the
Latvian government adopted the draft Fiscal Discipline Law, which is currently
being scrutinised by Parliament. The draft law is in line with the commitments
made by the Latvian government under the balance of payments programme and
seeks to implement the evolving EU acquis in the area of fiscal
governance in Latvia’s legislation. The authorities also intend to pass
constitutional amendments to enhance the legal standing of the law.

Once implemented, the new law would considerably strengthen the
fiscal framework in Latvia. The current draft clearly lays down: the principles
of a counter-cyclical fiscal policy; a balanced budget rule as an instrument
for a sustainable and counter-cyclical policy; a debt rule; transitional
provisions, including consistency with the Stability and Growth Pact; escape
clauses; the requirement to publish a report in case of deviations from the
target; and regular monitoring and reporting requirements to ensure compliance
with the fiscal rules. Once the Fiscal Discipline Law is adopted, the
authorities also plan to adopt the medium-term budget framework law, setting
binding expenditure ceilings for 2+1 years on a rolling basis.

Tax system

Latvia has one of the
lowest tax-to-GDP ratios in the EU, at 27.8 % of GDP in 2011. The tax
system relies relatively heavily on consumption taxes, compared with other EU
states, although labour taxes (in particular, social contributions) still form
the largest tax revenue category. The taxation framework can be considered
growth-friendly, although the high tax wedge on low wage earners requires some
attention. The government plans to shift taxation further from labour to other
sources. The overall tax system shows a low degree of progressivity.

The government plans to lower the tax burden
on labour substantially — by about nine percentage points in the long run
according to the programme. The Parliament recently approved in the first
reading a bill to reduce value added tax rate (from 22% to 21% as of 1 July
2012) and the personal income tax rate (from 25% to 20% over the three-year
period starting from 2013). The tax cuts were not accompanied by measures to
improve the structural balance. The reduced VAT rate runs contrary to the
strategy of shifting the burden of taxation to other sources and limits further
opportunities to reduce taxes on labour. Even though the NRP mentions tax
policy as one of the main instruments to tackle poverty and foresees several
measures (increasing non-taxable PIT threshold, increasing tax reliefs for
dependants or introducing progressive income taxes), these considerations were
not reflected in the recent tax changes.

The sizeable fiscal consolidation that took
place in 2009-2012 helped to adjust public finances to a more sustainable
growth pattern. Over half of the consolidation effort, which was equivalent to
17 % of GDP over these years (albeit coming after a period of
unsustainable growth of public spending prior to 2009), took place on the
expenditure side. These cuts took the form, in particular, of downsizing
government expenditure by implementing large-scale reforms in health and
education along with the territorial administrative reform. On the revenue
side, although tax rates increased in almost all tax categories during the
period of fiscal consolidation in 2009-2012, the biggest increase was in
consumption taxes. The consolidation thus supported growth in the medium term,
since to a large extent it took the form of the least harmful measures — cuts
in government consumption and increases in consumption taxes.

The full benefit of the significant increases
in consumption tax introduced between 2009 and 2012[3] did not materialise, however, as they were accompanied by growth in
the share of the informal economy, as demonstrated by an increase in the VAT
compliance gap[4]
from 16 % in 2007 to 47 % in 2011. Recent studies[5] suggest that the informal economy
is considerably larger in Latvia than in peer group countries and is
concentrated in sectors like construction, services and retail. Part of the
reason for engaging in informal economic activities stems from dissatisfaction
with the taxation system and with government spending as well as poor law
enforcement. The ‘Doing Business 2011’ report ranks Latvia the lowest of the
three Baltic countries in the category ‘paying taxes’. This is due to
time-consuming tax compliance procedures (on average it takes 293 hours to
comply with tax administration requirements), whereas the number of taxes and
the tax rate in relation to profits score favourably.

The government is stepping up the efforts to
combat the informal economy. After several initial delays, the Action Plan to
Combat the Shadow Economy is now being implemented and several legislative
measures (e.g. application of reverse VAT in sectors prone to undeclared
activity) have entered into force from 2012. Moreover, the Law on Individual
Declaration of Property and Reporting of Undeclared Income was adopted recently
with effect from June 2012. It introduces the possibility to legalise
previously undeclared taxable income and aims to improve oversight over an
individual’s financial position, in particular the accuracy of expenses
incurred and the payment of taxes and the legality of income derived. However,
the results of the strategy will not be visible until the medium term and the
impact is difficult to quantify.

Environmental taxes remain relatively underdeveloped and are heavily
dominated by motor fuel taxation, whereas taxation of other energy sources,
pollution and use of natural resources is below the EU average, sometimes
significantly so, even though taxes on disposal of municipal, construction and
industrial waste increased considerably in 2009. Nevertheless, further
broadening the tax base to other sources of environmental taxation, in
particular on pollution, combined with broader-based taxation of energy sources
would help to achieve environmental goals while providing room for a shift away
from taxation of labour.

3.2. Financial sector

Financial stability

In the banking sector, both solvency and liquidity risks have abated
substantially. Despite a delayed return to profitability, continued capital
support from parent institutions and from government for two state-owned banks
(Parex Bank, the second largest bank prior to the crisis, and the Mortgage and
Land Bank (MLB)) kept capital adequacy ratios comfortable at 15 % on
average at the end of 2011. The deterioration of the loan quality has come to
an end, as the proportion of non-performing loans (overdue by more than 90
days) peaked at 19.4 % in July 2010 before declining to 18.4 % in
2011. In the framework of the international financial assistance, banking
supervision and regulation have been tightened (capital, liquidity and
reporting requirements) and cooperation with foreign supervisors improved.

