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Falling headline inflation due to lower energy and food prices and rising nominal wages will support real incomes and raise private consumption in 2024 and 2025. Although tight financial conditions will weigh on private investment, the significant inflow of EU funds will boost public infrastructure investment over the next years. Export demand will slowly recover. Wage growth will remain strong due to skills shortages and planned increases in public sector and minimum wages, leading to sticky core inflation. Fiscal policy should be gradually tightened to reduce high fiscal deficits, lower inflationary pressures and stabilise public debt.

Since the global financial crisis, weak investment, skilled labour shortages and slow digital adoption have weighed on potential growth and public sector capacity. High risk aversion of banks, weak competition and shallow capital markets have reduced access to finance for firms. A strong fiscal adjustment and falling wages after the global financial crisis weighed on public sector capacity and the quality of public services, particularly in health care and education. Many high-skilled young adults have left to work abroad, which has exacerbated skilled labour shortages, particularly in STEM and ICT professions. In addition to a lack of digital skills, digital adoption has been hampered by the prevalence of many small firms with low training investment.

Accelerating structural reforms is key to raise productivity and living standards. Reducing informality and barriers to competition and firm growth, particularly in services, would help strengthen business dynamism and innovation. Lowering informality requires reducing labour taxes for low-wage earners, improving tax enforcement and raising trust in institutions. Strengthening the powers of the Competition Council to enforce competitive neutrality of state-owned enterprises would help to reduce barriers to competition. Addressing skilled labour shortages will need facilitating skilled migration, improving the quality of health, education and training services as well as active labour market policies, and encouraging more young women to enter high-skilled occupations in short supply.

Financing rising spending needs in defence and health care and reducing old-age poverty will require raising tax revenue and spending efficiency and reallocating spending. The tax burden should be shifted from labour to other income, property, and environmental taxes.

High social security contributions, particularly for low-wage earners, reduce incentives to formalise work (Figure?2). The shadow economy has not decreased since 2012, which is mainly related to the practice of envelope wages, where workers earn the minimum wage and receive top-up payments in cash. Reducing the labour tax wedge for lower incomes while financing the reform through general tax revenue should be a priority.

Further strengthening tax enforcement and the fight against corruption and money laundering can do much to reduce the shadow economy and broaden the tax base. Implementing the planned mandatory filing of an electronic income tax declaration for all taxpayers should be combined with making electronic payment of wages mandatory. Moreover, raising trust in institutions is key to improve the tax morale. Implementing a comprehensive lobbying register at all levels of government would help to raise transparency and reduce corruption.

Shifting the tax burden towards property taxes would improve municipal finances, reduce distortions and lower inequality. Raising revenue from recurrent taxes on immovable property by updating cadastre values with market prices, while continuing to provide tax reductions for the primary residence of poorer households, would stabilise local public finances and raise incentives for spending efficiency. Introducing inheritance taxes, while allowing for exemptions for low-value inheritances, could help decrease inequality and raise revenue.

Continuing to improve human resource policies is key to raise the quality of the public administration. High staff turn-over has led to losses in human capital and institutional memory with negative consequences for the quality and effectiveness of public policies and services and the efficiency of public spending. The recent public employment reform and wage increases should be combined with better training opportunities for public employees, with a particular focus on digital and management skills.

Digitalisation of public services has significantly improved, strongly reducing the administrative burden. However, the use of data for ex-ante and ex-post impact evaluation of regulation remains weak, particularly at the municipal level. This reduces the effectiveness and efficiency of public spending, for example in infrastructure planning. Centralising procurement for standardised goods and services, such as pharmaceutical drugs or IT and software equipment, would help raise spending efficiency. Setting unified transparency, accountability and performance standards for all SOEs and centrally monitoring their performance is also key to improve spending efficiency.

Carbon emissions remain high in transport and heating. Lowering tax expenditures for fossil fuel and establishing a metropolitan transit authority to prioritise investments in public transport and facilitate coordination among municipalities are important steps to reduce transport emissions. Simplifying the administrative burden for support programmes and standardising technical documentations for renovations of similar multi-owner buildings would help reduce costs and support building renovations.

Investment has slowed down since the global financial crisis. Credit supply decreased due to high risk aversion of banks, weak competition and shallow capital markets (Figure?3). High informality, barriers to competition and skilled labour shortages have weighed on business dynamism, innovation and investment demand.

Despite rising deposits and high profitability, banks have been reluctant to lend. Low customer mobility and weak competition in the banking sector have led to high borrowing costs and collateral requirements, reducing corporate borrowing (Figure?3). To improve access to finance it is key to foster competition in financial markets by raising transparency on deposit rates, commissions and fees, reducing switching costs for bank customers and strengthening competition enforcement.

High risk aversion of banks is related to low asset recovery and money laundering cases in the past. Recent reforms, including the establishment of a specialised Economic Court, have significantly improved insolvency procedures and the fight against corruption and money laundering. Expanding the remit of the Economic Court and establishing a deed register for all leased assets could further improve contract enforcement and help ease collateral requirements. Reducing the administrative burden related to the implementation of anti-money laundering regulation and requiring regular training of financial sector employees could foster corporate lending while minimising money laundering risks.

Capital markets are shallow, limiting non-bank financing for firms. Listing minority stakes in large SOEs, providing low-cost creditworthiness information on smaller firms and fostering financial literacy would help increase the supply of securities traded in capital markets. Facilitating greater exposure of second-pillar pension funds to domestic securities would help to deepen capital markets.

Barriers to firm growth and competition and high informality hinder the reallocation of resources to more productive firms, while labour shortages are high. Many firms in Latvia stay small, partly operate in the informal economy and have low productivity due to weak management skills, low digital adoption and insufficient training provision for workers. Raising incentives to formalise work, strengthening tax enforcement and the fight against corruption, and lowering barriers to firm exit, such as high costs for filing insolvency, would increase allocative efficiency and foster business dynamism and investment demand. Entry barriers in services sectors should be lowered, including by strengthening the power of the Competition Council to enforce competitive neutrality.

Raising innovation requires more investments in human capital. To reduce high drop-out rates, particularly in ICT and STEM studies, university funding should better incentivise raising graduation rates and funding for students’ living costs should increase. Improving coordination among firms and VET institutes in design and implementation of training is key to provide workers with the skills needed by firms.