requirements.<sup>11</sup> In this chapter, the design of fiscal policy will be discussed from the perspective of growth and job creation. The question specifically is whether a more appropriate fiscal framework for public spending is desirable from that perspective. Lessons from theory and history show that the design of fiscal institutions can have potentially large effects, for good or ill, on economic performance.<sup>12</sup> This is particularly true in the case of Latvia where, because of the fixed exchange rate regime, fiscal policy is the main macroeconomic tool at the government’s disposal to limit the current account deficit.

Latvia’s already high tax burden severely constrains rate increases to improve government revenue. In fact, like all Baltic countries, Latvia has been trying to reduce direct taxes to attract more foreign investment, while at the same time harmonizing its tax system with EU requirements and norms. In this chapter, we argue that, in order to sustain economic growth and maintain a business environment favorable to job creation, Latvia should maintain its medium-term objective of a balanced budget and place more emphasis on fiscal policy rules (especially spending rules) within the boundaries set by the Stability and Growth Pact. Latvia’s current fiscal framework is geared toward achieving a balanced budget in the medium term. En route, annual deficits are supposed to follow a declining path as articulated in the country’s 2002-06 National Development Program. However, fiscal discipline eroded in 2002; the government deficit reached 2.7 percent of GDP (1 point over the target agreed with the IMF), and the 2003 budget initially projected a deficit of 3 percent of GDP (the actual outcome was about 2 percent).

On the **monetary front** , things seem to be under control. From a purely legal and institutional viewpoint, Latvia does not have to make any major change in its exchange rate regime prior to EU membership. However, after EU accession and as the prospects of adopting the euro increase, monetary and exchange rate policies in Latvia are expected to face new pressures for mutation. Like all acceding countries, Latvia will be expected to participate in the exchange rate mechanism (ERM II) arrangement that will limit fluctuations of non-EMU (European Economic and Monetary Union) EU countries’ national currencies relative to the euro. The Latvian authorities have already indicated that they intend to join ERM II in 2004-2005 and to repeg the Lats to the euro at the same time. But while EU accession itself does not imply any major changes to existing monetary policy, Latvian authorities should take into account the fact that their exchange rate policy will become a “matter of common concern,” starting on May 2004.

The role that monetary policy could play in reducing unemployment in Latvia appears to be relatively modest, given the central bank’s emphasis on exchange rate stability. The current stable exchange rate imposes a constraint on domestic monetary policy (the so-called nominal anchor), which is perceived by the private sector and foreign investors as a useful safeguard against unsound policies. This makes it even more desirable to implement labor market reforms that will reduce wage pressure and further reduce inflation.

> 11 According to an IMF study, _acquis_ -related expenditure will be sizable, as the annual costs of meeting environmental requirements alone could reach 2 percent of GDP. As a NATO member, Latvia is expected to raise its military expenditure to 2 percent of GDP over the medium term. “While transfers from the EU to finance such spending could exceed 1 percent of GDP during the pre-accession phase and reach up to 4 percent of GDP after accession, this would still imply a significant contribution from national budgets.” (Mueller et al. 2002:4).

> 12 Masson (2000: 112). See also Tanzi and Zee (1997).

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