The restructuring and sales of the three state-owned banks — Parex,
Citadele and MLB — to comply with the Commission’s state aid decisions are the
most pressing issues in the field of financial stability. The strategy for the
work-out and sale of the assets of Parex Bank and Citadele Bank, taking into
account possible market interest, state aid-related issues and any pending
legal challenges, is being implemented. MLB’s divestment of commercial assets
to form the basis for a real development bank is well under way.

To assess clients’ creditworthiness and lending risks better, the
authorities, in consultation with experts, are making legislative changes to
increase transparency and regulated access by operators in the financial sector
to wider information on individuals’ solvency situation (e.g. the online State
Revenue Service and State Social Security Agency data or the reports of state-
and municipality-owned companies on individuals’ payment discipline).

The policy agenda is not sufficiently focused on surveillance of the
non-resident banking sector, especially in view of the experience of Parex Bank
and Latvijas Krajbanka. Regulatory and supervisory measures, as illustrated in
the case of Krajbanka, have not fully covered possible risks associated with
this particular sector.

Access to finance

Access to finance is a
challenge and the cost of capital is relatively high, hindering both debt and
equity financing. Information disclosure, corporate governance and
entrepreneurial culture would need to be improved to allow greater access to
financing. Most of the support programmes available for SMEs and start-ups,
financed mostly from EU structural funds, are rather fragmented and lack
coherence; the programmes offering loans and guarantees for the manufacturing
industry as well as the microcredit programme for SMEs have had moderate
success. Only a small part of the available venture capital funds (seed and
start-up financing for SMEs
and microenterprises) have been invested so far. Consolidation of various state
support programmes is planned, with the creation of a Financial Development
Institution (in line with the commitment made in the Supplemental Memorandum of
Understanding).

Given the problems with
access to credit financing and equity capital and the need to increase
knowledge transfer, there is room for improving promotion of Latvian SMEs among
potential foreign investors. Ongoing measures and coordination to attract
foreign investment are being re-assessed in line with effectiveness criteria
and in view of the strong competition from the other Baltic countries and Poland.

3.3. Labour market, education and social policies

Labour market policies

The labour market is slowly
recovering from the effects of recession, but the employment levels are still
far below the pre-crisis levels and the unemployment rate is among the highest
in Europe. High long-term unemployment (7.4 % of the active population)
and youth unemployment (26.3 %) are the most serious legacies of the
crisis. Most of the young unemployed have no professional qualifications (only
basic or general secondary education), partly due to the fact that the
vocational education and training system and curricula are generally considered
weak and unattractive. Together with the high inactivity rate and emigration,
these issues pose threats to future labour supply. The level of early school
leaving is relatively high.

To tackle unemployment, the
government reallocated some structural funds financing for active labour market
policies in 2011. However, activation of unemployed is still among the lowest
in the EU. In previous years, active labour market policies were financed
almost exclusively by the European Social Fund. However, its financing will be
exhausted soon and no national financing is planned. Consequently, the funding
and activation of the unemployed for 2012-2013 have decreased compared with
2010-2011 and are insufficient given the challenges on the labour market. Due
to the low social protection of the unemployed, the active labour market
policies are also performing the role of a social safety net, as the public
works programme and training grants are a significant source of income for the
unemployed. This dual role of the active labour market policies limits the
resources available for genuine activation measures and decreases their
efficiency.

Efforts have been made to
improve the effectiveness of active labour market policies (e.g. planned
introduction of profiling, evaluations of active labour market policies,
monitoring and assessment system of training providers, activation measures in
the public works programme, planned measures to facilitate regional mobility,
etc.). However, active labour market policies could still be made more
effective, in particular by making training more relevant to labour market
needs, simplifying and increasing the choice within the training voucher
system, providing effective counselling and job-search assistance, increasing
the efficiency of the wage subsidy and on-the-job training programmes,
introducing safeguards to prevent abuse, keeping programmes attractive for
employers, setting clear goals for the programmes and promoting the
self-employment and business start-up programmes managed by MLB and the State
Employment Agency. To increase the employment rates, the government plans to
lower taxes on labour, improve the effectiveness of active labour market
policies and stimulate demand for labour (measures to support entrepreneurship)
and support for regional mobility.

To tackle youth unemployment,
specially designed active labour market policies targeted at youth have been
implemented: a 1-1.5-year short-cycle vocational education and training
programme, ‘job trials’ in vocational schools, voluntary work and wage
subsidies for young workers. However, given the scale of the problem, these
limited activities have a relatively small impact. Insufficient efforts and financing
are directed towards bringing unemployed youths with no professional
qualifications back into education. Cooperation between the Education Ministry
and municipalities to improve career guidance and social services for 15- to
19-year olds is also weak.

Following the European Council
of 30 January 2012, the Latvian authorities together with the Commission
examined possible action to reduce youth unemployment, including through
refocusing structural funds, the government plans to tackle youth unemployment
through twelve measures. Most proposals focus on using existing measures and
the available national and EU funding allocations. In some cases it is proposed
to adjust measures and sharpen the focus on youth: for example, an additional
300 training vouchers targeted specifically at youth. Only two measures —
modernisation of vocational education and training infrastructure and the additional
2 000 short-term vocational education stipends — envisage additional
funding through over-commitments. In view of the extent of the problem these
measures will not be sufficient to make a significant impact.

