The Latvian authorities have long recognized the need to limit discretion in fiscal policy. The government decided in 2000 to move toward a Medium-Term Expenditure Framework (MTEF). A reform program was adopted that includes several important elements of an MTEF, such as a medium-term fiscal policy statement, a budget priorities statement, and the development of guidelines for line ministries to design their own strategic plans. While these were important steps, Latvia would benefit from additional fiscal rules that could constrain fiscal policy. Indeed, beyond the substantial public finance challenges ahead, the level of public expenditure is still high, and the implications of the aging population for future social spending have yet to be fully quantified. The rules needed would obviously operate within the broader constraints of the Stability and Growth Pact. In Latvia’s case, the key issues to be addressed after EU accession will be the choice between expenditure and deficit rules, the implementation mechanisms (enforcement), and the relationship between the central government and the various levels of local government.<sup>20</sup>

# **4.1.5 Strengthening the MTEF with New Rules and Targets**

While the current plan for an MTEF is appropriate for Latvia, the country would benefit from strengthening public finance management with more stringent rules and targets. Recent difficulties in containing distortions in the budget process point to the need to address the remaining deficit bias either through some type of deficit rule or through an expenditure ceiling that would constrain spending ministries, agencies, and local governments.

Latvia could anchor its medium-term fiscal policy on a numerical rule relating to the central government fiscal balance, the level of aggregate public expenditure, or the public debt. The authorities have already expressed their goal to balance the budget over the medium term—a rule as simple as the SGP rule on a maximum budget deficit of 3 percent of GDP. Such a decision has the advantage of being straightforward and easy for the private sector and general public to understand and monitor. But recent experience shows that it does not adequately address the bias toward excessive spending, as the government can raise taxes to finance higher expenditures. Furthermore, in Latvia’s case, fiscal policy would remain procyclical: an adverse shock reducing public revenues and raising expenditure would inevitably result in discretionary tightening to maintain the budget balance.

In principle, Latvia could address some of the difficulties of its medium-term balance rule by targeting the budget structural balance.<sup>21</sup> This supposes having some good quantitative indicators and parameters to measure business cycles and their implications on government revenues and expenditures. But given the enormous methodological problems of such an approach in the Latvian context, the scope for uncertainty over the numbers could be large. Even if an independent and credible institution is in charge of estimating the cyclically adjusted deficit, enforcement and monitoring problems will remain. Indeed, it would be

> 20 See the World Bank 2003 report on Latvia’s territorial reform.

> 21 Following the IMF (WEO), the structural budget position is defined as the actual budget deficit (or surplus) less the effects of cyclical deviations of output from potential output. Because of the margin of uncertainty that attaches to estimates of cyclical gaps and to tax and expenditure elasticities with respect to national income, indicators of structural budget positions can only be interpreted as broad orders of magnitude. Moreover, it is important to note that changes in structural budget balances are not necessarily attributable to policy changes but may reflect the built-in momentum of existing expenditure programs.

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