The grueling budgetary process in which Latvia has been engaged for months is coming to some resolution with a final adoption of the 2010 budget scheduled by Dec. 1.

Latvia’s politicians are faced with unpalatable choices of cutting more expenditure and trying to raise revenue in a declining economy. They are being carefully watched by international institutions fearful that a total collapse in Latvia’s economy may rebound onto other countries, but concerned that Latvia is still able to meet its obligations to pay its considerable debts.

At the heart of the problem of revenue has been Latvia’s reliance on two taxes that most affect those on poorer incomes: an income tax with a flat rate of 23 percent and a value-added tax, which was raised from 19 percent to 21 percent this year for most goods. The huge property boom of the past 10 years, when Rīga prices hit those of the largest European capitals, was unhindered by any capital gains tax (a sure sign of the economic interests of previous governments), and unhindered too by any tax on bank interest.

The disproportionate reliance on income tax is linked to two features that underlie both official corruption and the sources of the private debt bubble that has now enveloped Latvia. As part of employees’ desire to reduce their taxes (and for employers to escape other charges associated with labour costs), the system of payment by “envelopes”  was widespread. In other words, workers were getting a lower official salary on which they paid tax but receiving under-the-table topping up that was untaxed. Readers will no doubt remember that President Valdis Zatlers fell into trouble with one variant: “envelope payments” to doctors and surgeons so that patients would be looked after better. For many in the workforce, such payments ensured a higher untaxed income at the expense of government revenue, a loophole that previous governments did very little to combat.

One disincentive for such envelope payments was provided by the social security system, which bases pensions on a base minimum plus regard to salary earners’ income and social service tax contributions, so those declaring less income than they received would gain a lower pension in the future. This was only a future disincentive, often not considered by present employees; moreover, constraints on the budget have meant that the gap in pension payments, between those who contributed substantially through their taxes and those who contributed little, has diminished.

However, the envelope payment system is also linked to private debt, as investigations into the operations of the banks have revealed. In determining loans to private individuals, banks would ask for what people earned, but would ask for total payment—official as well as envelope payments—to determine risk. Thus the corruption of the public sector tax evasion also affected private borrowing.

The government’s negotiations with the International Monetary Fund and European Commission to plug deficits and to enable structural reform are nearing their end, with the government agreeing to cut another LVL 500 million from the 2010 budget to minimise the budget deficit, and look to new revenue-raising methods. But the negotiations have been continually interrupted by the political positioning of some coalition parties, and a difficulty in having a rational debate over budgetary measures. International institutions were concerned when some coalition partners doubted whether further budgetary cuts were necessary. With populist language, those coalition partners claimed the cuts will hurt those most vulnerable, but dragged their feet over new and long-overdue tax measures: a capital gains tax, a tax on bank interests and discussions over a progressive income tax. The various proposals are before the Saeima (parliament) now together with the 2010 budget.

The big picture needs to be kept in mind. Latvia must eventually be able to balance its own budget, not continually borrow from international institutions. Moreover, for Latvia to be able to enter the eurozone by 2014, the budget deficit cannot afford to blow out. The problem for Latvia’s politicians is to focus on this, knowing the pain inflicted by them on the population may be well remembered at the next year’s Saeima elections.

Of the measures proposed, the capital gains tax seems to now have approval. The taxes would amount to a tenth of a percent of cadastral value for owner-occupied properties, with progressive rises for those not owner-occupied, an important move but one that will only bring returns in future years and be very dependent on the property market improving. Intense debate is continuing over reform of income tax. It now seems clear that no progressive tax will be introduced, as no other Baltic country has one, and it is feared companies would register in Estonia or Lithuania to take advantage of flat tax. Debate now centres on whether there should be a reduction of the tax-free threshold (from LVL 35 to LVL 25 a month, a move that would hurt the poorest people) or an increase in the tax rate as a whole from 23 percent to 25 percent.

In other cases, desperate measures have been proposed. Prime Minister Valdis Dombrovskis should have known better, but his government raised a short-term proposal to ease private debt pain by adopting the American solution of limiting the debt incurred on a property loan to the value of the property. In other words, if one has borrowed more than the current property is worth because of the declining property market,  one is only responsible up to the value of the current property. Such a provision in the United States has seen thousands of debtors simply walk away from their properties, leaving them to the banks that cannot chase up the balance of the debt. Originally introduced to ensure banks would lend money with due and careful regard to the property market, the phenomenon of sub-prime lending threw this caution to the wind. Luckily, the howl of protest quickly sunk the proposal in Latvia. 

Finally, two other issues deserve comment. Many readers of this column will have used the Internet version of Latvia’s leading newspaper Diena, whose outspoken commentaries on Latvian politics, and relentless exposure of corruption and political chicanery, was one of the antidotes to Latvia’s odious political culture. But in moves that have not yet been fully explained, Diena‘s ownership changed (it was previously owned by a Swedish publishing company), and the new owners (seemingly related to murky British interests but with suspicious links to some of Latvia’s oligarchs) began an immediate cleaning out of the most outspoken journalists, causing others to resign in protest. While the official explanation for these machinations was falling advertising revenues, the change in the character of Diena has been marked, with a decidedly less critical edge to current journalism. Meanwhile, the Diena refugees have started their own online publication, Cita Diena.

And despite the priority of the budget, the Saeima has no forgotten other political necessities as well. In a shock result for the Latvian judicial system, the Saeima in a secret ballot refused to appoint Administrative Court Judge Māris Vīgants to the Supreme Court. Vīgants, supported by the Judicial College and by the Saeima’s own Judicial Committee, was one of the judges who sent Venspils mayor and chief oligarch Aivars Lembergs to prison in 2007. His political opponents in the Union of Greens and Farmers, who had once proposed Lembergs as prime minister, ensured the defeat and underlined once more the considerable forces that still protect corruption at the highest levels in Latvia. In a sublime footnote, Lembergs claimed that he should be considered to have furthered Vīgants’ career, not hindered it.