Social policies

During the last three years the
income inequality and relative poverty rates have been on a downtrend trend,
but they are still among the highest in the EU. Severe material deprivation has
increased considerably over the same period. In 2011, 40 % of the
population were at risk of poverty or social exclusion. This is not only a
major social problem, but also has implications for the employability of the
workforce and future growth prospects. Families with children and unemployed
are at a particularly high risk of poverty. The coverage of unemployment
benefits is low — around one quarter of the unemployed are entitled and the
entitlement rules have been tightened with effect from 2012. Child poverty
affects not only children living in jobless households but also households with
high work intensity. Social transfers have little impact on reducing child
poverty. Older people are the only group of the population who benefited from
improvements in the poverty rate during the crisis. However, the pension
indexation has been frozen until the end of 2013, while wage growth and
inflation are projected to be relatively high. Consequently, the
at-risk-of-poverty rate amongst older people is likely to increase again in
2012-2013.

While social protection
expenditure as a share of GDP increased during the crisis (automatic stabiliser
effect), Latvia spends relatively little on social protection and social
transfers have little impact on poverty reduction, as a large share of them are
redistributed back to middle- and high-income earners. Spending on means-tested
benefits is low and the active labour market policies grants are partly
performing the role of a social safety net. The design of social assistance
benefits also contains poverty and unemployment traps and there are concerns
about benefit targeting, adequacy and insufficient activation of the benefit
recipients. Large inequalities exist in access to social assistance across
local governments. Poor transparency, lack of effective data management and
monitoring systems, and lack of research in this area complicate evidence-based
decision-making (in line with the condition set in the Supplemental Memorandum
of Understanding, the World Bank will undertake a comprehensive social
assistance study in 2012-2013).

Government policies to reduce
poverty are concentrating on reducing income inequality, lightening the tax
burden on working families and increasing access to the labour market. The
government has decided to continue in 2012 most of the measures in the
Emergency Social Safety Net Strategy. The main components are the public works
programme for the unemployed, an increase in the guaranteed minimum income (50 %
co-financed from central government), free healthcare for the poor, central
government co-financing for housing benefits (to be phased out in April 2012)
and transport compensation for vulnerable groups.

The effects of an ageing
population and emigration will appear soon, posing serious challenges to the
future sustainability and adequacy of the pension system. Several reforms have
been introduced in line with the conditions set in the Supplemental Memorandum
of Understanding: retirement and early retirement age limits will be gradually
increased from 2014 on, the minimum insurance period will be raised from 10 to
15 years and the pension indexation will remain frozen until the end of 2013
(consumer price index-linking will be introduced afterwards). Also, the contribution
rates to the mandatory funded pension scheme are to be restored from 2 %
to 6 % in January 2013 (in line with the commitment made in the
Supplemental Memorandum of Understanding). The national reform programme
mentions plans to increase the retirement age as of 2014.

Education and lifelong
learning

Education and training budgets
suffered significant cuts during the crisis and measures are being taken to
ensure cost-efficiency: for example, the general education school network has
been consolidated and the ‘money follows pupil’ funding model introduced.
Funding from the EU structural funds has been invested in developing
specialised vocational schools, modernising higher education and creating
competence centres.

Despite the relatively high
educational attainment (tertiary attainment rates improved significantly from
18.6 % in 2000 to 32.3 % in 2010 and have almost reached the EU
average), a significant share of the workforce have no professional
qualifications and limited access to quality education, especially higher
education. Universities perform poorly in worldwide rankings (also compared
with other Baltic countries). Higher education suffers from low international
competitiveness (low share of international students, publications and
international lecturers) and weak cooperation between universities and
businesses. The share of mathematics, science and technology graduates is the
lowest in the EU. There are concerns about decision-making and governance in
higher education institutions. One of the main measures implemented in higher
education is a large-scale assessment of study programmes that will form the
basis for future decisions. Performance-based financing is not expected to be
introduced before 2013.

The share of students enrolled
in vocational education and training is among the lowest in Europe. The
challenge remains to improve the quality, effectiveness and attractiveness of
vocational education and training, including providing modern material and
technical bases in vocational education and training institutions, adapting
curricula to match labour market needs better and promoting quality
apprenticeships. Delays are reported in implementation of the measure funded by
the European Regional Development Fund on ‘Vocational education infrastructure’,
putting at some risk the end of 2015 deadline for completing the programme.
Additional resources (more than EUR 44 million) to fulfil the initial programme
goals are to be found within the current Operational Programme. Targeted
measures to bring early school leavers back into education are missing. More
support for poor families with children in vocational or general education
institutions, coupled with more budget places and scholarships and wider
availability of student loans in universities, would be one way to reverse this
trend.

Participation in lifelong
learning is also low. There has been little progress on implementing the
strategy and the quality and effectiveness of the existing schemes should be
improved, especially by increasing their relevance to labour market needs.
Since enterprises are not active in training their staff, support for companies
providing training for their employees could be considered.

The government has planned a
number of measures to make vocational education and training more attractive,
such as modernisation of infrastructure and equipment, development of modular
vocational education and training, improvement of vocational education and
training programmes in cooperation with sectoral expert councils and
development of the National Qualifications Framework. In the area of higher
education, the main measure is the evaluation of study directions which will provide
a basis for taking further decisions. There are also plans to improve the
infrastructure and equipment and to introduce a new model for financing higher
education institutions plus legislative amendments to improve the quality and
flexibility of higher education.

3.4. Structural measures promoting growth
and competitiveness

Latvia’s export structure has become more
diversified over the years and the recent growth in exports has contributed
significantly to the overall economic recovery and the rebalancing of the
economy towards tradable sectors. Nevertheless, major structural problems
remain. Latvia’s labour productivity, in terms of real GDP per employed person,
is still significantly below the EU average and countries with economic
similarities such as Lithuania and Estonia.

