Central and Eastern European countries outlines the main elements of a strategy that would benefit Latvia:<sup>19</sup> (i) more public resources should be left in the hands of the private sector where they help foster factor productivity growth; (ii) subsidies and transfers should be curtailed—Latvia still spends more than twice as much relative to GDP (4 percent) as the average EU country on enterprise subsidies (1.5 percent); and (iii) some social transfers, especially in the education sector (see chapter 11), should also be reduced to enhance quality of service and efficiency in the use of public resources.

# **4.1.4 The Need to Rethink Fiscal Rules in Latvia**

In spite of Latvia’s overall good track record in managing public finances, many challenges remain. During pre-electoral contexts, politicians tended to discount the future more heavily than private sector agents. In 2001-02, differences of opinions among ruling coalition partners often generated disagreements over the budget process and slowed down fiscal consolidation. Also, the very nature of Latvia’s fragmented political system and the collective form of decisionmaking on budget matters has tended to create the “common pool problem,” that is, high spending or policy distortions reflecting the aggregation of uncoordinated decisions made at the level of each ministerial department (as parties in the ruling coalition sometimes ask for expenditures programs to satisfy their constituencies without taking into account their implications for the budget).

In spite of Latvia’s overall good track record in managing public finances, many challenges remain. During pre-electoral contexts, politicians tended to discount the future more heavily than private sector agents. In 2001-02, differences of opinions among ruling coalition partners often generated disagreements over the budget process and slowed down fiscal consolidation. Also, the very nature of Latvia’s fragmented political system and the collective form of decisionmaking on budget matters has tended to create the “common pool problem,” that is, high spending or policy distortions reflecting the aggregation of uncoordinated decisions made at the level of each ministerial department (as parties in the ruling coalition sometimes ask for expenditures programs to satisfy their constituencies without taking into account their implications for the budget).

As noted in the 2001 Public Expenditure Review, the lack of policy priorities has often led to an increase in unfunded mandates and ineffectiveness in the budget formulation process. Among the circumstances that tend to lead to over-commitments and unpredictability of resources, thus limiting incentives and program performance are the absence of a forum where alternative policy proposals compete, poor policy formulation in some sectors, a budget process based on incremental budgeting, and ad hoc commitments to unfunded policy proposals during budget preparation or execution. Placing policies at the center of budget decisions is further hampered by structural rigidities in the budget (limited fungibility), notably earmarking in special budgets (about 42 percent of Latvia’s revenues are earmarked), the existence of own revenue, and the proliferation of autonomous agencies (208 agencies in 2000). Similarly, fairly rigid rules on financing and allocations limit the scope for true policy decisions.

> 19 See Funck (2002). For more specific policy recommendations on expenditure management, see World Bank 2002.

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