In 2008–09, Latvia lost 24 percent of its GDP. It was heading toward a budget deficit of 19 percent of GDP in 2009 without a program of radical austerity.
A new Latvian government came to power in March 2009, when GDP was in free fall. It told people how bad the situation was, and the various social partners responded by signing up to a truly radical austerity program. One-third of the civil servants were laid off; half the state agencies were closed, which prompted deregulation; the average public wage was cut by 26 percent in one year. But this was a socially considerate program. Top officials were hit more, with 35 percent in wage cuts, while in the end pensions were not cut. In particular, public servants were no longer allowed to sit on state corporate boards and earn more than from their salaries, a malpractice that is still common in many European countries. The government exposed high-level corruption. Yet, many schools and most of the hospitals were closed.
This was a truly front-loaded program. Of a total fiscal adjustment of 17 percent of GDP, 9.5 percent of GDP was carried out in 2009. Two-thirds of the adjustment was expenditure cuts that are more easily executed in a crisis, and only one-third revenue increases, mainly through consumption taxes. The low corporate profit tax of 15 percent was maintained to stimulate business. Latvia needed international financial support, and fortunately the IMF, the European Union, and neighboring countries did both commit and deliver on time.
At the outset of the crisis, the IMF favored devaluation, but the Latvians resisted firmly with strong popular support. Throughout the crisis, the Latvian government has insisted on maintaining its flat personal income tax, as most other East European countries have.
Results According to the IMF
Latvia’s economy continues to recover strongly. Following real GDP growth of 5.5 percent in 2011, growth is expected to exceed 5 percent again this year despite recession in the euro area. Labor market conditions are improving. The unemployment rate fell from 16.3 percent at the beginning of the year to 13.5 percent at the end of the third quarter, despite an increase in participation rates. Real wage growth remains restrained. Consumer price inflation has declined sharply, easing to 1.6 percent at end-October after peaking at 4¾ percent in mid-2011. Robust export growth is expected to keep the current account deficit at about 2 percent despite recovering import demand.
Latvia has a flat personal tax, low corporate tax, fired one third of civil workers and the results speak for themselves: low inflation, high growth, and politicians re-elected.
Contrast Greece and Spain with Latvia. The latter fired huge numbers of public workers in one fell swoop, while implementing work rule changes and not hiking taxes. Greece and Spain raised taxes while doing relatively little about work rule reforms, pension reforms, or making it easier to fire workers.
Latvia rejected the IMF's recommendation for a progressive income tax, and as a result of the recovery, the IMF can no longer dictate Latvia policy.
Iceland is also in recovery after telling the IMF and the rest of Europe where to go.
The only mystery is why Latvia would want to join the eurozone giving up control down the road to a bunch of socialist nannycrats who will not like Latvia's low corporate tax structure or its non-progressive flat income tax.