The role of EU funds

For the period 2007–2013, Latvia has been allocated EUR 4.5 billion
from the structural funds and the Cohesion Fund under the ‘Convergence’
objective. Latvia is implementing three Operational Programmes: ‘Human
resources and employment’ supported by the European Social Fund,
‘Entrepreneurship and innovations’ supported by the European Regional
Development Fund and ‘Infrastructure and services’ supported by the European
Regional Development Fund and the Cohesion Fund. Absorption of EU funds stands
at 36.4 % of the total available financing, corresponding to the EU-27
average of above 35 % (European Social Fund execution is high at 60.04 %,
with execution of the European Regional Development Fund at 33.4 % and of
the Cohesion Fund at 32.1 %). In 2010 and 2011 absorption of structural
funds was delayed compared with the ambitious budget plans, mainly due to
delays in public procurement, insufficient administrative capacity in line
ministries and lack of bank financing.

Implementation of financing is critical for major Cohesion Fund
projects in the transport sector, e.g. the modernisation of railway stock and
reallocation of port activities in Krievu sala. The poor overall condition of
transport infrastructure is being slowly addressed with EU financing, though
the quality standards for roadbuilding need further improvements in line with
the conditions set in the Supplemental Memorandum of Understanding. Also, the
development of ICT infrastructure shows a significant divide in broadband
coverage between densely populated and rural areas.

Overall, the experience gained from implementing cohesion policy in Latvia highlights weaknesses related to the intervention logic of investments, including
the evaluation capacity. Coordination of support with neighbouring Member
States is insufficient, in particular in the context of the Baltic Sea
Strategy.

Research and innovation

Latvia’s poor innovation performance — the country
is consistently ranked amongst the last on the Innovation Union scoreboard —
could impair its long-run competitiveness. There is no systematic and effective
research and innovation strategy and little research and innovation investment
by either domestic companies or foreign affiliates to support specialisation in
knowledge-intensive and innovation-driven sectors. Latvia also has the lowest
business R&D intensity in the EU (0.22 % of GDP in 2010) and licence
and patent revenue is rather low. The national innovation system is
overshadowed by low scientific performance, as measured by the share of
publications in the top 10 % most cited which, at only 2.9 %, is the
second lowest score in Europe.

The national research and innovation system faces a number of
challenges:

(i) There is limited capacity to design, implement and coordinate
research and innovation policy: Latvia has a complicated decision-making
process for such a small country and the effectiveness of policy measures has
been undermined by a lack of systematic evaluations (an external evaluation is
ongoing and planned to be finished by the end of November 2012).

(ii) The scientific and research infrastructure is underdeveloped
and the limited research and innovation resources available are spread too
thinly to be efficient.

(iii) Cooperation between businesses and academics continues to be
poor: companies are barely using the research potential of universities or state
research institutes and their participation in the ongoing competence centres
programme is rather low. The level of commercialisation of research is low: the
technology transfer contact points operating in several universities produce
modest results, in part due to the incomplete legal framework for protecting
intellectual property rights.

(iv) There is a lack of highly qualified scientists and engineers;
the number of new doctorates awarded remains low and many scientists pursue
their careers abroad.

In the course of fiscal consolidation, R&D intensity fell to
0.46 % in 2009 after peaking at 0.7 % in 2007. With the help of
structural funds (EUR 466 million or 10 % of the total allocations are
earmarked for implementation of R&D and innovation policies), R&D
intensity recovered somewhat to 0.6 % in 2010, which is still one of the
lowest in the EU. In view of the heavy dependence on structural funds and the
low level of business investment, the national target of increasing R&D
intensity to 1.5 % by 2020 is rather ambitious.

There is no systematic monitoring to create a continuous and stable
basis for basic research activities. The growing share of structural funds in
R&D funding is tilting the previous balance between institutional and
competitive funding more towards project-based, competitive funding. One major
issue is funding of R&D after 2013, before the new round of structural
funds is available. Moreover, as the level of support will remain constrained
and there is a risk of some of the direct support measures being poorly funded,
the merits of introducing broader tax incentives for research and innovation
have to be considered.

In order to address these weaknesses, Latvia has taken the following
steps: (i) governance is being improved by setting up a cross-departmental
coordination centre under the Prime Minister; (ii) efforts are being made to
modernise the scientific infrastructure — nine national research centres were
established in 2011; (iii) measures have been taken to attract foreign academics,
to increase the number of researchers and to attune the education system more
to business needs by involving employers’ organisations in the governance of
universities and assessing vocational study programmes; (iv) steps are being
taken to promote commercialisation of science, encourage industrial innovation
and support the development of innovative enterprises (business development
involving new products and technologies, competence and technology transfer
centres, innovation vouchers, etc.).

Further efforts should be made to improve the quality of the science
base and to rationalise research and higher education institutions in line with
the thematic priorities and budgetary constraints. This should result in fewer but
larger entities more able to build up critical mass in specialised areas of
education and research, coupled with progressive introduction of competitive
funding based on independent evaluation. In order to address the current
challenges and to qualify for the EU funding within the post 2013+ period, Latvia should draw up a research and innovation strategy for smart specialisation, so that
EU structural funds can be used more efficiently and synergies between
different EU and national policies, as well as public and private investments,
can be increased.

Energy markets

Energy markets in Latvia remain dominated by horizontally and
vertically integrated monopolies. Due to limited interconnection, the gas and
electricity markets are largely separated from other EU Member States.
Increasing interconnection capacity would contribute to enhancing competition
in energy markets.

The concentration in the electricity generating sector is very high:
the dominant utility Latvenergo produced more than 90 % of all power in
the country in 2010. In the gas market, 100 % of imports are purchased by
JSC ‘Latvijas Gaze’ from Russia. Concentration at retail level is very high on
both the electricity and gas markets. Latvia has notified measures fully
transposing both the electricity and the gas directives (with a derogation for
gas) and the regulator — the Public Utility Commission — is legally independent
since amendments to the relevant law came into force in August 2011.

A risk assessment is under way on gas interconnections with Estonia and Lithuania, plus an assessment of pipeline projects (the Poland-Lithuania ‘Baltic
Connector’ gas pipeline) and of a regional liquefied natural gas terminal. As
regards electricity, for historical reasons the system is interconnected with
the networks of Belarus, Russia, Estonia and Lithuania (BRELL Ring agreement).
Consequently, synchronisation with the EU electricity system is not possible
without negotiations with Russia and Belarus on technical operation of the
networks.

The policy response to the challenges facing the energy sector
consists mainly of: (i) following the legal transposition, it is time to
implement the Third Energy Package in practice for both electricity and gas,
which as a first step entails the certification of the independence of the
electricity transmission system operator which is expected later this year;
(ii) preparing the gas sector for the end of isolation and subsequent
creation of market structures (e.g. decision on a regional liquefied natural
gas terminal in the Baltic region); (iii) linking the gas network to the
EU (e.g. the Latvia/Lithuania reverse-flow project); (iv) strengthening
Latvia’s national electricity grid to transport energy from Finland, Sweden or
Poland; (v) continuing cooperation with the Commission in negotiations
with Russia and Belarus on operation of the electricity network; and
(vi) continuing work with a view to joining Nord Pool Spot and creating a
Baltic regional electricity market.

Renewable energy

Latvia has committed itself to meet a target of 40 % of
renewable energy sources in final energy consumption and a 10 % share for
renewable energy in the transport sector by 2020 (in 2010 Latvia was close to
its interim target for 2011/2012 of 34 %). Latvia has notified measures
fully transposing the EU Renewable Energy Sources Directive. However,
insufficient progress has been made on developing a coherent, stable and
predictable framework to support renewable energy. Support schemes are not
fully adequate in terms of the tariff levels and/or cost reductions due to
technical development, but retroactive changes must be avoided given the
negative effect on overall investor confidence.

Resource efficiency and the environment

The Second National Energy Efficiency Action Plan assumes that both
the EU Cohesion Policy Fund and the Climate Change Financial Instrument will
continue to play a major role in financing improvements in energy efficiency. Latvia has put forward a mix of policy measures addressing energy saving in the main
sectors of the economy. In the years ahead more than 70 % of energy
savings are expected to be generated in the buildings sector. However, without
placing any major burden on public budgets, Latvia could significantly increase
the benefits derived from energy efficiency investments by introducing the
legal and fiscal framework necessary for energy performance contracting.

The tax system does not provide sufficient incentives for reducing
energy costs and shifting consumption towards energy-efficient products
(vehicles or insulation of buildings and heating systems). The impact of the
natural resources tax is small and insufficient to penalise inefficient energy
use. Quality standards in construction and waste management are low. The
potential for reducing dependence on energy imports is untapped and the share
of net energy imports in the foreign trade balance for goods increased to about
50 % in 2010-11.

In 2011, the Energy Strategy for 2030 was launched to complement and
update the 2007–2016 Energy Development Guidelines. It includes large-scale
infrastructure projects, fiscal measures (including energy and carbon taxes)
and national targets in the energy sector. In this context, programmes to
increase energy efficiency in public buildings and production facilities are in
progress. Measures include technological upgrades and replacing fossil fuels by
renewable energy in heating systems. Also, a first set of agreements have been
signed for projects to reduce emissions from public lighting. The EU funds and
the Climate Change Financial Instrument have been playing a key role in
financing energy efficiency measures already implemented or planned. However,
considering that Latvia’s energy intensity is still more than double the EU-27
average, especially for industrial companies, further efforts are clearly
necessary. For example, Latvia could significantly increase the benefits reaped
from investments in energy efficiency by introducing the legal and fiscal
framework necessary for energy performance contracting.

Latvia has committed itself to limit the increase
in greenhouse gas emissions in sectors not covered by the emissions trading
system by 17 % (of 2005 levels) by 2020. According to the latest
projections, based on existing measures, emissions are expected to increase by
14.7 % (compared with 2005), leading to an overachievement by 2 percentage
points. However, energy efficiency is low in transport, which is the sector
with the largest emissions in Latvia, with 25.9 % of the country’s
greenhouse gas emissions in 2009. The public transport network is not
sufficiently consolidated and use of renewable energy and further
electrification of the railways have not been fully explored. While
acknowledging the high share of the transport sector in Latvia’s greenhouse gas emissions, the national reform programme does not put forward specific
measures addressing this problem (e.g. intermodal shifts). Although the
national reform programme reports compulsory admixture and exemptions from
excise duties for biofuels, the action taken so far has not led to significant
emission cuts.

The structure of the waste management system in Latvia is still not in line with the principles of resource efficiency. Latvia still landfills 90 %
of municipal waste and the level of landfill taxes remains low compared with
other countries. Separate waste collection, reuse, recycling and recovery are
limited. The limited producer responsibility system is not able to cover the
full costs of separate collection and recycling of the main waste streams. No
incentives are in place to promote prevention and participation in separate
collection (pay-as-you-throw schemes). Latvia is not likely to reach the 2020
recycling target (50 %) without substantial investment. This creates
significant opportunities for growth in sectors connected with waste management
and recycling. Latvia has also taken major steps to develop quality water
supply and waste water management services further. Continued efforts are
needed in the years ahead to ensure steady growth of the share of the population
with access to these services.

Other structural measures

To tighten management of state-owned enterprises and real estate, in
line with the commitments made in the Supplemental Memorandum of Understanding,
in December 2011 the authorities adopted the ‘Concept paper on state-owned
enterprises governance’ that lays down the principles for setting up a
centralised state-owned enterprises manager, governing relations with line
ministries, measuring the performance of state-owned enterprises, revising
dividend and remuneration policies and reviewing the institutions responsible
for supervising government- and municipality-owned companies. Also, plans for
the final stages of further centralisation of state real estate management
under the State Real Estate Agency have been developed, deciding which real
estate assets to keep or to auction off and which need to be transferred to the
Agency, while centralising decisions on real estate investment projects in the
process of drafting the state budget.

The competition climate in Latvia can be improved, especially in
sectors like construction, healthcare and pharmacy, public services and food
supply (dominated by two big chains). The Competition Council has inadequate
capacity to perform more active, targeted market surveillance. There is also
insufficient competition in public procurement, notably for maintenance works
and construction of roads and bridges. As regards public services, port
authorities occasionally run commercial-like activities and prevent private
companies from offering their services, leading to legal disputes. In this
context, the Supplemental Memorandum of Understanding contains a commitment to
introduce, by mid-2012, a proper assessment system to monitor observance and
uniform application of the criteria for government and municipal authorities to
engage in commercial activities, including port services.

Latvia adopted the horizontal law transposing the
Services Directive with some delay in April 2010. The law was amended in March
2012 to ensure better compliance with the directive. In general, no major
obstacles have been identified but some restrictions on cross-border provision
of services still exist in tourism and construction. The number of restrictions
on regulated professions is moderate, except for the profession of notary where
Latvia refused to repeal the nationality requirement, despite the judgments
of the Court of Justice of the EU of 24 May 2011 (concerning six other Member
States). The ‘point of single contact’ provides relatively good information,
except on cross-border service provision. Completion of procedures is mostly
possible for national service providers, whereas technical solutions are needed
for cross-border use of e-identification and e-signatures.

The ‘Rail Baltic’ project, which has gained new impetus in the reviewed
trans-European transport network policy, would connect the main EU networks
with north-east Europe. Electrified European-gauge railway infrastructure is to
be built, providing a strong stimulus for economic growth and reducing
greenhouse gas emissions through a modal shift to rail. In this context, it is
important to ensure that competition in the rail freight sector, including rail
traffic management, is effective and that new entrants can gain access to the
market.

The take-up of broadband internet is below the EU average due to the
rural broadband gap. The rural broadband state aid scheme co-financed by EU
funds and approved in 2011 should lower the broadband deployment cost in rural
areas; however, it needs to be implemented as part of an overall national
broadband strategy, which the authorities plan to adopt by the end of 2012.
Also, in accordance with the recently agreed EU policy on radio spectrum for
wireless broadband, Latvia should work on authorising use of the digital
dividend spectrum to stimulate competitive and ubiquitous mobile broadband
services.

3.5. Modernisation of public administration

Latvia has allocated EUR 22.8 million, or 3.9 %
of the overall EU funding available, to modernisation of public administration
under the priority ‘Administrative capacity-building’ of the Operational Programme
on ‘Human resources and employment’ funded by the European Social Fund.
Although some improvements have been made, a great deal remains to be done. In
particular, the authorities need to move away from financing basic operations
(e.g. temporary staff recruitment) that lead to supporting low value-added,
short-term projects. Instead, narrowing the number of eligible activities and
clearly targeting them on reforms in public administration would provide
greater efficiency.

Despite earlier delays in implementing the
relevant conditions in the previous Supplemental Memorandums of Understanding,
the authorities have committed themselves to preparing a strategy on public
administration by spring 2012, which will, inter alia, establish a stronger
institutional model responsible for human resources and recruitment policy and
payroll, normalise the distribution of employees within the unified wage grid
based on effective skills assessment, introduce central control for
establishment of new posts and reward the performance of employees through
earnings and career development. In this area, however, given past delays, it
is unclear how far these commitments will be put into practice.

While Latvia has made efforts to lighten the
administrative burden on businesses, a focus on real efficiency gains is
lacking and the initiatives taken have been fragmented. The government lacks a
comprehensive strategy on supporting enterprises and improving the business
environment. Nevertheless, in 2010 and 2011 a number of measures were taken to
help micro-companies and self-employed to start a business, especially by
reducing start-up costs related to registration, equity capital requirements
and taxation. In addition, the time it takes to obtain a permanent electricity
connection has been shortened and the management of EU structural funds
projects has been simplified. However, the new Construction Law, supposed to
simplify construction procedures, as well as legislation for the protection of
investors, are yet to be adopted by Parliament. Also, the compliance
requirements for tax administration remain to be simplified and the electronic
registration of enterprises, the electronic procurement system and the one-stop
shop for the registration of property are yet to be completed.

As regards the efficiency of the Latvian
civil justice system, the main challenges are the large case backlog and the
lengthy proceedings in civil and commercial cases. The situation is similar for
administrative courts, which are empowered to rule on licences, registrations
and tax issues. Latvia has a low clearance rate (i.e. the capacity of courts to
deal with new and pending cases) and a high disposition time (i.e. the number
of days necessary to dispose of pending cases). The situation has deteriorated
in the last few years, with only 73 % of cases adjudicated within one year
in 2011. Moreover, many cases do not get resolved at first instance, which
creates delays and backlogs at all instances, up to the Supreme Court. The
inefficiency was particularly acute in insolvency proceedings. New insolvency
legislation has been adopted to streamline and expedite the insolvency process
and introduce a reorganisation option for companies. However, its effects still
need to be fully analysed. Further improvements of Latvia’s insolvency laws are
being discussed. There is also some concern that the Latvian judiciary is not
maintaining and updating its knowledge of EU law.

The number of cases handled per year by judges
is very high, while the judicial support staff may not always be sufficiently
qualified to assist the judges. There is also concern about the qualifications
and the accountability of the judiciary. The creation of an independent Council
for the Judiciary in 2010, responsible for evaluating the professional
performance of judges, should improve the situation, while guaranteeing the
independence of the judiciary.

The authorities are taking measures to
improve the performance of the judicial system. In particular, they are working
towards improving court infrastructure (audio, videoconferencing and IT
solutions) and the efficiency of procedural law, setting up a system for
publication of judgments, levelling the workload of different courts and
developing the legal framework for mediation. The Annual Action Plan
for Improvement of the Business Environment for 2012 includes measures to
ensure use of e-services in legal proceedings. It is too early to assess the
relevance and efficiency of the measures proposed.

In 2011 the government also passed the
Electronic Government Development Plan for 2011–2013 estimating that 50 %
of the population will use e-government in 2015. By late 2011, 20 e-services had
been introduced and about 150 more are expected to be introduced in 2012
followed by another 50 e-services in 2013.

4. Overview table

2011 commitments || Summary assessment

Euro Plus Pact (national commitments and progress)

•               Adoption of fiscal discipline principle: committed to cut deficit below 3 % of GDP for 2012 and aiming for a 2.5 % of GDP deficit; the goal is to improve the fiscal position so that the general government deficit would be 1.9 % of GDP in 2013 and 1.1 % in 2014. •               Preparation of a Medium-Term Budget Framework Law. •               Measures to ensure the long-term financial stability of the state pension system: in accordance with the draft law submitted to Parliament, from 2016 to 2021 a gradual increase is planned in the retirement age from 62 to 65 years and in the qualification period from 10 to 15 years; measures to preserve the sustainability of the three pension pillars and to restore contributions to the second pillar to 6 % of gross salaries by 2013. || Latvia has almost fully implemented the commitments in the fiscal and fiscal governance field, in particular as regards strong and front-loaded fiscal adjustment which should allow the country to exit the Excessive Deficit Procedure in spring 2013. On the down side, there have been some delays as regards the Fiscal Discipline Law and there is still some uncertainty about reversing the second pension pillar contributions to 6 %.

•               Tax measures beneficial to labour: priority is given to substantial increases in indirect taxation, with VAT increased to 22 %, higher excise tax and doubling of the real-estate tax rates from initially low levels; the tax policy for 2011-2014 is directed in a way to ensure stability and predictability with limitations of new revenue measures; a further shift of the tax burden from labour to consumption and property is planned over the medium term; the tax system could include action to support entrepreneurship. •               Measures to fight the shadow economy. •               Labour market reform: plan to carry out a set of comprehensive and interrelated policy measures supported by the EU structural funds with the aim of decreasing the risk of structural unemployment, increasing labour market participation, investing in job quality and increasing the competitiveness of the education system. || The commitments have been implemented partly. The government has proposed to start reducing the tax wedge on labour (personal income tax rate and non-taxable thresholds) from January 2013, but it remains to be seen how ambitious the reforms will be: e.g. some of the ambition can be taken away by the proposed VAT reduction or Maastricht inflation criteria considerations. The fight against the grey economy, in particular against envelope salaries that hinder fair competition, has not been ambitious and aggressive enough. There has been a welcome reassessment of the effectiveness of existing active labour market policies and their financing, but further and more comprehensive steps are needed to address the high levels of structural and youth unemployment. There has been some progress as regards streamlining the vocational school system, mostly with the financing from EU funds.

•               Measures to align salary and productivity developments: to link the future increase in the wage bill in the public sector with the productivity growth rates in the economy. •               Measures to promote international cooperation in the area of research and raise the competitiveness of research. •               Higher education reform: develop an improved external quality assurance system for higher education by preparing a transition from study programme accreditation to study direction accreditation and introducing performance-based funding —the ‘money follows quality’ principle — in national legislation. •               Measures to promote vocational education: further work is planned to develop a national qualification system and restructure vocational education, including development of module-based vocational education programmes: optimisation and differentiation of vocational education institutions. •               Measures to improve the business environment: reducing the administrative burden on businesses, as well as ensuring appropriate e-services for businesses; measures to provide on-line business registration, to reduce the procedures and the time taken to obtain a construction permit and to improve legislation for investor protection by providing greater transparency. •               Measures fostering innovations by developing a framework for more efficient cooperation between scientists and entrepreneurs. || The commitments have been implemented partly. The new Education Minister has proposed a number of ambitious and long overdue reforms/measures as regards vocational and higher education and research and science, inter alia: refocusing EU funding in the vocational school programme; highlighting the education quality issues; proposing a wage scheme for teachers that would reward merits; attracting external assessment of the science base and policy, etc. It remains to be seen how much of the above will actually be implemented.        There have been some steps towards improving the business environment (as evidenced by the high Doing Business rankings). However, much remains to be done as regards tax compliance procedures, construction procedures, ensuring fair procurement, providing a sufficiently skilled labour force, making the support to businesses from EU funds more efficient, improving the justice system, etc. The efforts/measures by the Latvian Investment and Development Agency to attract foreign investment are insufficient and rarely produce successful outcomes.

•              Measures to strengthen supervision of the financial system: amendment of the supervisory framework as needed to keep pace with evolving international best practice; amendments to the legal acts strengthening the capital base and liquidity requirements will be adopted in 2011–2012 to implement the Fourth Capital Requirements Directive; intensive supervision will continue focusing, in particular, on capital adequacy and the quality of restructured loans, as well as close monitoring of lending to non-residents. •               Measures to improve risk and crisis management: the work on practical arrangements for cooperation (coordinated decision-making, burden sharing, establishment of a common database and monitoring of financial stability) is going on at the level of the working groups established and the results will be presented to the Stability Group during its meeting at the end of 2011. •               Incentives to tackle bad loans and renew lending, promotion of responsible lending. •               Restructuring of the state-owned banks. || The Latvijas Krajbanka experience shows that these commitments have not been implemented fully, though follow-up action should further improve the stability of the financial system. In particular, closer relations with neighbouring financial sector regulators are important to avert future cross-border crises. There has been good progress, albeit belated, as regards restructuring of the Mortgage and Land Bank, although the sale of commercial assets has not yet happened. It is unclear if anything has been achieved as regards encouraging banks to tackle bad loans.

Europe 2020 (national targets and progress)

Employment rate target (in %, 20-64 age group): 73 % || The employment rate stood at 67.1 % in 2009, 65 % in 2010 and 67.2 % in 2011. All these figures will be revised downwards based on the latest population census.

R&D target (% of GDP): 1.5 % || Gross domestic expenditure on R&D stood at 0.46 % of GDP in 2009 and 0.6 % in 2010. In view of the heavy dependence on structural funds and the low level of business investment, the national target of increasing R&D intensity to 1.5 % by 2020 is rather ambitious.

Greenhouse gas (GHG) emissions target: +17 % (compared with 2005 emissions) || Change in greenhouse gas emissions between 2005 and 2010: +5 % (this figure corresponds to the current scope of the emissions trading scheme).

Renewable energy target: 40 % by 2020 (RES Directive 2009/28/EC). || In 2009 Latvia had achieved its 2011/2012 interim target of 34 % but, based on the data in the National RES Progress Report, in 2010 the share of renewables slipped back again (to 32.5 %). Further efforts are needed to sustain the progress towards the target for 2020.

Energy efficiency — reduction in primary energy consumption by 2020 (0.67 Mtoe) || The energy efficiency objectives are based on national circumstances and national formulations. As the method to express the impact of these objectives on energy consumption in 2020 in the same format was agreed only recently, the Commission is not yet able to present this overview.

Early school leaving target: 13.3 % || The proportion of early leavers from education and training (percentage of the population aged 18-24 with at most lower secondary education and not in further education or training) stood at 13.3 % in 2010. Over the last decade Latvia has made progress on reducing the number of early school leavers (from 16.9 % in 2002 to 13.3 % in 2010). It is currently performing better than the EU average of 14.1 %. Based on current trends, Latvia is likely to achieve its national target of 13.9 %, but it is not ambitious enough (the EU headline target is set at 10 % in 2020).

Poverty target: At risk of poverty 21 % 121 000 people (at-risk-of-poverty and jobless households) || The at-risk-of-poverty rate fell from 25.7 % in 2009 to 19.3 % in 2011. Thus, the target in relative terms has been reached. The main driver behind the developments in the at-risk-of-poverty rate was a significant drop in the poverty threshold (the population as a whole is worse off). The improvements in the target value are not the result of any deliberate policy action and will have no long-lasting impact. The real challenge will be to prevent the at-risk-of-poverty rate from increasing as the economy continues to recover.

Tertiary education target: 32.3 % || Tertiary educational attainment stood at 32.3 % in 2010, a 5.3 pps increase since 2008. Tertiary attainment rates have improved significantly over the last decade (from 18.6 % in 2000 to 30.1 % in 2009 and 32.3 % in 2010) and have almost reached the EU average of 33.6 %. Latvia has set a national target of 34–36 % of graduates by 2020, which, based on current trends, is likely to be achieved.

Annex

Table I.
Macroeconomic indicators

Table II. Comparison of macroeconomic developments and forecasts

Table III. Composition of the budgetary adjustment

Table IV. Debt dynamics

Table V. Long-term sustainability indicators

Figure. Medium-term debt projection

Source:
Commission, 2012 convergence
programme.
Table VI. Taxation indicators

Table VII. Financial market indicators

Table VIII. Labour market and social
indicators

Table IX. Product market performance and policy indicators

Table X. Green growth
performance

[1]       Cyclically-adjusted balance net of one-off and temporary
measures, recalculated by the Commission on the basis of the information
provided in the programme, using the commonly agreed methodology.

[2]       Compared with the recalculated structural balance, the
programme forecasts higher structural budgetary improvement, by 0.5 % of
GDP annually in 2013-2015. The discrepancy is mainly due to a different
assessment of the starting cyclical point between the common methodology and
the approach taken in the programme. Subsequently, the programme attributes a
higher share of the targeted nominal improvement to the structural component than
in the recalculated information.

[3]       In particular, an increase in the standard VAT rate from 19 %
to 22 % and in the reduced rate to 12 % while significantly narrowing
the scope of the reduced rate, but also numerous excise tax increases.

[4]       The VAT compliance gap measures the ratio between VAT
actually collected to theoretically possible collection, based on the value of
private consumption taking into account the existence of preferential rates.
While the gap is likely to reflect the illegal tax avoidance, it could also
mirror other aspects like a shift in consumption preferences towards goods with
lower rates and/or recourse to legal means of tax avoidance.

[5]       See Sauka, A. and Putniņš, T. (2011), Shadow Economy
Index for the Baltic Countries 2009 and 2010, Stockholm School of Economics in Riga, May 2011.

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